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ADVANCED FINANCIAL MANAGEMENT

CA FINAL - PAPER 2: ADVANCED FINANCIAL MANAGEMENT

The subject “Advanced Financial Management” primarily involves the application of financial management theories
and techniques in strategic decision-making. In this regard, an attempt has been made to convey the concepts of Ad-
vanced Financial Management to students in a clear and straightforward manner through capsules. These capsules
are designed to aid students in quickly revising particular chapters. While every effort has been made to simplify the
concepts presented in capsule form, it should not be considered a replacement for the Study Material provided by
ICAI. Therefore, students are advised to refer to the ICAI Study Material and other publications such as Revisionary
Test Papers, Mock Test Papers, etc.

Chapter 1 – Financial Policy And Corporate Strategy

Advanced Role of Strategic Strategy at

CFO in various Financial Different
matters including Decision Making Hierarchy
Chapter Value Creation Framework Levels
Overview
Balancing
Interface of
Financial
Financial Financial Policy
Goals vis-à-vis
Planning and Strategic
Sustainable
Management
Growth

Advanced Role of CFO in various matters including Value Creation

In addition to the traditional role the role of CFO has been advanced in the following areas:
a. Risk Management: Now a days the CFOs are expected to look after the overall functioning of the framework of Risk Management system
of an organisation.
b. Supply Chain: Since CFOs are caretakers of finance of the company, considering the financial viability of the Supply Chain Management
their role has now become more critical.
c. Mergers, Acquisitions, and Corporate Restructuring: Since to capture the market share there has been a spate of
Mergers and Acquisitions, the role of CFOs has become more crucial because any error in them can lead to collapse of the whole business.
d. Environmental, Social and Governance (ESG) Financing: With the evolving of the concept of ESG their role has been shifted from
traditional financing to sustainability financing.

Strategic Financial Decision Making Framework

Fundamentals of Business

Financial Right
A clear and
resources, management
realistic
controls and team and
strategy
systems processes

Meaning of Strategic Financial Management

 Defined as application of financial management techniques to strategic decisions to help achieve the
decision-maker’s objectives.
 It combines the backward-looking, report focused discipline of (financial) accounting with the more
dynamic, forward-looking subject of financial management.

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ADVANCED FINANCIAL MANAGEMENT

Functions of Strategic Financial Management

Key decisions falling within the scope of Financial Strategy;

a. Financing Decisions b. Investment Decisions
c. Dividend Decisions d. Portfolio Decisions

Financing Investment Dividend Portfolio

Decisions Decisions Decisions Decisions

Strategy At Different Hierarchy Levels

Corporate Level Strategy

Fundamentally concerned with selection of businesses in which a company should compete and should be able to
answer three basic questions:
(a) Suitability - Whether the strategy would work for the accomplishment of common objective of the company.
(b) Feasibility - Determines the kind and number of resources required to formulate and implement the strategy.
(c) Acceptability - It is concerned with the stakeholders’ satisfaction and can be financial and non-financial.

Business Unit Level Strategy

At this level, the strategic issues are about practical coordination of operating units.

Functional Level Strategy

 The functional level is the level of the operating divisions and departments. The strategic issues at this level are related to
functional business processes and value chain.
 Among the different functional activities viz production, marketing, finance, human resources and research and development,
finance assumes highest importance during the top down and bottom-up interaction of planning.

Financial Planning
There are 3 major components of Financial Planning:
l Financial Resources (FR)
l Financial Tools (FT)
l Financial Goals (FG)
Financial Planning = FR+ FT + FG

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ADVANCED FINANCIAL MANAGEMENT

Interface of Financial Policy And Strategic Management

l The starting point of an organization is money and the end point of that organization is also money.
l Sources of finance and capital structure are the most important dimensions of a strategic plan.
l Dividend policy is yet another area for making financial policy decisions affecting the strategic performance of the
company.
l Another important dimension of strategic management and financial policy interface is the investment and fund
allocation decisions.
l The financial policy of a company cannot be worked out in isolation of other functional policies.
l Corporate strategy is the cause and financial policy is the effect and sometimes financial policy is the cause and
corporate strategy is the effect.

