A.

FINANCIAL MANAGEMENT FUNCTION

1. Nature and purpose of financial management
Financial management means managing a company’s money. It has 3 main jobs:
Decide where to invest money (projects, assets)
Decide how to get money (loans, shares)
Decide how much profit to pay to shareholders
In simple terms, it helps the business use money well to grow and survive.

2. Relationship between financial management, financial accounting, and management accounting

Financial accounting records past results for outsiders.
Management accounting gives information inside the company for planning and control.
Financial management uses both to make future decisions.
So, financial accounting looks back, management accounting looks inside, and financial management looks forward.

FINANCIAL OBJECTIVES & CORPORATE STRATEGY

3. Relationship between financial objectives, corporate objectives, and strategy
Corporate objectives are the big goals (growth, survival).
Financial objectives are money goals (profit, shareholder wealth).
Corporate strategy is the plan to reach these goals.
Simply: corporate objectives = goals, financial objectives = money goals, strategy = plan.

4. Types of financial objectives

Shareholder wealth maximisation: increase company value for shareholders.
Profit maximisation: make highest possible profit.
Earnings per share growth: increase profit per share.

STAKEHOLDERS
5. Stakeholders and their objectives
Shareholders want higher returns.
Employees want good pay and job security.
Customers want good quality and low prices.
Suppliers want timely payments.
Government wants taxes.
Community wants safe, ethical behaviour.
Lenders want interest and repayment.

6. Conflicts between stakeholder objectives

Examples:
Shareholders want high profit but customers want low prices.
 Employees want high salaries but shareholders want low costs.
Government wants more tax but companies want to save tax.
What one group wants can sometimes hurt another group.

7. Role of management and agency theory

Agency theory: managers run the company for shareholders but may act for themselves.
Management’s job is to balance stakeholder needs and work for long-term success, not just themselves.

8. Measuring achievement of corporate objectives

Look at changes in share price and dividends paid. Together, these show total shareholder return (TSR). If TSR rises, goals are b

9. Encouraging managers to meet stakeholder objectives

Reward managers with share options or pay linked to performance.
Follow rules like corporate governance codes and stock market regulations to ensure fairness and good behaviour.

NOT-FOR-PROFIT ORGANISATIONS
10. Impact of not-for-profit status on objectives
NFPs don’t aim for profit but to provide services. Their financial goal is to stay within budget and use money wisely.

11. Value for Money (VfM)

VfM means using resources:
Economically (buy cheaply)
Efficiently (use well)
Effectively (achieve goals)

12. Measuring objectives in NFPs

Measure by:
Number of people helped
Quality of service
Waiting times
Customer satisfaction
Cost savings
Target achievement
NFP success is about serving people well, not profit.
B. Financial Management Environment
1. The economic environment for business

a) Main macroeconomic policy targets:

Economic growth: Increase the size of the economy and production.

Low inflation: Keep price rises stable and not too high.

Low unemployment: Make sure most people who want jobs can find one.

Stable balance of payments: Keep the country’s imports and exports balanced.

Stable currency: Avoid big changes in money value (exchange rates).

b) Role of policies:

Fiscal policy: Government controls spending and taxes to influence the economy. For example, lowering taxes to encourage

Monetary policy: Central bank controls money supply and interest rates to control inflation and growth.

Interest rate policy: Adjusting interest rates to influence borrowing and spending.

Exchange rate policy: Managing currency value to keep exports competitive and control inflation.

c) How government economic policy interacts with business planning:

Businesses must consider government policies (like taxes, interest rates, regulations) when making plans.

For example, if the government increases interest rates, businesses may borrow less and delay investment.

Policies affect costs, demand, and business risks, so companies adjust their strategies accordingly.

d) Need for and interaction with planning and decision-making in business of:

Competition policy: Ensures fair competition, so businesses must plan to compete effectively without breaking laws.
 Government assistance for business: Grants or subsidies can help businesses grow or innovate, so businesses plan to use th

Green policies and sustainability: Businesses need to plan for environmental laws and sustainable practices to avoid penalti

Corporate governance regulation: Ensures businesses act responsibly and transparently; companies must plan to follow the

2. The nature and role of financial markets and institutions

a) Nature and role of money and capital markets (national and international):

Money markets: Deal with short-term borrowing and lending (less than 1 year).

Capital markets: Deal with long-term funds, like stocks and bonds.

These markets help businesses and governments raise money and investors to earn returns.

International markets allow businesses to access funds globally.

b) Role of financial intermediaries:

Financial intermediaries (like banks, insurance companies) connect savers with borrowers.

They make borrowing easier and safer by assessing risks and providing advice.

c) Functions of stock market and corporate bond market:

Stock market: Helps companies raise capital by selling shares; investors can buy and sell ownership.

Corporate bond market: Companies borrow money by issuing bonds to investors who get interest payments.

d) Impact of Fintech:

Fintech (financial technology) has made financial services faster, cheaper, and more accessible.

Examples: Mobile banking, online loans, cryptocurrencies.

It changes how markets operate and makes services more efficient.

3. The nature and role of the money market

a) Roles:

Short-term liquidity: Provides businesses and governments with quick access to cash.

Short-term trade finance: Helps companies pay for goods and services before they sell products.

Managing foreign currency and interest rate risk: Allows companies to protect themselves from currency value changes and

b) Role of banks and other financial institutions:

Banks act as intermediaries in money markets, lending and borrowing short-term funds.

Other institutions (like money market funds) help facilitate trading and manage risks.

c) Principal money market instruments:

Interest-bearing instruments: Pay interest over short periods (e.g., certificates of deposit).

