Mod- 1

Financial management is the strategic planning organizing, directing and

controlling of financial undertaking in an organization. It involves applying
management principle to an organization financial assets to ensure financial
health and sustainability.

Four Management function

Planning: Calculating capital required, determining allocation, creating budget

and forecasts.

controlling: Assessing whether the organization meets objects ensuring assets

are used competently and securely.

Organizing & : Structuring financial activities directing and guiding financial

operations

Decision making: Making investment and financial decision.

objective of FM

The primary objective center around profit and wealth maximization, with several
supporting goal.

Profit Maximization : Generate maximum monetary gains by managing cash flow

risk and investment to maximize return.

Wealth Maximization : Increase the net worth and market value of shareholder
shares.

Maintenance of : Ensure healthy cash flow with minimum liquidity backup to

continue operations during setbacks.
Liquidity
Scope of FM

1. Financing decisions

●​ Assessing financial needs and estimating capital requirements.

●​ Deciding capital structure.
●​ Selecting sources of finance.

2. Investment Decisions
●​ Capital budgeting - Investing in long term assets for future benefit.
●​ Determining optimal asset levels and which assets to acquire.
●​ Allocating / investing funds.

3. Dividend Decision
●​ Determining profit distribution to shareholders vs. retention.
●​ Managing share profit and creditor payment.

Role of Finance Manager

A finance manager is in charge of a company's financial resources, optimizes

financial performance, and support strategic decision making. They take care of
all important financial functions in an organization.

Key Responsibility

1. Financial Analysis & Planning : Determining how much money is needed,

when and how obtain required financing.

2. Investment Decisions: Allocating funds efficiently to specific assets, selecting

assets for investment based on safety profitability and liquidity

3. Financing & Capital structure: Raising funds on favorable terms deciding

optimal debt equity ratio, choosing sources of funds.

4. Cash flow Management: Planning and monitoring cash inflows/outflows to

ensure cash is available when needed
5. Working capital management: Managing day to day financial resources
including current assets and liabilities.

Concept of Time Value Money

The time value of money is a fundamental financial principle stating that money
available today is worth more than the same amount in the future due to its
potential earning capacity.

core idea

A dollar today is worth more than a dollar in the future because you can invest it,
earn interest and grow it over time.

(n * t)
Future Value (FV) = FV = PV * [1 + (i / x)]

(n * t)
Present Value = PV = FV / [1 + ( i / n )]
x

Techniques for dealing with TVM

1. compounding technique

Also known as Future Value Method, this technique estimates how much
current money will grow over time if invested at a certain rate.

2. Discounting Technique

This technique is known as the present value of future money by discounting it

back to today value.
mod -2

Cost of Capital

Cost of Capital is the minimum rate of return on profit a company must earn
before generating value. It represents the expense of funding operations and
investment, reflecting what a company must pay to obtain funds from investors
and lends.

Cost of Equity: the rate of return a company must pay out to equity investors

Cost of debt: the cost of using bank or financial institution money, calculated as
Interest rate x (1- Tax rate)

Weighted Average Cost of Capital (WACC)

WACC is the most common method for calculating cost of capital, equally
averaging a company debt and equity from all source

WACC = (We x Re) + (Wd x Rd x (1- t ))

We = Proportion / Weight t = Tax rate

Re = Cost of equity
Wd = Proportion / Weight of debt
Rd = Cost of debt

Different Source of Finance

1. By Timing / Duration

short-term : upto 1 year, working capital, day to day operations.

Medium term: 1-5 years, Equipt purchase, expansion.

Long term: 5+ years, fixed capital, major expansion, acquisitions.

2. By ownership

Equity financing : Raising capital by selling ownership shares.

Dilute ownership but no repayment required.

Debt financing : Borrowing funds that must be repaid with interest.

Must repay principle + interest doesn't dilute ownership.

3. Main Source

Retained Earnings : Internal funds from business operations reinvested in the

company.

Debt Capital : Borrowed funds from banks financial institutions.