Balancing Financial Goals vis-à-vis Sustainable Growth

Too fast or too slow growth will go against enterprise growth and development.

What makes an organization financially sustainable?

 have more than one source of income.  have more than one way of generating income.
 do strategic, action and financial planning regularly.  have adequate financial systems.
 have a good public image.  be clear about its values (value clarity).
 have financial autonomy.

Sustainable Growth Rate

Sustainable Growth Rate (SGR), of a firm is the maximum rate of growth in sales that can be achieved, given the firm’s
profitability, asset utilization, and dividend pay-out and debt (financial leverage) ratios. It is a measure of how much a firm
can grow without borrowing more money. The SGR can be calculated as follows:
SGR = Return on Equity (ROE) x (1- Dividend payment ratio)
Economists and business researchers contend that achieving Sustainable Growth is not possible without paying heed to
twin cornerstones:
l growth strategy and l growth capability.

have a clear strategic direction

have an adequate administrative and financial infrastructure.

What be able to scan its environment or context to identify opportunities for its work.
makes an
organization
sustainable? be able to attract, manage and retain competent staff.

be able to demonstrate its effectiveness and impact in order to leverage further resources.

get community support for, and involvement in its work.

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 ADVANCED FINANCIAL MANAGEMENT

Chapter 3 – Advanced Capital Budgeting Decisions

Chapter Overview Impact of change in Government Policies on Capital Budgeting

Decisions
Internal and External
Current Trends Dealing with Risk Impact of change of Policies on Domestic Capital
Factors affecting
in Capital in Investment Budgeting Decisions.
Capital Dudgeting
Budgeting Decisions
Decision
• Since the change in interest rates are decided by Government
Methods of through its Monetary Policy, this can affect the Cost of Capital
incorporating Replacement Adjusted Present because the Cost of Debt is normally dependent on the bank
risk in Capital Decision Value rate of interest as they are considered as one of the important
Budgeting factors to compute YTM.
• Another important change (Government Policy) is related to
CURRENT TRENDS IN CAPITAL BUDGETING Fiscal Policy. Since Fiscal Policy forms the basis of Tax Rate and
Annual Cash Flows are dependent on Rate of Depreciation of
Investment projects are exposed to various types of factors some of Tax Rate, any drastic change in any of these two items may call
which are as follows: for revision of estimated cash flows.
• Inflation
• Change in technology
• Change in Government Policies Impact of change of Policies on International
Capital Budgeting Decisions.
Impact of Inflation on Capital Budgeting Decisions
• In International Capital Budgeting Decisions, the foreign
• Adjustment for inflation is a necessity because the net revenues exchange rates play a very important role. A change in bank
after adjustment for inflation shall be equal to net revenues in rate and money supply is decided as per Monetary Policy, the
current terms. change in any of these two impacts the rate of Foreign Exchange
• Due to inflation investors require the nominal rate of return to and it may call for revision of estimates.
evaluate the project. • Change in Tax Rates relating to Foreign Income or changes
in provisions of Double Tax Avoiding Agreement (DTAA) as
Impact of change in technology on Capital Budgeting Decisions decided in Fiscal Policy may call for revision of estimates.