Discount instruments: Sold below face value and mature at face value (e.g., Treasury bills).

Derivative products: Contracts based on the value of underlying assets, used to manage risk (e.g., futures, options).

E. Business Finance
Sources of, and raising, business finance

Businesses raise short-term finance for working capital (e.g., bank overdrafts, trade credit).

Long-term Islamic finance methods include:

Mudarabah: Profit-sharing partnership.

 Murabaha: Cost-plus financing (seller discloses cost + profit).

Ijara: Leasing.

Sukuk: Islamic bonds.

These comply with Islamic law by avoiding interest (riba).

F. Business Valuations
Efficient Market Hypothesis (EMH) and valuation of shares

Weak form efficiency: All past price info is reflected in share prices; technical analysis won't help predict prices.

Semi-strong form efficiency: All public information is reflected in prices; fundamental analysis won’t give an advantage.

Strong form efficiency: All information, public and private, is reflected; no one can consistently outperform the market.

G. Risk Management
Causes of exchange rate differences and interest rate fluctuations

Interest rate fluctuations caused by:

Structure of interest rates and yield curves: Relationship between short-term and long-term rates.

Expectations theory: Investors’ expectations about future interest rates influence current rates.

Liquidity preference theory: Investors prefer liquidity and demand higher rates for less liquid investments.

Market segmentation: Different investors focus on different maturities, affecting rates independently.
arket products.
Superiority of Discounted Cash Flow (DCF) methods over non-DCF methods
What are DCF methods?

DCF methods (like NPV and IRR) calculate the present value of all expected future cash flows from a project or investment, d

This means they consider time value of money — money today is worth more than the same amount in the future because

What are non-DCF methods?

Non-DCF methods (like Payback Period or Accounting Rate of Return (ARR)) do not consider the time value of money. They

Why are DCF methods superior?

1. Time Value of Money:

DCF accounts for the fact that receiving $100 today is better than $100 in 3 years. Non-DCF ignores this.

2. Cash Flow Focus:

DCF uses actual cash flows, not accounting profits, giving a better picture of real money generated.

3. Considers all cash flows:

DCF methods include all future cash flows over the life of the project, while some non-DCF methods may only focus on ear

4. Risk and return:

The discount rate in DCF can reflect risk and opportunity cost, helping to better evaluate projects with different risk levels.

5. Better decision criteria:

DCF provides clear decision rules (e.g., NPV > 0 means accept), making it easier to compare projects.
Relative merits of NPV and IRR
NPV (Net Present Value):

Definition: Total present value of cash inflows minus outflows.

Merits:

Measures actual value added in currency terms.

Easy to interpret: positive NPV means profit, negative means loss.

Works well with different project sizes and mutually exclusive projects.

Uses a clear discount rate based on cost of capital or required return.

IRR (Internal Rate of Return):

Definition: The discount rate that makes the NPV zero. It shows the project’s expected rate of return.

Merits:

Easy to understand as a percentage rate.

Useful for comparing projects when the discount rate is unknown or varies.

Widely used in practice for quick decision-making.

Key differences and issues:

Aspect NPV

Decision rule Accept if NPV > 0

Measures Value added in currency terms

Handles scale Compares different project sizes well

Multiple IRRs No issue

Reinvestment
Assumes reinvestment at discount rate (realistic)
assumption

Preferred for Value maximization

Summary:

NPV is generally considered better because it measures actual value added and handles different project sizes well.

IRR is useful for quick comparisons but can give misleading results if cash flows are unusual or when comparing projects of d
DCF) methods over non-DCF methods

all expected future cash flows from a project or investment, discounted back to today’s value using a required rate of return (discount rat

y is worth more than the same amount in the future because it can be invested.

Return (ARR)) do not consider the time value of money. They look at raw numbers or simple averages.

than $100 in 3 years. Non-DCF ignores this.

etter picture of real money generated.

project, while some non-DCF methods may only focus on early returns (like payback period).

, helping to better evaluate projects with different risk levels.

), making it easier to compare projects.

s the project’s expected rate of return.

own or varies.

IRR

Accept if IRR > required rate

 Rate of return (%)

Can mislead with different project sizes

May have multiple IRRs for complex cash flows

Assumes reinvestment at IRR (may be unrealistic)

Simplicity and return rate focus

value added and handles different project sizes well.

ults if cash flows are unusual or when comparing projects of different sizes.
ate of return (discount rate).
D. Investment Appraisal
1. Identify and calculate relevant cash flows for investment projects

Relevant cash flows are the actual cash inflows and outflows caused directly by the investment project.

Initial investment cost (outflow)

Operating cash inflows (e.g., sales revenue)

Operating cash outflows (e.g., costs, maintenance)

Changes in working capital (increase = outflow, decrease = inflow)

Salvage (resale) value at the end of the project

Exclude sunk costs (already spent, no change) and financing costs (like interest) when calculating project cash flows.

2. Allowing for inflation and taxation in DCF

Inflation affects cash flows by increasing prices and costs over time.

Taxation reduces net cash flows by tax payments but may offer tax benefits on depreciation.

3. Real-terms and nominal-terms approaches to investment appraisal

Nominal terms: Cash flows and discount rate include inflation.

Use actual money values expected in the future (with inflation).

Discount rate also includes inflation (nominal rate).

Real terms: Cash flows and discount rate exclude inflation.

Use cash flows adjusted for inflation (constant money value).

Discount rate excludes inflation (real rate).

Important: You must be consistent — either use nominal cash flows with nominal discount rate or real cash flows with rea
4. Calculate taxation effects of relevant cash flows

Tax reduces profits and hence cash flows.

