UNIT- 1

Financial management
(Theory part)

•Concept of financial management ?

Financial Management refers to the planning, organizing, directing, and
controlling of financial activities of an organization. It involves managing
money in such a way that the firm can achieve its financial goals efficiently.

In simple words, financial management deals with how a business earns,

spends, and manages its funds.
Key objectives include:
Proper investment of funds
Raising capital from suitable sources

Efficient use of financial resources

Maximizing the wealth of owners/shareholders

•Nature and Scope of financial mgt?

Nature…
The nature of financial management refers to the characteristics and basic
features that define how financial management works in an organization.
Managerial Activity
Financial management is a part of overall management. It involves planning,
organizing, directing, and controlling financial resources of a business.
Decision-Making Function
It helps managers take important financial decisions such as investment
decisions, financing decisions, and dividend decisions.
Continuous Process

Financial management is not a one-time activity. It is a continuous process

because financial planning and control are required at every stage of
business.
Goal-Oriented
Its main aim is to maximize the wealth of shareholders and ensure financial
stability of the business.

Integrative Function
It coordinates with other departments like production, marketing, and HR to
ensure proper use of funds.
Analytical in Nature
Financial management uses financial analysis, forecasting, budgeting, and
other techniques for making decisions.

Scope…

The scope of financial management refers to the different areas or activities

covered under financial management.

Financial Planning
Estimating the amount of capital required for business operations and
planning how to obtain it.
Investment Decision (Capital Budgeting)
Deciding where and how to invest funds in long-term assets like machinery,
buildings, and projects.
Financing Decision
Deciding the best sources of finance such as equity, debt, loans, or retained
earnings.

Dividend Decision
Determining how much profit should be distributed as dividends to
shareholders and how much should be retained for future growth.
Working Capital Management
Managing short-term assets and liabilities like cash, inventory, and
receivables.

Financial Control
Monitoring financial activities through budgeting, financial statements, and
performance evaluation.

•Financial Management Process?

The financial management process refers to the systematic steps through

which a business plans, obtains, and uses financial resources efficiently to
achieve its objectives.
1. Financial Planning
This is the first step in financial management. It involves estimating the
financial requirements of the business and deciding how much capital is
needed for operations and expansion.
2. Procurement of Funds
After determining the financial needs, the business raises funds from different
sources such as equity shares, debentures, bank loans, or retained earnings.
3. Investment of Funds
The funds raised are then invested in productive activities like purchasing
machinery, equipment, raw materials, and other assets to generate profit.
4. Financial Control

Financial control ensures that funds are used properly. Tools such as
budgeting, financial statements, and ratio analysis help monitor financial
performance.
5. Profit Distribution
After earning profits, the company decides how much profit should be
distributed to shareholders as dividends and how much should be retained for
future growth.
6. Financial Review and Evaluation
The last step is evaluating financial performance to check whether the
financial decisions taken were effective and to make improvements for the
future.

•Objectives in Contemporary Business Environment?

1. Profit Maximization and 2. Wealth Maximization

In the modern business environment, the main objective of
financial management is to make the best use of financial
resources to increase the value of the business.
Traditionally, two major objectives are considered: Profit
Maximization and Wealth Maximization.
1. Profit Maximization
Profit maximization means increasing the total profit of a
business to the highest possible level. It focuses on earning
more revenue and reducing costs.
Features:
Emphasizes maximum earnings.
Focuses mainly on short-term financial gains.
Helps in measuring the efficiency of business operations.
Profit acts as an important indicator of business success.
Limitations:
It ignores the time value of money.
Does not consider risk and uncertainty.
Focuses only on short-term gains rather than long-term
growth.
May ignore the interests of shareholders and society.
2. Wealth Maximization
Wealth maximization means increasing the market value of
shareholders’ wealth by increasing the value of the
company’s shares.
Features:
Focuses on long-term growth of the company.
Considers risk and time value of money.
Ensures maximum benefit to shareholders.
Improves the market value of the company.
Advantages:
It is a realistic and practical objective.
Helps in sustainable business growth.
Considers both profit and shareholder value