Why it is important to analyze the impacts of

change in technology. DEALING WITH RISK IN INVESTMENT DECISIONS

• Change in technology can significantly alter production

process. Decision Making
• Changes can also yield benefits such as improved quality,
delivery time greater flexibility, etc. There can be 3 types of Decision making :
• Changed technology can also result in reduction in cost of (i) Decision making under certainty: When cash flows are
capital certain.
• Improved cash inflows can be achieved through technological
(ii) Decision making involving risk: When cash flows involve
changes.
• There may be need to incur additional cost in the form of risk and probability can be assigned.
additional capital expenditure. (iii) Decision making under uncertainty: When cash flows are
• The sale volume can be impacted as the anticipated life cycle of uncertain and probability cannot be assigned
the product can be shortened because of change in consumer
preference.
What is Risk and Uncertainty and how is it measured?
Various ways in which the impact of change
in technology can be incorporated in Capital
What is Risk and Uncertainty and
Budgeting decisions
how is it measured?
• At the time of making Capital Budgeting Decisions the risk
of change in technology should be considered using various • Risk is the variability of possible outcomes from the expected
techniques such as Sensitivity Analysis, Scenario Analysis, one.
Simulation Analysis etc. • Uncertainty is a situation when probability of cash flows are
• Once project has been launched analyze the impact of change
unknown.
in technology both positive or negative and revise estimates in
monetary terms. • Risk is measured by the Variance or Standard Deviation (SD).
• If continuation of project is proving to be unviable then look SD is a commonly used tool which measures the dispersion of
for abandonment option and evaluate the same (discussed possible outcomes around the mean.
later).
• Suitably adjusting the discounting rate.

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ADVANCED FINANCIAL MANAGEMENT

Reasons for adjustment of risk in Capital Budgeting Decisions METHODS OF INCORPORATING RISK IN CAPITAL
BUDGETING
Adjustment of risk is necessary to help make the decision as to
whether the returns of the project are proportionate with the risks
Techniques of Risk Analysis in Capital Budgeting
borne and whether it is worth investing in the project over the
other investment options available.
Statistical Conventional Others
Risk adjustment is required to know the real value of the Cash Techniques Techniques Techniques
Inflows. Higher risk will lead to higher risk premium and also
expectation of higher returns Risk-adjusted Sensitivity
Probability
discount rate analysis

Variance or Certainty Scenario

INTERNAL AND EXTERNAL FACTORS AFFECTING Standard equivalents analysis
CAPITAL BUDGETING DECISIONS Deviation

Internal Factors Coefficient of

Variation
• Risks which are related to a particular project and
Project- affects the project’s cash flows.
specific • It includes completion of the project in scheduled
risk time, error of estimation in resources and allocation, Statistical Techniques Probability
estimation of cash flows etc.

• Risk which arises due to company-specific factors

PROBABILITY IS A MEASURE ABOUT THE CHANCES
Company- like downgrading of credit rating, changes in key
THAT AN EVENT WILL OCCUR.
specific managerial persons, dispute with workers etc.
risk • All these factors affect the cash flows of an entity
and access to funds for capital investments. Event certain to occur
Probability = 1

External Factors No Chance of happening an event:

Probability = 0
These are the risks which affect the whole industry
Industry- in which the company operates. These risks include
specific regulatory restrictions on industry, changes in Expected cash flows are assigned a probability factor (Pi) and net
risk technologies etc. cash flows are calculated.
n
E (R)/ENCF = i=1 NCFi ×P i
Where,
The risk which arises due to market related conditions E (R)/ENCF = Expected Cash flows
Market like entry of substitute, changes in demand conditions, Pi = Probability of Cash flow
risk availability and access to resources etc. NCFi = Cash flows

These are risks related with competition in the market

in which a company operates. These risks are risk of Statistical Techniques Variance
Competition
entry of rival, product dynamism and change in taste
risk
and preference of consumers etc.
IT MEASURES THE DEGREE OF DISPERSION BETWEEN
These are the risks which are related with macro- NUMBERS IN A DATA SET FROM ITS AVERAGE.
economic conditions like changes in monetary
Economic policies by central banks, changes in fiscal policies like
conditions Variance is calculated as below:
introduction of new taxes and cess, inflation, changes
in GDP, changes in savings and net disposable income
etc.

Where, = Variance in net cash flow;

These are risks which are related with conditions P = Probability and ENCF = Expected Net Cash Flow.
International which are caused by global economic conditions
risk like restriction on free trade, restrictions on market Variance MEASURES the uncertainty of a value from its
access, recessions, bilateral agreements, political and average. Thus, variance helps an organization to understand the
geographical conditions etc. level of risk it might face on investing in a project.

