HARISH PATEL (ASSISTANT PROFESSOR, JDG &SHREE SAS COLLEGE OF MANAGEMENT)

STRATEGIC FINANCIAL MANAGEMENT

Chapter 1: Introducton to Strategy and Financial Management
TY BBA (SEM – 5)
Introduction:
Strategic planning is long-range in scope and has its focus on the organization
as a whole. The concept is based on an objective and comprehensive
assessment of the present situation of the organization and the setting up of
targets to be achieved in the context of an intelligent and knowledgeable
anticipation of changes in the environment. The strategic financial planning
involves financial planning financial forecasting provision of finance and
formulation of finance policies which should lead the firm's survival and
success. The responsibility of a Finance manager is providing a basis and
information for strategic positioning of the firm in the industry. The firm's
strategic financial planning should able to meet the challenges and
competition and it would lead to firm's failure or success.
Meaning of Strategic Financial Management:
The expression strategic financial management' refers to an approach,
which being focused on long-term financial health, offers a solution to this
short- termism. Given that the maximization of short-run accounting profits
is inappropriate, the best starting point is with the question of what
constitutes an appropriate financial objective.

The strategic financial planning should enable the firm to judicious allocation
of funds, capitalization of relative strengths, mitigation of weaknesses, early
identification of shifts in environment, deployed, timely estimation of funds
requirement, identification of business and financial risk etc.

The strategic financial planning is needed to counter the uncertain and

imperfect market conditions and highly competitive business environment.
While framing financial strategy, the shareholders should be considered as
one of the constituents of a group of stakeholders i shareholders, debenture
holders, banks, financial institutions, government, managers, employees,
suppliers, customers etc. The strategic planning should concentrate on
multidimensional objectives like profitability, expansion growth, survival,
leadership, business success, positioning of the firm, reaching global
markets, brand positioning etc. The financial policy requires the deployment
of firm’s resources for achieving the corporate strategic objectives. The
financial policy should align with the company's strategic planning. It allows
the firm in overcoming its weaknesses, enable to maximize the utilization of
its competencies and mould the prospective business opportunities and threats
to the advantage of the firm Therefore, the Finance manager should take the
investment and finance decisions in consonant to the corporate strategy.
In accordance with the classical management theory, the financial function of
an enterprise has five main objectives of forecasting, organizing, planning,
coordination and control. Each of these objectives has its own range of related
themes.
 Forecasting
Demand and sales volume/revenues
Cash flows Prices
Inflation rates
Labour union
behaviour Technology
changes Inventory
requirements
 Organizing
Financial relation
Liaison with financial institutions and clients
Accounting system
 Planning
Investment planning
Manpower planning
Development process
Marketing strategies
 Coordination
Linking finance function with other areas
 Linking with national budget and five-year plans - Linking with labour
Union policies.
Liaison with media
 Control
Financial charges
Achievement of desired objectives
Overall monitoring of the system
Equilibrium in the capital.
Meaning of Strategy: A course of action including the specification of
resources required, to achieve a specific objective. Financial strategy is the
aspect of strategy which falls within the scope of financial management, which
will include decisions on investment, financing and dividends.
Definition of Strategic Financial Management:
1. “Strategic financial management can be defined as “being the
application to strategic decisions of financial techniques in order to help
in achieving the decision-maker's objectives.”
2. Strategic Financial Management can be defined as “the identification of
the possible strategies capable of maximizing an entity's net present
value, the allocation of scarce capital resources among the competing
opportunities and the implementation and monitoring of the chosen
strategy so as to achieve stated objectives”.

 Strategic financial management integrates the financial management

function into business strategy and every other part of an organization’s
operation. Applying strategic financial management knowledge and
skills improves an organization's effectiveness and efficiency. In today's
highly competitive business environment, both private and government
organizations are increasingly putting more emphasis in this area to
achieve their objectives.
Strategy + Finance + Management The fundamentals of business
  Strategic Financial Management assesses the complex decision-
making necessary at the higher levels of management, including
evaluating and setting up reward systems for subordinates and other
personnel, evaluating expansion opportunities, mergers and
acquisitions, spin-offs and sales of existing assets, and making
decisions on complex investment opportunities and managing risk. It
helps to develop the financial know-how, necessary for senior
management to skilfully guide any organization toward success.

3. Strategic financial management is defined as the application of financial

techniques to strategic decisions in order to help achieve the decision-
makers objectives. Strategic decisions are those which affect the whole
organization, take into account factors in the external environment and
refer to the longer-term (five years or more) direction of an organization.
Strategic financial management requires the existence of objectives and
acknowledges that financial techniques are an integral part of policy
making and control:

Significance/ Advantages of Strategic Financial Management:

Strategic financial management is important because its study enables the
finance manager to:
1. Understand the limitations of traditional accounting models in an
increasingly dynamic and fast-changing world.
2. Contribute more effectively to corporate strategy by taking a more
proactive and forward-looking approach.
3. React to conditions of rapid change through enhanced awareness,
anticipation and adaptation.
4. Understand and use alternative expressions of profit that start with a
recognition of the impact on cashflow of the various stakeholders in a
company.
 5. Understand the different relationships between profits, expansion and
cashflow model in the traditional accounting and financial
management models.

Strategic Planning:
Meaning of Strategic Planning:
Strategy is defined as "where the organization wants to go to fulfil its
purpose and achieve it ton provides the framework for guiding choices
which determine the organisations nation and direction and these choices
relate to the organisation's products or services, market, key capabilities,
growth, return of capital and allocation of resources.
Definition of Strategic Planning:
1. According to Scott, "long range business planning is a systematic
approach to decision-making about issues, which are fundamental and
of crucial importance to its continuing long-term effectiveness".
2. According to Alfred Chandler, strategic planning is "concerned with
the determination of the basic long-term goals and objectives of an
enterprise and the adoption of courses of action and allocation
resources necessary for carrying out these goals".

A strategy is, therefore, a declaration of intent. It defines what the organization

wants to become in the longer sperm. The overall aim of strategy at corporate
level will be to match or fit the organization to its environment in the most
advantageous way possible Strategies form the basis for strategic
management and the formulation of strategic plans Strategic planning is a
systematic, analytical approach which reviews the business as a whole in
relation to its environment with the object of the following:
1. Developing an integrated, coordinated and consistent view of the route
the company wishes to follow, and
2. Facilitating the adaptation of the organization to environmental
change.
The aim of strategic planning is to create a viable link between the
organization's resources and its environmental opportunities. Whatever the
industry, there are five competitive forces central to formulating and
implementing business strategy.
a. The threat of new entrants.
b. The threat of substitute products or services. ANTZ
c. The rivalry amongst existing organizations within the industry
d. The bargaining power of suppliers.
e. The bargaining power of consumers.

The relative strength of each competitive force tends to be a function of

industry structure Le., its underlying economic and technological
characteristics. This can change overtime, with the result that the relative
strength of competitive forces will also change, hence the industry's
profitability. The basic way an enterprise might seek to achieve above average
returns in the long-term via sustainable competitive advantage.

Process of Strategic Planning Process:

A systematic approach to formalizing strategic plans consists of the following
steps:
1. Define the organization's mission and its overall purpose.
2. Set objectives and definitions of what the organization must achieve
to fulfil its mission
3. Conduct environmental scans by internal appraisals of the strengths
and weaknesses of the organization and external appraisals of the
opportunities and threats which face it (SWOT analysis).
4. Analyse existing strategies and determine their relevance in the light
of the environmental scan. This may include gap analysis to establish
the extent to which environmental factors might lead to gaps between
what is being achieved and what could be achieved if changes in
existing strategies were made. In a corporation with a number of
 distinct businesses, an analysis of this portfolio of businesses can take
place to establish strategies for the future of each business.

Figure: STRATEGIC PLANNING PROCESS

Defne Mission

Internal appraisal (Strengths and weaknesses) External appraisal(Opportunites and thr

Set Objecties

Analyze existng strategies

Defne Strategic Issues

Deielop new or reiised strategies

Determine critcal success factors

Prepare Plans

Implement Plans Monitor

5. Define strategic issues in the light of the environmental scan, the gap
analysis and, where appropriate, the portfolio analysis. This may
include such questions as the following:
a. How are we going to maintain growth in a declining market for
our most profitable product?
b. In the face of aggressive competition, how are we going to
maintain our competitive advantage and market leadership?
c. What action are we going to take as a result of the portfolio
analysis of our strategic business units?
d. To what extent do we need to diversify into new products and
markets and in which directions should we go?
 e. What proportion of our resources should be allocated to research
and development?
f. What are we going to do about our aging machine tools?
g. What can we do about our overheads?
h. How are we going to finance our projected growth?
i. How are we going to ensure that we have the skilled workforce we
need in the future?
6. Develop new or revised strategies and amend objectives in the light
of the analysis of strategic issues.
7. Decide on the critical success factors related to the achievement of
objectives and the implementation of strategy
8. Prepare operational, resource and project plans designed to achieve
the strategies and meet the critical success factor criteria.
9. Implement the plans.
10.Monitor results against the plans and feedback information which can
be used to modify strategies and plans.

Financial Planning:
Meaning of Financial Planning:
Planning includes attempting to make optimal decisions, projecting the
consequences of these decisions for the firm in the form of a financial plan
and then comparing future performance against that plan.
Definition of Financial Planning:
1. According to William King, "Planning is the process of thinking
through and making explicit the strategy, actions, and relationships
necessary to accomplish an overall objective".
2. "The financial plan of a corporation has two-fold aspects; it refers not
only to the capital structure of the corporation but also to the financial
policies which the corporation has adopted or intends to adopt".

In a well-organized business, each Function department should arrange its

activities to maxima its contributions towards the attainment of corporate
goals. The finance function should focus its attention in financial aspects of
management des financial management is primarily concerned with the
investment and financing decisions. The Financial management of a concern
should fit into its strategic planning financial objectives of the firm should
enable the firm to achieve its overall objectives. The investment decisions
create the cashflow, which is central to the success of the firm, the finance
decisions influence the cost of capital. The investment decisions are
associated with business risk where as finance decisions are associated with
financial risk The financial decisions should enable the risk return trade off,
to maximize the value of firm.

Financial Planning Process:

The financial planning process involves the following steps:
1. Clearly defined Mission and Goal: At the outset, the top management
should realize and recognize the importance of setting the
organizational mission goal and objectives which should be clearly
defined and communicated.
2. Determination of Financial Objectives: In developing the financial
objectives, a firm must consider purpose, mission, goal and overall
objectives of the firm. The financial objectives can again be transformed
into strategic planning. The financial objectives can be classified into
(a) Long Term Objectives, and (b) Short Term Objectives. The long-term
financial objectives may relate to earning in excess over the targeted
return on capital employed, increase in EPS and market value of share,
increase in market share of its product, achieve targeted growth rate in
sales, maximization of value for shareholders etc. The short-term
financial objectives relate to profitability, liquidity, working capital
management, current ratio, operational efficiency etc.
3. Formulation of Financial Policies: The next step in financial
planning and decision-making process a both long-term and short-
term financial
 objectives. For example, the company can frame is financial policies
like:
a. Debt-equity ratio and current ratio of the firm may be fixed at 3:2
and 2: I respectively.
b. A minimum cash balance has to be maintained at Rs. 1,00,000
always.
c. The minimum and maximum levels are to be fixed for all items of
raw material and consumable.
d. The equity to be raised only by issue of equity shares.
e. Profitability centre concept to be implemented for all divisions in
the organization.
f. The inter-divisional transfers to be priced at pre-determined
transfer prices etc.
4. Designing Financial Procedures: The financial procedures helps the
Finance manager in day-to-day functioning, by following the pre-
determined procedures. The financial decisions are implemented to
achieve the organizational goals and financial objectives. The financial
procedures outline the cashflow control system, setting up of standards
of performance, continuous evaluation process, capital budgeting
procedures, capital expenditure authorization procedures, financial
forecasting techniques to be used, preparation standard set of ratios,
using of budgetary control system etc.
5. Search for Opportunities: This involves a continuous search for
opportunities which are compatible with the firm's objectives. The
earlier opportunity is identified the greater should be the potential
returns before competitors and imitators react
6. Identifying Possible Course of Action: This requires the development
of business strategies from which individual decisions emanate. The
available courses of action should be identified keeping in view the
marketing, financial and legal restrictions or other forces not within the
control of decision maker. For example, the additional funds
 requirement for expansion of the plant can be met by raising of finances
from various sources.
7. Screening of Alternatives: Each course of action is subjected to
preliminary screening process in order to assess its feasibility
considering the resources required expected returns and risks involved.
Readily available information must be used to ascertain whether the
course of action is compatible with existing business and corporate
objectives and likely returns can compensate for the risks involved.
8. Assembling of Information: The Finance manager must be able to
recognize the information needs and sources of information relevant to
the decision. The cost-benefit trade-off must be kept in view in
information gathering. To obtain more reliable information, the costs
may be heavy in data gathering. The relevant and reliable information
ensures the correct decision making and confidence in the decision
outcome.
9. Evaluation of Alternatives and Reaching a Decision: This step will
involve the evaluation of different alternatives and their possible
outcomes. This involves comparing the options by using the relevant
data in such a way as to identify the best possible course of action that
can enable in achieving the corporate objectives in the light of prevailing
circumstances.
10. Implementation, Monitoring and Control: After the course of decision
is selected, attempts to be made to implement the decision to achieve
the desired results. The progress of action should be continuously
monitored by comparing the actual results with the desired results.
The progress should be monitored with feedback reports, control
reports, post audits, performance audits, progress reports etc. Any
deviations from planned course of action should be rectified by
making supplementary decisions.
Financial Forecasting: Meaning of Forecast:
A forecast is a prediction of what is going to happen at a result of a given set
of circumstances dictionary meaning of “forecast” prediction, provision
against future, calculation of p events, foresight, prevision. In business sense
it is defined as ‘the calculation of probable events. When estimates of future
conditions are made on a systematic basis the process is referred to as
forecasting and the figure or statement obtained is known as forecast.
Forecast is a prediction of what is going to happen as a result of a given set
of circumstances. The growing competition, rapid change in circumstances
and the trend towards automation et demand that decisions in business are
not to be based purely on guess work, rather on careful analysis of data
concerning the future course of events.

Forecasting aims at reducing the areas of uncertainty that surround

management decision forecasting, both macro and micro-economic factors
like price levels, inflationary trends, monsoons international industry
trends, governmental changes, cost of finance, competition, company
forecast is a mere assessment of future events. A forecast includes projection
of variables both controllable and noncontrollable that are used in
development of budgets. A budget is a plan. whereas a forecast is a
prediction of future events and conditions

Forecasts are needed in order to prepare budgets. In forecasting events that

will the pat future, a forecaster must rely on information concerning events
that have occurred in the pat in order to prepare a forecast, the forecaster
must analyse past data and must base the forecast on the result of the
analysis. The object of business forecasting is not only to determine the
definite statistical data, which will enable the firm to take advantage of future
conditions to a greater extent than it could do without them. There always
must be some range of error allowed for in the forecast. While forecasting one
should note that it is impossible to forecast the future precisely. Forecasting
is an initial step in financial planning process.
It starts with predicting the future events that will have significant impact on
the firm's business and its success or failure. It is an estimation of future
events in advance and forecasts the future funds requirements and its
utilization. The forecasts will be converted into plans for action and
presentation of plans in the form of financial statements and put them for
action. In other words, forecasts will lead to setting up of goals of firm and
translating the goals into operational plans for action. The finance function
involves the both in setting up of goals and to see that goals are achieved
through financial planning decision making and control.
Meaning of Financial Forecasting:
Financial forecasting provides the basic information on which systematic
planning is based on Sometimes the financial forecasting is used as a control
device to set the way for firm's future course of action. For strategic
planning, financial forecasting is a prerequisite. In financial forecasting the
future estimates are made through preparation of statements like projected
income statement, projected balance sheet, projected cashflow and funds
flow statements, cash budget, preparation of projected financial statements
with the help of ratios etc. Financial forecasting helps making decisions like
capital investment, annual production level, operational efficiency
required, requirement of working capital, assessment of cashflow, raising of
long-term funds, estimation of funds requirement of business, estimated
growth in sales etc.

Definition of Financial Forecasting:

1. “Financial forecasting is that process in which the future financial
condition of the firm is shown on the basis of past accounts, funds flow
statements, financial ratios and economic conditions of the firm and
industry.”
  The projection of future plan of management in terms of finance is
financial forecasting. Financial forecasting shows financial planning
activities of a firm for specific period of time. For example, the
principal driver of the forecasting process is generally the sales
forecast. Since most Balance Sheet and Income Statement accounts are
related to sales, the forecasting process can help the firm assess the
increase in current and fixed assets which will be needed to support
the forecasted sales level. Similarly, the external financing which will
be needed to pay for the forecasted increase in assets can be
determined.
2. Financial forecasting describes the process by which firms think about
and prepare for the future. The forecasting process provides the means
for a firm to express its goals and priorities, and to ensure that they are
Internally consistent. It also assists the firm in identifying the asset
requirements and needs for external financing.

Benefits of Financial Forecasting:

The financial forecasts help the Finance manager in the following ways:
a. It provides basic and necessary information for setting up of objectives
of firm and for preparation of its financial plans.
b. It acts as a control device for firm's financial discipline.
c. It provides necessary information for decision making of all functions
in an organization.
d. It monitors the optimum utilization of firm's resources.
e. It projects the funds requirement and utilization of funds in advance,
f. It alarms the management when the events of the concern going out of
control.
g. It enables the preparation and updating of financial plans according to
the changes economic environment and business situations.
h. It provides the information needed for expansion plans of business and
future growth needs of the organization.
Techniques of Financial Forecasting:
Some of the important techniques that are employed in financial forecasting
is given below:
1. Days Sales Method: It is a traditional technique used to forecast the
sales by calculating the number of days sales and establishing its
relation with the balance sheet items to arrive at the forecasted
balance sheet. This technique is useful for forecasting funds
requirement of a firm.
2. Percentage of Sales Method: It is another commonly used method in
estimating financial requirements of the firm basing on forecast of sales
Any change in sales is likely to have impact on various individual items
of assets and liabilities of the balance sheet of a firm. This will help in
forecasting financial needs of the firm by establishing its relation with
the changes in levels of activity, Proper understanding of the
relationship of sales level changes with the balance sheet items is
necessary before any financial forecast is made
3. Simple Linear Regression Method: Simple linear regression is
concerned with bivariate distributions that is distributions of two
variables. Simple regression analysis provides estimates of values of the
estimation procedure is the regression line. For financial forecasting
purpose, sales is taken as an independent variable and then values of
each item of asset (dependent on sales) are forecasted. Under this
method, every time only one item of asset level can be determined. Then
all forecasted figures are then put into the projected balance sheet to
know the financial needs of the firm in future.
4. Multiple Regression Method: Multiple regression analysis is further
application and extension of the simple regression method for
multiple variables. This method is applied when behaviour of variable
is dependent on more than one factor. In this method of financial
forecasting, it is assumed that sales are a function of several variables.
But in case of simple regression method only one variable can be
considered each time, with the increase in the number of independent
 variables Computations may be easily made with the help of computer.
The method used forecasting depend on the requirements and accuracy
needed in forecasting
5. Projected Funds Flow Statement: The funds flow statement presents
the details of financial resources that are available during the
accounting period and the ways in which those resources are applied
in the business. It is a statement of sources and application of funds
analysing the present the data relating to procurement of further funds
from various sources and their Possible application in fixed assets or
repayment of debts or increase in current assets or decrease in current
liabilities etc. The funds flow statement establish relationship between
sources in application of funds and its impact on working capital. It is
a powerful tool extensively used in financial forecasting.
6. Projected Cashflow Statement: It is a detailed projected statement of
income realized in cash and focus on the cash inflow and outflow of
various items represented in the income statement and balance sheet.
The projected cashflow statement shows the cashflows arising from the
operating activities, investing activities and financing activities. A
projected cashflow statement is used in forecasting the financial
requirements of the firm.
7. Projected Income Statement and Balance Sheet: The projected
income statement is prepared on the basis of forecast of sales and
anticipated expenses for the period under estimation. The projected
funds and acquisition or disposal of fixed assets and estimation working
capital items with reference to the estimated sales
Strategic Financial
Management
 Strategy
• “The Chandler definition is typical: "the
determination of the basic long-term goals and
objectives of an enterprise, and the adoption of
courses of action and the allocation of resources
necessary for carrying out these goals".
• "Strategy is the direction and scope of an
organization over the long-term which
achieves advantage for the organization through
its configuration of resources within a
challenging environment, to meet the needs
of markets and to fulfill stakeholder expectations"
 Strategic Planning
• Strategic planning that clearly defines objectives
and accesses both the internal and external
situation to formulate strategy, implement the
strategy, evaluate the process and make
necessary adjustment to stay on track.
• SP determines where an organization is going
over the next years, how it's going to get there and
how it'll know if it got there or not. The focus of a
strategic plan is usually on the entire organization,
while the focus of a business plan is usually on a
particular product, service or program.
 Financial Planning
• Financial Planning is the process of
estimating the capital required and
determining it’s competition.
• It is the process of framing financial
policies in relation to procurement,
investment and administration of funds of
an enterprise.
Continue…
Financial Planning is process of framing
objectives, policies, procedures,
programmes and budgets regarding the
financial activities of a concern. This
ensures effective and adequate financial
and investment policies.
Objectives of Financial Planning
• Determining capital requirements

• Determining capital structure

• Framing financial policies

 Financial Strategy
• It is still widely accepted that the normative
objective of the financial management is to
maximize the shareholder wealth.
• But reversely from what we observed in
last semester, the theory requires to
satisfy the objective of a company is
“Long term course of action”. And this
is where the strategy fits.
 FS comprises of…
Corporate Strategy
CS is the over all long term plan of actions
that comprises of portfolio construction of a
functional business strategies designed to meet
the specified objectives.

Financial strategy itself

FS is the portfolio constituents of corporate
strategy plan that embraces the optimum
investment and financing decision requires to
attain…
 Functions of Financial Strategy
▪ The continuous search for investment
opportunities

▪ The selection of most profitable opportunity

▪ The determination of appropriate financing

▪ The establishment of financial control system

▪ The analysis for further future decision making.

Strategic Financial Management
• Strategic Financial Management focuses
on identifying possible strategies to
maximize the market value of a company.
• This is the allocation of scarce capital
resources among competing opportunities.
It also includes the implementation and
monitoring of the strategy chosen to
achieve the agreed goals.
Continue…
Strategic financial management refers to study
of finance with a long term view considering the
strategic goals of the enterprise.

Thus financial management is nowadays

increasingly referred to as "Strategic Financial
Management”
 Meaning
• Strategy implies a careful devised plan of action
to achieve a goal. Strategy can also be
described as the art and science of developing
carrying out such a plan.

• Finance is an art of managing the monetary

resources of an organization.

• Management means the organizing and

controlling of the affairs of an organization.
Continue…
• So SFM is an optimum combination of
investment and financing policies which
maximize shareholder’s wealth as measured by
overall return on ordinary shares (ROE –
Dividend + Capital Gain).

• Strategic Financial Management focuses on

identifying possible strategies to maximize the
market value of a company.
 Continue…
• SFM involves the allocation of scarce capital
resources among competing opportunities. It also
includes the implementation and monitoring of the
strategy chosen to achieve the agreed goals.

• Strategic financial management refers to study of

finance with a long term view considering the
strategic goals of the enterprise.

• Thus financial management is nowadays

increasingly referred to as "Strategic Financial
Management”
 Key Decisions of SFM
• Financial Decision:
(Sources and their proportionate relationship)
• Investment decision:
(Capital Budgeting)
• Dividend decision:
(Dividend and Retention Policies)
 SFM comprises of…
• Financial Planning Strategy
• Project Planning and Control
• Risk Evaluation and Capital Budgeting
• Analysis of Risk and Uncertainty
• Designing Capital Structure
• Dividend Policy
• Business Valuation
• Business Restructuring
 Significance of SFM
• Adequate funds are ensured

• Helps in balancing inflow and outflow

• Helps in planning growth and expansion

• Reduces uncertainties with respect to changing

market trend

• Ensure stability and profitability of the firm

Thank you
Question Time????
Financial Forecasting
 Financial Forecasting

A financial forecasting is a prediction of what is

going to happen as a result of given set of
circumstances.
The dictionary meaning of forecast is ‘Prediction,
provision against future, calculation of probable
events, foresight, prevision.’
When estimates of future conditions are made on a
systematic basis the process is referred as
forecasting and the figure or statement obtained is
known as forecast.
 Conti…

Financial forecasting provides the basic information

on which systematic planning is based on.
In financial forecasting, the future estimates are
made through preparation of statements like
Projected income statement, projected balance
sheet, projected cash flow and funds flow
statements, cash budget, preparation of projected
financial statements with the help of RATIOs.
 Aims

▪ It aims at reducing uncertainties

▪ To prepare budgets
▪ To determine the trend of figures that will tell
exactly what will happen
▪ To make analysis based on definite statistical data
▪ To take advantage of future conditions
▪ To setting up of goals of firm and translating goals
into operational plans
 Techniques

▪ Days Sales Method

▪ Percentage of Sales Method
▪ Simple Linear Regression Method
▪ Multiple Regression Method
▪ Projected Funds Flow Statement
▪ Projected Cash Flow Statement
▪ Projected Income Statement and Balance Sheet
 Financial Planning Process
Define mission and goal
Determination of financial objectives
Formulation of financial policies
Designing financial procedure
Search for opportunities
Identify course of action
Screening of alternatives
Evaluation and reaching a decision
Implementation, control and monitoring
 Unit – 2
Project Management
Chapter Outline
Concept of Project & PM
Project classifications
Project Risk
Scope of the Project
 What is a Project?
A project is a sequence of unique,
complex, and connected activities
having one goal or purpose and that
must be completed by a specific time,
within budget, and according to
specifications.
Project Characteristics

Defined goal
Primary sponsor or customer
Set of activities
Unique, complex, sequenced
Start & finish
Temporary, time frame for
completion
Limited resources
Dollars, people
Uncertainty, risk
 Project Management Criteria

• Projects are oriented towards a goal.