•Sources of funds
1. Sources of Short-Term Funds
Short-term funds are required for less than one year and are
mainly used to meet working capital needs such as paying
wages, purchasing raw materials, and meeting day-to-day
expenses.
Major sources include:
Trade Credit
Credit provided by suppliers for purchasing goods without
immediate payment.
Bank Credit
Banks provide short-term loans, cash credit, and overdraft
facilities to businesses.
Commercial Paper
An unsecured short-term promissory note issued by large
companies to raise funds.
Public Deposits
Companies may accept deposits from the public for a short
period at a fixed interest rate.
Factoring
A financial institution purchases a company’s receivables
and provides immediate cash.
Customer Advances
Advance payments received from customers before
delivering goods or services.
2. Sources of Long-Term Funds
Long-term funds are required for more than one year and are
used for capital investment, such as purchasing machinery,
buildings, and expansion of business.
Major sources include:
Equity Shares
Funds raised from shareholders who become owners of the
company.
Preference Shares
Shares that provide a fixed dividend and priority over equity
shareholders.
Debentures
Long-term loans taken from the public with a fixed rate of
interest.
Retained Earnings
Profits that are kept in the business instead of being
distributed as dividends.
Term Loans from Financial Institutions
Loans obtained from banks or financial institutions for a long
period.
Venture Capital
Investment provided to new or growing businesses with high
potential.
 UNIT – 2

PART A: COST OF CAPITAL

1. Meaning of Cost of Capital

Cost of capital is the minimum rate of return that a company must earn on its investments to
satisfy its investors (shareholders and lenders). It is the cost of using funds raised from different
sources like equity, debentures, loans, etc.

Example:
If investors expect a return of 12%, then the firm must earn at least 12%, otherwise the value of
the firm will decrease.

2. Significance (Importance) of Cost of Capital

Cost of capital is very important in financial decisions:

1. Helps in capital budgeting decisions

2. Used to evaluate investment projects

3. Helps in capital structure decisions

4. Used as a discount rate in NPV and DCF methods

5. Helps in pricing of securities

6. Indicates risk level of the firm

3. Components of Cost of Capital

A. Cost of Debenture (Kd)

Debentures are long-term borrowed funds.

• Interest on debentures is a fixed cost

• Interest is tax deductible

Formula (After tax):

[ Kd = I (1 - T) ]
Where:
I = Interest rate
T = Tax rate Since tax benefit is available, cost of debentures is low.
B. Cost of Preference Share Capital (Kp)

Preference shareholders get fixed dividend.

• Dividend is not tax deductible

• Dividend must be paid before equity shareholders

Formula:
[ Kp = \frac{D}{P} ]
Where:
D = Annual preference dividend
P = Net proceeds of preference shares

C. Cost of Term Loans

Term loans are long-term loans taken from banks or financial institutions.

• Interest is tax deductible

• Similar to debentures

Formula:
[ K_{term\ loan} = I (1 - T) ]

D. Cost of Equity Capital (Ke)

Equity capital is the most risky source of finance.

Shareholders expect high return because:

• No fixed dividend

• High risk

There are two main methods:

❖ Dividend Discount Model (DDM)

Used when dividends are stable or growing.

Formula:
[ Ke = \frac{D}{P} + g ]
Where:
D = Dividend per share
P = Market price of share
g = Growth rate

❖ Capital Asset Pricing Model (CAPM)

CAPM considers risk.

Formula:
[ Ke = Rf + \beta (Rm - Rf) ]

Where:
Rf = Risk free rate
Rm = Market return
β = Beta (risk factor)

Higher risk = Higher return.

E. Cost of Retained Earnings (Kr)

Retained earnings are profits kept in business instead of paying dividends.

• No explicit cost

• But has opportunity cost

Formula:
[ Kr = Ke ]

Cost of retained earnings is equal to cost of equity.

4. Weighted Average Cost of Capital (WACC)

Meaning

WACC is the overall cost of capital of the firm. It is the weighted average of costs of all sources
of finance.

