MBA Financial Management Topics

Unit I: The Role of Financial Management and Time Value of Money

Concept of Finance, Scope and Objective of Finance: Finance is the lifeblood of business,
involving the acquisition, allocation, and management of financial resources. The scope of
finance includes investment, financing, and dividend decisions, while the objective is to
maximize shareholder wealth by increasing the value of the firm.

Profit Maximisation vs. Wealth Maximisation: Profit maximisation focuses on short-term gains
and is concerned with maximizing net income. Wealth maximisation, on the other hand, aims
at increasing the overall value of the firm in the long run, considering both current and future
profits, and is the preferred objective in financial management.

Functions of Finance Manager in Modern Age: The finance manager’s functions include
financial planning, investment decision-making, financing decisions, managing cash flow, and
financial risk management. In the modern age, these functions are increasingly influenced by
technology, globalization, and regulatory changes.

Financial Management Process: The financial management process involves planning,

organizing, controlling, and monitoring financial resources to achieve organizational goals. It
includes activities such as budgeting, forecasting, financial analysis, and reporting.

Investment Decision: Investment decisions involve selecting the best projects or assets in
which to invest the firm’s resources. This includes evaluating potential investments’ expected
returns and risks, and aligning them with the company’s strategic objectives.

Financing Decision: Financing decisions pertain to determining the best mix of debt and
equity to finance the firm’s operations and growth. This involves assessing the cost of capital,
financial leverage, and the impact on shareholder value.

Asset Management Decision: Asset management decisions focus on efficiently managing the
firm’s current and fixed assets to maximize returns. This includes managing working capital,
inventory, receivables, and fixed assets.

Value Creation: Value creation is the ultimate goal of financial management, involving actions
and strategies that increase the firm’s value for shareholders. This can be achieved through
profitable investments, efficient operations, and strategic financing decisions.

Managing and Acquiring Assets: Managing assets involves ensuring optimal utilization and
maintenance of the firm’s resources. Acquiring assets requires careful evaluation of
investment opportunities and financing options to support the firm’s growth.
Financing Assets: Financing assets involves securing the necessary funds to purchase or
lease assets needed for the firm’s operations. This includes evaluating various financing
sources, such as loans, leases, and equity.

Simple Interest: Simple interest is calculated on the principal amount of a loan or investment
for a specific period at a predetermined rate. It is straightforward and used for short-term
loans or investments.

Future Value (Terminal Value): Future value is the value of an investment at a specific point
in the future, considering compound interest over time. It helps in assessing the potential
growth of investments.

Present Value: Present value is the current value of future cash flows, discounted at a
specific interest rate. It is used to evaluate the attractiveness of investment opportunities.

Compound Interest: Compound interest is calculated on the initial principal and the
accumulated interest from previous periods. It leads to exponential growth of investments
over time.

Single Amounts: Single amounts refer to a one-time cash flow received or paid at a specific
point in time. It is used in time value of money calculations to determine present or future
values.

Compound Growth: Compound growth involves the reinvestment of earnings to generate

additional returns. It leads to exponential growth of investments and is a key concept in
financial planning.

Discount Rate (Capitalization Rate): The discount rate is the interest rate used to discount
future cash flows to their present value. It reflects the opportunity cost of capital and the risk
associated with the investment.

Capitalization Rate: The capitalization rate is used in real estate and business valuation to
estimate the value of an asset based on its expected income. It is calculated as the ratio of
net operating income to the asset’s current market value.

Annuities: An annuity is a series of equal payments made at regular intervals over a specific
period. Annuities can be used for investment, retirement planning, and loan repayments.

Perpetuity: Perpetuity is a type of annuity that provides infinite periodic payments. It is used
to value investments that generate a constant cash flow indefinitely.

Time Value of Money: The time value of money is the concept that a sum of money has
greater value today than in the future due to its potential earning capacity. It is a fundamental
principle in finance used for investment and financing decisions.
Unit II: Capital Budgeting

The Capital Budgeting Process: The capital budgeting process involves identifying potential
investment opportunities, evaluating their expected cash flows and risks, selecting the most
promising projects, and allocating resources to maximize the firm's value. It is a critical
decision-making process for long-term investments.

Capital Budgeting and Estimating Cash Flows: Estimating cash flows in capital budgeting
involves forecasting the inflows and outflows associated with a project, including initial
investment costs, operating revenues, expenses, taxes, and salvage value. Accurate cash
flow estimation is essential for evaluating the project's viability.