• There is something unique about every
project.
• Projects have a finite duration.
• Projects require coordination of
interrelated activities.
 What is Project Management?

• Project management is a set of

principles and tools for
– Defining
– Planning
– Executing
– Controlling . . . and
– Completing a PROJECT
Continue…

PM is the application of knowledge,

skills, tools and techniques to
project activities in order to meet
project requirements.

PM is an art.
is a science.
has a set of tools & methods.
What Is a Program?

A collection of projects
NASA
Ongoing Activities

Have opposite characteristics to

projects
• Similar, often identical products or
services
• No defined end
• Staffing & management practices
geared to above
Project Parameters

Scope
Quality
Cost
Time
Resources
The Triple Constraints

Cost Time
Scope
Quality

Resources
 Project Classification
❖ Quantifiable and Non Quantifiable
Projects
❖ Sectoral Projects
▪ Agricultural and Allied
▪ Irrigation and Power
▪ Industry and Mining Sector
▪ Transport and Communication
▪ Social Service Sector
▪ Miscellaneous
Continue…
❖ Financial Institution or purposive
▪ New Projects
▪ Expansion Projects
▪ Modernization Project
▪ Diversification
▪ Rehabilitation Project
▪ Mergers and Acquisition
Continue…

❖ Service Projects
▪ Welfare Projects
▪ R & D Projects
▪ Educational Project
❖ Turnkey Project
❖ Based on Size
▪ Large Projects
▪ Medium Projects
▪ Small Projects
Continue…

❖ Based on ownership
▪ Public Sector Projects
▪ Private Sector Projects
▪ Joint Sector Project
 Type of Project Product of Project (Examples)

1. Administrative Installing a new acc system

2. Construction A building or road

Computer Software
3. A new computer program
Development
4. Design of Plans Architectural or engineering plans
Equipment or System
5. A telephone system or IT system
Installation
Olympiads or a move into a new
6. Event or Relocation
building
Maintenance of Process Petro-chemical plant or electric
7.
Industries generating station
A new drug or aerospace/defense
8. New Product Development
product
A feasibility study or
9. Research
investigating a chemical
- By Robert Youker
Project Risk
❖ Design Risk
❖ Implementation Risk
❖ Operational Risk
❖ Environmental Risk
❖ Finance Risk
❖ Interest Rate Risk
❖ HR Risk
❖ Management Risk
❖ Technology Risk
Project Life Cycle (Frame)

Concept
Planning
Execution
Closeout
Operation
Maintainance
 Project Plan
A project plan is the blue prints for
how a company's project is to
progress from its initiation until its
conclusion.
The better the plan is constructed
will only increase the project
becoming a success.
Steps in Setting up of a Project
Initial selection of project ideas
Selection of project location
Selection of project site
Soil and topography
Choice of technology
SWOT analysis
Zero Date
Financial closure
Cont…
Project visibility
Work Break Down Structure (WBS)
Project Execution Plan
Cost and Quality trade off
Time and cost trade off
Monitoring of capital expenditure
Network Analysis
Variance and performance analysis
Cost-Benefit Analysis (CBA)
 What is Cost Benefit Analysis

◼ CBA is defined as “an Analytical tool in decision

making which enables a systematic comparison to be
made between the estimated cost of undertaking of
project and estimated value and benefits which may
arise from the operation of such a project”.

◼ It conducts monetary assessment of the total costs

and revenues or benefits of the project, paying more
attention to social costs and benefits.
 Objectives of CBA

◼ To identify and quantify as many tangible and intangible

costs and benefits as possible.

◼ To see strategy which achieves the maximum benefit for

the minimum cost.

◼ To describe the techniques for making investment

decisions in a non profit making organization.
 CBA and investment decision
Generally public or private sector projects assessment
criterion acceptance will be the profit potential of the
project in comparison with other investment
opportunities currently available.

In short, the only factor which influences the decision will

be those costs and benefits incurred and received
privately by the firm.

In contrast, society point of view, projects might have

impact in the community which confer both costs and
benefits on society as a whole.
 CBA is used to determine
▪ Whether or not a specific operation should be
undertaken

▪ Which of the possible alternative project should be

selected

▪ Which time cycle would be most beneficial to the project

 CBA Procedure
▪ Determine problem to be considered

▪ Ascertain alternative solutions to problem

▪ Estimate and analyze costs and benefits

▪ Appraise estimated costs and benefits

▪ Decide on optimal solution

 Techniques of CBA

▪ Discounted Cash Flow Techniques

▪ Net Present Value (Time, Cost, Benefit, Discount Rate)

▪ Internal Rate of Return

▪ Benefit/Cost Comparison

▪ Benefit/Cost Ratio
 Overall Appraisal of CBA
Cons:
- intangibles
- BC analysts and information sources are often biased
- distributional Issues occasionally objectionable
* weigh same period impacts equally
* weigh future impacts less

Pros:
- help prevent bad decisions which would otherwise be
undiscovered
- counters rent-seeking (which might normally be
successful in the political process).
 CBA Example
Someone has proposed a 4-period pollution control project
that will cost EUR 100.000 to construct in the initial
period. After that, the project will cost EUR 10.000 to
operate in each following period. After the construction
is completed, the benefits of this project will be EUR
40.000 in the first period, EUR 45.000 in the second, and
EUR 50.000 in the last period. The facility is expected to
be non-functional for any future periods. There are no
intangibles to be considered for this project.

Calculate Net Present Value (NPV), and Benefit-Cost Ratio

(BCR) using a discount rate of 5%.
 CBA- Example
r = 5%
t Bt Ct NBt Bt Ct NBt
(1 + r ) (1 + r ) (1 + r )
t t t

0 0 100 -100
1 40 10 30

2 45 10 35

3 50 10 40
totals

NPV = ???
BCR = ???
Project Appraisal
 Project Appraisal
Meaning : Project appraisal means “the assessment of a project”.
It is made for both proposed (Ex-ante analysis) and executed
projects (Post-ante analysis).
For an financial institution project appraisal “is a process
whereby a leading financial institution makes an independent
and objective assessment of the various aspects of an
investment proposition for arriving at a financial decision and
is aimed at determining the viability of the project”
Methods of Project Appraisal:
Appraisal of a proposed project includes,
1. Economic Analysis
2. Financial Analysis
3. Market Analysis
4. Technical Feasibility
5. Managerial Competence
 Methods of Project Appraisal
1. Economic analysis :
Economic feasibility basically deals with the
marketability of the product. Basic data regarding
demand and supply of a product in the domestic
market and the market analysis is an essential part of
full appraisal.
Economic appraisal comprises of Requirement of
raw materials, level of capacity utilization,
anticipated sales, anticipated expenses and the
probable profits, location of the enterprise.
 Cont…
2. Financial Analysis :
Financial Analysis means assessment of the
financial requirements both- fixed and working
capital with respect to cost incurred in each means
of financing.
The basic data required for this analysis can be grouped
as:
▪ Cost of project and means of financing
▪ Cost of product and profitability
▪ Cash flow estimates
▪ Pro-forma balance sheets
 Cont…
1. Cost of project:
Land and site development
Buildings and civil works
Plant and machinery
Technical know how and engineering fees
Miscellaneous fixed costs
Preliminary and pre-operative expenses
Provision for contingencies and escalation
2. Means of financing
Share capital Loans from friends and relatives
Subsidies Retained earnings
Long term borrowing
 Methods of Project Appraisal

3. Market Analysis
The methods to estimate the demand for a product are
a. Complete Enumeration method : All probable
customers of the product are approached and their
probable demands for the product are estimated and
then summed.
b. Sample Survey : Some number of consumers out of
their total population is approached and data on their
probable demands for the product during the forecast
period are collected and summed. The total demand
of sample customers is finally blown up to generate
the total demand for the product.
 Cont…
c. Sales Experience Method : Sample market is surveyed
before the new product is offered for sale. The
results of the market surveyed are then projected to
the universe in order to anticipate the total demand
for the product.
Life Cycle Segmentation Analysis : Divided into 5
stages,
⚫ Introduction
⚫ Growth
⚫ Maturity
⚫ Saturation
⚫ Decline
 Project Appraisal
4. Technical Feasibility:
While assessing the technical feasibility of the project, the
following inputs covered in the projects should also be taken
into consideration,
i. Location
ii. Land and building
iii. Plant and machinery
iv. Availability of water, power, transport, communication
facilities
v. Availability of servicing facilities like machine shops,
electric repair shops
vi. Coping with anti-pollution law
vii. Availability of required raw material as per quality and
quantity.
 Project Appraisal

5. Managerial Competence:
The success of business enterprise depends on the
resourcefulness, competence and integrity of its
management. However, assessment of managerial
competence has to be necessarily qualitative, calling for
understanding and judgment.
For a new entrepreneur it will always be advisable to
build up a competent team of specialists in the required
discipline to join hands with an entrepreneur who has
the requisite organizational and managerial expertise in
the implementation and operation of the project.
What is Capital Budgeting…???

• Capital Budgeting is the process of determining which real

investment projects should be accepted and given an
allocation of funds from the firm.

• However, to evaluate capital budgeting processes, their

consistency with the goal of shareholder wealth
maximization is of utmost importance.

• The planning and control of capital expenditure is termed as

capital budgeting.

• CB is the art of finding assets that are worth more than they
cost, to achieve the predetermined goal i.e. optimizing the
wealth of a business enterprise.
Characteristic features of Cap Investment

• Related to underlying corporate objectives and strategy

• Wealth creation approach
• Large sums of money
• Long time span
• Carry some degree of risk and uncertainty
• Irreversible commitment of resources
• Complex decision making
Types of Capital Investment Decisons

• Capital investment decisions are concerned with the

process of planning, setting goals and priorities, arranging
financing, and using certain criteria to select long-term
assets.
• The process of making capital investment decisions often is
referred to as capital budgeting.

• Two Basic Types:

– Independent projects are projects that, if accepted or
rejected, do not affect the cash flows of other projects.
– Mutually exclusive projects are those projects that, if
accepted, preclude the acceptance of all other competing
projects.
Capital Investment Decision Models

• Capital investment analysis (cont.)

– Non-discounting models ignore the time value
of money. (PBP, ARR)
– Discounting models explicitly consider the
time value of money. (NPV, DPBP, IRR, PI)
Case: Three Lessons from Disney

• Disney’s decision to invest $17.5 million to build

Disneyland park in California is an example of
capital budgeting decision.
• Subsequently, Disney opened theme parks in
Orlando, Tokyo, Paris and most recently invested
$3.5 billion to build a theme park in Hong Kong.
Today parks and resorts account for over 30% of
Disney’s Revenue.
Three Lessons from Disney

1. Capital budgeting decisions are critical in

defining a company’s success.
2. Very large investments are frequently the result
of many smaller investment decisions that
define a business strategy.
3. Successful investment choices lead to the
development of managerial expertise and
capabilities that influence the firm’s choice of
future investments.
The Typical Capital Budgeting Process

• Phase I: The firm’s management identifies

promising investment opportunities.

• Phase II: The value creating potential of

various opportunities are thoroughly
evaluated.
The Capital Investment Decision Process

1. Available investment opportunities

2. Search for opportunities
3. Screening
4. Definition, analysis and generation of feasible
alternatives
5. Evaluation (Internal and External, Market-
Technical-Financial-Economic Analysis)
6. Selection
7. Authorization
8. Implementation
9. Review
The Capital Investment Process

• Capital investment analysis in the

management process (cont.)
– Establishment of the acceptance-rejection
standard
– Evaluation of proposals
– Capital investment decisions
 The study of the underlying uncertainty of a given
course of action.
 Risk analysis refers to the uncertainty of forecasted
future cash flows streams, variance of portfolio/stock
returns, statistical analysis to determine the probability
of a project's success or failure, and possible future
economic states.
 Thus, Risk Analysis is the process of identifying,
assessing, and reducing risks to an acceptable level.
2
 An analytic discipline with three parts:

• Risk assessment: determine what the risks are.

• Risk management: evaluating alternatives for

mitigating the risk.

• Risk communication: presenting this material in an

understandable way to decision makers and/or the
public.

 Risk analysis can broken up into 3 types:

(1) Certainty, (2) Risk and (3) Uncertainty 3

 Possibility of a future loss  All future outcomes which can
not be predicted with
which can be foreseen.
accuracy.
 This happens when decision
 It exists when the decision
maker has some historical
maker has no historical data
data on the basis of which he
from which to develop a
assign probabilities to other
probability distribution, and
projects of the same type.
must intelligent guesses in
order to develop a subjective
probability distribution.

4
 Systematic Risk
• Market Risk

• Interest Rate Risk

• Purchasing Power Risk

 Unsystematic Risk
• Business Risk

• Financial Risk

5
 Probability Distribution Method
 Risk-adjusted Discounted Rate Approach
 Certainty-Equivalent Approach
 Decision-tree Approach
 Sensitivity Analysis
 Value of Information method
 Simulation Technique
 Standard Deviation & Coefficient of Variation

7
 UNIT 3: LONG TERM STRATEGIC DECISIONS

3.1 INVESTMENT DECISION PROCESS

3.2 COST OF PROJECT

3.3 MEANS OF FINANCING
3.4 RISK EVALUATION IN CAPITAL BUDGETING
A. Business Risk

B. Financial Risk
Financial risk is the potential losses incurred by an investor when investing in a business that uses
borrowed money. When a firm uses a large amount of debt, it incurs a significant interest expense and
obligation to repay principal that makes it more likely to have financial difficulties if its cash flows decline.
Or, if the entity is a government, it cannot raise sufficient cash from taxes to pay for its bond obligations.

3.5 TECHNIQUES/MODELS FOR CALCULATION OF RISK AND UNCERTAINTY

A. PROBABILITY ANALYSIS
B. DECISION TREE ANALYSIS
HW SUMS:
C. SENSITIVITY ANALYSIS
D. SIMULATION ANALYSIS
 STRATEGIC FINANCIAL MANAGEMENT_UNIT_3

Unit 3 Long Term Strategic Financial Decision

Techniques and models in taking decision under risk and uncertainty

Risk

Risk is the variability in the actual returns in relations to the estimated returns

1. Sensitivity Analysis

One measure which expresses risk in more precise terms is sensitivity analysis. Its analysis
provides information as to how sensitive the estimated project parameters, namely, the
expected cash flow, the discount rate and the project life are to estimation errors. The analysis
on these lines is important as the future is always uncertain and there will always be
estimation errors. Sensitivity analysis takes care of estimation errors by using a number of
possible outcomes in evaluating a project. The method adopted under sensitivity analysis is to
evaluate a project using a number of estimated cash flows to provide to the decision maker an
insight into the variability of the outcomes.

Sensitivity Analysis is a behavioural approach that uses a number of possible values for
a given variable to assess its impact on aa firms return.

Sensitivity analysis provides different cash flow estimates under three assumptions:

(i) the worst (i.e., the most pessimistic),

(ii) the expected (i.e., the most likely), and
(iii) the best (i.e., the most optimistic) outcomes associated with the project.

Meaning

(a) Sensitivity analysis enables investigation into how projected performance will
vary along with changes in the key assumptions on which capital project
projections are based.
(b) It is one of the objective methods to ascertain the impact on final probability by
taking specific changes in each critical factor or variable.
(c) It is used in determination of risk factor in capital budgeting decisions.
(d) It aids in Identifying the most sensitive factor, that may cause the error in
estimation.
(e) The NPV of a project is based upon the series of cash flows and the discount factor.
 (f) Both these determinants depend upon so many variables such as sales revenue,
input cost, competition etc.
(g) It tells about the responsiveness of each factor on the project's NPV or IRR.
(h) For example, a 5% change in the selling price will cause 10% change on NPV,
that means an increase of 5% in the selling price will increase 10% of the amount
of NPV.
(i) If any of the variable’s changes, the value of NPV will also change. It means that
the value of NPV is sensitive to those variables.
(j) Sensitivity analysis is done for all factors like:
 Materials cost
 Labour cost
 Variable overhead
 Fixed overhead etc.

(k) The most sensitive factor of all will be identified to evaluate the risk of that particular
factor.

Steps

Sensitivity analysis involves the following three steps:

1. Identification of all those variables having influence on the project's NPV or IRR.
2. Definition of the underlying quantitative relationship among the variables.
3. Analysis of the impact of the changes in each of the variables on the NPV of the project.

Merits

1. It gives greater visibility to the weak spots in an investment.

2. It will help management to more critically investigate such factors to validate the
assumptions.
3. It aids management in proper decision-making.

Demerits

1. Variables are often interdependent, which makes examining them each individually
unrealistic. For example, change in selling price will effect change in sales volume.
2. The analysis is based on using past data/experience which may not hold in future.
 3. Assigning a maximum and minimum or optimistic and pessimistic value is open to
subjective interpretation and risk preference of the decision-maker.
4. It is neither risk-measuring nor a risk-reducing technique. It does not produce any
clearer decision rule.

2. Simulation

Simulation is a statistical technique employed to have an insight into risk in a capital

budgeting decision. This technique applies predetermined probability distributions and
random numbers to estimate risky outcomes.

Simulation is a statistically based behavioural approach used in capital budgeting to get

a feel for risk by applying predetermined probability distributions and random
numbers to estimate risky outcomes.

A simulation model is akin to sensitivity analysis as it attempts to answer 'what if questions.

However, the advantage of simulation is that it is more comprehensive than sensitivity
analysis. Instead of showing the impact on the NPV for change one key variable (say, change
in sales price or cost of capital) at one point of time in sensitivity analysis, simulation enables
the distribution of probable values (of NPV), for change in all the key variables, in one
iteration/run only. Being so, it provides more information and better understanding about the
risk associated with investment decisions to the finance manager.

To be effective, simulation requires a sophisticated computing package as it then enables to

try out a large number of outcomes with much ease. The first step in any simulation exercise
is to develop the precise model of the investment project to be used by the computer. Once
the model is developed, the computer calculates a random value of project returns (say, in
terms of NPV) for each variable identified for the model. From each set/iteration/run of
random values (consisting of all the variables listed in the model), a new series of cash flows
(cash inflows and cash outflows) is generated and so also of NPV. The important variables in
any typical capital budgeting project (most often used in the model) are market size and its
growth rate, market share the proposed project is likely to capture, sales price, unit variable
cost, total fixed costs, salvage value of the asset, economic useful life span of the project, cost
of capital, working capital requirement, tax rate and so on.
This process of generating a random set of values is repeated numerous times (perhaps as
many as a thousand times or even more for very large and complex investment
projects). This
iteration exercise enables the decision maker to develop a probability distribution of the net
present value of the proposed investment project; this probability distribution is then used to
compute the project's expected mean value of NPV and its standard deviation. The value of
standard deviation then can be used to assess the level of risk associated with the project.

3. Probability Distribution Approach

In the earlier part of this chapter dealing with basic risk concepts, we had introduced the use
of the concept of probability for incorporating risk in evaluating capital budgeting proposals.
As already observed, the probability distribution of cash flows over time provides valuable
information about the expected value of return and the dispersion of the probability
distribution of possible returns. On the basis of this information an accept-reject decision can
be taken. We discuss the application of probability theory to capital budgeting in this section.

The application of this theory in analysing risk in capital budgeting depends upon the
behaviour of the cash flows, from the point of view of behavioural cash flows being (i)
independent or
(ii) dependent. The assumption that cash flows are independent over time signifies those
future cash flows are not affected by the cash flows in the preceding or following years. Thus,
cash flows in year 3 are not dependent on cash flows in year 2 and so on. When cash flow in
one period depend upon the cash flow in previous periods, they are referred to as dependent
cash flows.

Meaning

(a) Probability analysis is basically a statistical technique to measure probability of

occurrence of an event and probability of its non-occurrence.
(b) Certainty or uncertainty cannot be forecasted with hundred per cent accuracy.
(c) Probability analysis is forecasting the probabilities of uncertainty.
(d) Probabilities are analysed based on expectations (events), influences and sensitivity of
events to influences.
(e) In probability analysis, an event is analysed for the -
 Statistical probability of occurrence
 Period of occurrence
 Extent of influence on the occurrence
 Impact of the occurrence ultimately leading to management of the event to
conform to plans
 (f) Depending on significance of impact of uncertainty on the event, weightage factors
could be assigned and be built into the analysis leading to action.
(g) Probability is highly useful for decision-making under conditions of risk.

Merits

(a) Simple to understand and easy to calculate.

(b) Represents whole distribution by a single figure.
(c) Arithmetically takes account of the expected variabilities of all outcomes.

Demerits

(a) By representing the whole distribution by a single figure it ignores the other
characteristics of the distribution, e.g. the range and skewness.
(b) Makes the assumption that the decision-maker is risk neutral, I.e., he would rank
equally two distributions.
4. Decision-tree Approach

The Decision-tree Approach (DT) is another useful alternative for evaluating risky
investment proposals. The outstanding feature of this method is that it takes into account the
impact of all probabilistic estimates of potential outcomes. In other words, every possible
outcome is weighed in probabilistic terms and then evaluated. The DT approach is especially
useful for situations in which decisions at one point of time also affect the tree form which
decisions of the firm at some later date. Another useful application of the DT indicates the
approach is for projects which require decisions to be made in sequential parts.

A decision tree is a pictorial representation in tree form which indicates the probability and
magnitude, probability and inter-relationship of all possible outcomes. The format of the
exercise of the investment decision has an appearance of a tree with branches and, therefore,
this method is referred to as the decision-tree method. A decision tree shows the sequential
cash flows and the NPV of the proposed project under different circumstances.

Meaning

1. A decision tree is a branching diagram which is similar to a probability tree.

2. Decision tree is a tool which helps to choose between several courses of action.
3. A decision tree is a diagrammatic representation of the relationships among decisions
states of nature and payoffs (or outcomes).
4. It is a graphic representation of the sequence of action-event combinations available to
the decision-maker.
5. It depicts in a systematic manner all possible sequences of decisions and consequences.
6. Decision trees are designed to illustrate the full range of alternatives and events that can
occur under all envisaged conditions.
7. The decision tree concept is applicable to various problem areas, such as introduction
of a new project, make or buy problems, investment decisions, marketing strategies etc.
8. Decision tree brings out logical analysis of a problem and enables a complete strategy
to be drawn up to cover all eventualities before a firm becomes committed to a scheme.
9. Decision tree is used to arrive at the optimum decisions for complicated processes
particularly when the decision problems are inter-related and sequential in nature.
10. Decision tree, does not constitute the decision itself, it only helps in decision making.
 Presenter:
Sanjay Joshi

1
 Business Valuation Introduction
 Equity Valuation and enterprise valuation
 Reasons for a Business Valuation
 Valuation Methodology
 FCFE Models

 DCF (Financial Synergy)

2
 “The act or process of determining the value of a
business enterprise or ownership interest therein.”

3
 Going Concern Value

 Liquidation Value

 Market Value
 Myth 1: A valuation is an objective search for “true”
value
◦ Truth 1.1: All valuations are biased. The only questions are how much
and in which direction.
◦ Truth 1.2: The direction and magnitude of the bias in your valuation is
directly proportional to who pays you and how much you are paid.
 Myth 2.: A good valuation provides a precise
estimate of value
◦ Truth 2.1: There are no precise valuations
◦ Truth 2.2: The payoff to valuation is greatest when valuation is least
precise.
 Myth 3: . The more quantitative a model, the better
the valuation
◦ Truth 3.1: One’s understanding of a valuation model is inversely
proportional to the number of inputs required for the model.
◦ Truth 3.2: Simpler valuation models do much better than complex ones.
 Value just the equity stake in the business

 Value the entire business, which includes,

besides equity, the other claimholders in the
firm
 The value of equity is obtained by discounting expected cash flows to
equity, i.e., the residual cash flows after meeting all expenses, tax
obligations and interest and principal payments, at the cost of equity,
i.e., the rate of return required by equity investors in the firm.
t=n CF to Equity t
Value of Equity =  (1+ k e )t
t=1
where,
CF to Equityt = Expected Cash flow to Equity in period t
ke = Cost of Equity

 The dividend discount model is a specialized case of equity valuation,

and the value of a stock is the present value of expected future
dividends. In the more general version, you can consider the cash flows
left over after debt payments and reinvestment needs as the free cash
flow to equity.
 Cost of capital approach: The value of the firm is
obtained by discounting expected cash flows to the
firm, i.e., the residual cash flows after meeting all
operating expenses and taxes, but prior to debt
payments, at the weighted average cost of capital,
which is the cost of the different components of
financing used by the firm, weighted by their
market value proportions.

t =n
CF to Firm t
Value of Firm =  t
t =1 (1 + WACC)
 Reasons for
Business Valuations

Primary Purposes of Appraisals

 Financial Reporting
 Buy/Sell Agreements
 Succession Planning
 Financing

9
 Cont…

New & Growing Businesses

 Estate Planning
 Partnership Dissolution
 Financing
 Sale of Business
 Getting Advantage of Venture Capital

10
 Cont…

Established Business or Public Company

 Corporate Planning
 ASC (Accounting Standard Certificate) 350
Goodwill Impairment Test
 Mergers & Acquisitions
 Privatization of Company
 Public Offering
 Restructuring

11
 Cont…

Other Reasons
 Ownership Disputes
 Life Insurance
 Employee Stock Ownership Plans
 Divorce or Divestment
 Change of Business Structure
 Recapitalization
 AND MANY MORE…

12
 Business Valuation
Methodology

Valuation Approaches

Income Based

Value Estimate
Determining a value indication
of a business using one or
more methods that convert
anticipated economic benefits
into a present single amount.