Long term finance Short term finance

1. More than 1 year (typically 3 - 5+ 1. Less than 1 year

years)

2. Capital expenditure expansion large 2. Working capital, daily operations,

project, acquiring major assets seasonal demand, cash flow gaps

3. Usually low interest rate but large 3. Usually higher interest rates for
amount involved quick access

4. Higher financial commitment over 4. Less risky, due to short repayment

long period time

Long term Sources

1. Equity Capital: funds via IPO or private investors, ownership is shared.
2. Preference shares: shares with fixed divided & priority repayment.
3. Debentures: Fixed interest instruments for long term borrowing
4. Term loans: Bank loans for 5-10+ years to fund big project/assets.
5. Retained Earnings: Profits reinvested in business instead of distribution
6. Bonds: Long term debt securities issued to raise capital.
Short Term Source

Trade credit : Credit from supplier to buy goods now, pay later.

Bank overdraft : Facility to withdraw more than account balance.

Cash credit : Borrow from bank against security.

Short term : Loans with repayment period loans under 1 year.

Cost of Capital

Cost of capital is the minimum rate of return or profit a company must earn
before generating value.

Company view : The cost of a company funds the rate of return the firm
must earn from investment to increase market value.

Investor view : The minimum return that investors expected for providing capital
to the company.

Relevance of Cost of capital

Cost of capital is "the most important number from buying new equipment to
opening a new branch"

●​ Investment Decision making:

Used to evaluate new projects, comparing expected return with cost of
capital tells you if the investment is worthwhile.

●​ Capital Budgeting:
used as the discount rate for NPV and IRR calculations to determine
projects.

●​ Performance Benchmark:
If company returns on employed capital is higher than cost to capital, it
creates value if not it erodes value.
 ●​ Financial planning:
Provides clarity on how much you're really paying to fund the Business,
making financial forecast & more accurate.

Classification of cost of capital

A. By source of capital
1. cost of Debt : Borrowed money (loans & debenture bonds) interest paid.
kd = interest Expense (1 - Tax Rate)

2. cost of Equity : Returned expected by shareholders

ke = Rf + β (Rm - Rf)

3. Cost of preference : The rate of return required by preferred shareholders.

cost = dividend / Net proceeds

4. cost of Retained Earning : Opportunity cost of profits kept in business

B. By Nature cost
1. Explicit cost : The discount rate that equals present value of cash inflow
with cash outflow, actual cost paid

2. Implicit cost : Opportunity cost & return forgone by choosing one alternative
over another.

3. By time Perceptual
1. Historical cost : cost based on past financing decision used for analysis of
past performance.

2. Future / Expected Cost: cost based on expected future returns used for
decision making on new projects

cost of capital

1. Specific cost of capital

A. Cost of Debt (kd)

The cost of borrowed money (loans / debentures bonds)

Before tax cost of debt:

kd = Interest Expense
_______________________
Net Proceeds from debt

After tax cost of debt:

kd = Interest Rate x (1 - T)

B. Cost of Equity (ke)

Method 1: Capital Asset Pricing Model

ke = Rf + Bi x (Rm - Rf)

Rf = Risk free rate of return,

B = Stock's volatility relative to market
Rm = Expected market rate of return
Rm - Rf = Market risk premium

Method 2 : Divided Yield plus Growth Model

Ke = D1/Po + g

D1 = Expected annual dividends

Po = Current stock price
g = Dividend growth rate
c. Cost of Preference Share Capital

kd = Divided
_______________________
Net Proceeds from Issue

D. Cost of Retained Earning

Kr = ke

2. Weighted Average Cost of Capital

WACC = ( E / V * ke ) + ( P / V * Kd * ( 1 - T ))

E = Market value of equity

D = Market value of debt
V = Total value ($E+D$)
Ke = Cost of equity
kd = Cost of debt
T = Tax rate

Example

Assume a company has

Equity (E) = 60 lakh, cost of Equity (Ke) = 12%

Debt (D) = 40 lakh, interest rate = 10%
Tax rate = 30%

Step 1 = Total value V = 60 + 40

= 100 lakh

Step 2 = weights
We = 60/100 = 0.60
Wd = 40/100 = 0.40
Step 3 = After tax cost of debt
Kd = 10% x (1 - 0.30) = 7%

Step 4 = WACC = (0.60 x 12%) + (0.40 x 7%)

WACC = 7.2% + 2.8% = 10%