## Chapter 1 – Scope and Objectives

**Financial accounting vs financial management**

- Financial accounting: records, classifies and summarizes monetary transactions and

prepares financial statements. [1]

- Financial management: uses accounting information plus other data to make decisions to
maximize shareholders’ wealth (investment, financing, dividend). [1]

- Accounting provides inputs (EPS, cash flow, profits, receivables/payables, liquidity,

post‑tax profits) which finance uses for decisions; “financial management starts where
financial accounting ends”. [1]

**Responsibilities and role of finance manager**

- Core functions:

- Raising of funds (choosing sources, timing, terms). [1]

- Proper allocation of funds to all parts of the enterprise (capital budgeting, working
capital). [1]

- Other responsibilities:

- Evaluate financial performance (profit, wealth maximisation). [1]

- Deal with banks, FIs, shareholders, etc. [1]

- Monitor share prices and market behaviour. [1]

- Three key decisions: investment (asset mix), financing (capital mix), dividend (profit
allocation). [1]

**Traditional, transitional and modern approach**

- Traditional: focus on procurement of funds; episodic; ignores working capital, utilization
of funds and internal perspective. [1]

- Transitional: post‑WWII scarcity; emphasis on efficient utilization of funds and capital

structure issues. [1]

- Modern: covers fund requirement, financing, investment and dividend decisions; financial
management a continuous, integral part of management. [1]

**Basic financial decisions (all involve risk–return trade‑off)**

- Fund requirement (capitalisation for LT and ST needs). [1]

- Financing (debt–equity mix, fixed vs variable cost funds). [1]

- Investment (capital budgeting and working capital). [1]

- Dividend (payout vs retention, influencing shareholders’ wealth). [1]

**Risk, business risk, financial risk**

- Risk: variability of actual return from expected return. [1]

- Systematic risk (non‑diversifiable): due to economy‑wide factors; includes market risk,

interest rate risk, purchasing‑power/inflation risk. [1]

- Unsystematic risk (diversifiable): firm‑specific; business risk and financial risk. [1]

- Business risk: variability in earnings due to internal (strikes, power shortage) and external
(demand, input prices) causes. Internal can be managed, external difficult. [1]

- Financial risk: arises from use of debt; fixed interest must be paid irrespective of profits;
higher debt → higher financial risk. [1]

**Risk–return trade‑off and portfolio diversification**

- Higher return is associated with higher risk; finance manager must balance maximum
return with minimum risk. [1]

- Diversification (combining securities with low/negative correlation) reduces portfolio risk

without proportionate fall in return. [1]
**Profit maximisation vs wealth maximisation**

- Profit maximisation:

- Focus on total profit. [1]

- Ignores timing (time value), risk, and impact on shareholders’ wealth (EPS, DPS, market
value). [1]

- ‘Profit’ itself is vague; not an operationally sound decision criterion. [1]

- Wealth maximisation:

- Goal is maximisation of market value per share (shareholders’ wealth). [1]

- Based on cash flows, time value and risk (discounted cash flow). [1]

- Consistent with interests of shareholders, creditors, employees and society; superior

operational guide. [1]

**Time value of money (TVM)**

- Money today is preferred to same amount in future because of uncertainty, preference for
current consumption and investment opportunities. [1]

- Expressed via interest rate; even at zero risk, risk‑free rate exists. [1]

- Cash flows of different periods are comparable only at present value; NPV method
explicitly uses TVM. [1]

**Agency problem and corporate governance**

- Agency problem: separation of ownership (shareholders/principals) and control

(managers/agents); managers may maximise own utility (remuneration, perks) rather than
shareholders’ wealth. [1]

- Resolution: shareholder monitoring, ESOPs, performance‑linked compensation. [1]

- Corporate governance: system ensuring management acts in best interest of all

stakeholders (shareholders, creditors, employees, etc.), resolving conflicts among them.
[1]
## Chapter 2 – Capital Budgeting Process

**Cash flow vs profit**

- Cash flows: actual inflows and outflows from project (sale proceeds, operating cash,
asset purchase, installation, working capital). [1]

- Profits include non‑cash items (depreciation etc.). [1]

- For capital budgeting, cash flows are preferred because they:

- Apply TVM.