Taxable profit = Revenue - allowable expenses (including depreciation)

Depreciation is tax-allowable but not a cash flow (it's an accounting expense).

Tax benefit from depreciation = Depreciation × tax rate (reduces tax paid, so it's a cash inflow)

Calculate tax liability based on taxable profit.

After-tax cash flow = Pre-tax cash flow - tax paid + tax shield from depreciation

5. Calculate and apply before-tax and after-tax discount rates

Before-tax discount rate: Used when cash flows are measured before tax.

After-tax discount rate: Used when cash flows are measured after tax.

After-tax discount rate = Before-tax discount rate × (1 - tax rate)

Using the right discount rate is crucial to correctly value the project depending on how cash flows are estimated.
Mixing them leads to wrong results.
D. Investment Appraisal: Specific Investment Decisions
1. Lease or Buy decision

Evaluate by comparing the costs of leasing versus borrowing to buy an asset.

Calculate the before-tax cost of debt (interest rate on borrowing).

Calculate the after-tax cost of debt since interest payments reduce taxable profit (after-tax cost = before-tax cost × (1 - tax r

Compare:
Total cost of leasing (lease payments)

Total cost of buying (loan repayments plus other costs)

Choose the option with the lower after-tax cost and better cash flow impact.

2. Asset replacement decisions

Use Equivalent Annual Cost (EAC) or Equivalent Annual Benefit (EAB) to compare assets with different lives.

EAC: Convert total costs of owning the asset into equal annual amounts (useful when minimizing cost).

EAB: Convert benefits into equal annual amounts (useful when maximizing benefits).

Choose the asset with the lowest EAC or highest EAB to decide replacement.

3. Investment decisions under single-period capital rationing

When capital (budget) is limited, choose projects that maximize return within the budget.

Methods:

Profitability Index (PI):

PI = Present Value of future cash flows / Initial investment

For divisible projects, rank by PI and invest until the budget is exhausted.
 Higher PI means better return per unit of investment.

NPV of combinations of non-divisible projects:

For projects that must be taken as whole (not divisible), calculate NPVs of all possible combinations that fit the budget.

Choose the combination with the highest total NPV.

Reasons for capital rationing:

Limited funds available for investment.

Risk control to avoid over-investment.

Management constraints or borrowing limits.

E. Business Finance: Sources of finance and their relative costs

1. Assessing impact of sources of finance on:

Financial position:

Borrowing increases liabilities and leverage.

Leasing may or may not appear as a liability depending on accounting rules.

Equity increases shareholders’ funds but dilutes ownership.

Financial risk:

More debt increases financial risk due to fixed interest payments.

Leasing may have similar risk to debt.

Equity financing carries less risk to the company but costs more (dividends are not obligatory).
 Shareholder wealth:

Aim to choose finance that minimizes overall cost of capital and maximizes shareholder value.

Consider impact on earnings per share (EPS) and control.

2. Leasing vs borrowing to buy

Leasing often requires no large upfront payment and includes maintenance, but total cost can be higher.

Borrowing to buy requires upfront payment or loan, with interest costs but asset ownership and potential tax benefits (depr

Compare costs after tax to decide which is cheaper and better for cash flow and risk.
D. Investment Appraisal
1. Discounted Payback Period (DPP)

What is it?
The time it takes for the discounted (present value) cash inflows to recover the initial investment.

How to calculate:

Discount each cash inflow to present value using the project’s discount rate.

Add discounted cash flows year by year until the initial investment is fully recovered.

The number of years taken is the discounted payback period.

Usefulness:

Considers time value of money (unlike simple payback).

Helps assess how quickly investment is recovered with risk adjustment.

Useful for liquidity and risk-averse investors.

However, it ignores cash flows after payback and doesn’t measure total profitability.

2. Risk and Uncertainty

Risk: Situations where probabilities of different outcomes are known or can be estimated.

Uncertainty: Situations where probabilities are unknown or cannot be estimated reliably.

Longer project life increases uncertainty because predicting future events becomes harder.

3. Sensitivity Analysis

Tests how sensitive a project’s NPV or other appraisal results are to changes in key variables (e.g., sales volume, costs, discou
 By changing one variable at a time, it shows which variables impact results the most.

Usefulness:

Helps identify critical factors and risks.

Shows how much variables can change before the project becomes unprofitable.

Helps management focus on key risks to control.

4. Probability Analysis

Uses probabilities for different outcomes to calculate expected values (like expected NPV).

Can use decision trees or probability distributions.

Usefulness:

Quantifies risk by considering different scenarios and their likelihood.

Helps compare projects under uncertainty more realistically than single-value estimates.

5. Other Risk Adjustment Techniques

Simulation (e.g., Monte Carlo simulation):

Uses random sampling of key variables repeatedly to model a range of possible outcomes and their probabilities.

Provides a probability distribution of possible NPVs.

Helps understand risk and variability comprehensively.

Adjusted Payback:
 Modifies payback period to reflect risk, often by using discounted cash flows or adjusting cash flows for risk factors.

Risk-Adjusted Discount Rates:

Increases discount rate for riskier projects to reduce present value of uncertain cash flows.

Projects with higher risk get higher discount rates, reflecting required higher returns.
, costs, discount rate).
E. Business Finance
1. Long-term sources of finance available to businesses

Equity finance: Money raised by selling shares (ownership) in the company. No obligation to repay, but shareholders expect

Venture capital: Financing provided by investors to startups or small companies with high growth potential in exchange for e
support and advice. Risky but can provide large funding.

2. Methods of raising equity finance

Rights issue: Offering existing shareholders the right to buy new shares at a discount before the public, to raise new capital.

Placing: Selling shares directly to selected investors, usually institutional investors.