13
 Business Valuation
Methodology

Income Approach
 Measures the current value of future cash flows
generated by the subject business
 Variables used to develop and support discount
rates or capitalization rates:
◦ Revenue projections
◦ Expenses
◦ Capital expenditure forecasts.
 There are several variations of an income based
approach, which underscores the need for a
qualified business valuation expert.

14
 Business Valuation
Methodology

Valuation Approaches

Income Based Asset Based

Value Estimate Value Estimate

Determining a value indication Determing a value indication
of a business using one or of a business based on the
more methods that convert value of the assets net
anticipated economic benefits liabilities.
into a present single amount.

15
 Business Valuation
Methodology

Asset Based Approach

 Focuses on the value of the underlying assets of
a business
◦ Real estate
◦ Machinery
◦ Equipment.
 This approach to value is useful for businesses
that are considered “asset rich”; possessing
undervalued real estate or a great deal of
machinery and equipment.

16
 Business Valuation
Methodology

Valuation Approaches

Income Based Asset Based Market Based

Value Estimate Value Estimate Value Estimate

Determining a value indication Determing a value indication Determining a value indication
of a business using one or of a business based on the of a business by using one or
more methods that convert value of the assets net more methods that compare
anticipated economic benefits liabilities. the subject to similar
into a present single amount. businessess that have been
sold.

17
 Business Valuation
Methodology

Market Based Approach

 Studies transactions in the current marketplace

 Identifies transactions that are comparable to

the business that is the subject of the valuation
 Depends on:
◦ Appropriate comparable transactions
◦ Adequate information from the publically traded
guideline companies.

18
 Business Valuation
Methodology

In the absence of appropriate comparable market

transactions, we use:

Guideline Company Approach

 Compares certain business barometers from
similar companies to value the subject

19
Basic Methods:
 Asset Based Valuation
 Earning Based Valuation
 Market Based Valuation
Other Variants:
 Book Value Approach
 Stock and Debt Approach
 Direct Comparison Approach
 Discounted Cash flow
 Cost of Capital
 Free Cash Flow to Firm
 Discounted EVA
 CHAPTER 4: VALUATION OF BUSINESS
4.1: MEANING AND NEED FOR VALUATION OF BUSINESS
Valuation is a process of appraisal or determination of the value of certain assets: tangible or
intangible, securities, liabilities and a specific business as a going concern or any company
listed or unlisted or other forms of organization, partnership or proprietorship.
‘Value’ is a term signifying the material or monetary worth of a thing, which can be estimated
in terms of medium of exchange. In other words, it is an assessment resulting in an expression
of opinion rather than arithmetical exactness. Business valuation requires a working
knowledge of a variety of factors, and professional judgment and experience.
This includes recognizing the purpose of the valuation, the value drivers impacting the subject
company, and an understanding of industry, competitive and economic factors, as well as the
selection and application of the appropriate valuation approach (es) and method(s). Recently,
valuation has become a source of political and economic debates in the wake of privatization
of state owned enterprises. Many owners and managers often ask,” How much is our business
worth? And how much is theirs?”
Due to increasing sophistication in business and changing economic and social environment
of business, professional valuers face questions like:
1. “What is our business worth?”
2. “What is their business worth?”
3. “What is the right price of that company?”
4. “What is the right price of our company?”
Valuation of business plays a very vital role, therefore a business owner or individual may
need to know the value of a business. The fair market value standard consists of an
independent buyer and seller having the requisite knowledge and facts, not under any
undue influence or stressors and having access to all of the information to make an
informed decision.
A business valuation is a complex financial analysis that should be undertaken by a qualified
valuation professional with the appropriate credentials. Business owners who seek a low
cost business valuation are seriously missing out on the important benefits received from a
comprehensive valuation analysis and valuation report performed by a certified valuation
expert.
These benefits help business owners negotiate a strategic sale of their business, minimize
the financial risk of a business owner in a litigation matter, minimize the potential tax that a
business owner or estate may pay in gift or estate tax as well as provide defense in an audit
situation.
The necessity for valuation arises for statutory as well as commercial reasons:
(i) Assessment under Wealth tax act, Gift tax act.
(ii) Formulation of scheme for amalgamation.
(iii) Purchase and sale of shares of private companies.
(iv) Raising loan on the security of shares.
(v) For paying court fees.
(vi) Conversion of shares.
(vii) Purchase of block of shares for the purpose of acquiring interest or otherwise in
another company.
(viii) Purchase of shares by the employees of the company where retention of such
shares is limited to the period of their employment.
(ix) Compensation to the shareholders by the government under a scheme of
nationalization.
(x) Acquisition of shares of dissenting shareholders under a scheme of
reconstruction.

Normally a stock exchange is the most common source of ascertaining the value of shares
especially for transactions involving small block of shares which are quoted on stock
exchanges. But stock exchange prices form an unreliable basis because prices on a
particular day are generally determined on the basis of demand and supply which are
influenced by factors outside the business.

The wide fluctuations in prices of shares at the stock exchange are the outcome of actions
and opinions of the private and institutional investors all over the country and indeed the
world. Thus the valuation of shares has to be done by the accountant by adopting sound
and reasonable basis of valuation.

The other key areas where valuation is needed are-

1. Mergers & Acquisitions: Valuation is an important aspect in M&A. It not only assists
business owners in determining the value of their business, but also helps them maximize
value when considering a sale, merger, acquisition, joint venture, or strategic partnership.
Valuation is often a combination of cash flow and the time value of money. A business’s
worth is in part a function of the profits and cash flow it can generate. As with many
financial transactions, the time value of money is also a factor. How much is the buyer
willing to pay and at what rate of interest should they discount the other firm’s future
cash flows? Both sides in an M&A deal will have different ideas about the worth of a target
company: its seller will tend to value the company at a higher price, while the buyer will
try to acquire the company at the lowest price.

2. Going Public: In general, when a new company goes for an Initial Public Offering (IPO),
for raising capital for setting up of business operations and to meet other long-term
financial requirements, in such a circumstance, a question arises as to how to evaluate
the fair value of the stock. The Indian Capital Market follows a free pricing regime and
thus the accurate pricing of an IPO is of immense importance. Example: The process of
going public often begins when a young company needs additional capital to grow its
business. In order to gain access to that capital, the firm will sometimes choose to sell an
ownership stake or shares of stock to outside investors. • IPO of Reliance Power in Year
2008: This IPO was sold between January 15 and January 18 of 2008 and was subscribed
about 70 times. Before Coal India, this IPO enjoyed the status of the ‘biggest IPO ever’
title. But the Rs 11,560 crore issue had another distinction

3. Dispute Resolution: Valuations are an increasingly important aspect of many

commercial disputes. Before deciding how to manage a dispute, it is necessary to
determine the likelihood of a successful outcome and the potential stake involved. Judicial
precedents are also available that affect the selection of valuation methodologies and
applicability of discounts/ premiums. For example, updating the current Market valuation
for tax purposes, publication to outline various dispute resolution mechanisms, including
the availability of expert valuer conferencing etc.

4.2: MEANING OF ENTERPRISE VALUE

4.3: MEANING OF EQUITY VALUE

Equity value, commonly referred to as the market value of equity or market capitalization,
can be defined as the total value of the company that is attributable to equity investors.
It is calculated by multiplying a company’s share price by its number of shares
outstanding.

Alternatively, it can be derived by starting with the company’s Enterprise Value as shown
below.
4.4: DISCOUNTED CASH FLOW METHOD

The discounted cash flow (DCF) formula is equal to the sum of the cash flow in each period
divided by one plus the discount rate (WACC) raised to the power of the period number.

Here is the DCF formula:

Where:

CF = Cash Flow in the Period

r = the interest rate or discount rate

n = the period number

THERE ARE TWO METHODS FOR DCF:-

IN DCF, TWO DIFFERENT CASH FLOWS CAN BE USED:
1) FREE CASH FLOW TO FIRM (FCFF: CALCULATION WE WILL SEE FURTHER)
2) FREE CASH FLOW TO EQUITY

USING FREE USING FREE

CASH FLOW TO CASH FLOW TO
FIRM (FCFF) EQUITY (FCFE)

DISCOUNTING
DISCOUNTING
RATE USED: COST
RATE USED: WACC
OF EQUITY (Ke)

FINAL ANS GIVES

FINAL ANS GIVES
ENTERPRISE
EQUITY VALUE OF
VALUE OF THE
THE FIRM
FIRM

WACC CALCULATION HAS BEEN COVERED IN CHAPTER 2- COST OF CAPITAL.

 4.5 FREE CASH FLOW TO FIRM

➢ FCFF, or Free Cash Flow to Firm, is the cash flow available to all funding providers
(debt holders, preferred stockholders, common stockholders, convertible bond
investors, etc.).
➢ This can also be referred to as unlevered free cash flow, and it represents the
surplus cash flow available to a business if it was debt-free.
➢ A common starting point for calculating it is Net Operating Profit After Tax
(NOPAT), which can be obtained by multiplying Earnings Before Interest and Taxes
(EBIT) by (1-Tax Rate).
➢ From that, we remove all non-cash expenses and remove the effect of CapEx and
changes in Net Working Capital, as the core operations are the focus.

Other methods of FCFF calculation are:

IMPORTANT POINTS:

– DCF value is a sum of present value of CF of a certain period (10 years generally)
and present value of terminal value.

– Terminal value = Projected cash flow for final year (1 + long-term growth rate) /
(discount rate - long-term growth rate) [Gordon Growth Model]

– FCFF (Free Cash Flow to the Firm): A measure of financial performance that
expresses the net amount of cash that is generated for the firm, consisting of
expenses, taxes and changes in net working capital and investments.

– FCFE (Free Cash Flow to Equity): A measure of how much cash can be paid to the
equity shareholders of the company after all expenses, reinvestment and debt
repayment.
Chapter 5: Corporate Restricting & Industrial Sickness

Corporate Restructuring: Meaning

(a) Corporate restructuring is defined as the process involved in changing the

organization of a business.
(b) It means a change in the business strategy of an organization resulting in
diversification, closing parts of the business etc. to increase its long-term profitability
(c) Implies rearranging the business for increased efficiency and profitability.
(d) It is a method of changing the organizational structure in order to achieve the strategic
goals of the organization or to sharpen the focus on achieving them.
(e) It can involve making dramatic changes to a business by cutting out or merging
departments that often has the effect of displacing staff members.
(f) It involves a process of consolidation or rearrangement in the organization and
business operations aimed at strengthening its financial position so as to achieve its
short-term and long-term business objectives in the competitive environment.
(g) The alterations through corporate restructuring have a significant impact on firm's
balance sheet by redeploying assets or by exploiting unused financial capacity.
(h) The corporate restructuring is a process by which a company can consolidate its
business operations and strengthen its position for achieving the desired objectives
staying synergetic, slim, competitive and successful.
(i) The underlying object of corporate restructuring is efficient and competitive business
operation by increasing the market share, branch power and synergies.

Reasons for corporate restricting

 Global Competition
Global market concept has necessitated many companies to restructure, because
lowest cost producers only can survive in the competitive global markets.
 Government Regulations
The changed fiscal and government policies like deregulation/decontrol have
companies to go for newer markets and customer segments.
 Information Technology
Revolution in information technology has made it necessary for companies to adopt
new changes for improving corporate performance.
 Wrong Segmentation
Many companies have divisionalized into smaller businesses, Wrong divisionalization
strategy has led to revamp themselves. Product divisions which do not fit into the
company's main line of business are being divested. Fierce competition is forcing the
companies to re-launch themselves.
 Strengths & Weaknesses
The identification of strengths and weaknesses of the company is needed in order to
bring focus of the attention of top management to essential needs of the company.
 Focus on Core Strengths
It needs to focus on core strengths, operational synergy and efficient allocation of
managerial capabilities and infrastructure.
 Cost Reduction
Improved productivity and cost reduction has necessitated downsizing of the work
both works and at managerial level.
 Rupee Convertibility
The convertibility of a rupee has attracted medium-sized companies to operate in the
global markets, which requires reorganization of the firm to meet global competition.
 Core Business
The competitive business necessitated to have sharp focus on core business activities,
to gain synergy benefits, to minimize the operating costs, to maximize efficiency in
operation and to tap the managerial skills to best advantage of the firm.
 Economies of Scale
The consolidation of economies of scale by expansion and diversion to extended
domestic and global markets.
 Revival of sick units
The Revival and rehabilitation of a sick unit by adjusting losses of the sick unit with
profits exploit of a healthy company. By restructuring the enterprise, a sick company
can be successfully revived and rehabilitated, and can be brought back to profitable
lines.
 Material and Technology
The acquiring constant supply of raw materials and access to scientific research and
technological developments
 Capital Restriction
The Capital restructuring by appropriate mix of loan and equity funds to reduce the
cost of servicing and improve return on capital employed
 Risk Minimization
By diversification of business activities, the minimization of business risks is possible
and it will enable the firm to achieve atleast the minimum target rate of return.
 Strategic tax Planning
With the integration of sick unit into the successful unit, the adjustment of unabsorbed
depreciation and write-off of accumulated loss is possible, there by the successful unit
can have strategic tax planning.
 Cost of Capital
Corporate restructuring includes financial reorganization, by bring the company to
achieve a desired balance of debt and equity, thereby reduce the overall cost of capital
and financial risks.
 Competition
The restructuring process will facilitate to have horizontal and vertical integration,
thereby the competition is eliminated and the company can have access to regular raw
materials and reaching new markets and accessibility to scientific research and
technological developments.
 Responsibility Accounting
The application of Information technology and responsibility accounting concepts
will facilitate to divide the total enterprise into strategic business units, a better way of
achieving the corporate goals.
 Resource Utilization
It ensures optimum utilization of all resources such that profit centres and drain
centres are segregated so as to improve the efficiency and eliminate the losses and
leakages.
 Business Re-engineering
It facilitates re-engineer the manufacturing, industrial and commercial operations in
such a way that the cost of capital deployed for each of those operations studied,
quantified and reduced.
Financial Restructuring: Meaning

(a) It is also referred to as financial reorganization'.

(b) It can be affected by making change in the capital structure of a company for
achieving a balanced operative result.
(c) Financial restructuring involves restructuring of assets and liabilities of the company.
in line with their cash flow needs, in order to promote efficiency, support growth and
maximize value to shareholders, creditors and other stakeholders.
(d) It involves restructuring the assets and liabilities, debt/equity mix, ideal allocation of
funds to balance short-term and long-term requirements etc. for achieving efficiency,
growth and values to shareholders, creditors and all other stakeholders.
(e) It is resorted to
1. bring balance in debt and equity funds
2. bring balance in short-term and long-term financing
3. achieve reduction in finance charges
4. reduce cost of capital
5. increase EPS
6. improve market value of share
7. Reduce the control of financiers on the management of the company etc.
(f) It will bring in change in capital structure, which depends on the following factors
1. Management control
2. Cost of different sources of capital
3. Flotation cost
4. Cost of servicing the equity and debt
5. Risk and return profile of the industry
6. Financial risks involved in debt financing
7. Flexibility in capital structure
8. Legal formalities etc.
Steps in Financial Restructuring

 valuation of Business

The valuation of business is carried out taking into account the current business situation,
prospective growth of business and its earning power. The valuation of a company is done to
implement the scheme of financial reorganization. The valuation of company should be based
on 'going concern' concept and should not be viewed from the angle of liquidation.

 Formulation of New Capital Structure

The reduction in total debt is brought by reducing of fixed charges burden by bringing in the
fresh equity or preference share capital. When the equity is more, the cost of servicing the
equity is also highest, can be reduced by relying on debt whenever further position improves
the company to strengthen its financial position from unbalanced capital structure.

 Exchange of Old securities for new securities

The old securities are valued its worth and are exchanged for new securities with new
obligations and rights and setup different combinations of ordinary and preference shares,
debentures and loan stock to recompensate various interests in the former business. Creditors
may take shares in settlement of their claims. Sometimes, fresh shares may also be issued to
mobilize funds for reorganized business situation.

COMPANIES ACT 2013 DEFINITION OF INDUSTRIAL SICKNESS: MEANING

Sick companies

Sections 253(1) of the Companies act 2013 define sickness as when on demand by the
secured creditors of a company representing the 50% or more of its outstanding amount of
debt and the company has failed to satisfy the secured creditor within 30days of the demand
notice. In such instance any of the Creditor, may file an application before the Tribunal that
company may be declared as a sick company. The application shall be submitted with
documentary evidences for example any agreement of loan, demand notice, account
statements etc. The tribunal herein abovementioned is National Company Law Tribunal as
defined in the section 2(90) of the Companies Act, 2013. The tribunal shall declare a
company as sick company within 60 days of the application. It is to be noted that under SICA
there is no such provision with regard to sickness and instead of Tribunal the authorities are
BIFR/AAIFR.
RBI DEFINITION OF INDUSTRIAL SICKNESS: MEANING

There are various criteria of sickness. According to the criteria accepted by the
Reserve Bank of India “a sick unit is one which has reported cash loss for
the year of its operation and in the judgment of the financing bank is likely
to incur cash loss for the current year as also in the following year.”

Industrial Sickness: Meaning

Growing Importance of Industrial Sickness

(a) World over sickness in industries is a recognized fact. Often, It is inevitable for various
reasons. In all economies, business failure is a reality of commercial life
(b) The technological development render -
i. Old technologies obsolete
ii. Industrial recessions make some unviable
iii. International trade policies make some uncompetitive
iv. Tardy progress in some related sectors shrink markets for others
(c) These features of Industrial sickness are generally combated by
i. Closing down unviable units
ii. Adopting new technologies
iii. Diversifying products.
iv. Nursing a few that are victims of trade cycles till recoveries set in
v. Revive those that are sustainable with appropriate measures
(d) A sick unit incurs cash losses and fails to generate internal surplus on a
continuing bass
(e) There are different forms, varieties and degrees of industrial sickness.
(f) Various authorities have viewed industrial sickness differently but in sense
and substance their findings are more or less the same.
(g) Factually, no single factor is responsible for malady of industrial sickness.
2. Industrial Sickness: Internal Causes

Planning and Implementation Stage

1. Technical Feasibility
(a) Inadequate technical know-how
(b) Location disadvantage
(c) Outdated production process

Economic Viability

(a) High cost of inputs

(b) Breakeven point too high
(c) Uneconomic size of project
(d) Underestimation of financial requirements
(e) Unduly large investment in fixed assets
(f) Overestimation of demand
(g) Cost over runs resulting from delays in getting licenses/sanctions etc.
(h) Inadequate mobilization of finance

Commercial Production Stage

Production Management

(b) Inappropriate product-mix

(c) Poor quality control
(d) Poor capacity utilization
(e) High cost of production
(f) Poor Inventory management
(g) Inadequate maintenance and replacement
(h) Lack of timely and adequate modernization
(i) High wastage of material in production process

Financial Management

(b) Poor resources management and financial planning

(c) Faulty costing
(d) Liberal dividend policy
(e) General financial indiscipline
 (f) Application of funds for unauthorized purposes
(g) Deficiency of funds
(h) Overtrading
(i) Unfavorable gearing
(j) Inadequate working capital
(k) Absence of cost consciousness
(l) Lack of effective collection machinery

Personnel Management

(a) Excessively high wage structure

(b) Inefficient handling of labour problems
(c) Excessive manpower
(d) Poor labour productivity
(e) Poor labour relations
(f) Lack of skilled/technical competent personnel

Marketing Management

(a) Dependence on limited number of customers

(b) Dependence on limited number of products

(c) Poor sales realization

(d) Defective pricing policy

(e) Booking large order at fixed price during inflation

(f) Weak market organization

(g) Lack of market feedback and market research

(h) Lack of knowledge of marketing techniques

(i) Unscrupulous sales/purchase practices

General Management

(a) Over centralization

(b) Lack of professionalism

 (c) Lack of feedback to management

(d)Lack of proper management information systems

(e) Lack of controls

(f) Lack of timely diversification

(g) Excessive expenditure of R&D

(h) Divided loyalties

(i) Incompetent management

(j) Dishonest management

Industrial Sickness: External Causes

Infrastructure Bottlenecks

(a) Non-availability irregular supply of critical raw materials or other inputs

(b) Chronic power shortage

(c) Transport bottlenecks

Financial Bottlenecks

(a) Non-availability of adequate finance at the right time

(b) Non-cooperation from Banks and Financial Institutions

Government Controls

(a) Government price controls

(b) Improper fiscal duties

(c) Abrupt changes in Govt. policies affecting

costs/prices/imports/exports/licensing

(d) Procedural delays on the part of the financial/licensing/other controlling or

regulating authorities.

Market Constrains

(a) Market saturation

 (b) Technological obsolescence
(c) Recession
(d) Fall in domestic/export demand
Extraneous Factors
(a) Natural calamities
(b) Political situation (domestic as well as international)
(c) Sympathetic strikes and Multiplicity of labour unions
(d) War
Prediction of industrial sickness: Multiple Discriminant Analysis (MDA)

Introduction

A. The computation and analysis of certain ratios based on the information taken from
financial statements allow the analyst to predict sickness or business failure.
B. The ratios are considered independent of each other, will not permit to express the
C. It would be more useful if the important ratios are combined together to measure
whole situation in a single measure. The probability of sickness or insolvency.
D. To overcome this difficulty Edward I. Altman (1968) developed Z score model". It is
called as 'multiple discriminant analysis (MDA).
E. It is a linear analysis used to develop with five variables.
F. MDA computes the discriminant coefficient while the independent variables are the
actual values taken from the financial statements.
G. The model was developed basing on empirical studies, to predict the sickness of a unit
in advance.
H. This model is used in order to detect the financial health of industrial units with a
view to prevent the industrial sickness.

Formula

Altman Z score model is expressed as under:

Z = 1.2x1 + 1.4x₂ + 3.3x₂ + 0.6x₂ + 1.0X5.

X1= Working capital/Total assets

X₂ Retained earnings/Total assets

X3 = Earnings before interest and taxes/Total assets

X4= Market value of equity/Book value of total debt

X5 = Sales/Total assets.

Analysis

The sickness is predicted basing on value of Z score model can be analysed as follows:

(a) If Z score is more than 2.99 - there is no danger of bankruptcy

(b) If Z score is below 1.81 - there is a definite failure

(c) If Z score is between 1.81 and 2.99 - it shows the grey area

Guidelines

Altman developed a guideline for Z score:

(a) If score is above 2.675 - firms can be classified as financially sound

(b) If score is below 2.675 - the firm is heading towards bankruptcy

(c) The lower the Z score, there is a greater possibility of bankruptcy and vice versa.

Conclusion

(a) Altman's model has established itself as the leading multivariate predictor model of
corporate failure and it has been the subject of numerous tests around the world.

(b) It would be useful to employ the Altman model in evaluating Indian firms and endeavour
establishes the reliability of the model.

(c) It could be that the cut-off point for the Z score should be altered from that established in
the original study.
The two techniques of financial restructuring are;

• Debt Restructuring
• Equity Restructuring

1. Debt Restructuring
Debt restructuring is the process of reorganizing the whole debt capital of the
company. It involves reshuffling of the balance sheet items as it contains the debt
obligations of the company. Debt restructuring is more commonly used as a financial
tool than compared to equity restructuring. This is because a company’s financial
manager needs to always look at the options to minimize the cost of capital and
improving the efficiency of the company as a whole which will in turn call for the
continuous review of the debt part and recycling it to maximize efficiency.

Debt restructuring can be done based on different circumstances of the companies.

These can be broadly categorized in to 3 ways.

1. A healthy company can go in for debt restructuring to change its debt part by
making use of the market opportunities by substituting the current high cost
debt with low cost borrowings.
2. A company that is facing liquidity problems or low debt servicing capacity
problems can go in for debt restructuring so as to reduce the cost of borrowing
and to increase the working capital position.
3. A company, which is not able to service the present financial obligations with
the resources and assets available to it, can also go in for restructuring. In short,
an insolvent company can go for restructuring in order to make it solvent and
free it from the losses and make it viable in the future.