Formula:

[ WACC = \sum (Weight \times Cost) ]

Steps:

1. Find cost of each source

2. Find weight of each source

 3. Multiply cost × weight

4. Add all values

WACC is used as discount rate in capital budgeting.

PART B: CAPITAL BUDGETING

1. Meaning of Capital Budgeting
Capital budgeting is the process of evaluating long-term investment projects.

Examples:

• Buying machinery

• Setting up a new plant

• Expansion projects

2. Concepts of Capital Budgeting

• Involves huge investment

• Returns are received over long period

• Decisions are irreversible

• Involves high risk

3. Capital Budgeting Techniques

A. Payback Period Method

Time required to recover initial investment.

Decision Rule:

• Shorter payback period = Better project

Merits:

• Simple to calculate

• Useful for liquidity

Limitations: Ignores time value of money & Ignores cash flows after payback
B. Average Rate of Return (ARR)
Measures average profit from investment.

Formula: [ ARR = \frac{Average\ Profit}{Investment} ]

Merits:

• Easy to understand

• Based on accounting profit

Limitations:

• Ignores time value of money

• Uses book values

C. Net Present Value (NPV)

Difference between present value of cash inflows and initial investment.

Decision Rule:

• NPV > 0 → Accept

• NPV < 0 → Reject

Merits:

• Considers time value of money

• Best method

Limitations:

• Difficult to calculate

• Depends on discount rate

D. Internal Rate of Return (IRR)

IRR is the rate at which NPV = 0.

Decision Rule:

• IRR > Cost of capital → Accept

Merits:

• Considers time value

 • Easy to compare

Limitations:

• Multiple IRR problem

• Not suitable for mutually exclusive projects

E. Profitability Index (PI)

Ratio of PV of cash inflows to investment.

Formula: [ PI = \frac{PV\ of\ inflows}{Initial\ investment} ]

Decision Rule:
PI > 1 → Accept

4. Comparing Projects with Different Lives

When projects have unequal life periods, comparison is difficult.

Methods:

1. Equivalent Annual Cost (EAC) Method

2. Replacement Chain Method

These methods help in making projects comparable.

5. Incorporating Risk in Capital Budgeting

Risk means uncertainty of returns.

Methods to Incorporate Risk:

1. Risk-adjusted discount rate

2. Sensitivity analysis

3. Scenario analysis

4. Probability analysis

Higher risk projects use higher discount rate.

Conclusion

• Cost of capital is the base for investment decisions

• Capital budgeting helps in efficient allocation of resources

• NPV and IRR are the most important techniques

• Risk must always be considered in capital budgeting decisions

 UNIT-3 – FINANCIAL
MNMT
EVERAGE ANALYSIS
1. Concept of Leverage
Leverage refers to the use of fixed costs (financial or operating) in order to increase the
potential return to shareholders.

It shows how a change in sales affects profitability (EBIT/EPS).

2. Significance of Leverage
 Helps in profit planning
 Measures business risk and financial risk
 Assists in decision-making
 Improves returns to shareholders
 Helps in capital structure decisions

3. Types of Leverage
A. Operating Leverage

Meaning

Operating leverage arises due to fixed operating costs (e.g., rent, salaries).

Formula

Degree of Operating Leverage (DOL):

DOL=ContributionEBITDOL = \frac{Contribution}{EBIT}DOL=EBITContribution

Impact

 High DOL → High business risk

 Small change in sales → Large change in EBIT
B. Financial Leverage

Meaning

Financial leverage arises due to fixed financial costs (interest on debt).

Formula

Degree of Financial Leverage (DFL):

DFL=EBITEBTDFL = \frac{EBIT}{EBT}DFL=EBTEBIT

Impact

 High DFL → High financial risk

 Affects earnings per share (EPS)

C. Combined Leverage

Meaning

Combined leverage considers both operating and financial leverage.