Public offer (IPO): Selling shares to the general public for the first time.

Stock exchange listing: Listing shares on a stock exchange to allow trading and increase liquidity and visibility.

3. Internal sources of finance

Retained earnings: Profits kept in the business instead of paid as dividends, used for reinvestment.

Increasing working capital management efficiency: Improving how a business manages its receivables, payables, and invent

Dividend policy and financing decision: Paying higher dividends means less retained earnings for financing. Lower dividends

4. Financing needs of Small and Medium-sized Enterprises (SMEs)

SMEs often need finance to start, grow, or manage cash flow.

5. Financing problems for SMEs

Funding gap: Difference between what SMEs need and what traditional lenders are willing to provide.

Maturity gap: SMEs often want long-term finance but lenders prefer short-term loans.

Inadequate security: SMEs often lack sufficient assets to offer as loan collateral.

6. Measures to ease SME financing problems

Government departments may offer grants, guarantees, or loan schemes.

 Financial institutions may provide special SME lending programs.

7. Financial impact of sources of finance for SMEs

Business angel financing: Wealthy individuals who invest personal funds in SMEs for equity and often business advice.

Government assistance: Grants, subsidies, tax incentives, or loan guarantees to reduce financing costs.

Crowdfunding: Raising small amounts of money from many people via online platforms. Can be equity-based, rewards-based

Lower dividends or no dividends mean more internal funds available.

Legal rules, company liquidity, shareholder expectations, and alternatives like share buybacks affect dividend decisions.

4. Financing needs of Small and Medium-sized Enterprises (SMEs)

SMEs often need finance to start, grow, or manage cash flow.

5. Financing problems for SMEs

Funding gap:
Difference between what SMEs need and what traditional lenders are willing to provide.

Maturity gap:
SMEs often want long-term finance but lenders prefer short-term loans.

Inadequate security:
SMEs often lack sufficient assets to offer as loan collateral.

6. Measures to ease SME financing problems

Government departments may offer grants, guarantees, or loan schemes.

Financial institutions may provide special SME lending programs.

7. Financial impact of sources of finance for SMEs

Business angel financing:
Wealthy individuals who invest personal funds in SMEs for equity and often business advice.

Government assistance:
Grants, subsidies, tax incentives, or loan guarantees to reduce financing costs.

Crowdfunding:
Raising small amounts of money from many people via online platforms.

Can be equity-based, rewards-based, or donation-based.

more internal funds available. Legal rules, company liquidity, shareholder expectations, and alternatives like share buybacks affect divide
e share buybacks affect dividend decisions.
E. Business Finance
1. Short-term sources of finance available to businesses

Overdraft: A facility allowing businesses to withdraw more money than they have in their bank account, up to an agreed lim

Short-term loan: Borrowing money for a fixed short period, often with regular repayments and interest.

Trade credit: An agreement where suppliers allow businesses to buy now and pay later, usually within 30-90 days.

Lease finance: Using leased assets with regular payments instead of buying, sometimes used short-term for equipment.

2. Long-term sources of finance available to businesses

Debt finance: Borrowing money for longer periods through loans or bonds, with fixed interest payments and repayment term

Lease finance: Long-term leasing of assets, allowing use without owning, with payments spread over years.

3. Finance for small- and medium-sized entities (SMEs)

Business angel financing: Wealthy individuals investing personal funds in SMEs, often providing advice and connections alon

Government assistance: Grants, subsidies, loans, or guarantees aimed to reduce financing barriers for SMEs.

Supply chain financing: Financing solutions that optimize cash flow by allowing SMEs to receive early payment on invoices th

Peer-to-peer funding: Borrowing or raising funds directly from individuals via online platforms, bypassing traditional banks.
B. Financial Management Environment
The nature and features of different securities in relation to risk/return trade-off

Securities are financial assets like shares and bonds issued by companies or governments.

Different securities have different risk and return characteristics:

Equity shares (common stock):

High risk because returns (dividends and capital gains) are uncertain and depend on company performance.

Potentially high return if the company grows.

Shareholders are last in line to get paid if company fails.

Preference shares:

Lower risk than common shares because they get fixed dividends.

Usually no voting rights.

Dividend payments are more certain but lower than equity’s potential return.

Debt securities (bonds or loans):

Lower risk because they pay fixed interest and have priority over equity in liquidation.

Returns are limited to interest payments.

Includes redeemable, irredeemable, and convertible bonds with varying features.

The risk/return trade-off means higher risk securities must offer higher potential returns to attract investors.
E. Business Finance
Estimating the cost of capital

Cost of equity estimation

Dividend Growth Model (DGM):

Formula: Cost of equity = (Dividend next year / Current share price) + Growth rate of dividends

Assumes dividends grow at a constant rate forever.

Advantages: Simple and uses observable market data.

Disadvantages: Not suitable if dividends are irregular or zero, sensitive to growth rate estimate.

Cost of debt estimation

Irredeemable debt:

Perpetual bonds that pay interest forever, no principal repayment.

Cost of debt = Interest / Net proceeds from issue.

Redeemable debt:

Bonds repaid at a specific date.

Cost of debt calculated as the yield to maturity (considering interest payments and redemption amount).

Convertible debt:

Bonds that can be converted into equity shares.

Cost depends on conversion terms, often lower than regular debt due to conversion option.
 Preference shares:

Fixed dividend payments; cost = Dividend / Net issue price.

Bank debt:

Loans from banks, cost = interest rate adjusted for tax benefits (since interest is tax deductible).

Sources of finance and their relative costs

Equity is generally more expensive because of higher risk and no guaranteed returns.