Components of debt restructuring

The components of debt restructuring are as follows

• Restructuring of secured long-term borrowings

• Restructuring of unsecured long-term borrowings
• Restructuring of secured working capital borrowings
• Restructuring of other term borrowings

Restructuring of secured long-term borrowings: Restructuring of secured long-

term borrowings will be done for the following reasons such as reducing the cost of
capital for healthy companies, for improving liquidity and increasing the cash flows for
a sick company and also for enabling rehabilitation for that sick company.
Restructuring of unsecured long-term borrowings: Restructuring of the long-term
unsecured borrowings will be done depending on the type of borrowing. These
borrowings can be public deposits, private loans (unsecured) and privately placed,
unsecured bonds or debentures. For public deposits, the terms of deposit can again
be negotiated only if the scheme is approved by the right authority.

Restructuring of secured working capital borrowings: Credit limits from

commercial banks, demand loans, overdraft facilities, bill discounting and commercial
paper fall under the working capital borrowings. All these are secured by the charge
on inventory and book debts and also on the charge on other assets. The restructuring
of the secured working capital borrowings is almost all the same as in case of term
loans.

Restructuring of other short term borrowings: The borrowings that are very short
in nature are generally not restructured. These can indeed be renegotiated with new
terms. These types of short-term borrowings include inter-corporate deposits, clean
bills and clean over drafts.

2. Equity Restructuring
Equity restructuring is the process of reorganizing the equity capital. It includes
reshuffling of the shareholders capital and the reserves that are appearing in the
balance sheet. Restructuring of equity and preference capital becomes a complex
process involving a process of law and is a highly regulated area. Equity restructuring
mainly deals with the concept of capital reduction.

The following are the some of the various methods of equity restructuring.

• Repurchasing the shares from the shareholders for cash can do restructuring of
share capital. This helps in reducing the liability of the company to its
shareholders resulting in a capital reduction by returning the share capital. The
other method that falls in the same category is to change the equity capital in
to redeemable preference shares or loans.
• Restructuring of equity share capital can be done by writing down the share
capital by certain appropriate accounting entries. This will help in reducing the
amount owed by the company to its shareholders without actually returning
equity capital in cash.
• Restructuring can also be done by reducing or waiving off the dues that the
shareholders need to pay.
• Restructuring can also be done by consolidation of the share capital or by sub
division of the shares.
Equity restructuring Methods:

➢ Shares buyback:
A buy-back of shares means a purchase of by a company of its own shares or specified securities. A
company may resort to buy-back for a variety of reasons, e.g., excess floating stock in the market,
poor performance of the share, utilisation of excess cash with the company, etc. Many times a
company has excess cash on its balance sheet which it wants to distribute amongst its shareholders.
A buyback is one of the modes by which it can achieve its objectives.

RATIONALE:
There are several management motivations for share buybacks. If management is having free cash
flows but no profitable growth opportunity is available, the best option is to return cash as special
dividends or buyback its own shares and thus create shareholder value.

If management increases dividends, it will build expectations for the future. The special dividends or
share buyback are normally viewed as one time activity and hence do not build the expectations of
the investors in the future. If management feels that market has not correctly valued its shares, it can
go in for share buyback to bring correction in the valuation of a share.

The share buyback could be used as a vehicle to increase the management shareholding in the
company and thus controlling stake, without any cost to the existing shareholders.

“When companies with outstanding businesses and comfortable financial positions find their shares
selling far below intrinsic value in the marketplace, no alternative action can benefit shareholders as
surely as repurchases.” – Warren Buffett.
Definition of Industrial Sickness:
❖ As per Companies Act 2013:

Where on a demand by the secured creditors of a company representing fifty per cent.
or more of its outstanding amount of debt, the company has failed to pay the debt
within a period of thirty days of the service of the notice of demand or to secure or
compound it to the reasonable satisfaction of the creditors, any secured creditor may
file an application to the Tribunal in 158 the prescribed manner along with the relevant
evidence for such default, non-repayment or failure to offer security or compound it,
for a determination that the company be declared as a sick company.

❖ As per RBI:
A Micro or Small Enterprise (as defined in the MSMED Act 2006) may be said to have
become Sick, if

a. Any of the borrowal account of the enterprise remains NPA for three months or
more

OR
b. There is erosion in the net worth due to accumulated losses to the extent of 50% of
its net worth during the previous accounting year.

SUMS OF ALTMAN Z SCORE MODEL:

QUESTION 1)

SOLUTION:
QUESTION 2:

SOLUTION:
 • Z = 1.2 * 0.04 + 1.4 * 0.13 + 3.3 * 0.19 + 0.6 * 3.72 + 0.99 * 0.73

• Z = 3.81

Therefore, the Altman Z score for Apple Inc. indicates that the company is

highly unlikely to go bankrupt.

CHAPTER 1:

Introduction to Strategy and financial management

(Ravi M. Kishore (2011), Strategic Financial Management, Second Edition, Taxmann

Publications Pvt. Ltd., NewDelhi.)

Strategic Planning

Strategy is defined as “where the organization wants to go to fulfil its purpose and achieve its
mission, it provides the framework for guiding choices which determine the organization's
nature and direction and these choices relate to the organization's products or services,
markets, key capabilities, growth, return on capital and allocation of resources”.

A strategy is, therefore, a declaration of intent. It defines what the organization wants to
become in the longer term. The overall aim of strategy at corporate level will be to match or
fit the organization to its environment in the most advantageous way possible. Strategies
form the basis for strategic management and the formulation of strategic plans. Strategic
planning is asystematic, analytical approach which reviews the business as a whole in
relation to its environment with the object of the following:

I. Developing an integrated, coordinated and consistent view of the route the company
wishes to follow, and
II. Facilitating the adaptation of the organization to environmental change.

The aim of strategic planning is to create a viable link between the organization’s objectives
and resources and its environmental opportunities. Whatever the industry, there are five
competitive forces central to formulating and implementing business strategy.
A. The threat of new entrants.
B. The threat of substitute products or services.
C. The rivalry amongst existing organizations within the industry.
D. The bargaining power of suppliers.
E. The bargaining power of consumers.
The relative strength of each competitive force tends to be a function of industry structure
i.e., its underlying economic and technological characteristics. This can change overtime,
with the result that the relative strength of competitive forces will also change, hence the
industry’s profitability. The basic way an enterprise might seek to achieve above average
returns in the long-term via sustainable competitive advantage. The steps in strategic
planning are illustrated in figure 1.1.
A systematic approach to formalizing strategic plans consists of the following steps:
(i) Define the organization's mission and its overall purpose.
(ii) Set objectives and definitions of what the organization must achieve to fulfil its mission.
(iii) Conduct environmental scans by appraisal of the strengths and weaknesses of the
appraisal of opportunities and threats which face it (SWOT analysis).
(iv) Analyze existing strategies and determine their relevance in the light of the
environmental scan. This may include gap analysis to establish the extent to which
environmental factors might lead to gaps between what is being achieved and what
could be achieved if changes in existing strategies were made. In a corporation with a
number of distinct businesses, an analysis of this portfolio of businesses can take
place to establish strategies for the future of each business.
(v) Define strategic issues - in the light of the environmental scan, the gap analysis and,
where appropriate, the portfolio analysis. This may include such questions as the
following:
(a) How are we going to maintain growth in a declining market for our most profitable
product?
(b) In the face of aggressive competition, how are we going to maintain our competitive
advantage and market leadership?
(c) What action are we going to take as a result of the portfolio analysis of our strategic
business units?
(d) To what extent do we need to diversify into new products and markets and in which
directions should we go?
(e) What proportion of our resources should be allocated to research and
development?
(f) What are we going to do about our ageing machine tools?
(g) What can we do about our overheads?
 (h) How are we going to finance our projected growth?
(i) How are we going to ensure that we have the skilled workforce we need in the
future?
(vi) Develop new or revised strategies and amend objectives in the light of the analysis of
strategic issues.
(vii) Decide on the critical success factors related to the achievement of objectives and the
implementation of the strategy.
(viii) Prepare operational, resource and project plans designed to achieve the strategies
and meet the critical success factor criteria.
(ix) Implement the plans.
(x) Monitor results against the plans and feedback information which can be used to modify
Strategies and plans.

Economic Environment of Business

The factors that influence the business organization are studied under the following three
heads:

International Factors
(a) Development of international communities like European union
(b) Foreign exchange rates of different countries
(c) Inflation rates, interest rates and wage rates in different countries
(d) Economic and trade agreements
(e) Double taxation relief agreements
(f) Entry barriers of different countries
(g) Globalization of economy and liberalization of trade
(h) Balance of trade and balance of payments of different countries
(i) Monitory and economic policies of different countries
(j) Personal and corporate tax rates of different countries
(k) Freedom of movement of capital, labour and technology
(l) Political situation of different countries

Factors influencing at National Level

(a) Inflation rate

(b) Growth rate of GDP
(c) Personal and corporate tax rates
(d) Balance of payment and balance of trade
(e) Exchange rate of national currency with other foreign currencies
(f) Monetary and economic policies of the government
(g) Government incentives and subsidies
(h) Protectionist policies of the government
(i) Fiscal deficit of the government
(j) Interest rates and attitude of developmental institutions in financing projects
(k) Entry and exit barriers
(l) Rate of unemployment
(m) Availability of technology and skilled manpower
 (n) Attitude of the country and government towards globalization of economy and
liberalization of trade.

Factors influencing at Organization Level:

(a) Nature of business
(b) Size of business
(c) Expected and market rate of return
(d) Asset and liability structure of the firm
(e) Efficiency of management and its commitment to business
(f) Ownership pattern
(g) Age of the firm
(h) Liquidity position
(i) Technology adopted
(j) Attitude of stakeholders over firm
(k) Ability to withstand competition
(I) Return on investment generated
(m) Efficiency of human resources

Strategic Financial Management

Strategic planning is long-range in scope and has its focus on the organization as a whole.
The concept is based on an objective and comprehensive assessment of the present
situation of the organization and the setting up of targets to be achieved in the context of
intelligent and knowledgeable anticipation of changes in the environment. Strategic financial
planning involves financial planning, financial forecasting, provision of finance and
formulation of finance policies which should lead to the firm’s survival and success. The
responsibility of a Finance Manager is to provide a basis and information for the strategic
positioning of the firm in the industry. The firm’s strategic financial planning should be able to
meet the challenges and competition and it would lead to the firm’s failure or success.

The strategic financial planning should enable the firm to the judicious allocation of funds,
capitalization of relative strengths, mitigation of weaknesses, early identification of shifts in
the environment, counter possible actions of competitor, reduction in financing costs,
effective use of funds deployed, timely estimation of funds requirement, identification of
business and financial risk etc.

Strategic financial planning is needed to counter the uncertain and imperfect market
conditions and highly competitive business environment. While framing financial strategy, the
shareholders should be considered as one of the constituents of a group of stakeholders viz,
shareholders, debenture holders, banks, financial institutions, government, managers,
employees, suppliers, customers etc. The strategic planning should concentrate on
multidimensional objectives like profitability, expansion growth, survival, leadership, business
success, positioning of the firm, reaching global markets, brand positioning etc. The financial
policy require the deployment of firms resources for achieving the corporate strategic
objectives. The financial policy should align with the company’s strategic planning. It allows
the firm in overcoming its weaknesses, enable to maximize the utilization of its competencies
and mould the prospective business opportunities and threats to the advantage of the firm.
Therefore, the Finance manager should take the investment and finance decisions in
consonant to the corporate strategy. In accordance with the classical management theory,
the financial function of an enterprise has five main objectives, viz, forecasting, organizing,
planning, coordination and control. Each of these objectives has its own range of related
themes.

Forecasting
- Demand and sales volume/revenues
- Cash flows
- Prices
- Inflation rates
- Labour union behaviour
- Technology changes
- Inventory requirements

Organizing
- Financial relation
- Liaison with financial institutions and clients
- Accounting system

Planning
- Investment planning
- Manpower planning
- Development process
- Marketing strategies

Coordination
- Linking finance function with other areas
- Linking with national budget and five year plans
- Linking with labour union policies
- Liaison with media

Control
- Financial charges
- Achievement of desired objectives
- Overall monitoring of the system
- Equilibrium in the capital

Financial Forecasting

Meaning of Forecast

A forecast is a prediction of what is going to happen as a result of a given set of

circumstances, The dictionary meaning of ‘forecast is ‘prediction, provision against future,
calculation of probable events, foresight, prevision’. In a business since it is defined as ‘the
calculation of probable event When estimates of future conditions are made on a systematic
basis, the process is referred to as forecasting and the figure or statement obtained is known
as ‘forecast’. Forecast is a prediction of what is going to happen as a result of a given set of
circumstances. The growing competition rapid change in circumstances and the trend
towards automation etc. demand that decisions in business are not to be based purely on
guesswork, rather on careful analysis of data concerning the future course of events.

Forecasting aims at reducing the areas of uncertainty that surround management decision
making with respect to costs, profit, sales, production, pricing, capital investment and so
forth. In forecasting, both macro and micro-economic factors like price levels, inflationary
trends, monsoons, international industry trends, governmental changes, cost of finance,
competition, company’s strategies and plans, consumer preferences, technological
innovation etc. will be considered. A forecast is a mere assessment of future events. A
forecast includes the projection of variables both controllable and noncontrollable that are
used in the development of budgets. A budget is a plan, whereas a forecast is a prediction of
future events and conditions.

Forecasts are needed in order to prepare budgets. In forecasting events that will occur in the
future, a forecaster must rely on information concerning events that have occurred in the
past. In order to prepare a forecast, the forecaster must analyze past data and must base
the forecast on the result of the analysis. The object of business forecasting is not only to
determine the trend of figures that will tell exactly what will happen in future but also to make
analysis based on definite statistical data, which will enable the firm to take advantage of
future conditions to a greater extent than it could do without them. There always must be
some range of error allowed for in the forecast. While forecasting one should note that it is
impossible to forecast the future precisely. Forecasting is an initial step in financial planning
process. It starts with predicting the future events that will have significant impact on the
firm’s business and its success or failure. It is an estimation of future events in advance and
forecasts the future funds requirements and its utilization. The forecasts will be converted
into plans for action and presentation of plans in the form of financial statements and put
them for action. In other words, forecasts will lead to setting up of goals of firm and
translating the goals into operational plans for action. The finance function involves the both
in setting up of goals and to see that goals are achieved through financial planning, decision
making and control.

Meaning and Techniques of Financial Forecasting

Financial forecasting provides the basic information on which systematic planning is based
on. Sometimes the financial forecasting is used as a control device to set the way for firm’s
future course of action. For strategic planning, financial forecasting is a prerequisite. In
financial forecasting, the future estimates are made through the preparation of statements
like projected income statement, projected balance sheet, projected cashflow and funds flow
statements, cash budget, preparation of projected financial statements with the help of ratios
etc. Financial forecasting helps making decisions like capital investment, annual production
level, operational efficiency required, the requirement of working capital, assessment of cash
flow, raising of long-term funds, estimation of funds requirement of business, estimated
growth in sales etc.

Some of the important techniques that are employed in financial forecasting is given below:
1. Days Sales Method: It is a traditional technique used to forecast sales by calculating
the number of days sales and establishing its relation with the balance sheet items to
arrive at the forecasted balance sheet. This technique is useful for forecasting the
funds’ requirement of a firm.
2. Percentage of Sales Method: It is another commonly used method in estimating the
financial requirements of the firm basing on the forecast of sales. Any change in
sales is likely to have an impact on various individual items of assets and liabilities of
the balance sheet of a firm. This will help in forecasting the financial needs of the firm
by establishing its relation with the changes in levels of activity. Proper understanding
of the relationship of sales level changes with the balance sheet items is necessary
before any financial forecast is made.
3. Simple linear Regression Method: Simple linear regression is concerned with
bivariate distributions, that is distributions of two variables. Simple regression
analysis provides estimates of values of the dependent variable from values of the
independent variable. The device used to accomplish this estimation procedure is the
regression line. For financial forecasting purposes, the sale is taken as an
independent variable and then values of each item of the asset (dependent on sales)
are forecasted. Under this method, every time only one item of asset level can be
determined. Then all forecasted figures are then put into the projected balance sheet
to know the financial needs of the firm in future.
4. Multiple Regression Method: Multiple regression analysis is a further application
and extension of the simple regression method for multiple variables. This method is
applied when the behaviour of one variable is dependent on more than one factor. In
this method of financial forecasting, it is assumed that sales are a function of several
variables. But in the case of a simple regression method, only one variable can be
considered each time, with the increase in the number of independent variables.
Computations may be easily made with the help of computers. The method used in
financial forecasting depends on the requirements and accuracy needed in
forecasting.
5. Projected Funds Flow Statement: The funds flow statement presents the details of
financial resources that are available during the accounting period and the ways in
which those resources are applied in the business. It is a statement of sources and
application of funds analyzing the changes taking place between two balance sheet
dates. The projected funds flow statement will present the data relating to the
procurement of further funds from various sources and their possible application in
fixed assets or repayment of debts or increase in current assets or decrease in
current liabilities etc. The funds flow statement establish a relationship between
sources and application of funds and its impact on working capital. It is a powerful
tool extensively used in financial forecasting.
6. Projected Cashflow Statement: It is a detailed projected statement of income
realized in cash and cash expenditure incorporating both revenue and capital items.
Projected cash flow statement focus on the cash inflow and outflow of various items
represented in the income statement and balance sheet. The projected cash flow
statement shows the cash flows arising from the operating activities, investing
activities and financing activities. A projected cash flow statement is used in
forecasting the financial requirements of the firm.
7. Projected Income Statement and Balance Sheet: The projected income statement
is prepared on the basis of a forecast of sales and anticipated expenses for the
 period underestimation. The projected balance sheet is also drawn based on the
future estimation of raising or repayment long-term funds and acquisition or disposal
of fixed assets and estimation of working capital items with reference to the
estimated sales.

Benefits of Financial Forecasting

The financial forecasts help the Finance manager in the following ways:

a. It provides basic and necessary information for setting up of objectives of the firm
and for the preparation of its financial plans.
b. It acts as a control device for a firm’s financial discipline.
c. It provides necessary information for the decision making of all functions in an
organization.
d. It monitors the optimum utilization of the firm’s resources.
e. It projects the funds’ requirement and utilization of funds in advance.
f. It alarms the management when the events of the concern going out of control.
g. It enables the preparation and updating of financial plans according to the changes in
the economic environment and business situations.
h. It provides the information needed for expansion plans of business and future growth
needs of the organization.
Financial Planning Process

In a well-organized business, each function/department should arrange its activities to

maximize its contribution towards the attainment of corporate goals. The finance function
should focus its attention in financial aspects of management decisions. Financial
management is primarily concerned with investment and financing decisions. The Financial
management of concern should fit into its strategic planning. Financial objectives of the firm
should enable the firm to achieve its overall objectives. The investment decisions create the
cashflow, which is central to the success of the firm, the finance decisions influence the cost
of capital. The investment decisions are associated with business risk whereas finance
decisions are associated with financial risk. The financial decisions should enable the
risk-return trade-off, to maximize the value of firm.

Steps in Financial Planning Process

The financial planning process involves the following steps:

1. Clearly defined Mission and Goal - At the outset, the top management should realize
and recognize the importance of setting the organizational mission, goal and
objectives, which should be clearly defined and communicated.

2. Determination of Financial Objectives - In developing the financial objectives, a firm

must consider its purpose, mission, goal and overall objectives of the firm. The
financial objectives can again be transformed into strategic planning. The financial
objectives can be classified into (a) long-term objectives, and (b) short-term
objectives. The long-term financial objectives may relate to earning in excess over
the targeted return on capital employed, increase in EPS and market value of a
share, increase in market share of its product, achieve targeted growth rate in sales,
maximization of value for shareholders etc. The short-term financial objectives relate
to profitability, liquidity, working capital management, current ratio, operational
efficiency etc,

3. Formulation of Financial Policies - The next step in the financial planning and
decision-making process is to formulate the financial policies which provide guides to
decision making for the attainment of both long-term and short-term financial
objectives. For example, the company can frame its financial policies like:

(a) Debt-equity ratio and current ratio of the firm may be fixed at 3:2 and 2: 1
respectively,
(b) A minimum cash balance has to be maintained at Rs. 1,00,000 always.
(c) The minimum and maximum levels are to be fixed for all items of raw material and
consumable.
(d) The equity to be raised only by issue of equity shares.
(e) Profitability centre concept to be implemented for all divisions in the organization.
(f) The inter-divisional transfers to be priced at pre-determined transfer prices etc.

4. Designing Financial Procedures - The financial procedures helps the Finance

manager in day to day functioning, by following the pre-determined procedures. The
 financial decisions are implemented to achieve the organizational goals and financial
objectives. The financial procedures outline the cashflow control system, setting up of
standards of performance, continuous evaluation process, capital budgeting
procedures, capital expenditure authorization procedures, financial forecasting
techniques to be used, preparation standard set of ratios, using of budgetary control
system etc.

5. Search for Opportunities - This involves a continuous search for opportunities which
are compatible with the firm’s objectives. The earlier opportunity is identified the
greater should be the potential returns before competitors and imitators react.

6. identifying Possible Course of Action - This requires the development of business

strategies from which individual decisions emanate. The available courses of action
should be identified keeping in view the marketing, financial and legal restrictions or
other forces not within the control of decision-makers. For example, the additional
funds’ requirement for expansion of the plant can be met by raising finances from
various sources.

7. Screening of Alternatives - Each course of action is subjected to a preliminary

screening process in order to assess its feasibility considering the resources
required, expected returns and risks involved. Readily available information must be
used to ascertain whether the course of action is compatible with existing business
and corporate objectives and likely returns can compensate for the risks involved.

8. Assembling of Information - The Finance manager must be able to recognize the

information needs and sources of information relevant to the decision. The
cost-benefit trade-off must be kept in view in information gathering. To obtain more
reliable information, the costs may be heavy in data gathering. The relevant and
reliable information ensures the correct decision making and confidence in the
decision outcome.

9. Evaluation of Alternatives and Reaching a Decision - This step will involve the
evaluation of different alternatives and their possible outcomes. This involves
comparing the options by using the relevant data in such a way as to identify the best
possible course of action that can enable in achieving the corporate objectives in the
light of prevailing circumstances.

10. Implementation, Monitoring and Control - After the course of decision is selected,
attempts to be made to implement the decision to achieve the desired results. The
progress of action should be continuously monitored by comparing the actual results
with the desired results. The progress should be monitored with feedback reports,
control reports, post audits, performance audits, progress reports etc. Any deviations
from the planned course of action should be rectified by making supplementary
decisions.
TYBBA/V/SFM/Unit-1/2020-21

PROF. V.B.SHAH INSITUTE OF MANAGEMENT,

AMROLI,SURAT

COURSE: B.B.A
YEAR: T.Y.BBA(SEM –V)

SUBJECT: STRATEGIC FINANCIAL

MANAGEMENT
Faculty: Mr. Soyeb Jindani & Dr. Nilesh Patel
Unit: 1 Introduction to Strategy and Financial Management (15%)

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1.1 Introduction:
The top management of an organization is concerned with the selection of a course of action
from among different alternatives to meet the organizational objectives. The process by which
objectives are formulated and achieved is known as strategic management and strategy acts
as the means to achieve the objective. Strategy is the grand design or an overall ‘plan’ which
an organization chooses in order to move or react towards the set of objectives by using its
resources. Strategies most often devote a general programme of action and an implied
deployed of emphasis and resources to attain comprehensive objectives. Without an
appropriate strategy effectively implemented, the future is always dark and hence, more are
the chances of business failure.

Strategic planning is long-range in scope and has its focus on the

organization as a whole. The concept is based on an objective and
comprehensive assessment of the present situation of the
organization and the setting up of targets to be achieved in the context
of an intelligent and knowledgeable anticipation of changes in the
environment. The strategic financial planning involves financial
planning financial forecasting provision of finance and formulation of
finance policies which should lead the firm's survival and success.
The responsibility of a Finance manager is providing a basis and
information for strategic positioning of the firm in the industry. The
firm's strategic financial planning should able to meet the challenges
and competition and it would lead to firm's failure or success.
Meaning of Strategic Financial Management:

The strategic financial planning is needed to counter the uncertain and

imperfect market conditions and highly competitive business environment.
While framing financial strategy, the shareholders should be considered as

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one of the constituents of a group of stakeholders i shareholders, debenture

holders, banks, financial institutions, government, managers, employees,
suppliers, customers etc.

The strategic planning should concentrate on multidimensional objectives

like profitability, expansion growth, survival, leadership, business success,
positioning of the firm, reaching global markets, brand positioning etc. The
financial policy requires the deployment of firm’s resources for achieving the
corporate strategic objectives. The financial policy should align with the
company's strategic planning. It allows the firm in overcoming its
weaknesses, enable to maximize the utilization of its competencies and mould
the prospective business opportunities and threats to the advantage of the
firm Therefore, the Finance manager should take the investment and finance
decisions in consonant to the corporate strategy.
• Forecasting
Demand and sales volume/revenues
Cash flows Prices
Inflation rates
Labour union behaviour
Technology changes
Inventory requirements
• Organizing
Financial relation
Liaison with financial institutions and clients
Accounting system
• Planning
Investment planning
Manpower planning

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Development process
Marketing strategies
• Coordination
Linking finance function with other areas
Linking with national budget and five-year plans - Linking
with labour Union policies.
Liaison with media
• Control
Financial charges
Achievement of desired objectives
Overall monitoring of the system
Equilibrium in the capital.
Meaning of Strategy:

“A strategy is a plan of action designed to achieve a specific goal or series of goals within an
organizational framework.”