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A variance value of ZERO would indicate that the cash flows

that would be generated over the life of the project would be The rate of return on Investments that bear
same. Risk-Free no risk. e.g., if Government securities yield a
Rate return of 6 % and since it bears no risk it will
be considered as the Risk-Free Rate.
A LARGE variance indicates that there will be a large variability
between the cash flows of the different years. The rate of return over and above the risk-free
rate, expected by the Investors as a reward for
Risk
bearing extra risk.
Premium
A SMALL variance would indicate that the cash flows would be For high risk project, the risk premium will be
somewhat stable throughout the life of the project. high and for low risk projects, the risk premium
would be lower.

If the risk is higher than risk involved in a similar kind of project,

Statistical Techniques Standard Deviation discount rate is adjusted upwards in order to compensate this
additional risk borne.

A degree of variation of individual items of a set of data from It is calculated as below:

its average. (The square root of variance is called Standard
Deviation)
Where, NCFt = Net cash flow;
For Capital Budgeting decisions, Standard Deviation is used to K = Risk adjusted discount rate;
calculate the risk associated with the estimated cash flows from I = Initial Investment
the project. t = Time

Statistical Techniques Coefficient of Variation • It is easy to understand.

Advantages • It incorporates risk premium in the
discounting factor.
The Coefficient of Variation calculates the risk borne for every
percent of expected return.
• Difficulty in finding risk premium and risk-
adjusted discount rate.
It is calculated as below: • Though NPV can be calculated it is not
Limitations
Standard Deviation possible to calculate Standard Deviation of a
Coefficient of variation =
Expected Return/Expected Cash Flow given project.

The investment
The Coefficient with lower ratio For selection Conventional Techniques Certainty Equivalent (CE)
of Variation of standard between two
calculates the deviation projects, a project
risk borne for to expected return, which has a
every percent of provides a better lower Coefficient To deal with risks in capital budgeting, risky future cash flows
expected return. risk – return of Variation is are expressed in terms of certain cash flows as their equivalent.
trade off. selected. Decision maker would be indifferent between the risky amount
and the (lower) riskless amount considered to be its equivalent.

Risk-Adjusted
Conventional Techniques Steps involved in the Certainty Equivalent (CE) approach
Discount Rate
• Remove risks by substituting equivalent certain cash
flows from risky cash flows
Step-1 • Multiply each risky cash flow by the appropriate αt
A RISK ADJUSTED DISCOUNT RATE IS A SUM OF RISK- value (CE coefficient)
FREE RATE AND RISK PREMIUM.
Discounted value of cash flow is obtained by applying
Risk-Free Rate of Return.
Step-2
Risk-
Risk adjusted
Risk free rate • To evaluate the project Normal Capital budgeting
premium discount
rate methods are applied except in case of IRR method.
Step-3 • In case of IRR, it is compared with risk free rate of
interest rather than the firm’s required rate of return
or cost of capital.

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ADVANCED FINANCIAL MANAGEMENT

CE Coefficient (αt) is calculated as below:

Certain cash flow Other Techniques Sensitivity Analysis
CE Coefficient (αt) =
Risky or expected cash flowt

A modelling technique
Certainty In industrial Sensitivity used in Capital Budgeting
The value Equivalent situation, cash Analysis decisions to study the impact
of Certainty Coefficient 1 flows are generally of changes in the variables on
Equivalent indicates that the uncertain and the outcome of the project.
Coefficient lies cash flow is certain managements
between 0 & 1. or management is are usually risk
risk neutral. averse.
As per CIMA terminology, “A modelling and risk assessment
procedure in which changes are made to significant variables in
order to determine the effect of these changes on the planned
outcome. Particular attention is thereafter paid to variables
identified as being of special significance”

Where,
NCFt = Forecasts of net cash flow for year ‘t’ without risk-
adjustment In this analysis, It is a way of
αt =  Risk-adjustment factor or the certainty equivalent the project finding impact
coefficient. outcome is The more sensitive in the project’s
Kf = Risk-free rate assumed to be constant for all periods. studied after is the NPV, the NPV (or IRR) for
I = Initial Investment. taking into more critical is the a given change
change in only variable. in one of the
one variable. variables.