Formula
DCL=DOL×DFLDCL = DOL \times DFLDCL=DOL×DFL

Impact

 Shows effect of sales change on EPS

 High combined leverage = High total risk

CAPITAL STRUCTURE DECISION

1. Concept
Capital structure refers to the mix of debt and equity used to finance a company.

2. Importance
 Affects cost of capital
 Influences profitability and risk
 Impacts firm value
3. Approaches to Capital Structure
A. Net Income (NI) Approach

 Capital structure affects firm value

 More debt → Lower cost of capital → Higher firm value

B. Net Operating Income (NOI) Approach

 Capital structure does not affect firm value

 Cost of capital remains constant

C. Traditional Approach

 Optimum capital structure exists

 Moderate use of debt reduces cost of capital

D. Modigliani-Miller (MM) Approach

Without Taxes

 Capital structure is irrelevant

With Taxes

 Debt increases firm value due to tax shield

DIVIDEND POLICY
1. Concept
Dividend policy refers to the decision regarding distribution of profits between dividends
and retained earnings.

2. Determinants of Dividend Policy

  Profitability
 Liquidity
 Stability of earnings
 Growth opportunities
 Legal restrictions
 Market conditions
 Shareholder expectations

3. Significance
 Affects shareholder wealth
 Influences market price of shares
 Builds investor confidence
 Reflects company performance

4. Types of Dividend Policies

A. Stable Dividend Policy

 Fixed dividend per share every year

B. Stable Payout Ratio

 Fixed percentage of profits distributed

C. Growth Dividend Policy

 Gradually increasing dividends

5. Dividend Theories
A. Relevance Theories
1. Walter’s Model

 Dividend policy affects firm value

 Depends on return on investment vs cost of capital

2. Gordon’s Model
  Investors prefer certain dividends (“bird in hand theory”)
 Dividend policy is relevant

B. Irrelevance Theory
Modigliani-Miller (MM) Theory

 Dividend policy does not affect firm value

 Investors are indifferent between dividends and capital gains

6. Bonus Shares and Stock Split

A. Bonus Shares
Meaning

Free shares given to existing shareholders from reserves.

Purpose

 Capitalization of profits
 Increase liquidity of shares

B. Stock Split
Meaning

Division of shares into smaller units (e.g., 1 share → 2 shares).

Purpose

 Reduce market price per share

 Increase marketability

7. Corporate Dividend Behaviour

Meaning
Refers to how companies decide when, how much, and in what form dividends are paid.
Factors Influencing Behaviour
 Earnings stability
 Past dividend trends
 Investor expectations
 Economic conditions

8. Legal and Procedural Aspects of

Corporate Dividend
Legal Aspects
 Dividend paid only out of profits
 Compliance with company laws
 Provision for depreciation
 No payment out of capital (except special cases)

Procedural Steps
1. Board of Directors recommend dividend
2. Approval by shareholders
3. Declaration in AGM
4. Payment within specified time

9. Dividend Distribution Tax (DDT)

Meaning
Tax paid by companies on dividends distributed to shareholders (note: in many countries,
now shifted to shareholder taxation).

Impact
 Reduces net dividend
 Affects dividend decisions
10. Empirical Evidence of Dividend Policy
Meaning
Based on real-world studies and observations.

Findings
 Many firms prefer stable dividends
 Investors value regular income
 Dividend announcements affect share prices
 Companies follow conservative dividend policies

Conclusion
Leverage analysis helps in understanding risk and return, while capital structure decisions
determine the optimal mix of financing. Dividend policy plays a crucial role in shareholder
satisfaction and firm valuation, supported by various theories and practical evidence.
 UNIT 4

📘 Working Capital Management – Detailed Notes

1. Meaning of Working Capital
Working capital refers to the funds required to run daily operations like purchasing raw materials, paying
wages, and covering expenses.