“Strategy is the determination of the basic long term goals and objectives of an enterprise and
the adoption of the course of action and the allocation of resources necessary for carrying out
these goals.”

Strategy which falls within the scope of financial management, which will
include decisions on investment, financing and dividends.

What is Financial Management

Financial management means the management of finance of a business or an organization

in order to achieve the financial objectives.
Definition of Strategic Financial Management:
1. “Strategic financial management can be defined as the application of
financial techniques to strategic decisions in order to help achieve the
decision-maker's objectives”
2. The term ‘’strategic financial management ‘’ aims at controlling and looking at all the

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finances of the company to achieve the desired targets and earn the desired profits for
the company.
3. Strategic Financial Management can be defined as “the identification of
the possible strategies capable of maximizing an entity's net present
value, the allocation of scarce capital resources among the competing
opportunities and the implementation and monitoring of the chosen
strategy so as to achieve stated objectives”.
Strategy + Finance + Management The fundamentals of business

Strategic financial management means not only managing a company’s finances, but also with
the intention of being successful – that is, achieving the company’s goals and objectives and
maximizing shareholder value over time. However, before a company can strategically manage
itself, it must first clearly define its goals, identify and quantify its available and potential
resources, and devise a specific plan for using its finances and other capital resources to achieve
its goals.

Strategic financial management is about generating profits for the company and ensuring an
acceptable return on investment (ROI). Financial management is accomplished through
business financial plans, the establishment of financial controls, and the making of financial
decisions.
The function of Strategic financial management starts from detecting the number of funds
required for the business, then looking for the means or the ways through which these funds
are raised at cheaper rates so that the financial requirement of the business are fulfilled. In other
words, it can also be termed as applying principles of management to the financial resources
of an organisation.

Prof.Soyeb Jiandani & Prof. Dr.Nilesh Patel

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2 Significance/ Advantages of Strategic

Financial Management:
Strategic financial management is important because its study enables the
finance manager to:
1. Understand the limitations of traditional accounting models in an
increasingly dynamic and fast-changing world.
2. Contribute more effectively to corporate strategy by taking a more
proactive and forward-looking approach.
3. React to conditions of rapid change through enhanced awareness,
anticipation and adaptation.
4. Understand and use alternative expressions of profit that start with a
recognition of the impact on cashflow of the various stakeholders in a

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company.
5. Understand the different relationships between profits, expansion and
cashflow model in the traditional accounting and financial
management models.

1.3 Strategic Planning:

Definition of Strategic Planning:
1. According to Scott, "long range business planning is a systematic
approach to decision-making about issues, which are fundamental and
of crucial importance to its continuing long-term effectiveness".
2. According to Alfred Chandler, strategic planning is "concerned with
the determination of the basic long-term goals and objectives of an
enterprise and the adoption of courses of action and allocation
resources necessary for carrying out these goals".

A strategy is, therefore, a declaration of intent. It defines what the

organization wants to become in the longer sperm. The overall aim of strategy
at corporate level will be to match or fit the organization to its environment
in the most advantageous way possible Strategies form the basis for strategic
management and the formulation of strategic plans Strategic planning is a
systematic, analytical approach which reviews the business as a whole in
relation to its environment with the object of the following:
1. Developing an integrated, coordinated and consistent view of the route
the company wishes to follow, and
2. Facilitating the adaptation of the organization to environmental
change.
The aim of strategic planning is to create a viable link between the
organization's resources and its environmental opportunities. Whatever the

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industry, there are five competitive forces central to formulating and

implementing business strategy.
a. The threat of new entrants.
b. The threat of substitute products or services. ANTZ
c. The rivalry amongst existing organizations within the industry d. The
bargaining power of suppliers.
e. The bargaining power of consumers.

The relative strength of each competitive force tends to be a function of

industry structure Le., its underlying economic and technological
characteristics. This can change overtime, with the result that the relative
strength of competitive forces will also change, hence the industry's
profitability. The basic way an enterprise might seek to achieve above average
returns in the long-term via sustainable competitive advantage.

Process of Strategic Planning Process:

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A systematic approach to formalizing strategic plans consists of the

following steps:
1. Define the organization's mission and its overall purpose.
2. Set objectives and definitions of what the organization must achieve to
fulfil its mission
3. Conduct environmental scans by internal appraisals of the strengths
and weaknesses of the organization and external appraisals of the
opportunities and threats which face it (SWOT analysis).
4. Analyse existing strategies and determine their relevance in the light of
the environmental scan. This may include gap analysis to establish the
extent to which environmental factors might lead to gaps between what is

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being achieved and what could be achieved if changes in existing strategies

were made. In a corporation with a number of distinct businesses, an analysis
of this portfolio of businesses can take place to establish strategies for the
future of each business.
5. Define strategic issues in the light of the environmental scan, the gap
analysis and, where appropriate, the portfolio analysis. This may include
such questions as the following:
a. How are we going to maintain growth in a declining market for our
most profitable product?
b. In the face of aggressive competition, how are we going to maintain
our competitive advantage and market leadership? c. What action are
we going to take as a result of the portfolio analysis of our strategic
business units?
d. To what extent do we need to diversify into new products and
markets and in which directions should we go?
e. What proportion of our resources should be allocated to research
and development?
f. What are we going to do about our aging machine tools? g. What
can we do about our overheads?
h. How are we going to finance our projected growth?
i. How are we going to ensure that we have the skilled workforce we
need in the future?
6. Develop new or revised strategies and amend objectives in the light of
the analysis of strategic issues.
7. Decide on the critical success factors related to the achievement of
objectives and the implementation of strategy
8. Prepare operational, resource and project plans designed to achieve
the strategies and meet the critical success factor criteria.

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9. Implement the plans.

10. Monitor results against the plans and feedback information which can
be used to modify strategies and plans.

1.4 Financial Planning:

Meaning of Financial Planning:
Planning includes attempting to make optimal decisions, projecting the
consequences of these decisions for the firm in the form of a financial plan
and then comparing future performance against that plan.

Definition of Financial Planning:

1. Financial Planning is the process of estimating the capital required and
determining it's competition. It is the process of framing financial policies
in relation to procurement, investment and administration of funds of an
enterprise.
2. According to William King, "Planning is the process of thinking
through and making explicit the strategy, actions, and relationships
necessary to accomplish an overall objective".
3. "The financial plan of a corporation has two-fold aspects; it refers not
only to the capital structure of the corporation but also to the financial
policies which the corporation has adopted or intends to adopt".

In a well-organized business, each Function department should arrange its

activities to maxima its contributions towards the attainment of corporate
goals. The finance function should focus its attention in financial aspects of
management deals financial management is primarily concerned with the
investment and financing decisions. The Financial management of a concern
should fit into its strategic planning financial objectives of the firm should

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enable the firm to achieve its overall objectives. The investment decisions
create the cashflow, which is central to the success of the firm, the finance
decisions influence the cost of capital. The investment decisions are
associated with business risk where as finance decisions are associated with
financial risk The financial decisions should enable the risk return trade off,
to maximize the value of firm.

1.5 Financial Planning Process:

The financial planning process involves the following steps:

1. Clearly defined Mission and Goal: At the outset, the top management
should realize and recognize the importance of setting the organizational
mission goal and objectives which should be clearly defined and
communicated.
2. Determination of Financial Objectives: In developing the financial
objectives, a firm must consider purpose, mission, goal and overall objectives
of the firm. The financial objectives can again be transformed into strategic
planning. The financial objectives can be classified into
(a) Long Term Objectives, and (b) Short Term Objectives.
The long-term financial objectives may relate to earning in excess over the
targeted return on capital employed, increase in EPS and market value of
share, increase in market share of its product, achieve targeted growth rate
in sales, maximization of value for shareholders etc.
The short-term financial objectives relate to profitability, liquidity, working
capital management, current ratio, operational efficiency etc.
3. Formulation of Financial Policies: The next step in financial planning
and decision-making process a both long-term and short-term financial
objectives. For example, the company can frame is financial policies like:

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a. Debt-equity ratio and current ratio of the firm may be fixed at

3:2 and 2:1 respectively.
b. A minimum cash balance has to be maintained at Rs. 1,00,000
always.
c. The minimum and maximum levels are to be fixed for all items
of raw material and consumable.
d. The equity to be raised only by issue of equity shares.
e. Profitability centre concept to be implemented for all divisions in
the organization.
f. The inter-divisional transfers to be priced at pre-determined
transfer prices etc.
4. Designing Financial Procedures: The financial procedures help the
Finance manager in day-to-day functioning, by following the pre-determined
procedures. The financial decisions are implemented to achieve the
organizational goals and financial objectives. The financial procedures outline
the cashflow control system, setting up of standards of performance,
continuous evaluation process, capital budgeting procedures, capital
expenditure authorization procedures, financial forecasting techniques to be
used, preparation standard set of ratios, using of budgetary control system
etc.
5. Search for Opportunities: This involves a continuous search for
opportunities which are compatible with the firm's objectives. The earlier
opportunity is identified the greater should be the potential returns before
competitors and imitators react.
6. Identifying Possible Course of Action: This requires the development of
business strategies from which individual decisions emanate. The available
courses of action should be identified keeping in view the marketing, financial
and legal restrictions or other forces not within the control of decision maker.

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For example, the additional funds requirement for expansion of the plant can
be met by raising of finances from various sources.
7. Screening of Alternatives: Each course of action is subjected to
preliminary screening process in order to assess its feasibility considering
the resources required expected returns and risks involved. Readily available
information must be used to ascertain whether the course of action is
compatible with existing business and corporate objectives and likely returns
can compensate for the risks involved.
8. Assembling of Information: The Finance manager must be able to
recognize the information needs and sources of information relevant to the
decision. The cost-benefit trade-off must be kept in view in information
gathering. To obtain more reliable information, the costs may be heavy in data
gathering. The relevant and reliable information ensures the correct decision
making and confidence in the decision outcome.
9. Evaluation of Alternatives and Reaching a Decision: This step will
involve the evaluation of different alternatives and their possible outcomes.
This involves comparing the options by using the relevant data in such a way
as to identify the best possible course of action that can enable in achieving
the corporate objectives in the light of prevailing circumstances.
10. Implementation, Monitoring and Control: After the course of decision
is selected, attempts to be made to implement the decision to achieve the
desired results. The progress of action should be continuously monitored by
comparing the actual results with the desired results. The progress should be
monitored with feedback reports, control reports, post audits, performance
audits, progress reports etc. Any deviations from planned course of action
should be rectified by making supplementary decisions.

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1.6 Financial Forecasting:

❖ Meaning of Forecast:

Forecast means prediction, provision against future.

A forecast is the prediction of the future based on a certain set of

circumstances that could be related to the past or present data. It involves
developing future estimates after a thorough analysis of different trends. In
other words, forecasting is a step-by-step process of predicting the future. In
finance, managers use different financial forecasting techniques to foresee
future trends and get the most accurate figures. The resulting statements are
known as financial forecasts.

Forecasting aims at reducing the areas of uncertainty that surround

management decision forecasting, both macro and micro-economic factors
like price levels, inflationary trends, monsoons international industry trends,
governmental changes, cost of finance, competition, company forecast is a
mere assessment of future events.
Meaning of Financial Forecasting:

• Financial forecasting forms the basis of decision-making in an

organization. It provides information regarding future aspects of a
business, around which strategies are formulated and planning is
done.
• Under financial forecasting, the forecasters develop future estimates
with the help of statements such as the projected income statement,
projected cash flow statement, etc.

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A company estimates/predicts two main things in a financial forecast:

1. Future Income
2. Future Expenses
• In financial forecasting the future estimates are made through
preparation of statements like projected income statement, projected
balance sheet, projected cashflow and funds flow statements, cash
budget, preparation of projected financial statements with the help of
ratios etc.
• Financial forecasting helps making decisions like capital investment,
annual production level, operational efficiency required, requirement of
working capital, assessment of cashflow, raising of long-term funds,
estimation of funds requirement of business, estimated growth in sales
etc. Eventually, it helps in making crucial investment decisions and
also, controlling the uncertain events and associated risks thereon.

Definition of Financial Forecasting:

• “Financial forecasting refers to foreseeing future trends to estimate
future aspects of a business, around which strategies and business
decision are formulated and planned.”
• “Financial forecasting is that process in which the future financial
condition of the firm is shown on the basis of past accounts, funds flow
statements, financial ratios and economic conditions of the firm and
industry.”

1.7 Benefits of Financial Forecasting:

The financial forecasts help the Finance manager in the following ways:

a. It provides basic and necessary information for setting up of objectives of firm and for
preparation of its financial plans.

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b. It acts as a control device for firm's financial discipline.

c. It provides necessary information for decision making of all functions in an
organization.
d. It monitors the optimum utilization of firm's resources.
e. It projects the funds requirement and utilization of funds in advance,
f. It alarms the management when the events of the concern going out of control.
g. It enables the preparation and updating of financial plans according to the changes
economic environment and business situations.
h. It provides the information needed for expansion plans of business and future growth
needs of the organization.

1.8 Techniques of Financial Forecasting:

Qualitative and Quantitative Methods of Financial Forecasting There are two ways
of developing financial forecasting by using either a qualitative method or a
quantitative method.
A. Qualitative Financial Forecasting Methods
The qualitative methods use the non-quantifiable or non-measurable data for forecasting
purpose. Herein, the manager gives due importance to the consumer’s opinion or expert
judgment for arriving at suitable results.

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These methods are widely used when past data is not available. For example, it would be wise
to research consumer’s preferences while launching a new product in the market. Some of the
qualitative methods are:
1. Executive Opinion
The opinions of the key staff hold great value. For example, the sales team comes in contact
with the customers and thus, they know their needs and requirements better.
Under the executive opinion’s method, the opinions of experts of different departments such
as production, sales, purchasing, and operations are taken to predict the future.

2. Market Research
The management team can undertake complete market research wherein a sample of current
and future customers will be selected to discuss and predict a good or service.
With market research, the forecaster can figure the demand of a particular good or service.
Whether the customers would like to buy a new product or a new variant of the existing product
or not? However, this forecasting method is a bit expensive and hence may not always be used.
3. Delphi Method
The Delphi technique revolves around a structured method. A facilitator is there to ease this
whole process of deriving the forecasts from a set of experts.
The first step of this method includes the gathering of data through the medium of
questionnaires. Multiple rounds are there. The analysis of data is done at every stage. So, the
result of preceding rounds forms the basis of the next round. The process of collecting and
analyzing iterations continues until they reach a consensus.
Consequently, the managers prefer the Delphi method for long-term forecasts only, given the
amount of time and effort required in this technique.
4. Reference Class Forecasting
The reference class forecasting is based upon human judgment. Under this method, the
forecaster predicts the future according to similar scenarios in other places or times.
The manager/forecaster makes the judgment on the expected outcome of a planned action in
the future.
Scenario Writing
5. Salesforce Polling
This method uses in-depth knowledge of the sales force about customer behavior. The insights
help in improving the product/service as per the consumer expectations. The forecaster
calculates the average of salesforce polling to derive future estimates.

B. Quantitative Financial Forecasting Methods

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In the quantitative methods, the forecasters use past observations to generate forecasts. Usually,
a forecaster manipulates and analyzes the existing quantitative data through various
quantitative and statistical tools to arrive at the most accurate results.
Some of the quantitative methods are:
1. Causal methods
In the causal method or, cause and effect method, the forecaster studies the relationship of one
variable with another relevant variable. Consequently, a change in one item causes the same
change in another.
The regression analysis is a widely used causal method. It can further be divided into:
2. Simple Linear Regression Method
The simple linear regression focuses on the distribution of two variables. Here, the forecaster
studies the bivariate distributions and calculates the estimated values of the dependent variable
according to the values of the independent variable.
3. Multiple Regression Method
It is an extension of the simple regression method where a variable is dependent on more than
one variable/factor.
For instance, sales could depend on more than just one variable. The analysis of one or more
of those factors determines the sales forecasts.
Some other examples of the causal financial forecasting techniques are:
4. Days Sales Financial Forecasting Technique
It is a traditional technique used to forecast the sales by calculating the number of days sales
and establishing its relation with the balance sheet items to arrive at the forecasted balance
sheet. This technique is useful for forecasting funds requirement of a firm.
5. Percentage of Sales Financial Forecasting Technique
The sales forecast paves the way for getting a clear picture of the expected future sales with
which a manager can forecast the financial requirements of the firm. Any change in the sales
will have much effect on other variables of the balance sheet particularly, the assets and
liabilities.
Thus, it’s crucial to make the sales forecast and establish its relationship with other variables
as accurately as possible.
6. Time-series methods
This is another popular quantitative method. It involves the gathering of data over different
periods for identifying trends. Then, the forecaster analyzes the trends to derive the forecasts
mainly for the short-term.
For example, simple averaging and exponential smoothing are popular time-series techniques.
Financial Statements for Financial Forecasting

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The financial statement is another important tool in the hands of a manager, especially when
there is an acquisition/ merger or, at the time of the formation of a new company.
Therefore, investors need these statements before providing the required capital to a
firm. These statements cover the costs and sales figures of the previous two to three years after
excluding some one-time costs.
7. Projected Funds Flow Statement and Projected Cash Flow Statement
The projected funds flow statement represents the data about further procurement of funds from
various sources and their application in assets or, repaying debts, etc. whichever the case be. It
helps in understanding the impact on working capital by establishing a relationship between
sources and application of funds.
On the other hand, the projected cash flow statement primarily focuses on the inflow and
outflow of cash. It covers the items which result in the realization of cash or expenditure in
cash, . It is a detailed statement of the projected cash flows generating from the operating
activities, investing activities and financing activities. Therefore, it proves to be a useful tool
for forecasting the financial requirements of the company.
8. Projected Income Statement and Balance Sheet
The projected income statement is prepared on the basis of forecast of sales and
anticipated expenses for the period under estimation. The projected funds and
acquisition or disposal of fixed assets and estimation working capital items with
reference to the estimated sales.

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PROF.V.B.SHAH INSTITUTE OF MANAGEMENT, AMROLI,SURAT 20
SFM/Unit 2/ Project Planning and Control/TYBBA Sem 5/Finance

PROF. V.B.SHAH INSTITUTE OF MANAGEMENT,

AMROLI, SURAT

COURSE: B.B.A
T.Y.BBA (SEM –V)
Finance Specialization
SUBJECT: Strategic Financial Management
Faculty: Prof. Soyeb Jindani & Dr. Nilesh Patel

Unit 2: Project Planning and Control (10%)

Meaning of Project Management, Classification of Projects, Stages in Setting up of
Project, Cost Benefit Analysis in Project, Project Appraisal Techniques and Appraisal
by Financial Institution

Meaning of Project:
“A Project is a scheme for investing resources which can be reasonable analyzed and
evaluated as an independent unit”
Where scheme is investment programme, analysis of cost and benefit and independent means
not dependent on any other scheme.

Meaning of Project Management:

“The Planning, analysis, financing, implementation and review of the resources to develop
facilities in order to provide goods and services to society is known as Project Management.”

Prof. Soyeb Jindani & Dr. Nilesh Patel

Prof.V.B. Shah Institute of Management, Amroli
SFM/Unit 2/ Project Planning and Control/TYBBA Sem 5/Finance

Classification of Projects:
Projects can be classified in many ways depending on different criteria and nature of projects.

Classification of Projects based on different criteria

Projects can be classified in many ways, namely:

 National and international projects

 Industrial and non-industrial projects
Project based on level of technology:

 High technology projects

 Conventional technology projects
 Low technology projects
Projects based on Assessment of Cost & Benefit:

 Quantifiable Projects
 Non-Quantifiable Projects
Projects based on size:

 Large projects
 Medium projects
 Small projects
 Micro Project
Projects based on ownership:

 Public Sector projects

 Private sector projects
 Joint sector projects
Projects according to purpose and classified by Financial Institution:

 Balancing project
 Modernization projects
 Replacement/renewal projects
 Expansion projects
 Diversification projects
 Rehabilitation (of sick units) projects
 Up gradation projects
 Maintenance projects
 Mergers and acquisition
 New project (innovation or invention)
The following are some projects which are classified as per purpose and it is also useful
for evaluation for Project loan approval by Financial Institutions.

Prof. Soyeb Jindani & Dr. Nilesh Patel

Prof.V.B. Shah Institute of Management, Amroli
SFM/Unit 2/ Project Planning and Control/TYBBA Sem 5/Finance

 Balancing Projects:
When the capacity utilization of the plant and machinery is unbalanced due to unutilized
capacity in some units, the balancing equipment is installed to remove the bottlenecks and to
increase the capacity utilization of total plant. By installing balancing equipment, there would
be free flow in the process and uninterrupted production is ensured and there will be more
revenues through higher output and attendant value addition. The value addition that takes
place due to addition of balancing equipment should pay for the investment on the project.
 Modernization Projects:
Due to technological development, wear and tear, the old plant and machinery that was
installed several years back, would require modernization. The old plant may cause high cost
of production, frequent interruptions in plant running, high cost of maintenance, low quality
products, etc. In modernization, old machines are removed and new machines are installed in
its place in order to cope with the dynamic and competitive business environment. The
modernization of plant will reduce the cost of production, increases productivity and improve
the morale of the employees. It will also improve the production methods, increase the
product quality.
 Replacement Projects:
Replacement does not imply a like for like substitution. Replacement of an existing asset with
more economic one. If any equipment is deteriorated due to obsolescence and its economic
life is completed, it should be replaced with a new machine, which may be equivalent to old
machine or it may also be more efficient than the old one. By such replacement, the
operational efficiency is increased, reducing the cost of production, minimization of
maintenance cost, increase in capacity utilization etc. Replacement project is similar to the
modernization but replacement is taken at individual machine level, but modernization takes
place at the complete plant level.
 Expansion Projects:
When the current production levels of existing plant could not meet the growing demand for
the product in the market, and such growth is of permanent nature, the management would
decide to increase the capacity of the plant by installing additional equipment and facilities
thereby the total production is increased. Expansion project is undertaken to enlarge its plant
capacity with a view to produce a large volume of output than the current level.
 Diversification Projects:
It is an investment decision to set up an entirely new project which is not connected with
existing line of business. The strategic consideration in going for diversification projects is to
minimize the risk by having a diversified portfolio of investments. The diversification will
increase the asset bases, increase in turnover and profits, better utilization of managerial
skills, use of latest technologies etc.
 Brown Field Project:
A project implemented in the precincts of a working plant/working facility is known as
“brown field project (BFP). Revamping, replacements, rehabilitation, renovation,
modernization projects comes under this category of BFP. The most common BFP is the
modernization/partial renovation of a running plant. Management of a BFP within the
precincts of an operating plant calls for much more imagination, detailed planning,
meticulous schedule control and an integrated team work from all the concerned departments
like maintenance, engineering, civil, construction departments etc.

Prof. Soyeb Jindani & Dr. Nilesh Patel

Prof.V.B. Shah Institute of Management, Amroli
SFM/Unit 2/ Project Planning and Control/TYBBA Sem 5/Finance

Stages in Setting up of Project:

Introduction:
Project can be set up with combination of various tasks/activities to be done by Project
Manager into three phases/stages i.e. (1) Pre-Operative Stage. (2) Operation Stage (3) Post-
Operation Stage. Pre-operative Stage usually includes Identification of Project idea, its
screening, preparing feasibility reports, Government Clearances, Decision on Location and
Site, Inputs, Appraisal and Evaluation by Financial Institution etc. Operation Stage includes
implementation and combination of resources/factors of production to run the project. Post-
Operation Stage includes review and control by promoters as well as financial institutions i.e.
periodic site visits by officers from financial institution, submission of periodic progress
reports to financial institutions etc.
Stages or Phases of Projects are as follow:
(a) Identification
(b) Formulation &Appraisal
(c) Selection
(d) Implementation
(e) Review
Following are comprehensive stages for setting up of a particular project.
(A) Identification:
It is a process of selecting a viable project after careful scanning of the environment of
investment opportunity and its likely risk and return. It includes Initial Selection of Project
Ideas: Before a project idea is considered for detailed study, the promoter must verify the
following:
(a) Project must match with the promoter‟s profile of qualifications, experience, interest
etc.
(b) Rough estimate of project cost and promoter‟s capability to mobilize the necessary
resources to the proposed project.
(c) Clear idea about market size and growth potential.
(d) The availability of inputs and proximity of market for final products.
(e) Costs involved in production, administration and marketing.
(f) Availability of technology and plant and machinery.
(g) Risks involved with the project. - Risk Aware Culture: The awareness of risk is an
important technique in successful completion of the project. The risk awareness culture is to
be developed at all levels of project management team to fight against any adversaries occur
in implementation of the project.
SWOT Analysis
In case of existing companies which are proposing diversification and expansion plans, will
conduct a detailed study about the strengths, weaknesses, opportunities and threats on the
basis of its past business experience. By conducting SWOT analysis, the strengths and
weaknesses of the proposed project is highlighted. Some of the aspects considered in SWOT
analysis are as follows:
(a) Internal financial resources
(b) Availability of funds in the capital market
(c) Extent of support from banks and financial institutions
(d) Existing and proposed level of investments and its impact on ROI, EPS and
market value of the firm
(e) The business and financial risks attached to the firm
(f) Technology developed internally or possibility to obtain reliable technical
know-how at cheaper cost
Prof. Soyeb Jindani & Dr. Nilesh Patel
Prof.V.B. Shah Institute of Management, Amroli
SFM/Unit 2/ Project Planning and Control/TYBBA Sem 5/Finance

(g) Brand loyalty of existing products

(h) Source of raw material and other infrastructure facilities
(i) Market share, distribution network
(j) Severity of competition
(k) Cost of production and managerial competence
(l) Cost of capital
(m) Governmental clearances and permissions
(n) Macro and micro economic environment in which the business operates etc.