- Reflect actual liquidity impact.

- Are unaffected by accounting policy changes. [1]

**Incremental and after‑tax cash flows**

- Incremental cash flows: only additional inflows/outflows attributable to the project;

common fixed overheads ignored unless changed by project. [1]

- Adjusted for tax; capital budgeting uses incremental after‑tax cash flows. [1]

**Capital budgeting & irreversibility**

- Capital budgeting: analysis and selection of long‑term investments (expansion,

diversification, replacement, modernisation). [1]

- Often irreversible because of large sunk costs; premature abandonment causes heavy
loss. Hence requires careful planning and forecasting. [1]

**Cash flow vs accounting profit approach**

- Accounting profit: based on accrual, affected by methods (depreciation, inventory

valuation). [1]
- Cash flow: receipts minus payments over period. [1]

- Cash flow approach is superior because:

- Single, objective way to compute.

- Removes non‑cash items.

- Recognises TVM and actual cash requirements. [1]

**Capital budgeting techniques overview**

- Traditional (non‑discounted):

- Payback Period (PBP).

- Accounting Rate of Return (ARR). [1]

- Discounted cash flow:

- Net Present Value (NPV).

- Profitability Index (PI).

- Internal Rate of Return (IRR). [1]

### Payback Period (PBP)

- Definition: time required to recover initial investment from cash inflows. [1]

- Equal inflows: PBP = Initial investment / Annual cash inflow. [1]

- Unequal inflows: use cumulative cash flows; PBP = A + B/C (A = last year with negative
cumulative CF, B = shortfall at A, C = CF in next year). [1]

- Decision: accept if PBP < target payback; shorter PBP preferred. [1]

**PBP – merits and demerits**

- Advantages: very simple; highlights liquidity and (indirectly) risk by stressing early inflows.
[1]
- Limitations:

- Ignores post‑payback cash flows and project life.

- Ignores TVM; treats all pre‑PBP inflows equally.

- Measures capital recovery, not profitability; hence “does not measure profitability”. [1]

- Still popular where outlook is uncertain, in politically unstable economies and for firms
facing liquidity crisis. [1]

### Accounting Rate of Return (ARR)

- ARR = (Average annual profit after tax) / (Average investment) × 100. [1]

- Average investment (SLM depreciation): ≈ (Initial cost + installation – salvage value +

salvage value)/2; add working capital if required. [1]

- Decision: accept if ARR ≥ required rate. [1]

- Advantages: simple, considers accounting profitability. [1]

- Limitations: ignores TVM; uses accounting profit not cash flow; ignores project life and
scale. [1]

### Net Present Value (NPV)

- NPV = Σ CFₜ/(1+k)ᵗ – C₀, where k is discount (required return/cost of capital). [1]

- Decision:

- Accept if NPV > 0 (adds to shareholders’ wealth).

- Reject if NPV < 0.

- Choose highest positive NPV among mutually exclusive projects; indifferent if NPV = 0.
[1]

- Merits: uses TVM; considers all cash flows; aligns with wealth maximisation; incorporates
risk via discount rate. [1]
- Demerits: requires appropriate k; tricky with unequal lives and different scales. [1]

### Profitability Index (PI)

- PI = PV of cash inflows / PV of outflows. [1]

- Decision:

- Accept if PI > 1; reject if PI < 1; indifferent if PI = 1. [1]

- For rationed capital, higher PI preferred. [1]

- Differences from NPV: NPV is absolute measure; PI is relative. NPV better generally; PI
useful under capital rationing and unequal outlays. [1]

### Internal Rate of Return (IRR)

- IRR: discount rate at which NPV = 0 (PV of inflows = initial outlay). [1]

- Computation: trial and error with two rates and interpolation; separate procedure for
equal vs unequal inflows. [1]

- Decision: accept if IRR > required rate (k); reject if IRR < k; choose highest IRR among
mutually exclusive projects (subject to limitations). [1]

### NPV vs IRR conflicts

- For a single independent project with conventional cash flows, NPV and IRR always give
same accept/reject decision. [1]

- Conflicts in ranking arise when:

- Projects differ in size (scale).