Debt is cheaper due to tax deductibility of interest and lower risk for lenders.

Creditor hierarchy and its connection with relative costs

In case of liquidation:

1. Secured creditors (e.g., banks with collateral) are paid first.

2. Unsecured creditors (e.g., suppliers, bondholders) paid next.

3. Preference shareholders after creditors.

4. Ordinary shareholders last.

Because secured debt is safer, its cost is lower than unsecured debt.

Equity, being last to get paid, carries the highest risk and thus highest cost.
E. Business Finance
Estimating the overall cost of capital

Average cost of capital: The overall cost of capital considering all the capital already raised by the company.

Marginal cost of capital: The cost of obtaining one more unit of new capital, which may differ if new finance is more expens

Weighted Average Cost of Capital (WACC):

WACC = (Weight of Equity × Cost of Equity) + (Weight of Debt × After-tax Cost of Debt) + (Weight of Preference Shares × Cos

Weights can be based on:

Book value (accounting values of debt and equity), or

Market value (current market prices of debt and equity, preferred as it reflects true cost).

Sources of finance and their relative costs

Problem of high levels of gearing (leverage):

High gearing means more debt relative to equity.

Increases financial risk due to fixed interest payments.

May increase cost of debt and equity because investors demand higher returns for increased risk.

Can lead to financial distress or bankruptcy risk.

Impact on financial position, risk, and shareholder wealth:

Use cash flow forecasting to ensure enough cash to cover debt payments.

Increasing debt can increase risk but also potential returns (due to tax shields).

Poor management of cash flow and high gearing can hurt shareholder wealth.
Impact of cost of capital on investments

Relationship between company value and cost of capital:

Company value is generally the present value of future cash flows discounted at the WACC.

Lower WACC → Higher company value (because future cash flows are discounted less).

Higher WACC → Lower company value.

When WACC can be used in investment appraisal:

When project risk is similar to company’s overall risk.

Used as discount rate to calculate NPV for typical projects.

Not suitable if project risk is significantly different.

Capital structure theories and practical considerations

Traditional view of capital structure:

Assumes there is an optimal gearing level where WACC is minimized, and firm value is maximized.

Before optimal gearing, debt is cheaper and increases value; after, high risk increases cost of debt and equity.

Miller and Modigliani (MM) theory without tax:

Capital structure is irrelevant to company value.

Cost of equity increases linearly with gearing but overall WACC stays constant.

No optimal capital structure.

MM theory with corporate tax:

 Debt interest is tax-deductible, so debt financing provides a tax shield.

Value of firm increases with more debt due to tax savings.

Suggests high gearing is better.

Capital market imperfections affecting MM views:

Bankruptcy costs, agency costs, asymmetric information.

These reduce the benefits of debt and may create an optimal capital structure.

Pecking order theory:

Firms prefer to finance first with internal funds (retained earnings), then debt, and issue equity as a last resort.

Based on costs of asymmetric information and desire to avoid external financing.

Pecking order theory:

Firms prefer to finance first with internal funds (retained earnings), then debt, and issue equity as a last resort.

Based on costs of asymmetric information and desire to avoid external financing.

. Business Finance
Estimating the cost of equity

Systematic and unsystematic risk:

Systematic risk: Risk that affects the entire market (e.g., economic downturns). Cannot be diversified away.

Unsystematic risk: Risk specific to a company or industry (e.g., management failure). Can be reduced by diversification.

Portfolio theory and CAPM:

Portfolio theory explains how diversification reduces unsystematic risk but not systematic risk.

CAPM builds on this by quantifying the expected return based on systematic risk only.

Capital Asset Pricing Model (CAPM):

Formula: Cost of Equity = Risk-free rate + Beta × (Market return − Risk-free rate)

Beta measures the stock’s sensitivity to market movements (systematic risk).

Assumptions: Efficient markets, investors hold diversified portfolios, single-period model, risk measured by beta.

Advantages: Provides a clear link between risk and expected return, widely used and accepted.

Disadvantages: Difficult to estimate beta and market returns accurately, assumes market efficiency, ignores unsystematic

Sources of finance and their relative costs

Impact of cost of capital on investments:

Advantages of CAPM over WACC for project-specific cost of capital:

 CAPM can provide a project-specific cost of equity by adjusting beta for the project’s risk, unlike WACC which reflects ov

More accurate for projects with risk different from the company’s average risk.

Application of CAPM in calculating project-specific discount rate:

Estimate project beta (reflecting risk relative to market).

Use CAPM formula to find cost of equity for the project.

Combine with cost of debt (if relevant) to get project-specific WACC as discount rate.
rall company risk.
C. Working Capital Management
The nature, elements, and importance of working capital

Nature of working capital:

Working capital is the money a business uses to run its day-to-day operations, mainly invested in current assets.

Elements of working capital:

Current assets: cash, inventories, accounts receivable (money owed by customers).

Current liabilities: accounts payable (money owed to suppliers), short-term borrowings.

Objectives of working capital management:

Liquidity objective: Ensure the business can meet its short-term obligations on time.

Profitability objective: Minimize the amount of funds tied up in working capital to increase profitability.

Conflict: Holding more working capital increases liquidity but reduces profitability (due to higher costs). Holding less impro

Central role in financial management:

Managing working capital efficiently ensures smooth operations, supports profitability, and reduces financial risks.