 Gross Working Capital = Total Current Assets

👉 Focuses on investment side (cash, stock, debtors)
 Net Working Capital = Current Assets – Current Liabilities
👉 Shows liquidity position
o Positive WC → Good liquidity
o Negative WC → Risk of insolvency

2. Working Capital Decisions

(1) Investment Decision

 Decides how much money to invest in current assets

 Too much investment → idle funds, low profitability
 Too little → shortage, business disruption

(2) Financing Decision

 Decides how to finance working capital

 Balance between short-term & long-term sources

Policies:

 Conservative Policy
o High current assets
o Low risk, but lower returns
 Aggressive Policy
o Low current assets
o High risk, but higher returns
 Moderate Policy
o Balanced approach

3. Concepts of Working Capital

  Gross Concept
o Focus on total current assets
o Useful for financial management decisions
 Net Concept
o Focus on difference between CA & CL
o Useful for liquidity analysis

4. Significance of Working Capital

Working capital is very important because:

 Ensures smooth production & operations

 Helps in timely payment of expenses (wages, rent, etc.)
 Maintains creditworthiness in market
 Prevents business interruption
 Improves profitability (efficient use of funds)

👉 Without proper WC, even profitable businesses can fail.

5. Determinants of Working Capital

 Nature of Business
o Trading firms → less WC
o Manufacturing → more WC
 Size of Business
o Large firms need more WC
 Production Cycle
o Longer cycle → more WC needed
 Credit Policy
o More credit to customers → more debtors → more WC
 Inventory Policy
o High stock → more WC
 Operating Efficiency
o Efficient firms need less WC
 Seasonal Demand
o Seasonal industries need extra WC
 Business Cycle
o Boom → more WC
o Recession → less WC

💰 6. Financing of Working Capital

(A) Short-Term Financing
Used for temporary or fluctuating needs

Examples:

 Bank overdraft / cash credit

 Trade credit (buy now, pay later)
 Bills discounting
 Commercial paper

👉 Quick and flexible but may be costly or risky

(B) Long-Term Financing

Used for permanent working capital

Examples:

 Equity shares
 Debentures
 Long-term loans
 Retained earnings

👉 Stable but involves higher cost and long commitment

📊 7. Working Capital Estimation

Purpose: To find exact amount of WC required

Steps:

1. Estimate cost of operations

2. Calculate holding periods:
o Raw material holding period
o WIP period
o Finished goods period
o Debtors collection period
o Creditors payment period
3. Compute investment in each stage
4. Add cash balance required
5. Deduct creditors & other liabilities

👉 Helps avoid excess or shortage of funds

🔄 8. Operating Cycle & Cash Cycle
Operating Cycle
Time taken to convert raw material → finished goods → sales → cash

Operating\ Cycle = R + W + F + D

👉 Longer OC = More funds blocked

Cash Cycle
Actual period for which cash is tied up

Cash\ Cycle = Operating\ Cycle - Creditors\ Period

👉 Shorter cash cycle is better (quick recovery of cash)

📦 9. Inventory Management
Inventory = Raw material + WIP + Finished goods

Objective:

Maintain optimum level (not too high, not too low)

Techniques:

 EOQ → Ideal order quantity to minimize cost

 ABC Analysis → Classify items based on importance
 JIT → Buy only when needed

👉 Benefits:

 Reduces storage cost

 Avoids stock-out
 Improves production flow

💳 10. Receivable Management

Focuses on managing credit sales & debtors

Key Decisions:

 Who to give credit

 How much credit
 For how long

Objectives:

 Increase sales through credit

 Reduce bad debts
 Ensure quick collection

👉 Too much credit = risky

👉 Too strict = loss of customers

💵 11. Cash Management

Cash is the most liquid asset.

Motives:

1. Transaction Motive → Daily expenses

2. Precautionary Motive → Emergency
3. Speculative Motive → Opportunities

Techniques:

 Cash budget (planning inflow/outflow)

 Cash flow analysis
 Speed up collections & delay payments

👉 Goal: Maintain optimum cash balance (not excess, not shortage)

⚡ Final Quick Understanding

 Working capital = lifeline of business
 Focus = Liquidity + Profitability balance
 Key areas = Inventory, Debtors, Cash
 Important formulas:
o WC = CA – CL
o OC = R + W + F + D
o Cash Cycle = OC – Creditors