• Simple and easy to understand and apply.

Advantages of
CE Method
• It can easily be calculated for different risk
levels applicable to different cash flows. STEPS INVOLVED IN SENSITIVITY ANALYSIS

1. Finding variables, which have an influence on the NPV

• CEs are subjective and vary as per each (or IRR) of the project
individual’s estimate.
Disadvantages • CEs are decided by the management based
of CE Method on their perception of risk. However, the risk 2. 
Establishing mathematical relationship between the
perception of the shareholders who are the variables.
money lenders for the project is ignored.

3. 
Analysing the effect of the change in each of the
RISK-ADJUSTED DISCOUNT RATE VS. CERTAINTY- variables on the NPV (or IRR) of the project.
EQUIVALENT

2 3 • Critical Issues: This analysis identifies critical

Each year’s CE Despite its soundness, Advantages factors that impinge on a project’s success or
Coefficient is based on CE is not preferable like failure.
level of risk impacting its Risk Adjusted Discount • Simplicity: It is a simple technique.
cash flow. Rate Method.

• Assumption of Independence: This analysis

1 assumes that all variables are independent i.e.
4
CE Method they are not related to each other, which is
Risk-adjusted It is difficult to Disadvantages unlikely in real life.
is superior to Discount Rate specify a series of • Ignore probability: This analysis does not look
RADR Method
Vs. CE Coefficients
as it does not to the probability of changes in the variables.
but simple to
assume that risk Certainty- adjust discount
increases with Equivalent
rates.
time at constant
rate.
Other Techniques Scenario Analysis

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ADVANCED FINANCIAL MANAGEMENT

This analysis starts with carrying out a simulation exercise to

This analysis brings in the
model the investment project.
probabilities of changes in
Scenario key variables and also allows It involves identifying the key factors affecting the project and
Analysis us to change more than one their interrelationships.
variable at a time.
It involves modelling of cash flows to reveal the key factors
influencing both cash receipt and payments and their inter-
relationship.
Scenario Analysis begins with base case or most likely set of This analysis specifies a range for a probability distribution of
values for the input variables. potential outcomes for each of the model’s assumptions.

Then, go for worst case scenario (low unit sales, low sale price, • We can predict all types of bad market
high variable cost and so on) and best case scenario. situations beforehand.
• Handle problems characterised by:
(a) numerous exogenous variables following
any kind of distribution.
Alternatively, Scenario Analysis is possible where some factors Advantages
are changed positively and some factors are changed negatively. (b) c omplex interrelationships among
parameters, exogenous variables and
endogenous variables.
(c) compels decision maker to explicitly
In a nutshell Scenario Analysis examines the risk of consider the inter-dependencies and
investment, to analyse the impact of alternative combinations uncertainties featuring the project.
of variables, on the project’s NPV (or IRR).

SENSITIVITY ANALYSIS VS. SCENARIO ANALYSIS Shortcomings

(1) Difficult to model the project and specify probability
distribution of exogenous variables.
Sensitivity Analysis
Vs (2) Simulation is inherently imprecise. Provides rough
Scenario Analysis approximation of probability distribution of NPV and hence
may be misleading when a tail of distribution is critical.
(3) Realistic simulation model being likely to be complex would
SENSITIVITY analysis probably be constructed by management expert and not by
SCENARIO analysis, on the
calculates the impact of other hand, is based on a the decision maker.
the change of a single input scenario. The scenario may be (4) Decision maker lacking understanding of the model may not
variable on the outcome of the recession or a boom wherein
project viz., NPV or IRR. The depending on the scenario, use it.
sensitivity analysis thus enables all input variables change.
to identify that single critical Scenario Analysis calculates
variable that can impact the the outcome of the project
outcome in a huge way and considering this scenario where Other Techniques Decision Tree Analysis
the range of outcomes of the the variables have changed
project given the change in the simultaneously.
input variable.