- Projects have different timing of cash flows.

- Projects have unequal lives or unconventional cash flows. [1]

- Preferred criterion: NPV, as it directly measures addition to shareholders’ wealth and
assumes reinvestment at cost of capital rather than at IRR. [1]

### Risk‑adjusted discount rate vs certainty equivalent

- Risk‑adjusted discount rate (RAD): increase k for riskier projects, lower it for safer ones;
simple and widely used. [1]

- Certainty equivalent approach (CEA): adjust cash flows (not k) to risk‑free equivalents
using certainty‑equivalent factors, then discount at risk‑free rate; theoretically superior
and more precise in measuring risk. [1]

## Chapter 3 – Cost of Capital and Financing Decision

**Explicit vs implicit cost**

- Explicit cost: observable required return to suppliers of funds (interest on debt,

preference dividend, expected equity return). [1]

- Implicit cost: opportunity cost where no explicit payment (e.g. retained earnings –
shareholders forgo alternative return). [1]

**Cost of retained earnings**

- Not free: represents dividend foregone by shareholders. [1]

- Approximated as cost of equity, adjusted for shareholders’ tax and brokerage: kᵣ = kₑ (1 –

t)(1 – B). [1]

- Hence “cost of retained earnings is same as cost of equity”, conceptually, apart from
floatation differences. [1]

**Cost of equity – main approaches**

- Dividend discount/valuation model:

- Constant growth: kₑ = D₁/P₀ + g. [1]

- Multi‑stage growth: present value of explicitly forecast dividends plus terminal value,
solved by trial and error. [1]

- CAPM approach (mentioned as alternative): kₑ = Rf + β(Rm – Rf) (not worked out in text but
standard). [1]

**Existing vs fresh equity issue**

- Cost of new equity shares > cost of existing equity because net proceeds (NP) < market
price (P₀) due to floatation cost; kₑ(new) = D₁/NP + g. [1]

- Hence statement “costs are always same” is incorrect. [1]

**Effect of tax and floatation costs**

- Tax: cost of debt after tax = kᵈ(1 – T). Higher tax rate → lower after‑tax cost of debt → lower
WACC. [1]

- Floatation cost: reduces net proceeds, increasing cost of new issues of debt/equity; new
capital always costlier than existing. [1]

**Market value weights vs book value weights**

| Aspect | Book value weights | Market value weights |

|--------|--------------------|----------------------|

| Basis | Balance sheet (face values) [1] | Current market prices of securities [1] |

| Volatility | More stable, but may be outdated [1] | Reflect current investor expectations [1] |

| Relevance to WACC | Less consistent with value‑based definition [1] | Better estimate of
required return and true WACC [1] |

- For marginal weights (new financing), market value basis is compulsory. [1]
**Cost of preference share capital vs equity**

- Preference: fixed dividend, priority over equity in dividends and capital on liquidation; risk
lower. [1]

- Equity: residual claim, highest risk; therefore cost of equity > cost of preference capital.
[1]

**Trading on equity / financial leverage**

- Trading on equity: using debt (and preference capital) to increase EPS when ROI > cost of
debt. [1]

- Limitations:

- Double‑edged sword: if ROI < cost of debt, leverage reduces EPS. [1]

- Increases financial risk and interest cost with more borrowing. [1]

- Harmful with volatile earnings; fixed charges strain firm in bad years. [1]

- Lenders/DFIs impose restrictive covenants if leverage too high. [1]

- Objective is to increase, not decrease, EPS; statement that it is used to “decrease EPS” is
wrong. [1]

**Leverage types and EBIT–EPS analysis**

- Operating leverage (OL): impact of change in sales on EBIT (due to fixed operating costs).
[1]

- Financial leverage (FL): impact of change in EBIT on EPS (due to fixed financial charges).
[1]