Management of inventories, accounts receivable, accounts payable, and cash

Cash operating cycle:

Time between paying suppliers (accounts payable) and receiving cash from customers (accounts receivable).
It includes:

Inventory holding period (time inventory is held before sale)

Average collection period (time to collect receivables)

Average payable period (time allowed to pay suppliers)

 Relevant accounting ratios:

Current ratio = Current assets / Current liabilities (measures liquidity)

Quick ratio = (Current assets – Inventory) / Current liabilities (more stringent liquidity measure)

Inventory turnover ratio = Cost of goods sold / Average inventory (how fast inventory is sold)

Average collection period = (Accounts receivable / Credit sales) × 365 days (time to collect payments)

Average payable period = (Accounts payable / Cost of sales) × 365 days (time to pay suppliers)

Sales revenue / Net working capital ratio (measures efficiency in using working capital)

Determining working capital needs and funding strategies

Calculate level of working capital investment:

Working capital = Current assets – Current liabilities.
The level depends on:

Length of working capital cycle (cash operating cycle)

Terms of trade (credit terms with suppliers and customers)

Company’s policy on investment in current assets (e.g., stock levels)

Industry characteristics (some industries need more working capital)

Key factors in funding strategies:

Permanent vs fluctuating current assets:

Permanent assets need stable long-term finance.

Fluctuating assets can be financed with short-term finance.

Cost and risk of finance:

Short-term finance usually cheaper but riskier due to refinancing needs.

Long-term finance costlier but more stable.

Matching principle: Match the maturity of finance to the asset type (long-term finance for permanent assets, short-term fo

Funding policies:

Aggressive: More short-term finance, higher risk, lower cost.

Conservative: More long-term finance, lower risk, higher cost.

Matching: Balanced approach, matching finance maturity with asset needs.

Other considerations:

Management’s risk tolerance

Past funding decisions

Size and nature of the organisation

risks liquidity problems.
C. Working Capital Management
Management of inventories

Economic Order Quantity (EOQ) model:

EOQ calculates the optimal order size that minimizes the total cost of ordering and holding inventory.

Formula balances:

Ordering costs (costs to place and receive an order)

Holding costs (costs to store and maintain inventory)

Helps avoid ordering too much (high holding cost) or too little (high ordering cost).

Usefulness: Reduces total inventory cost and improves cash flow.

Limitations: Assumes constant demand and lead time, no stockouts, and immediate replenishment, which may not be real

Just-in-Time (JIT) techniques:

Aim to keep inventory levels as low as possible by ordering and receiving goods only when needed.

Benefits include lower holding costs, less waste, and improved efficiency.

Requires reliable suppliers and good coordination.

Risks include potential stockouts if supply delays occur.

Management of accounts payable

Benefits of bulk purchase discounts:

Suppliers often offer discounts for buying in large quantities.

Bulk discounts can reduce the cost of goods purchased, increasing profitability.

However, buying in bulk may increase holding costs and risk of obsolete inventory.

Businesses should weigh discount savings against increased holding costs to decide if bulk buying is beneficial.
C. Working Capital Management
Reasons for holding cash

Transaction motive: Cash is needed to pay day-to-day expenses like salaries, suppliers, and bills.

Precautionary motive: To have cash ready for unexpected events or emergencies.

Speculative motive: Holding cash to take advantage of unexpected opportunities (e.g., buying materials at a discount).

Techniques in managing cash

Cash flow forecasts:

Prepare forecasts of cash inflows and outflows to predict future cash balances.

Helps ensure the business has enough cash to meet obligations and avoid shortages or excesses.

Centralised treasury management and cash control:

Pooling cash from different parts of the business into a central system improves control and efficiency.

Allows better cash forecasting, reduces borrowing costs, and improves investment of surplus cash.

Cash management models:

Baumol model:

Calculates the optimal cash balance by balancing the fixed cost of converting securities to cash and the opportunity cost o

Assumes predictable, steady cash outflows.

Miller-Orr model:
 Designed for unpredictable cash flows.

Sets upper and lower cash limits and controls cash by transferring funds when limits are breached.

Investing short term:

Excess cash can be invested in short-term, low-risk instruments like treasury bills or money market funds to earn returns w
C. Working Capital Management
Managing Accounts Receivable

Assessing creditworthiness:

Evaluate customers’ ability to pay on time using credit checks, financial statements, credit scores, and payment history.

Helps reduce bad debts and delays in payments.

Managing accounts receivable:

Set clear credit terms and limits.

Monitor receivables regularly to identify overdue accounts.

Use credit control policies to minimize late payments.

Collecting amounts owing:

Send timely invoices and payment reminders.

Use collection agencies if necessary.

Implement penalties for late payments if appropriate.

Offering early settlement discounts:

Encourage customers to pay early by giving a small discount (e.g., 2% if paid within 10 days).

Improves cash flow but reduces revenue slightly.

Using factoring and invoice discounting:

 Factoring: Sell receivables to a third party (factor) who collects payments, improving immediate cash flow but at a cost.

Invoice discounting: Use receivables as collateral to borrow money; company retains control of collections.

Managing foreign accounts receivable:

Manage risks like currency fluctuations and longer collection periods.

Use hedging techniques to reduce foreign exchange risk.

Consider export credit insurance.

Managing Accounts Payable

Using trade credit effectively:

Negotiate favorable credit terms with suppliers to improve cash flow (e.g., longer payment periods).

Avoid late payments to maintain good supplier relationships.

Evaluating benefits of early settlement discounts:

Some suppliers offer discounts for early payments.

Paying early can save money but reduces cash availability.

Businesses should weigh the cost of using funds early against savings from discounts.

Managing foreign accounts payable:

Monitor exchange rates and timing of payments to avoid currency losses.

Use hedging instruments to reduce foreign exchange risk.

Negotiate payment terms in stable currencies if possible.

G. Risk Management
Types of Foreign Currency Risk

Translation risk:
Risk of changes in reported financial statements due to currency conversion when consolidating foreign operations.