Market Survey
Before undertaking any new project it is customary to undertake a market survey. Perhaps the
best known form of market research is the market survey. This is not only used to forecast the
level of demand for a product, but may be used for a wide range of other purposes as well,
including testing buyers reactions to different product configurations and packaging, and
identifying links between purchasing behaviour and other variables, like buyers' age, sex,
social status and income. If the aim is to estimate the level of demand, a sample of buyers is
asked direct questions about intentions with respect to purchasing the product within a
specified future period. That information is used in conjunction with other evidence about the
potential market to construct estimate of the total volume of sales. Market surveys may also
be useful for new products where there is no past data on sales, so that time-series analysis or
estimation is not possible. Once the entrepreneur comes to a conclusion that the project can
be taken up for detailed study. He/she can start with preparation of feasibility study report.

(B) Formulation & Appraisal:

It is a process of translation of the idea into project with examining the important preliminary
aspects of projects and Feasibility studies to be taken for projects. Following are different
preliminary aspects which an entrepreneur must analyze before commissioning the project
activities. It includes various aspects like Market, Technical, Managerial, Economic, Social,
Financial etc.
Sequential Steps of Project Formulation:
1. Feasibility Analysis- Feasibility Study Report
Before a project investment is finalized, the entrepreneur will conduct a feasibility study to
confirm about the techno-commercial strength of project and prepares a report called
feasibility study report. It is not very elaborate, but contains substantial information for
selection of the project. The report normally contains the following details:
(a) Study of the configuration of the project idea in all aspects
(b) Identifying the type and size of the project with justification
(c) Study of location
(d) Study of demand of products/services
(e) Survey of material requirements
(f) Project schedule
(g) Project cost and sources of finance
(h) Profitability and cash flow analysis
(i) Cost benefit analysis
(j) Identifying and quantifying risk element
(k) social costs and benefits
(l) Study of economic, political and legal environments

Prof. Soyeb Jindani & Dr. Nilesh Patel

Prof.V.B. Shah Institute of Management, Amroli
SFM/Unit 2/ Project Planning and Control/TYBBA Sem 5/Finance

The above report is also called 'pre-investment study report. It is prepared for establishing the
prima facie project's viability with sufficient backup for the purpose of evaluation of
investment proposal by the entrepreneur. This report is a base for preparation of detailed
project report:
2. Techno-Economic Analysis- It includes following TECHNICAL ASPECTS for the
project to be analyzed.
Selection of Project Location: The following are the factors generally considered for
selection of location for setting up of a Project:
Proximity of Inputs, Proximity of Market, Availability of Power, Availability of Water ,
Availability of Transportation, Communication Facilities, Government Policies, Manpower
Availability, Weather and Climatic Conditions, Environmental Factors and Other
Regulations, General Living Conditions, the cost of living, education, housing, medical,
transportation and Recreation facilities of the area will be considered for location selection of
a project.
Selection of Project Site & Checking of Soil/Topography Conditions.
Location refers to the broad area for setting up the industry, while site refers to a specific
piece of land where project would be set up. The following factors will influence in selection
of site:
Availability of land:
- Large to meet present requirements with provision for further expansion
- Proper layout of plant and equipment must be possible
- Land should be for industrial use
Cost of site depends upon:
- Proximity to city
- Industrial area developed by Government etc.
Cost of site preparation and development depends on:
- Physical features of the site
- Getting utility connections like power, water etc.
- Railway siding, feeder/approach roads facility for disposal of effluents etc.
Topography means formation of soil and its contour. If topography is much undulating, it
needs big quantity of cutting of earth and filling of earth and also dressing. If soil of
topography is not favourable, the project cost may go up and also may delay the project to
make it set right. If the soil strength is not enough there may be extra burden due to laying of
heavy foundation. In case the machines are light even the low-soil strength would be
adequate. If the soil is rocky and has got enough bearing capacity and low foundation cost,
otherwise it requires the leveling of land which would be too costly.
Choice of Technology: The task to identify the plant and machinery begins with selection of
a particular technology. The following factors will influence in the choice of technology:
Plant Capacity, Principal, Inputs Investment Outlay and Production Costs, Way by other
units, Product Mix, Latest, Developments Ease of Absorption appropriateness.
3. Project Design and Network Analysis
Preparation of Work Breakdown Structure, Network Diagram (PERT & CPM), CAT
and RAT Schedule: The total project work is broken down according to the various
components and will establish the connection between various components is termed as work
breakdown structure. The project work is divided into logical series of smaller tasks. This
facilitates efficient planning and execution of project as well as exercise of project cost
control. The work breakdown structure helps in construction of network diagrams under

Prof. Soyeb Jindani & Dr. Nilesh Patel

Prof.V.B. Shah Institute of Management, Amroli
SFM/Unit 2/ Project Planning and Control/TYBBA Sem 5/Finance

PERT (Program Evaluation and Review Technique) and CPM (Critical Path Method). It
includes preparation of Project Schedule using different methods like CAT Schedule
(Committed Activity Target Schedule) & RAT (Reserved Activity Target Schedule), Line of
Balance.
4. Input Analysis- Input includes Raw Materials and Human Resources. Input analysis
includes recurring and non-recurring resources requirement of project. It will aid in
assessment of project cost which is necessary for financial analysis or cost-benefit
analysis of project.
5. Financial Analysis - Preparation of Feasibility Report- Financial Closure- The
entrepreneur will prepare and submit a detailed project report called „techno-
economic feasibility report to the financial institutions for obtaining term loans for
project financing. On the basis of the said report, he will obtain the governmental
clearances, statutory permissions. After the necessary government clearances
obtained, he will start negotiating with the financial institutions for financing the
project. Once the financial institutions decide to finance the project, he will enter into
necessary agreements for funding the project. Such loan agreements will contain the
terms and conditions of sanctioning the term loans and terms about the share of
promoter‟s contribution. After entering into loan agreements, the project in all aspects
is ready for implementation and this state of readiness for monetary support of project
is called „financial closure‟.
6. Cost- Benefit Analysis: CBA conducts a monetary assessment of the total costs and
revenues or benefits of a project, paying particular attention to the social costs and
benefits.
7. Pre-Investment Analysis: Pre-Investment appraisal is to present a project idea in a
form in which the project sponsoring body, project implementing body can take an
investment decision regarding the project.
(C) Selection: Selection is the stage where project is chosen based on project
appraisal depending upon cost-benefit analysis. Once the project is selected following
important work can be conducted for implementation of project.
Setting up of Zero Date: Zero date of a project means a date is fixed up from which the
implementation of the projects begins. The progress in implementation of the project is
monitored by taking zero date as a base For counting the time as well as cost of project. Zero
date is also taken as starting point for incurring cost on project, cost monitoring, technical
parameters of the project, infrastructure facilities, formation of a company, governmental
clearances etc. From the zero date, the project is monitored to see whether the project is
progressing as per schedule of implementation. The project completion date is counted from
the zero date. The clock starts ticking from zero date. All those activities which are to be
completed before zero date are called „pre-project activities.‟ The project implementation
schedule is normally fixed up in terms of months. In case of very short term projects,
planning can be done in terms of weeks.
Project Procedure Manual: A project procedure manual is required to coordinate the
various subsystems like contract management, configuration management, time management,
cost, fund, materials, men and communications management. This manual is prepared in such
a way that the interacting agencies are able to see their roles and mutual relationships in
pursuance of the common goal.

Prof. Soyeb Jindani & Dr. Nilesh Patel

Prof.V.B. Shah Institute of Management, Amroli
SFM/Unit 2/ Project Planning and Control/TYBBA Sem 5/Finance

(D) Implementation: Implementation is the stage of allocating the resources for

commissioning the project. It includes some important concepts which can be applied
for better implementation of project.
Value Engineering Review: The primary focus of the concept is on the identification and
elimination of unnecessary function and thereby reduction of cost which do not add value.
The concept of value engineering can be adopted at the project implementation stage itself by
examining the working of plant, various systems and subsystems in it.

(E) Review
It is a process of comparing of all stages of implementation with what had been planned.
Techniques like Variance and Performance analysis, Time and Cost Trade off, Monitoring of
Capital Expenditure etc. are useful for review and control of project. Further it is useful in
making correction in deviations or defects. It includes submission of various progress reports
to financial institutions.

Cost Benefit Analysis:

Introduction:
Cost benefit analysis (CBA) is a more sophisticated technique recently introduced in long-
term decision making in capital projects appraisal. It is the measurement of resources used in
an activity and their comparison with the value of the benefit to be derived from the activity.
CBA conducts a monetary assessment of the total costs and revenues or benefits of a project,
paying particular attention to the social costs and benefits which do not normally feature in
conventional costing exercises. The underlying object of CBA is to identify and quantify as
many tangible and intangible costs and benefits as possible. The aim is then to see a strategy
which achieves the maximum benefit for the minimum cost. Only where benefits exceed
costs, a project can be undertaken. CBA has been used in its more specialized sense to
describe techniques for making investment decisions in a non-profit making organizations.

Meaning: CBA is defined as “an analytical tool in decision making which enables a
systematic comparison to be made between the estimated cost of undertaking of project and
the estimated value and benefits which may arise from the operation of such a project.”
CBA is used to determine:
(a) Whether or not a specific operation should be undertaken?
(b) Which of the possible alternative projects should be selected?
(c) Which time cycle would be most beneficial to the project?
CBA Procedure
In seeking to help public organizations and nationalized industries in investment decisions,
cost benefit analysis serves as a means of establishing the factors which need to be taken into
account when making the investment choices. The objective of private concern is one of
profit maximization. In the public sector, the objective is the maximization of social welfare.
A suggested procedure for embarking on a CBA study is as follows:

Determine Problem to be considered – It is important to establish at the outset exactly what

is being attempted and, if possible, to establish the objectives and possible advantages
of pursuing such a scheme. In the case of large scale investments, the number of
people and groups affected is likely to be large and it must be recognized that the
effects may be direct or indirect, but for CBA both must be taken into account. The
costs and benefits which accrue to bodies other than the one sponsoring the project is
Prof. Soyeb Jindani & Dr. Nilesh Patel
Prof.V.B. Shah Institute of Management, Amroli
SFM/Unit 2/ Project Planning and Control/TYBBA Sem 5/Finance

termed as externalities. An essential difference between CBA and private sector

project appraisal is that the former takes full account of such externalities in
establishing a net present value for a project.
Ascertain Alternative Solutions to Problem – It may be that there is only one solution to
the problem, in such case there will be a simple go-ahead/not go-ahead decision.
However, in most of the cases there will be alternative possibilities. At this stage it is
essential to establish the existence of any constraints, because these will be the key
factors in solutions. Constraints are those factors which inhibit or even prohibit
certain actions, for example legal constraints will restrict setting up of a certain
project e.g. under „green belt‟ regulations while financial constraints may inhibit
projects involving expenditure above a certain limit.
Estimate and Analyze Costs and Benefits -This is the stage of the analysis which involves
most work. Having identified all the affected parties, the projects influence on their
welfare must be expressed in monetary terms, as it would be valued by them. There
are a few costs/benefits which cannot be valued in this way and they remain as
separate issues for consideration when the final decisions on the project are made. In a
capital budgeting decision costs and benefits will be specific to the company
concerned. It is not particularly interested in costs and benefits which may accrue to
any one outside the company. However, in CBA we are interested in all the costs and
benefits, in other words we are considering a wider spectrum.
Appraise Estimated Costs and Benefits-This stage is probably the most difficult, but most
crucial one. The problems inherent in forecasting are considerable and particularly in
projects which have a long time cycle the problem of forecasting costs and revenues is
of some magnitude. However, there is the added problem in CBA of calculating to
social costs and benefits. An attempt must be made to quantify these items, although
in many cases this may prove to be virtually impossible. Any evaluation of social
costs must be subjective or relative, but atleast it is a guide to the decision-maker.
Decide on Optimal Solution-The estimated costs and benefits for each alternative solution
have been computed and presented to management for decision making.

Benefits and Limitations of CBA

Benefits
1. CBA can be used simply to ensure that value for money is obtained from a project
which requires the investment of funds.
2. It can and does go beyond this by providing a basis for assessing the merits of
different projects in terms of the benefits they produce and the costs that will be
incurred.
3. CBA studies attempt to allow for social costs and benefits. And as there are a feature
of most, if not all, public sector projects, the discipline of trying to apply a consistent
method of measurement in these areas should help to produce better decisions which
take important subjective factors into account. The difficulty is, of course, placing
realistic values on such things as good health, quiet houses or protection from a
potential enemy.
4. CBA have sometimes attempted the impossible and the task of listing relevant costs
and benefits if in itself a valuable discipline.
Limitations
1. CBA study is limited by the accuracy of data input. Not only are estimated costs and
benefits difficult to forecast, but often they are even more difficult to quantify.
2. It is clear that CBA is simply a special form of capital budgeting which is applicable
to the public sector. In view of the problems that can be encountered both in
Prof. Soyeb Jindani & Dr. Nilesh Patel
Prof.V.B. Shah Institute of Management, Amroli
SFM/Unit 2/ Project Planning and Control/TYBBA Sem 5/Finance

determining the value of the costs and benefits and in fixing a social rate of discount,
it is a method which must be used with great care.
3. Because a number of effects of a project may be unquantifiable, subjective judgment
will also be an important part of cost-benefit analysis, but despite these drawbacks it
must still be recognized that in standardizing procedures for public sector project
appraisal, the technique makes a significant contribution towards improved decision-
making.

Social Cost Benefit Analysis

Social cost‟ is a sacrifice or detriment to society. Whether economic, internal or external,
social costs are the sacrifices of the society for which the business firm is responsible like air-
pollution, water pollution, deficiency due to bankruptcy, depletion and destruction of animal
resource, soil erosion, deforestation, impairment of human factor of production, monopoly
and social losses, production of dangerous products and explosives, deterioration in the law
and order conditions in the industrial estates etc. Social benefit‟ is a compensation made to
the society in the form of increase in per capita income, employment opportunities, etc.
Social cost benefit analysis (SCBA) is a systematic evaluation of an organization‟s social
performance as distinguished from its economic performance. It is concerned with the
possible influences on the social quality of life instead of economic quality of life. It analyses
all such activities which have a social or macro impact. The development of an economy not
only depends on the quantum of investment but also on the rational and prudent allocation of
resources among various competing projects. The technique is most popular for making
socially viable decisions of selection or rejection of projects is based on an analysis of social
costs and social benefits of projects. In other words, social cost-benefit analysis is an
important technique of comparing economic alternatives. It is used to determine, (a) which
alternative or choice is socially viable (or most suitable) and (b) which alternative is the
optimal or the best solution. The need for SCBA arises due to the reason that the criterion
used to measure commercial profitability that guides the capital budgeting in the private
sector may not be an appropriate criteria for public or social investment decisions. Private
investors are more interested in minimizing the private costs and therefore, take into account
only those elements which directly affect their private gain i.e. private expenses and private
benefits. Both the private benefits and private expenses are valued at prevailing market
prices. But the existence of externalities in benefits and expenses introduces bias in market
price based investment decisions. The total benefits expected from a project to the society are
composed of the private benefits (internal profit or returns) accruing to owner of the project
plus the external benefits (also known as externalities or spillovers). Thus social benefits or
returns equals to internal benefits to the owner plus the external benefits to the society as
whole.
SCBA is a systematic evaluation of an organization‟s social performance as distinguished
from its possible inferences on the social quality of life instead of economic quality of life. It
analyses all such activities which have a social or macro impact. The development of an
economy not only depends on the quantum of investment but also on the rational and prudent
allocation of resources. The technique is most popular for making socially viable decisions of
selection or rejection of projects based on an analysis of social cost and social benefits of
projects. As an aid to planning, evolution and decision making, the cost-benefit analysis is a
scientific quantitative appraisal of a project to determine whether the total social benefits of
the project justify the total social cost. United Nations Industrial Development Organization
(UNIDO) and Organization of Economic Cooperation and Development (OECD) have
extensively conducted studies on SCBA.

Prof. Soyeb Jindani & Dr. Nilesh Patel

Prof.V.B. Shah Institute of Management, Amroli
SFM/Unit 2/ Project Planning and Control/TYBBA Sem 5/Finance

Project Appraisal Techniques:

Techniques of CBA
The decision maker will evaluate the project in any of the following manner:
A. Discounted Cash Flow Techniques For a private sector project, the rate of discount
is the marginal or weighted average cost of capital for the business. In the public
sector, the selected rate of discount must reflect the cost of investment funds to
society as a whole, so it is generally referred to as „social rate of discount. This is
complex because, in selecting a discount rate, one is effectively placing a value on
consumption in the future relative to consumption today. If the government spends
Rs. 2 crores on constructing new hospitals, that Rs. 2 crores will provide better
medical care facilities at the sum invested, which could, for example have been used
to reduce the rate of income-tax. As a simple way out of the problem, the discount
rate could be set at the market rate of interest on long-term risk free investments such
as gilt-edged securities. In practice, the market interest rate does not necessarily
reflect the value to society of investment. A market interest rate, therefore, forms the
starting point for determining a social rate of discount and this will then be adjusted to
a level which ensures an optimal consumption: investment ratio; this optimum is
government determined.

 Net Present Value (NPV)

This is a discounted cash flow technique and thus it attempts to consider the
time value of money, i.e. Re.1 today is of more value than Re.1 tomorrow. It
discounts future earnings to make them comparable with present investment.
This is done using standard DCF procedures on the familiar equation.
𝐵−𝑐
NPV = (1+𝑟)𝑛
Where, B Sum of the benefits of the project C = Sum of the costs of
the project
r = Social rate of discount Expected project life n = Expected
project life

NPV is a widely used technique in decision-making and is particularly useful

when considering cash flows over a relatively long time cycle.

 Internal Rate of Return (IRR)

This is also discounted cash flow technique and is sometimes referred to as the
„trial and error‟ technique. Unlike NPV technique, it does not have an
accepted discount or cut-off rate, but it calculates a discounted rate at which
the cash outflows are equated with the cash inflows. Thus if Rs. 100 is to be
earned in one year from the investment in a machine which ho will cost Rs.
1,000 now, then the I.R.R. is
𝑅𝑠. 100
× 100 = 10%
𝑅𝑠. 1,000

I.R.R. is not as popular as N.P.V. because of inherent mathematical

complications which may arise when solving the rate. The project is
acceptable under NPV method if there is a positive return by a project after

Prof. Soyeb Jindani & Dr. Nilesh Patel

Prof.V.B. Shah Institute of Management, Amroli
SFM/Unit 2/ Project Planning and Control/TYBBA Sem 5/Finance

discounting benefits and costs at given rate. The project is acceptable under
IRR if the rate of return after discounting benefits and costs is greater than the
cost of capital.
B. Benefit/Cost Comparison The estimated benefits and the estimated costs which may
arise from undertaking a project are compared and the project is undertaken if benefits
are considered to be greater than costs. The method is clearly unsatisfactory because it
does not allow for time value of money, i.e. it does not consider that Re.1 received
today is better than Re. 1 to be received next year. Another problem with this method
is that it does not give much guidance to the decision makers because the figures are
not relative, e.g. it may show that projects A and B are expected to produce a return of
Rs. 5,000 and Rs. 1,000 respectively, which makes project A look satisfactory until it
is revealed that investment in A is Rs. 1,00,000 while that in B is only Rs. 5,000.

C. Benefit/Cost Ratio This is a ratio which assesses estimated benefits as a ratio to

estimated costs. If the resulting figure is greater than I it is positive and if less than 1 it
is negative. It suffers from the same fault as (b) above regarding the lack of
consideration of the time value of money, but it does produce relative figures enabling
comparisons between projects to be made. However, it can also be used after
discounting cash flows, which makes it much more useful because the benefit/ cost
used in the calculation will have been based on discount rates.

Appraisal by Financial Institutions:

Meaning: Project appraisal is the process by which a financial institution makes an
independent and objective assessment of the various aspects of the investment proposition for
arriving at a financing decision.
There are four broad aspects of appraisal: (1) Financial feasibility, (2) Technical feasibility.
(3) Economic feasibility, and (4) Management competence.
(1) Financial Feasibility
The basic data required for a financial feasibility analysis can be grouped as under:
i. Cost of project and means of financing
ii. Cost of production and profitability
iii. Cash flow estimates during the period of loans outstanding
iv. Proforma balance sheets as at the end of each financial year during the period of loan.
Cost of Project The cost of the project can be broadly classified into the following:
a. Land and Site Development - It includes the cost of the land, conveyance expenses,
premium payable on leasehold land, cost of levelling the site and other site
development expenses, cost of internal roads, cost of fencing and compound wall and
cost of providing gates etc.
b. Buildings and Civil Works - It includes construction cost of main factory building,
building for auxiliary services, factory administrative building, storehouse,
workshops, godowns, warehouses, open yard facilities, canteen, workers rest rooms,
sanitary works, staff quarters etc.
c. Plant and Machinery - It includes the cost of main plant and machinery, stores and
spares, auxiliary equipment, transportation cost, installation cost, cost of testruns,
foundation cost, cost of erection and commissioning.
d. Technical know-how and Engineering Fees - It includes fees payable to provide the
technology and know-how and travelling expenses payable to technicians and foreign
collaborators etc.

Prof. Soyeb Jindani & Dr. Nilesh Patel

Prof.V.B. Shah Institute of Management, Amroli
SFM/Unit 2/ Project Planning and Control/TYBBA Sem 5/Finance

e. Miscellaneous Fixed Assets - It includes the cost of office furniture and equipment
like tables, chairs, air conditioners, water coolers, miscellaneous stores items etc.
f. Preliminary and Pre-operative Expenses - The preliminary expenses includes the cost
of raising finances like public issue expenses, commission and fees payable to brokers
and consultants in raising term-loans, expenses incurred for incorporation of the
company, legal charges, underwriters commissions, cost of advertising the public
issue etc. The pre-operative expenses include salaries, establishment expenses, rent,
trail-run expenses and other miscellaneous expenses incurred before the commercial
production.
g. Provision for Contingencies and Escalation - It includes the provision for meeting the
unforeseen expenses and costs not provided in the other heads of the cost of the
project. It also includes the cost of escalation of the major heads of cost like land and
site development, building and civil works, plant and machinery, technical know-how
fees etc.
h. Working Capital Margin - The working capital margin required for the project, which
is not being financed by the banks, will also be included in the cost of project.
Though machinery cost often constitutes a major element in the total project cost, its
estimation need not pose major problems since this can be based on competitive quotations.
On the other hand, cost of items such as land, site development expenses, ancillary facilities
like power and water connections, intangibles like preliminary expenses and pre-operative
expenses, necessitate a careful inquiry and assessment. A realistic assessment of project cost
with built in cushions (say a reasonable contingency margin) for absorbing normal cost
escalations, could take care of the consequences of delay and cost overrun.
Means of Financing There is no ideal pattern concerning means of financing for a project.
The means of financing is determined by a variety of factors and considerations like
magnitude of funds required, risk associated with the enterprise, nature of industry, prevailing
taxation, laws etc. The following are the sources of finance:
A. Share capital
B. Subsidies
C. Long-term borrowing from financial institutions and banks
D. Loans from friends and relatives
E. Retained earnings
Financial institutions specify certain debt-equity ratios and promoters will have to raise own
finances to match these ratios.
Cost of Production and Profitability The next step is the assessment of the earning capacity
of the project. The unit should be in a position to manufacture the product at a reasonable cost
and sell them at a reasonable price which would allow adequate profit margin even in a
competitive market. The profitability of an enterprise depends on the total cost of production
and the aggregate sale price of the output. The cost of production and sale estimates are also
useful in working out the break-even point, the point at which the income from sales would
cover the working costs of the project. At this point the unit begins to make profit.
Cash flow Estimates The cash flow estimates are essential to ensure availability of cash to
meet the requirements of the project from time to time. The cashflow estimates will show the
sources of funds including those arising from depreciation and profits as well as uses of funds
including repayment of term loan instalments. The debt service coverage ratio is arrived at by
dividing cash accruals comprising net profits (after taxes, interest on term loans and
depreciation added back) by total interest charges and instalments. This will indicate whether
the cashflow would be adequate to meet the debt obligations and also provide sufficient
margin of safety, the repayment of term loans being drawn taking into consideration the
above aspect.
Prof. Soyeb Jindani & Dr. Nilesh Patel
Prof.V.B. Shah Institute of Management, Amroli
SFM/Unit 2/ Project Planning and Control/TYBBA Sem 5/Finance

Proforma Balance Sheets Proforma balance sheets are drawn for existing concerns going for
expansion, as well as, for new projects. However in the case of existing concerns going for
expansion, the balance sheets for the past three years are also analyzed and compared, with
the projections. The projected balance sheets can be drawn for the cashflow estimates and
profitability projections. Various ratios are derived from the balance sheets and inferences
drawn therefrom.