• Basically, decision tree is a graphic display of the relationship

Simulation Analysis between a present decision and future events, future decision,
Other Techniques
(Monte Carlo) and their consequences.
• This approach assumes that there are only two types of
situations that a finance manager has to face. The first situation
It is the exact replica of the
actual situation. To simulate an is where the manager has control or power to determine what
actual situation, a model shall happens next. This is known as “Decision”, as he can do what
Simulation be prepared, in which infinite
he desires to do.
Analysis calculations are made to obtain
the possible outcomes and
probabilities for any given action.

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ADVANCED FINANCIAL MANAGEMENT

STEPS INVOLVED IN DECISION TREE ANALYSIS

Net present value = Present value of benefits –
Step IV. Present value of costs
Define Investment: Decision Tree Analysis can
be applied to a variety of business decision-making
scenarios.

Decision rule. Accept when present value of benefits

> present value of costs. Reject when the opposite is
Identification of Decision Alternatives: It is very Step V. true.
essential to clearly identity decision alternatives.

Drawing a Decision Tree: After identifying decision

alternatives, at the relevant data such as the projected Optimum Replacement Cycle
cash flows, probability distribution, expected present
value etc. should be put in diagrammatic form called
decision tree. • To determine optimal replacement cycle, concept of
Equivalent Annual Cost (EAC) is used.
Evaluating the Alternatives: After drawing out the • The formula to compute EAC is as follows:
decision tree the next step is the evaluation of alternatives.
PV of Cash Outflow
PVAF
• This decision is based on assumption that as the machine
REPLACEMENT DECISION
(asset) becomes older its efficiency decreases leading to
The replacement decision can be divided into following two types of increase in operating cost and reduction in resale value.
decisions.

Replacement Decision
ADJUSTED PRESENT VALUE

Replacement of Existing Optimum Replacement • This approach separates the investment decision and
Machine Cycle financing decision.
• Following formula is used to evaluate a project as per this
Replacement of Existing Machine approach:
Base Case NPV + PV of Tax Benefit on Interest
This is a decision concerning whether an existing asset should be replaced • Base Case NPV is calculated using cost of equity assuming
by a newer version of the same machine or even a different type of machine the company is unlevered i.e., all equity financed. Now
that has the same functionality as the existing machine.
question arises: how to calculate the Unlevered Cost of
Equity?
• This method provides a broader view to evaluate a project
STEPS INVOLVED IN DECISION TO REPLACE EXISTING considering the benefit of increased use of debt in financing
MACHINE of any project.

Net cash outflow (assumed at current time /[Present

value of cost]):
a. (Book value of old equipment - market value of
CROSSWORD SOLUTION – FEBRUARY 2024
old equipment) × Tax Rate = Tax payable/ savings 1
A N T
2 3
I 4
T R U
5
S
6
T
7
A
8
D
9
Step I. from sale
b. Cost of new equipment – [Tax payable/savings U 10
C E A 11
P I O E E
from sale + market value of old equipment] = 12
C 13
I G 14
I P B 15
R V
Net cash outflow
16
T I 17
M E 18
L I O
Estimate change in cash flow per year, if replacement 19
I M F 20
L E 21
M O N 22
S L
decision is implemented.
Change in cash flow = [(Change in sales ± Change in O 23
E O 24
T A U
Step II.
operating costs) – Change in depreciation] (1 – tax 25
N 26
S 27
G 28
B N 29
A P T
rate) + Change in depreciation
30
S D R 31
E M E X 32
A I
33
F E 34
M A Y 35
F A O
Present value of benefits = Present value of yearly
cash flows + Present value of estimated salvage of 36
F 37
C R 38
M 39
E 40
I P N
Step III. new system 41
D 42
T 43
I 44
E 45
A M I
46
I N S U R A N C E 47
Q E

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