Transaction risk:
Risk of exchange rate changes affecting the value of outstanding receivables or payables denominated in foreign currency.

Economic risk:
Long-term effect of exchange rate changes on a company’s market value and competitiveness.

Types of Interest Rate Risk

Gap exposure:
Risk from mismatches in timing between interest rate-sensitive assets and liabilities.

Basis risk:
Risk that interest rates on related but different financial instruments move differently, affecting hedges.
Basis risk is the risk that the interest rate of the asset and the interest rate of the hedge instrument do not move exactly toge

Causes of Exchange Rate Fluctuations

Balance of payments:
Imbalances in trade and capital flows affect currency demand and supply, impacting exchange rates.

Purchasing Power Parity (PPP) theory:

Exchange rates adjust to equalize the price of a basket of goods between countries.

Interest Rate Parity (IRP) theory:

Differences in interest rates between countries are offset by changes in exchange rates to prevent arbitrage.

Four-way equivalence:
Shows relationships between spot exchange rates, forward exchange rates, interest rates, and inflation.

Forecasting Exchange Rates

Using PPP:
 Predict exchange rate changes based on inflation differentials.

Using IRP:
Forecast forward exchange rates using interest rate differentials.

Causes of Interest Rate Fluctuations

Expectations theory:
Long-term interest rates reflect expected future short-term rates.
It Is Considered to be unbiase as sometime it is low and sometime it is high

Hedging Techniques for Foreign Currency Risk

Traditional/basic methods:

Currency of invoice: invoice in home currency to avoid exchange risk.

Netting and matching: offsetting receivables and payables in same currency.

Leading and lagging: speeding up or delaying payments based on expected currency movements.

Forward exchange contracts: locking exchange rates today for future transactions.

Money market hedging: using borrowing and lending in different currencies to cover exposures.

Asset and liability management: matching assets and liabilities in foreign currencies.

Comparison:
Each method varies in cost, complexity, and effectiveness. Forward contracts provide certainty, netting reduces transaction v

Foreign currency derivatives:

Options, futures, forwards, swaps used to hedge currency risk by locking rates or protecting against adverse movements.

Hedging Techniques for Interest Rate Risk

 Traditional/basic methods:

Matching and smoothing: aligning asset and liability maturities to reduce risk.

Asset and liability management: managing the balance between fixed and variable rates.

Forward rate agreements (FRAs): contracts to fix future interest rates.

Interest rate derivatives:

Instruments like interest rate swaps, options, and futures help manage exposure to rate changes.

1. Options

A contract giving the right, but not the obligation, to buy or sell currency at a fixed rate before a set date.
Used to protect against adverse currency moves while keeping the chance to benefit if rates move favorably.

2. Futures

A contract to buy or sell currency at a fixed rate on a specific future date.

It’s a legal obligation to exchange at that rate, locking in the price.

3. Swaps

An agreement to exchange cash flows or currencies between two parties, often swapping fixed and floating interest payment
Used to manage or reduce risk over time.

4. Matching and Smoothing

A technique to match the timing of cash inflows and outflows (assets and liabilities) to reduce exposure to interest rate chang
Smoothing spreads out payments to avoid sudden shocks.

5. Forward Rate Agreements (FRAs)

A contract to fix the interest rate for a loan or deposit that will start at a future date.
It locks in the cost of borrowing or return on investment ahead of time.

1. Call Option

Buying a call: Right to buy an asset (e.g., currency) at a fixed price before expiry. You expect prices to go up.

Selling a call: Obligation to sell the asset at the fixed price if the buyer wants. You receive a premium but risk losing if price r

2. Put Option

Buying a put: Right to sell an asset at a fixed price before expiry. You expect prices to go down.

Selling a put: Obligation to buy the asset at the fixed price if the buyer wants. You get a premium but risk loss if price falls.

Quick summary table:

Option Type

Call

Put
g/lagging requires good forecasting.
rrencies at agreed rates.
 Seller’s Buyer’s
Buyer’s
Obligatio Expectati
Right
n on
Price will
Buy asset Sell asset
rise
Price will
Sell asset Buy asset
fall
Business Valuations
Nature and purpose of valuation of business and financial assets

Reasons for valuing businesses and financial assets:

Buying or selling a business

Mergers and acquisitions

Raising finance

Financial reporting and taxation

Legal reasons such as divorce or shareholder disputes

Investment analysis

Information requirements and limitations:

Financial statements, market data, industry trends, economic forecasts

Limitations include outdated data, management bias, market volatility, and uncertainty about future cash flows.

Models for valuation of shares

Asset-based valuation models:

Net book value: Value based on the company’s statement of financial position (assets minus liabilities at historical cost).

Net realisable value: Value based on the estimated selling price of assets less selling costs.

Net replacement cost: Cost to replace the company’s assets at current prices.

Income-based valuation models:

 Price/Earnings (P/E) ratio method: Share value = Earnings per share × P/E ratio (based on market or industry comparables

Earnings yield method: Earnings yield = Earnings / Market price; helps compare returns to other investments.

Cash flow-based valuation models:

Dividend valuation model (DVM): Values shares based on expected future dividends.

Dividend growth model: Assumes dividends grow at a constant rate; formula: Value = Dividend next year / (Cost of equity

Discounted Cash Flow (DCF): Values shares based on the present value of expected future free cash flows.

Valuation of debt and other financial assets

Irredeemable debt: Valued as the present value of infinite interest payments (perpetuity).

Redeemable debt: Valued as the present value of interest payments plus redemption amount.

Convertible debt: Valued considering both debt and equity conversion options.