(2) Technical Competence

The technology may be indigenous or imported through foreign collaboration. In the case of
indigenous technology it should be ensured that suitable technical personnel are available.
For technology acquired through collaboration tie-ups, the key areas to be probed are:
a. The standing of the collaborators and past experience concerning tie-up arrangements
with them.
b. Adequacy of the scope and competitiveness of the terms of the collaboration in
relation to the requirements of the project, project engineering, equipment
specifications, drawings, process know-how, erection and commissioning of the plant,
trial-run operations and performance test, training facilities etc.
c. Performance guarantee and it's adequacy in relation to rated capacity of plant and
machinery.
d. Reasonableness of financial and other costs by way of down payment, royalties etc.
e. The cost of the project should provide for the know-how fee, training expenses,
foreign trips etc.
The project needs to be examined with particular reference to the following points regarding
the technical feasibility:
Location - The success of a project generally depends on its proper location yielding the
advantages of nearness to the sources of raw material, labour; availability of power
and transport facilities and market. The subsidies and other concessions available at
certain specified areas are to be compared with these basic infrastructure aspects.
Land and Building – The land should necessarily be sufficient to take care of future
expansion. If the land is on lease, the terms and conditions of the lease to be verified
and so also whether the municipal laws regarding construction of building are
complied. Actual plant lay out is to be studied before deciding on the size of the
building.
Plant and Machinery – The important aspect to be noted in examining the list of plant and
equipments is to ascertain the appropriateness of the process of technology, capacity
and the related sectional balances amongst various assembly lines. It has to be
ensured that the cost of equipment is based on proper quotations from suppliers and
that suitable provisions have been made for insurance, freight, duty and
transportation to site, erection charges and allied expenses. Adequate provision for
spare parts is also essential especially if the same have to be imported.

(3) Economic Feasibility

The economic feasibility basically deals with the marketability of the product. Basic data
regarding demand and supply of a product in the domestic market so also marginal and also
artificial. Man made shortages are not to be reckoned as genuine demand and the market
analysis is an essential part of a full appraisal. Projection or forecasting of demand is no
doubt a complicated matter but is of vital importance. Equally important is to examine the
sales promotion proposed by the enterprise and its adequacy.

(4) Managerial Competence

Prof. Soyeb Jindani & Dr. Nilesh Patel
Prof.V.B. Shah Institute of Management, Amroli
SFM/Unit 2/ Project Planning and Control/TYBBA Sem 5/Finance

The success of a business enterprise depends largely on the resourcefulness, competence and
integrity of its management. However assessment of managerial competence has to be
necessarily qualitative, calling for understanding and judgment. The managerial requirements
are the experience and capability of the principal promoters to implement and run the project.
The adequacy of the management set up for day to day operations like production,
maintenance, marketing, finance etc. and also the homogeneity of the management set up.
For a new entrepreneur it will always be advisable to build up a competent team of specialists
in the required discipline to join hands with an entrepreneur who has the requisite
organizational and managerial expertise in the implementation and operation of the project.

Project Appraisal under Inflationary Conditions

The project cash flows will arise over a period of time in future. Normally the cash flows are
estimated and projected income statement and balance sheet are prepared without considering
the uncertainty in projections due to inflation factor. But inflationary situation over the period
of projections will make us to take wrongful investment and financing decisions. Therefore it
is necessary to consider the following factors while project appraisal is made under
inflationary conditions:
(a) During periods of inflation all the input costs like raw material, wages, power,
establishment expenses will be escalated.
(b) Simultaneously the sales realization will also be higher, even though there is no
increase in the capacity utilization.
(c) The value of opening and closing stock of finished goods will also be required to
show at escalated cost due to increase in cost of production.

Prof. Soyeb Jindani & Dr. Nilesh Patel

Prof.V.B. Shah Institute of Management, Amroli
 STRAGTEGIC FINANCE MANAGEMENT _UNIT_4

CONCEPTUAL FRAMEWORK OF VALUATION

The term 'valuation' implies the task of estimating the worth/value of an asset, a security or a
business. The price an investor or a firm (buyer) is willing to pay to purchase a specific asset/
security would be related to this value. Obviously, two different buyers may not have the same
valuation for an asset/business as their perception regarding its worth/value may vary; one may
perceive the asset/business to be of higher worth (for whatever reason) and hence may be
willing to pay a higher price than the other. A seller would consider the negotiated selling price
of the asset/business to be greater than the value of the asset/business he is selling.

CHAPTER 4: VALUATION OF BUSINESS

4.1: MEANING AND NEED FOR VALUATION OF BUSINESS
Valuation is a process of appraisal or determination of the value of certain assets: tangible or
intangible, securities, liabilities and a specific business as a going concern or any company
listed or unlisted or other forms of organization, partnership or proprietorship.
‘Value’ is a term signifying the material or monetary worth of a thing, which can be estimated
in terms of medium of exchange. In other words, it is an assessment resulting in an expression
of opinion rather than arithmetical exactness. Business valuation requires a working knowledge
of a variety of factors, and professional judgment and experience.
This includes recognizing the purpose of the valuation, the value drivers impacting the subject
company, and an understanding of industry, competitive and economic factors, as well as the
selection and application of the appropriate valuation approach (es) and method(s). Recently,
valuation has become a source of political and economic debates in the wake of privatization
of state-owned enterprises. Many owners and managers often ask,” How much is our business
worth? And how much is theirs?”
Due to increasing sophistication in business and changing economic and social environment of
business, professional valuers face questions like:
1. “What is our business worth?”
2. “What is their business worth?”
3. “What is the right price of that company?”
4. “What is the right price of our company?”
Valuation of business plays a very vital role, therefore a business owner or individual may need
to know the value of a business. The fair market value standard consists of an independent
buyer and seller having the requisite knowledge and facts, not under any undue influence or
stressors and having access to all of the information to make an informed decision.
A business valuation is a complex financial analysis that should be undertaken by a qualified
valuation professional with the appropriate credentials. Business owners who seek a low-cost
business valuation are seriously missing out on the important benefits received from a
comprehensive valuation analysis and valuation report performed by a certified valuation
expert.

NAIRUTI SUNILKUMAR CHOKKAS

D.R PATEL and R.B PATEL COMMERCE COLLGE & BHANIBEN CHHIMKABHAI PATEL BBA COLLEGE
 STRAGTEGIC FINANCE MANAGEMENT _UNIT_4

These benefits help business owners negotiate a strategic sale of their business, minimize the
financial risk of a business owner in a litigation matter, minimize the potential tax that a
business owner or estate may pay in gift or estate tax as well as provide defence in an audit
situation.
The necessity for valuation arises for statutory as well as commercial reasons:
(i) Assessment under Wealth tax act, Gift tax act.
(ii) Formulation of scheme for amalgamation.
(iii) Purchase and sale of shares of private companies.
(iv) Raising loan on the security of shares.
(v) For paying court fees.
(vi) Conversion of shares.
(vii) Purchase of block of shares for the purpose of acquiring interest or otherwise in another
company.
(viii) Purchase of shares by the employees of the company where retention of such shares is
limited to the period of their employment.
(ix) Compensation to the shareholders by the government under a scheme of nationalization.
(x) Acquisition of shares of dissenting shareholders under a scheme of reconstruction.

Normally a stock exchange is the most common source of ascertaining the value of shares
especially for transactions involving small block of shares which are quoted on stock
exchanges. But stock exchange prices form an unreliable basis because prices on a particular
day are generally determined on the basis of demand and supply which are influenced by
factors outside the business.
The wide fluctuations in prices of shares at the stock exchange are the outcome of actions and
opinions of the private and institutional investors all over the country and indeed the world.
Thus the valuation of shares has to be done by the accountant by adopting sound and reasonable
basis of valuation.
The other key areas where valuation is needed are-
1. Mergers & Acquisitions: Valuation is an important aspect in M&A. It not only assists
business owners in determining the value of their business, but also helps them maximize value
when considering a sale, merger, acquisition, joint venture, or strategic partnership. Valuation
is often a combination of cash flow and the time value of money. A business’s worth is in part
a function of the profits and cash flow it can generate. As with many financial transactions, the
time value of money is also a factor. How much is the buyer willing to pay and at what rate of
interest should they discount the other firm’s future cash flows? Both sides in an M&A deal
will have different ideas about the worth of a target company: its seller will tend to value the
company at a higher price, while the buyer will try to acquire the company at the lowest price.

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2. Going Public: In general, when a new company goes for an Initial Public Offering (IPO),
for raising capital for setting up of business operations and to meet other long-term financial
requirements, in such a circumstance, a question arises as to how to evaluate the fair value of
the stock. The Indian Capital Market follows a free pricing regime and thus the accurate pricing
of an IPO is of immense importance. Example: The process of
going public often begins when a young company needs additional capital to grow its business.
In order to gain access to that capital, the firm will sometimes choose to sell an ownership stake
or shares of stock to outside investors. • IPO of Reliance Power in Year 2008: This IPO was
sold between January 15 and January 18 of 2008 and was subscribed about 70 times. Before
Coal India, this IPO enjoyed the status of the ‘biggest IPO ever’ title. But the Rs 11,560 crore
issue had another distinction
3. Dispute Resolution: Valuations are an increasingly important aspect of many commercial
disputes. Before deciding how to manage a dispute, it is necessary to determine the likelihood
of a successful outcome and the potential stake involved. Judicial precedents are also available
that affect the selection of valuation methodologies and applicability of discounts/ premiums.
For example, updating the current Market valuation for tax purposes, publication to outline
various dispute resolution mechanisms, including the availability of expert valuer conferencing
etc.

Business valuation methods

Earnings Measure on Cash Flow Basis (DCF Approach)
The P/E ratio approach, as a measure of valuation of equity shareholders wealth, is essentially
based on accounting profits/earnings. Normally, such earnings are either of the current year or
prospective earnings of the next year. The single year earnings can be camouflaged by either
recording revenues earlier or by postponing expenses. Ideally, valuation should be based on
the likely earnings of all the future years. The cash flow approach is superior to the accounting
profit approach. The discounted cash flow method is also driven by the firm's cash flow
generating ability in future years.
Discounted cash flow approach is used to evaluate capital expenditure proposals in terms of
their potential for creating net present value for the firm. The DCF approach is applied to the
entire business, which may consist of individual capital budgeting projects. Accordingly, the
value of business/firm is equal to the present value of expected future cash flows (CF) to the
firm, discounted at a rate that reflects the riskiness of the cash flows (k). In equation terms:
Value of firm, = ∑CF to Firmt/(1+k0)t
To use the DCF approach, accounting earnings (as shown by the firm's income statement) are
to be converted to cash flow figures as shown in Format 1.

FORMAT 1 Computation of Cash Flows

After tax operating earnings*
Plus: Depreciation

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Plus: Other non-cash items (say, amortisation of non-tangible asset, such as patents, trade
marks, etc and loss on sale of long-term assets)
*The interest costs are included as a part of the discount rate (K).
However, analysts/valuers prefer to discount expected future free cash flows (FCFF) to
operating cash flows (as per Format 1) for the purpose of firm valuation. The reason is that
firms, in general, are required to make investments in long-term assets as well as in working
capital to generate/earn future cash flows; hence, the need for adjusting operating cash flows
to free cash flows.
Above Format 1 shows computation of operating free cash flows (OFCF) for the purpose of
valuation of a business.

FORMAT 2 Determination of Operating Free Cash Flows (OFCFF)

After tax operating earnings*
Plus: Depreciation, amortisation and other non-cash items
Less: Investments in long-term assets
Less: Investments in operating net working capital**
Operating free cash flows (OFCFF)
*Exclusive of income from (i) marketable securities and non-operating investments and (ii)
extraordinary incomes or losses.
**Addition is to be made in the event of decrease of net working capital.

The free cash flow (FCFF) is the legitimate cash flow for the purpose of business valuation in
that it reflects the cash flows generated by a company's operations for all the providers (debt
and equity) of its 'capital. The FCFF is a more comprehensive term as it includes cash flows
due to after tax non-operating income as well as adjustments for non-operating assets. Format
32.3 exhibits the procedure of determing FCFF.

FORMAT 3 Determination of Free Cash Flows (FCFF)

Operating free cash flows (as per Format 2)
Plus: After tax non-operating income/cash flows Plus: Decrease (minus increase) in non-
operating Assets, say marketable securities
Free cash flows to Firm (FCFF)
Non-operating income (1 tax rate)

Since the FCFFs are available to all the capital providers of a corporate enterprise, the discount
rate to be applied to such cash flows should be indicative of the opportunity cost of the funds
made available by them, weighted by their relative contribution to the total capital of a
corporate enterprise. The opportunity cost is equivalent to the rate of return the investors expect
to earn on other investments of equivalent risk. The cost to the firm equals the investors' cost
less any tax benefits received by the company itself (say, tax advantage on the payment of

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interest) plus any tax payments required to be made (say, dividend payment tax), The value of
the firm is given by Equation
Value of firm0 = Σ. FCFF to all investorst / (1 + K0)t
Thus, the value of a firm is the present value of FCFF through infinity. The equity valuation
can be deduced by subtracting the total external liabilities (debtholders and preference
shareholders) from the value of the firm. Alternatively, the value of equity can be obtained,
straight way, by discounting future free cash flows available to equity-holders, (FCFE), after
meeting interest, preference dividends and principal payments, the discount rate being rate of
return required by equity investors, that is, cost of equity (k)
Valuation of equity = Σ FCFE to equityholderst/(1+ke)t
Thus, there are varying connotations of FCFF to serve different needs. However, while the
valuation of a firm and equity use different definitions of FCFF as well as of discount rates,
they provide identical answers as long as the same set of assumptions is used in both the
equations.

4.2: MEANING OF ENTERPRISE VALUE

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4.3: MEANING OF EQUITY VALUE

Equity value, commonly referred to as the market value of equity or market capitalization, can
be defined as the total value of the company that is attributable to equity investors. It is
calculated by multiplying a company’s share price by its number of shares outstanding.
Alternatively, it can be derived by starting with the company’s Enterprise Value as shown
below.

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4.4: DISCOUNTED CASH FLOW METHOD

The discounted cash flow (DCF) formula is equal to the sum of the cash flow in each period
divided by one plus the discount rate (WACC) raised to the power of the period number.
Here is the DCF formula:

Where:
CF = Cash Flow in the Period
r = the interest rate or discount rate
n = the period number
There are two methods for DCF: -
In DCF, two different cash flows can be used:
1) free cash flow to firm (FCFF: calculation we will see further)
2) free cash flow to equity

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WACC calculation has been covered in chapter 2- cost of capital.

4.5 FREE CASH FLOW TO FIRM

• FCFF, or Free Cash Flow to Firm, is the cash flow available to all funding providers
(debt holders, preferred stockholders, common stockholders, convertible bond
investors, etc.).
• This can also be referred to as unlevered free cash flow, and it represents the surplus
cash flow available to a business if it was debt-free.
• A common starting point for calculating it is Net Operating Profit After Tax (NOPAT),
which can be obtained by multiplying Earnings Before Interest and Taxes (EBIT) by
(1-Tax Rate).
• From that, we remove all non-cash expenses and remove the effect of CapEx and
changes in Net Working Capital, as the core operations are the focus.

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Other methods of FCFF calculation are:

IMPORTANT POINTS:
• DCF value is a sum of present value of CF of a certain period (10 years generally)
and present value of terminal value.
• Terminal value = Projected cash flow for final year (1 + long-term growth rate) /
(discount rate - long-term growth rate) [Gordon Growth Model]
• FCFF (Free Cash Flow to the Firm): A measure of financial performance that
expresses the net amount of cash that is generated for the firm, consisting of
expenses, taxes and changes in net working capital and investments.
• FCFE (Free Cash Flow to Equity): A measure of how much cash can be paid to the
equity shareholders of the company after all expenses, reinvestment and debt
repayment.

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Different Terminologies
Evidently, there are unavoidable subjective considerations involved in the task and process of
valuation. Inter-se, the task of business valuation is more awesome than that of an asset or an
individual security. In the case of business valuation, the valuation is required not only of
tangible assets (such as plant and machinery, land and buildings, office equipments, and so on)
but also of intangible assets (like, goodwill, brands, patents, trademark and so on) as well as
human resources that run/manage the business. Likewise, there is an imperative to take into
consideration recorded liabilities as well as unrecorded/contingent liabilities so that the buyer
is aware of the total sums payable, subsequent to the purchase of business. Thus, the valuation
process is affected by subjective considerations. In order to reduce the element of subjectivity,
to a marked extent, and help the finance manager to carry out a more credible valuation exercise
in an objective manner, the following concepts of value are explained in this Section: (i) book
value, (ii) market value, (ili) intrinsic value, (iv) liquidation value, (v) replacement value, (vi)
salvage value, (vii) value of goodwill and (viii) fair value.
Book Value
The book value of an asset refers to the amount at which an asset is shown in the balance sheet
of a firm. Generally, the sum is equal to the initial acquisition cost of shown in balance an asset
less accumulated depreciation. Accordingly, this mode of valuation of ass is as per the going
concern principle f accounting. In other words, book value of an asset shown in balance does
not reflect its current sale value. Book value of a business refers to total book value of all
valuable assets (excluding fiction assets, such as accumulated losses and deferred revenue
expenditures, like advertisement, nary expenses, cost of issue of securities not written off less
all external liabilities (including preference share capital). It is also referred to as net worth.
Market Values
In contrast to book value, market value refers to the price at which an asset can be sold in the
market. The market value can be applied with respect to tangible assets only; intangible assets
(n isolation), more often than not, do not have any sale value. Market value of a business refers
to the aggregate market value (as per stock market quotation) of all equity shares outstanding.
The market value is relevant to listed companies only.
Intrinsic/Economic Value
The intrinsic value of an asset is equal to the present value of incremental future cash inflows
likely to accrue due to the acquisition of the asset, discounted at the appropriate required rate
of Intrinsic return (applicable to the specific asset intended to be purchased). It represents the
(economic) value maximum price the buyer would be willing to pay for such an asset. The
principle of is the present valuation based on the dis-counted cash flow approach (economic
value) is used in value of incre- capital budgeting decisions.
In the case of business intended to be purchased, its valuation is equivalent to the present value
of incremental future cash inflows after taxes, likely to accrue to the acquiring firm, discounted
at the relevant risk adjusted discount rate, as applicable to appropriate the acquired business.
The economic value indicates the maximum price at which discount rate. the business can be
acquired.

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Liquidation Value
As the name suggests, liquidation value represents the price at which each individual asset can
be sold if business operations are discontinued in the wake of liquidation of the firm. In
operational terms, the liquidation value of a business is equal to the sum of (i) realisable value
of assets and (ii) cash and bank balances minus the payments required to discharge all external
liabilities. In general, among all measures of value, the liquidation value of an asset/or business
is likely to be the least.
Replacement Value
The replacement value is the cost of acquiring a new asset of equal utility and usefulness It is
normally useful in valuing tangible assets such as office equipment and furniture and fixtures,
which do not contribute towards the revenue of the business firm.
Salvage value
Salvage value represents realisable/scrap value on the disposal of assets after the expiry of their
economic useful life. It may be employed to value assets such as plant and machinery. Salvage
value should be considered net of removal costs.
Value of Goodwill
The valuation of goodwill is conceptually the most difficult. A business firm can be said to
have real' goodwill in case it earns a rate of return (ROR) on invested funds higher than the
ROR eamed by similar firms (with the same level of risk). In operational terms, goodwill results
when the firm earns excess (super) profits, defined in this way, the value of goodwill is
equivalent to the present value of super profits (likely to accrue, say for 'n' number of years in
future), the discount rate being the required rate of return applicable to such business firms.
The value of goodwill in terms of the present value of super profits method can serve as a
useful benchmark in terms of the amount of goodwill the firm would be willing to pay for the
acquired business. In the case of mergers and acquisition decisions, the value of goodwill paid
is equal to the net difference between the purchase price paid for the acquired business and the
value of assets acquired net of liabilities the acquiring firm has undertaken to pay for.
Fair Value
The concept of 'fair' value draws heavily on the value concepts discussed above, in Fair value
particular, book value, intrinsic value and market value. The fair value is hybrid in nature and
often is the average of these three values. In India, the concept of fair book value, is the average
of value has evolved from case laws (and hence is more statutory in nature) and is market value
applicable to certain specific transactions, like payment to minority shareholders.
It may be noted that most of the concepts related to value are 'stock' based in that they are
guided by the worth of assets at a point of time and not the likely contribution they can make
towards earnings/cash flows of the business in the future. Ideally, business valuation should be
related to the cash flow generating ability of acquired business. The intrinsic value reflects the
firm's capacity to generate cash flows over the long-run and, hence, seems to be more aptly
suited for business valuation.

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In fact, in general, business firms are not acquired with the intent to sell their assets in the post-
acquisition period. They are to be deployed primarily for generating more earnings. However,
from the conservative point of view, it will be useful to know the realisable value, market value,
Tiquidation value and other values, if the acquiring firm has to resort to liquidation. In brief,
the finance manager will find it useful to know business valuation from different perspectives.
For instance, the book value may be very relevant form accounting/tax purposes; the market
value may be useful in determining share exchange ratio and liquidation value may provide an
insight into the maximum loss, if the business is to be wound up.
Earnings Measure on Cash Flow Basis (DCF Approach)
The P/E ratio approach, as a measure of valuation of equity shareholders wealth, is essentially
based on accounting profits/earnings. Normally, such earnings are either of the current year or
prospective earnings of the next year. The single year earnings can be camouflaged by either
recording revenues earlier or by postponing expenses. Ideally, valuation should be based on
the likely earnings of all the future years. The cash flow approach is superior to the accounting
profit approach. The discounted cash flow method is also driven by the firm's cash flow
generating ability in future years.
Discounted cash flow approach is used to evaluate capital expenditure proposals in terms of
their potential for creating net present value for the firm. The DCF approach is applied to the
entire business, which may consist of individual capital budgeting projects. Accordingly, the
value of business/firm is equal to the present value of expected future cash flows (CF) to the
firm, discounted at a rate that reflects the riskiness of the cash flows (k). In equation terms:
Value of firm= ∑ CF to Firm,
(1+k)t
To use the DCF approach, accounting earnings (as shown by the firm's income statement) are
to be converted to cash flow figures.

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SFM/Unit 5/ Corporate Restructuring and Industrial Sickness/TYBBA Sem 5/Finance

PROF. V.B.SHAH INSTITUTE OF MANAGEMENT,

AMROLI, SURAT

COURSE: B.B.A
T.Y.BBA (SEM –V)
Finance Specialization
SUBJECT: Strategic Financial Management
Faculty: Prof. Soyeb Jindani & Dr. Nilesh Patel

Unit 5: Corporate Restructuring and Industrial Sickness (20%)

Meaning and Reasons for Corporate Restructuring, Meaning, Process and Techniques Financial
Restructuring, Definition of Industrial Sickness as per Companies Act, 2013 and RBI, Causes of
Sickness, Prediction of Sickness: Multiple Discriminant Analysis(Z-Score Model with Numeric)

Meaning of Corporate Restructuring:

Corporate restricting defined as a process by which company can consolidate business operations and
strengthen its position for achieving the desired objectives and staying synergetic, competitive and
successful. This increases company’s market share, brand power.
Corporate restructuring can be defined as any change in the business capacity or portfolio that is
carried out by an inorganic route.
Following are points that describe fundamental concept of corporate restricting.
1. Restructuring means overall enterprise reorganizing, renewing all its functions.

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SFM/Unit 5/ Corporate Restructuring and Industrial Sickness/TYBBA Sem 5/Finance

2. Any change in the ownership of or control over the management of the company or a
combination of any two or all of the above.
3. Restructuring deals with the structure of company and usually associated with cultural change
due to it.
4. Restructuring is a process of making major change in size of business, technology, financial
portfolio of company.
5. Corporate restructuring is defined as the process involved in changing the organization of a
business.
6. It means a change in the business strategy of an organization resulting in diversification, closing
parts of the business etc. to increase its long-term profitability
7. Implies rearranging the business for increased efficiency and profitability.
8. It is a method of changing the organizational structure in order to achieve the strategic goals of
the organization or to sharpen the focus on achieving them.
9. It can involve making dramatic changes to a business by cutting out or merging departments
that often has the effect of displacing staff members.
10. It involves a process of consolidation or rearrangement in the organization and business
operations aimed at strengthening its financial position so as to achieve its short-term and long-
term business objectives in the competitive environment.
11. The alterations through corporate restructuring have a significant impact on firm's balance sheet
by redeploying assets or by exploiting unused financial capacity.
12. The corporate restructuring is a process by which a company can consolidate its business
operations and strengthen its position for achieving the desired objectives staying synergetic,
slim, competitive and successful.
13. The underlying object of corporate restructuring is efficient and competitive business operation
by increasing the market share, branch power and synergies.