- Combined leverage: effect of change in sales on EPS (OL × FL). [1]

- EBIT–EPS analysis: compares EPS at different EBIT levels under alternative capital
structures to choose financing mix; high leverage desirable only if expected ROI > cost of
debt and EBIT is stable. [1]

- Finance manager must monitor degree of FL; high OL should normally be combined with
lower FL to avoid excessive total risk. [1]

**Financial break‑even point**

- Financial break‑even EBIT: EBIT at which EPS = 0; covers interest (I) and preference
dividend (PD, after tax): roughly EBIT = I + PD/(1 – t). [1]

- Lower break‑even is safer; used in financial planning. [1]

## Chapter 5 – Working Capital Decision (from extract)

**Permanent vs temporary working capital**

- Permanent (fixed) WC: minimum level of current assets (cash, stock, receivables)
required at all times to run business; similar to fixed assets. [1]

- Temporary (fluctuating) WC: extra current assets required to meet seasonal/ cyclical or
special demand; varies with sales level. [1]

**Sources of working capital**

- Long‑term (for permanent WC): equity, preference shares, debentures, term loans,
retained earnings. [1]

- Short‑term (for variable WC):

 - Bank credit: demand loans, overdrafts, cash credit, advances, discounting of bills,
letters of credit. [1]

- Trade credit from suppliers. [1]

- Advances from customers. [1]

- Bill discounting (convert receivables into cash quickly). [1]

**Motives for holding cash**

- Transaction: meet expected regular payments where inflows and outflows are not
perfectly synchronized. [1]

- Precautionary: cushion against unexpected contingencies (delays, emergencies). [1]

- Speculative: exploit unexpected profitable opportunities (e.g. bargain purchases). [1]

- Compensation: maintain minimum balances to compensate banks for services like

current accounts. [1]

**Non‑synchronisation of cash flows and short costs**

- Non‑synchronisation: mismatch in timing and quantum of cash inflows and outflows →

need for cash balances. [1]

- Short costs (costs of cash shortage):

- Transaction cost (selling marketable securities to raise cash). [1]

- Borrowing cost (interest on emergency loans). [1]

- Loss of cash discounts. [1]

- Extra interest and penalty due to deterioration in credit rating and delayed payments. [1]

**Managing cash inflows (collection)**

- Encourage prompt payment: correct and timely billing, clear due dates, self‑addressed
envelopes, cash discounts. [1]

- Faster conversion of remittances into cash: reduce mail, processing and collection time;
decentralised collections. [1]

**Float management**

- Payment float: cheques issued but not yet cleared reduce firm’s book balance but not
bank balance. [1]

- Collection float: cheques received and recorded but not yet realised by bank. [1]

- Net float = payment float – collection float; proper “playing the float” can temporarily
reduce required cash but is risky. [1]

**Concentration banking and lock‑box system**

- Concentration banking: multiple regional collection centres; local deposits periodically

swept to head office account (“concentration bank”). [1]

- Lock‑box system: customers mail payments to PO box operated by bank; bank collects
and deposits directly, reducing collection float and processing delays. [1]

- With modern banking tech, both methods are less relevant, but remain important exam
concepts. [1]

**Cash budget**

- Cash budget: short‑term estimate of cash receipts, payments and resulting balances
(usually monthly). [1]

- Uses: ensure timely payments; plan borrowings for expected shortages; invest expected
surplus; assess feasibility of capital spending from internal funds. [1]
**Baumol model of cash management**

- Objective: determine optimal cash withdrawal/transfer size that minimises total cost =
transaction cost + opportunity cost. [1]

- Optimal cash balance: C* = √(2bt/i), where b = fixed cost per transaction, t = total cash
requirement over period, I = interest rate. [1]

- Assumes constant cash usage; useful conceptually for trade‑off between holding and
transaction costs. [1]

**Miller–Orr model (brief)**

- Sets lower limit, upper limit and target cash balance; when cash hits upper limit, invest
excess; when it hits lower limit, sell securities/borrow to return to target. [1]

- More realistic for random cash flows than Baumol.