Preference shares: Valued like perpetuities if dividends are fixed and indefinite.

Efficient Market Hypothesis (EMH) and practical considerations

Marketability and liquidity:

More marketable and liquid shares are generally more valuable because they can be sold quickly at fair prices.

Availability and sources of information:

Quality and quantity of information affect valuation accuracy.

Market imperfections and pricing anomalies:

Factors like transaction costs, taxes, and irrational investor behaviour can cause prices to deviate from intrinsic values.

Market capitalisation:
Total market value of a company’s outstanding shares; reflects the market’s valuation of the company.
Investor speculation and behavioural finance

Investor speculation: Buying or selling shares based on expectations or trends rather than fundamentals.

Behavioural finance: Explains investor decisions by psychological biases, herd behaviour, overconfidence, and emotions that

Behavioural Finance (Simple Explanation)

Behavioural finance explains how real investors and managers make decisions, which often are not fully logical or rational.

The market paradox: For markets to work efficiently, investors must sometimes believe the market is not efficient. If everyo

Herding (herd mentality): People like to follow the crowd because:

They want to fit in (e.g., fund managers copying each other).

Individual investors feel safer following others, thinking the group can’t be wrong.

Herding can cause big price rises and bubbles in certain sectors.

Noise traders buy or sell without real analysis, often following trends or reacting too much to news. They usually make bad ti

Loss aversion: Some investors avoid risk of losses even if it means missing bigger long-term gains. They prefer steady but sm

Momentum effect: When prices rise, investors expect them to keep rising, making them more willing to buy. This can extend

Overconfidence: Some investors think they are better than they really are, leading to risky mistakes.

Illusion of control: Investors believe they can control or influence the market, even when they cannot.

Optimism bias: Investors are too positive about their future and investments.

Confirmation bias: Investors only look for information that supports what they already believe, ignoring other facts. This can

Because of these behaviours, investors don’t always act logically, which can cause prices to be too high or too low.
historical cost).
stry comparables).

/ (Cost of equity − Growth rate).

nsic values.
and emotions that can cause mispricing.

ogical or rational. This is different from traditional theories that assume everyone makes smart decisions.

efficient. If everyone thought the market was perfect, no one would trade, and prices wouldn’t change.

sually make bad timing decisions.

fer steady but small profits over risky big profits.

y. This can extend booms or busts.

her facts. This can lead to poor decisions and less diversified portfolios.
Simple Meanings + Examples Table

Word
Crawling Peg
The Euro
Derivative Product
Liquidity Preference Theory
Expectation Theory
Market Segmentation Theory
Capital Rationing
Single Period Capital Rationing
Multi-Period Capital Rationing
Sensitivity Analysis
Simulation
Dividend Irrelevance Theory
Supply Chain Finance
M&M With Tax
M&M Without Tax
Gap Exposure
Basis Risk
Forward Rate Agreement (FRA)
Interest Rate Option
Smoothing & Matching
Market Capitalisation
Options
Futures
Swaps
Very Simple Meaning Very Simple Example
Currency price changes slowly, small steps. Like moving a ruler 1 cm every day
Money used in many European countries. When you go to France, you pay wi
A contract whose value comes from something else. If sugar price goes up, your sugar co
People love to keep cash because it feels safe. Keeping money in a wallet instead
Interest rates depend on what people think will happen. People expect rates to rise → long-
Different investors prefer different loan times. Some like 1-year loans, some like 1
Not enough money to do all projects. You have Rs100 but 3 toys cost Rs1
Not enough money for projects for 1 year only. This year only you have low money
Not enough money for many years. You will have low money for 3 year
Change one thing at a time to see effect. What if cost goes up 10%? What if
Test many “what ifs” at the same time. A computer tries 1,000 versions of
Paying dividend or not does not change company value. If you take money as dividend or ke
Helps businesses pay suppliers faster using a bank. Supplier gets cash quickly, compan
Debt increases company value because interest is tax-deductible. You pay less tax when using loans.
Debt does not change company value. No tax → loan or no loan makes no
Cash in and cash out timings don’t match. You pay bills on Monday but you ge
Hedge price and main price do not move together. You hedge with wheat, but the rea
Fix an interest rate now for a future loan. You agree today that next year you
A choice (not obligation) to take a certain rate. If rate goes above 7%, your option
Make cash inflow and outflow timing equal. You collect money on the 1st and p
Total value of a company. Share price Rs10 × 1 million shares
Right to buy or sell later. Movie ticket booking: you book a s
Promise you must follow to buy or sell later. You promise to buy apples next mo
Two parties exchange interest or currency. One pays fixed rate, the other pays
ng a ruler 1 cm every day instead of jumping fast.
u go to France, you pay with euros, not rupees.
rice goes up, your sugar contract also goes up.
money in a wallet instead of investing it.
pect rates to rise → long-term rates rise now.
1-year loans, some like 10-year loans, so markets stay separate.
Rs100 but 3 toys cost Rs150, so you must choose.
only you have low money, next year you’re fine.
ave low money for 3 years, so must choose carefully.
ost goes up 10%? What if sales fall 5%?
er tries 1,000 versions of the future.
e money as dividend or keep it inside, total wealth same.
ets cash quickly, company pays bank later.
ess tax when using loans.
loan or no loan makes no difference.
ills on Monday but you get money on Friday.
e with wheat, but the real wheat price acts differently.
today that next year your loan will be 6%.
es above 7%, your option protects you.
ct money on the 1st and pay bills on the 1st.
e Rs10 × 1 million shares = Rs10 million.
ket booking: you book a seat but don’t have to go.
ise to buy apples next month at Rs50.
fixed rate, the other pays floating rate.