Reasons for Corporate Restructuring:

Global Competition: Global market concept has necessitated many companies to restructure, because
lowest cost producers only can survive in the competitive global markets.
Synergy: If the resource of one company is merged with another company, it will result in higher
productivity. This effect will be termed as synergy 2+2 =5. E.g. company A with strong marketing set
up merges with co. B having strong research. Then the sales and profitability of combined firm will be
much higher than the sum of individual.
Government Regulations: The changed fiscal and government policies like deregulation/decontrol
have led companies to go for newer markets and customer segments.
Information Technology: Revolution in information technology has made it necessary for companies
to adopt new changes for improving corporate performance.
Wrong Segmentation: Many companies have divisionalized into smaller businesses, Wrong
divisionalization strategy has led to revamp themselves. Product divisions which do not fit into the
company's main line of business are being divested. Fierce competition is forcing the companies to
relaunch themselves.
Strengths & Weaknesses: The identification of strengths and weaknesses of the company is needed in
order to bring focus of the attention of top management to essential needs of the company.
Focus on Core Strengths: It needs to focus on core strengths, operational synergy and efficient
allocation of managerial capabilities and infrastructure.
Cost Reduction: Improved productivity and cost reduction has necessitated downsizing of the work
both works and at managerial level.
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Prof.V.B. Shah Institute of Management, Amroli
SFM/Unit 5/ Corporate Restructuring and Industrial Sickness/TYBBA Sem 5/Finance

Rupee Convertibility: The convertibility of a rupee has attracted medium-sized companies to operate
in the global markets, which requires reorganization of the firm to meet global competition.
Core Business: The competitive business necessitated to have sharp focus on core business activities,
to gain synergy benefits, to minimize the operating costs, to maximize efficiency in operation and to
tap the managerial skills to best advantage of the firm.
Economies of Scale: The consolidation of economies of scale by expansion and diversion to extended
domestic and global markets.
Revival of sick units: The Revival and rehabilitation of a sick unit by adjusting losses of the sick unit
with profits exploit of a healthy company. By restructuring the enterprise, a sick company can be
successfully revived and rehabilitated, and can be brought back to profitable lines.
Material and Technology: The acquiring constant supply of raw materials and access to scientific
research and technological developments.
Capital Restriction: The Capital restructuring by appropriate mix of loan and equity funds to reduce
the cost of servicing and improve return on capital employed.
Risk Minimization: By diversification of business activities, the minimization of business risks is
possible and it will enable the firm to achieve at least the minimum target rate of return.
Strategic tax Planning: With the integration of sick unit into the successful unit, the adjustment of
unabsorbed depreciation and write-off of accumulated loss is possible, there by the successful unit can
have strategic tax planning.
Cost of Capital: Corporate restructuring includes financial reorganization, by bring the company to
achieve a desired balance of debt and equity, thereby reduce the overall cost of capital and financial
risks.
Competition: The restructuring process will facilitate to have horizontal and vertical integration,
thereby the competition is eliminated and the company can have access to regular raw materials and
reaching new markets and accessibility to scientific research and technological developments.
Responsibility Accounting: The application of Information technology and responsibility accounting
concepts will facilitate to divide the total enterprise into strategic business units, a better way of
achieving the corporate goals.
Resource Utilization: It ensures optimum utilization of all resources such that profit centers and drain
centers are segregated so as to improve the efficiency and eliminate the losses and leakages.
Business Re-engineering: It facilitates re-engineer the manufacturing, industrial and commercial
operations in such a way that the cost of capital deployed for each of those operations studied,
quantified and reduced.

A model of Bowman and Singh identified following types of corporate restructuring:

1. Portfolio Restructuring: involves a reconfiguration of the company’s line of business through
merger/acquisitions (purchasing a new business) and divestiture/divestment (selling a part of
company). It involves following terms.
A. Mergers B. Acquisitions or takeover. C. Sell offs D. Spin offs (Split up, split off).E. Joint
Ventures and strategic alliances.

2. Financial Restructuring: involves altering its capital and ownership structure. It involves
following terms.
A. Re-purchase of equity shares from open market or private market.
B. Share Buyback via tender offer.
C. Offer to debt holders to become owners in time of financial troubles.
D. Existing company sold to third party involves management buy-outs (MBO) or Leveraged buy-
outs (LBO).
E. Stock Split ups
F. Bonus Shares
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Prof.V.B. Shah Institute of Management, Amroli
SFM/Unit 5/ Corporate Restructuring and Industrial Sickness/TYBBA Sem 5/Finance

3. Organizational or manpower restructuring: involves changes in structure of organization.

Following terms are related to it.
A. Downsizing: reduction in number of employees to cut the costs.
4. Technological Restructuring: This involves investment in research and development and also
alliances with overseas companies to exploit technological strengths.
5. Market Restructuring: This involves decisions regarding the product market segments where
the company plans to operate based on its core competencies.

Meaning of Financial Restructuring:

(a) It is also referred to as financial reorganization'.
(b) It can be affected by making change in the capital structure of a company for achieving a
balanced operative result.
(c) Financial restructuring involves restructuring of assets and liabilities of the company, in line
with their cash flow needs, in order to promote efficiency, support growth and maximize
value to shareholders, creditors and other stakeholders.
(d) It involves restructuring the assets and liabilities, debt/equity mix, ideal allocation of funds to
balance short-term and long-term requirements etc. for achieving efficiency, growth and
values to shareholders, creditors and all other stakeholders.
(e) It is resorted to
1. bring balance in debt and equity funds
2. bring balance in short-term and long-term financing
3. achieve reduction in finance charges
4. reduce cost of capital
5. increase EPS
6. improve market value of share
7. reduce the control of financiers on the management of the company etc.
(f) It will bring in change in capital structure, which depends on the following factors
1. Management control
2. Cost of different sources of capital
3. Flotation cost
4. Cost of servicing the equity and debt
5. Risk and return profile of the industry
6. Financial risks involved in debt financing
7. Flexibility in capital structure
8. Legal formalities etc.

Process /Steps of Financial Restructuring:

a. Valuation of Business: The valuation of business is carried out taking into account the current
business situation, prospective growth of business and its earning power. The valuation of a
company is done to implement the scheme of financial reorganization. The valuation of
company should be based on 'going concern' concept and should not be viewed from the angle
of liquidation.
b. Formulation of New Capital Structure: The reduction in total debt is brought by reducing of
fixed charges burden by bringing in the fresh equity or preference share capital. When the
equity is more, the cost of servicing the equity is also highest, can be reduced by relying on
debt whenever further position improves the company to strengthen its financial position from
unbalanced capital structure.

Prof. Soyeb Jindani & Dr. Nilesh Patel

Prof.V.B. Shah Institute of Management, Amroli
 SFM/Unit 5/ Corporate Restructuring and Industrial Sickness/TYBBA Sem 5/Finance

c. Exchange of Old securities for new securities: The old securities are valued its worth and are
exchanged for new securities with new obligations and rights and setup different combinations
of ordinary and preference shares, debentures and loan stock to recompensate various interests
in the former business. Creditors may take shares in settlement of their claims. Sometimes,
fresh shares may also be issued to mobilize funds for reorganized business situation.

Techniques of Financial Restructuring:

Introduction

Financial restructuring is the process of reshuffling or reorganizing the financial structure, which
primarily comprises of equity capital and debt capital. Financial restructuring can be done because of
either compulsion or as part of the financial strategy of the company. This financial restructuring can
be either from the assets side or the liabilities side of the balance sheet. If one is changed, accordingly
the other will be adjusted. The two techniques of financial restructuring are; (a) Debt restructuring
(b) Equity Restructuring
The poor capital structure may be due to:
 Project cost overrun
 Technological obsolescence
 Accumulated loss and unrepresented value of assets in balance sheet
 Insufficient working capital
 Financing of fixed assets with short-term funds
 Financing of current assets with long-term funds
 Investment in non-core business and assets which does not contribute to profitability
 Over gearing increases financial risk of the firm
 Operating profits insufficient to service debt
 Poor current ratio
 Inadequate return on capital employed
The financial reorganization scheme should able to minimize the cost of capital, maximize the return
on equity, increase EPS and market price of equity shares.

(A) Debt Restructuring:

Debt restructuring is the process of reorganizing the whole debt capital of the company. It involves
reshuffling of the balance sheet items as it contains the debt obligations of the company. Debt
restructuring is more commonly used as a financial tool than compared to equity restructuring. This is
because a company’s financial manager needs to always look at the options to minimize the cost of
capital and improving the efficiency of the company as a whole which will in turn call for the
continuous review of the debt part and recycling it to maximize efficiency.
Debt restructuring can be done based on different circumstances of the companies. These can be
broadly categorized in to 3 ways.

1. A healthy company can go in for debt restructuring to change its debt part by making use of the market
opportunities by substituting the current high cost debt with low cost borrowings.
2. A company that is facing liquidity problems or low debt servicing capacity problems can go in for debt
restructuring so as to reduce the cost of borrowing and to increase the working capital position.
3. A company, which is not able to service the present financial obligations with the resources and assets
available to it, can also go in for restructuring. In short, an insolvent company can go for restructuring
in order to make it solvent and free it from the losses and make it viable in the future.

Prof. Soyeb Jindani & Dr. Nilesh Patel

Prof.V.B. Shah Institute of Management, Amroli
 SFM/Unit 5/ Corporate Restructuring and Industrial Sickness/TYBBA Sem 5/Finance

Components of debt restructuring: The components of debt restructuring are as follows

 Restructuring of secured long-term borrowings: Restructuring of secured long-term borrowings will

be done for the following reasons such as reducing the cost of capital for healthy companies, for
improving liquidity and increasing the cash flows for a sick company and also for enabling
rehabilitation for that sick company.
 Restructuring of unsecured long-term borrowings: Restructuring of the long-term unsecured
borrowings will be done depending on the type of borrowing. These borrowings can be public deposits,
private loans (unsecured) and privately placed, unsecured bonds or debentures. For public deposits, the
terms of deposit can again be negotiated only if the scheme is approved by the right authority.
 Restructuring of secured working capital borrowings: Credit limits from commercial banks,
demand loans, overdraft facilities, bill discounting and commercial paper fall under the working capital
borrowings. All these are secured by the charge on inventory and book debts and also on the charge on
other assets. The restructuring of the secured working capital borrowings is almost all the same as in
case of term loans.
 Restructuring of other short term borrowings: The borrowings that are very short in nature are
generally not restructured. These can indeed be renegotiated with new terms. These types of short-term
borrowings include inter-corporate deposits, clean bills and clean over drafts.

(B) Equity restructuring is the process of reorganizing the equity capital. It includes reshuffling of
the shareholders capital and the reserves that are appearing in the balance sheet. Restructuring
of equity and preference capital becomes a complex process involving a process of law and is a
highly regulated area. Equity restructuring mainly deals with the concept of capital reduction.
The following are the some of the various methods of equity restructuring.

 Repurchasing the shares from the shareholders for cash can do restructuring of share capital. This
helps in reducing the liability of the company to its shareholders resulting in a capital reduction by
returning the share capital. The other method that falls in the same category is to change the equity
capital in to redeemable preference shares or loans.
 Restructuring of equity share capital can be done by writing down the share capital by certain
appropriate accounting entries. This will help in reducing the amount owed by the company to its
shareholders without actually returning equity capital in cash.
 Restructuring can also be done by reducing or waiving off the dues that the shareholders need to pay.
 Restructuring can also be done by consolidation of the share capital or by sub division of the
shares.
 Shares buyback:

A buy-back of shares means a purchase of by a company of its own shares or specified

securities. A company may resort to buy-back for a variety of reasons, e.g., excess floating
stock in the market, poor performance of the share, utilisation of excess cash with the
company, etc. Many times a company has excess cash on its balance sheet which it wants to
distribute amongst its shareholders. A buyback is one of the modes by which it can achieve
its objectives.

 Stock Splits:
 A Stock Split means division of an existing outstanding equity share into two or more
parts.
 Stock split adds no value but increases the number of shares in the ratio of the split.
 By Splitting of shares the capital of the company does not increase, but the capital is
only redistributed by increased number of shares.
Prof. Soyeb Jindani & Dr. Nilesh Patel
Prof.V.B. Shah Institute of Management, Amroli
 SFM/Unit 5/ Corporate Restructuring and Industrial Sickness/TYBBA Sem 5/Finance

 A stock split is usually done by companies that have seen their share price increase to
levels that are either too high or are beyond the price levels of similar companies in
that sector
 The Objective is to make shares seem more affordable to small investors even though
the underlying value of the company has not changed.
 Stock splits help to make shares more affordable to small investors and provide
greater marketability and liquidity in the market.
 With subdivision more shares will be in floating, thereby, increase liquidity of share.
 It also facilitates the small investors to hold the shares.
 Sometimes the management will resort to subdivision of shares to protect their
control over the firm in cases of hostile bids.

 Bonus Shares: Bonus shares are commonly called as “Scrip Dividends”.

 If a company is profit-making, its accumulated profits and reserves will go on
increasing.
 The actual capital employed i.e. share capital plus accumulated free reserves is much
higher than the amount of share capital.
 The profit earned might appear to be much higher as compared to share capital.
 To avoid this abnormality in capital structure, part of free reserves can be distributed
among the existing shareholders by issue of bonus shares.
 As a alternative to paying out cash dividends every year, a company may choose to
issue bonus shares.
 It involves issuing new shares on a pro rata basis to the current shareholders while
the firm’s assets, its earning, the risk being assumed and the investors percentage of
ownership in the company remain unchanged.
 When bonus shares are issued to shareholders, no money is received from them and
therefore the assets side of the balance sheet remains unaffected.
 On the liabilities side of the balance sheet the reserve is reduced by the amount of the
increase in the equity share capital.

Reasons behind equity restructuring: The following are the reasons for which equity restructuring is
done:

 Correction of over capitalization

 Shoring up management stakes
 To provide respectable exit mechanism for shareholders in the time of depressed markets by providing
them liquidity through buy back.
 Reorganizing the capital for achieving better efficiency
 To wipe out accumulated losses
 To write off unrecognized expenditure
 To maintain debt-equity ratio
 For revaluation of the assets
 For raising fresh finance.

Prof. Soyeb Jindani & Dr. Nilesh Patel

Prof.V.B. Shah Institute of Management, Amroli
SFM/Unit 5/ Corporate Restructuring and Industrial Sickness/TYBBA Sem 5/Finance

Introduction to Industrial Sickness:

Growing Importance of Industrial Sickness
(a) World over sickness in industries is a recognized fact. Often, It is inevitable for various
reasons. In all economies, business failure is a reality of commercial life
(b) The technological development render -
i. Old technologies obsolete
ii. Industrial recessions make some unviable
iii. International trade policies make some uncompetitive
iv. Tardy progress in some related sectors shrink markets for others
(c) These features of Industrial sickness are generally combated by
i. Closing down unviable units
ii. Adopting new technologies
iii. Diversifying products.
iv. Nursing a few that are victims of trade cycles till recoveries set in
v. Revive those that are sustainable with appropriate measures
(d) A sick unit incurs cash losses and fails to generate internal surplus on a
continuing bass
(e) There are different forms, varieties and degrees of industrial sickness.
(f) Various authorities have viewed industrial sickness differently but in sense and
substance their findings are more or less the same.
(g) Factually, no single factor is responsible for malady of industrial sickness.
Definition of Industrial Sickness as per Company Act 2013 and RBI:

 Definition of Sick companies and Industrial Sickness as per Company Act, 2013:

Sections 253(1) of the Companies act 2013 define “sickness as when on demand by the secured
creditors of a company representing the 50% or more of its outstanding amount of debt and the
company has failed to satisfy the secured creditor within 30days of the demand notice.”

In such instance any of the Creditor, may file an application before the Tribunal that company
may be declared as a sick company. The application shall be submitted with documentary
evidences for example any agreement of loan, demand notice, account statements etc.

The tribunal herein above mentioned is National Company Law Tribunal as defined in the section
2(90) of the Companies Act, 2013. “The tribunal shall declare a company as sick company within 60
days of the application.”

It is to be noted that under SICA there is no such provision with regard to sickness and instead of
Tribunal the authorities are BIFR/AAIFR.

 RBI’s Definition of Industrial Sickness:

There are various criteria of sickness. According to the criteria accepted by the Reserve Bank of India
“a sick unit is one which has reported cash loss for the year of its operation and in the judgment of the
financing bank is likely to incur cash loss for the current year as also in the following year.”

Causes of Industrial Sickness:

(A) Internal Causes
(I) Planning and Implementation Stage:
Technical Feasibility
Prof. Soyeb Jindani & Dr. Nilesh Patel
Prof.V.B. Shah Institute of Management, Amroli
SFM/Unit 5/ Corporate Restructuring and Industrial Sickness/TYBBA Sem 5/Finance

 Inadequate technical know-how

 Locational disadvantage
 Outdated production process
Economic Viability
 High cost of inputs
 Breakeven point too high
 Uneconomic size of project
 Underestimation of financial requirements
 Unduly large investment in fixed assets
 Overestimation of demand
 Cost over runs resulting from delays in getting licenses/sanctions etc.
 Inadequate mobilization of finance

(II) Commercial Production Stage:

Production Management
 Inappropriate product-mix
 Poor quality control
 Poor capacity utilization
 High cost of production
 Poor Inventory management
 Inadequate maintenance and replacement
 Lack of timely and adequate modernization
 High wastage of material in production process

Financial Management
 Poor resources management and financial planning
 Faulty costing
 Liberal dividend policy
 General financial indiscipline
 Application of funds for unauthorized purposes
 Deficiency of funds
 Overtrading
 Unfavourable gearing
 Inadequate working capital
 Absence of cost consciousness
 Lack of effective collection machinery

Personnel Management
 Excessively high wage structure
 Inefficient handling of labour problems
 Excessive manpower
 Poor labour productivity
 Poor labour relations
 Lack of skilled/technical competent personnel

Marketing Management
Prof. Soyeb Jindani & Dr. Nilesh Patel
Prof.V.B. Shah Institute of Management, Amroli
SFM/Unit 5/ Corporate Restructuring and Industrial Sickness/TYBBA Sem 5/Finance

 Dependence on limited number of customers

 Dependence on limited number of products
 Poor sales realization
 Defective pricing policy
 Booking large order at fixed price during inflation
 Weak market organization
 Lack of market feedback and market research
 Lack of knowledge of marketing techniques
 Unscrupulous sales/purchase practices
General Management
 Over centralization
 Lack of professionalism
 Lack of feedback to management
 Lack of proper management information systems
 Lack of controls
 Lack of timely diversification
 Excessive expenditure of R&D
 Divided loyalties
 Incompetent management
 Dishonest management
(B) External Causes of Industrial Sickness:
Infrastructure Bottlenecks
 Non-availability irregular supply of critical raw materials or other inputs
 Chronic power shortage
 Transport bottlenecks

Financial Bottlenecks
 Non-availability of adequate finance at the right time
 Non-cooperation from Banks and Financial Institutions

Government Controls
 Government price controls
 Improper fiscal duties
 Abrupt changes in Govt. policies affectingcosts/prices/imports/exports/licensing
 Procedural delays on the part of the financial/licensing/other controlling or regulating
authorities.
Market Constrains
 Market saturation
 Technological obsolescence
 Recession
 Fall in domestic/export demand
Extraneous Factors
 Natural calamities
 Political situation (domestic as well as international)
 Sympathetic strikes and Multiplicity of labour unions
 War

Prof. Soyeb Jindani & Dr. Nilesh Patel

Prof.V.B. Shah Institute of Management, Amroli
SFM/Unit 5/ Corporate Restructuring and Industrial Sickness/TYBBA Sem 5/Finance

Reasons for Business Failure

At one level, a company either ceases to trade because the bank or creditors stop it or voluntarily
ceases to trade and calls in the receivers or the administrators. In either case, action is taken
because the firm is unable to pay its debts or likely to be unable to pay in the near future. Why do
firms get into this situation? The accounts of the company do not cause it to go broke.
Rather, accounting information reveals what has gone wrong and there are two levels of cause (i) the
accounting manifestation (n) the root problem.
Accounting Manifestation of Failure

(a) Too much working capital

(b) Insufficient working capital
(c) Too high interest charges
(d) Too much debt
(e) Over & high dividends
(f) No cash
(g) Making a trading loss
(h) No growth
(i) Selling parts of the firm at a loss
(j) Very poor profit margins
(k) Marginal profitability
No one of these on its own is a cause of collapse, but when several appear together, the danger signs
are there.

Root Problems for Failure

(a) Not selling enough

(b) Not selling at the right prices
(c) Not modernizing
(d) No product development or research
(e) Buying useless assets
(f) Failure to control costs
(g) Failure to control working capital
(h) Reckless borrowing
(i) Having a cavalier dividend policy Detection of Incipient Sickness
The sickness creeps into the industrial unit in a gradual and slow moving process. If the incipient
sickness is not detected in its early stages, it becomes chronic over a period of time and ultimately
ends-up with closure of the unit, in terms of insolvency. The management is required recognize the
symptoms of sickness and set it right immediately to avoid the embracing financial situation in the
future, as well as, to save the unit from permanent closure. If necessary, the management should
engage the services of specialists for proper diagnosis of the situation. A planned course of action with
coordination and cooperation of all functions and staff can enable to counter the sickness. If
necessary, the real situation should be put before the stakeholders like shareholders, banks, financial
institutions, government, creditors etc. to bring the operation to the smooth-flow.

Prof. Soyeb Jindani & Dr. Nilesh Patel

Prof.V.B. Shah Institute of Management, Amroli
SFM/Unit 5/ Corporate Restructuring and Industrial Sickness/TYBBA Sem 5/Finance

Prediction of Industrial Sickness:

(A) Univariate Models:
Beaver (1966) who tested groups of ratios covering cash flow, net income, gearing, liquidity and
turnover. His research indicated that 'Cash flow to Total debt' was the best predictor.
In a later study Beaver carried out a more detailed analysis of the liquidity ratios and their potential as
predictors of business failure. On the basis of his study, he made the following generalizations
about failing firms:
(a) They generate less sales and the sales growth is less than that of non-failed firms.
(b) They have less current assets but more current debt.
(c) They have less inventory than non-failed firms.
His data showed that the 'Net working capital and Quick asset ratios' predicted better than the
'Current asset ratio'. The 'Cash ratio' predicted best-of all.
Fitz Patrik (1 074) examined companies that failed in the 1920's and found the best profit to Net
worth.'
Smith (1974) came up with 'Working capital to Total assets' as the best indicator of failure.
Merwin (1974) also found Smith’s ratio be the best.

(B) Multiple Discriminant Analysis (MDA):

Introduction
A. The computation and analysis of certain ratios based on the information taken from
financial statements allow the analyst to predict sickness or business failure.
B. The ratios are considered independent of each other, will not permit to express the
C. It would be more useful if the important ratios are combined together to measure whole
situation in a single measure. the probability of sickness or insolvency.
D. To overcome this difficulty Edward I. Altman (1968) developed Z score model". It is called
as 'multiple discriminant analysis (MDA).
E. It is a linear analysis used to develop with five variables.
F. MDA computes the discriminant coefficient while the independent variables are the actual
values taken from the financial statements.
G. The model was developed basing on empirical studies, to predict the sickness of a unit in
advance.
H. This model is used in order to detect the financial health of industrial units with a view to
prevent the industrial sickness.
Formula: Altman Z score model is expressed as under:
Z = 1.2x1 + 1.4x₂ + 3.3x₂ + 0.6x₂ + 1.0X5.
X1= Working capital/Total assets
X₂= Retained earnings/Total assets
X3 = Earnings before interest and taxes/Total assets
X4= Market value of equity/Book value of total debt
X5 = Sales/Total assets.
Analysis: The sickness is predicted basing on value of Z score model can be analysed as follows:

(a) If Z score is more than 2.99 - there is no danger of bankruptcy

(b) If Z score is below 1.81 - there is a definite failure

(c) If Z score is between 1.81 and 2.99 - it shows the grey area

Guidelines: Altman developed a guideline for Z score:

Prof. Soyeb Jindani & Dr. Nilesh Patel
Prof.V.B. Shah Institute of Management, Amroli
SFM/Unit 5/ Corporate Restructuring and Industrial Sickness/TYBBA Sem 5/Finance

(a) If score is above 2.675 - firms can be classified as financially sound

(b) If score is below 2.675 - the firm is heading towards bankruptcy

(c) The lower the Z score, there is a greater possibility of bankruptcy and vice versa.

Conclusion

(a) Altman's model has established itself as the leading multivariate predictor model of
corporate failure and it has been the subject of numerous tests around the world.
(b) It would be useful to employ the Altman model in evaluating Indian firms and endeavour
establishes the reliability of the model.
(c) It could be that the cut-off point for the Z score should be altered from that established in the
original study

Prof. Soyeb Jindani & Dr. Nilesh Patel

Prof.V.B. Shah Institute of Management, Amroli