Capital Budgeting Techniques: Project Evaluation and Selection: Various techniques are
used in capital budgeting to evaluate and select projects, including Net Present Value (NPV),
Internal Rate of Return (IRR), Payback Period, and Profitability Index. These techniques help
in comparing and ranking investment opportunities.

Alternative Methods: Payback Period: The payback period method measures the time
required to recover the initial investment in a project. While simple and easy to understand, it
does not consider the time value of money or cash flows beyond the payback period.

Internal Rate of Return: The Internal Rate of Return (IRR) is the discount rate that makes the
net present value of a project's cash flows equal to zero. It represents the project's expected
rate of return and is used to compare and select investment opportunities.

Net Present Value: Net Present Value (NPV) is the difference between the present value of
cash inflows and outflows of a project. A positive NPV indicates a profitable investment, while
a negative NPV suggests the project should be rejected.

Profitability Index: The Profitability Index (PI) is the ratio of the present value of cash inflows
to the present value of cash outflows. It is used to rank projects, with a PI greater than one
indicating a desirable investment.

Multiple Internal Rates of Return: In some cases, a project may have more than one IRR due
to alternating positive and negative cash flows. This situation complicates the decision-
making process and requires additional analysis to determine the project's viability.

Potential Difficulties Dependency and Mutual Exclusion: Capital budgeting decisions may
involve projects that are dependent on each other or mutually exclusive. Dependency means
the acceptance of one project affects another, while mutually exclusive projects require
choosing the best option among alternatives.
Ranking of Projects: Multiple Internal Rates of Return: When dealing with multiple projects,
ranking is essential to prioritize investments based on their expected returns, risks, and
strategic alignment with the firm's objectives. Techniques such as NPV and IRR help in
ranking projects.

Multiple Internal Rates of Return: In some situations, a project may have more than one IRR
due to complex cash flow patterns. Multiple IRRs require careful analysis to understand the
project's profitability and risk.

Unit III: Cost of Capital

Overall Cost of Capital of the Firm: The overall cost of capital is the weighted average cost of
all sources of financing used by the firm, including debt, equity, and preferred stock. It
represents the minimum return required to satisfy all providers of capital and is used as a
discount rate in investment appraisal.

Cost of Debt: The cost of debt is the effective interest rate that the company pays on its
borrowed funds. It is calculated after tax since interest payments are tax-deductible, reducing
the effective cost of debt.

Cost of Preferred Stock: The cost of preferred stock is the dividend required to be paid on
preferred shares expressed as a percentage of the market price of the preferred stock.
Preferred dividends are typically fixed and must be paid before any dividends can be paid to
common shareholders.

Cost of Equity: The cost of equity is the return required by equity investors for investing in the
company. It can be estimated using models such as the Capital Asset Pricing Model(CAPM),
which considers the risk-free rate, the equity market risk premium, and the stock's beta.

Break Even Point of Marginal Cost of Capital: The break-even point of the marginal cost of
capital is the level of new financing at which the cost of a new source of capital equals the
return on the investment financed by that capital. It helps in understanding the impact of
additional financing on the firm's overall cost of capital.

Expected Return: The expected return is the weighted average of the probable returns of an
investment, considering the likelihood of each return occurring. It helps in assessing the
potential profitability and risk of an investment.

Factors that can Affect Cost of Capital: Several factors influence the cost of capital, including
market conditions, the firm's operating and financial risk, tax policies, and the company's
capital structure. Understanding these factors helps in managing the cost of financing.

Capital-Asset Pricing Model Approach: The Capital Asset Pricing Model (CAPM) is used to
estimate the cost of equity by relating the expected return of a stock to its systematic risk
(beta). The formula is: Cost of Equity = Risk-Free Rate + Beta * Market Risk Premium.

Cost of Equity: The cost of equity represents the return that equity investors expect for their
investment in the company. It is a crucial component of the firm's overall cost of capital and is
influenced by market conditions, investor expectations, and the firm's financial performance.

Before-Tax Cost of Debt Plus Risk Premium Approach: This approach calculates the cost of
debt before taxes and adds a risk premium to account for the additional risk of equity
financing. It provides an alternative method to estimate the cost of equity.

Rationale for a Weighted Average Cost: Using a weighted average cost of capital (WACC)
ensures that the overall cost of capital reflects the proportional costs of each source of
financing. It provides a comprehensive measure for evaluating investment opportunities and
making financing decisions.

Economic Value Added (EVA): Economic Value Added (EVA) is a measure of a company's
financial performance that shows the value created beyond the required return of its
shareholders. It is calculated as the net operating profit after taxes minus the product of the
cost of capital and the firm's invested capital.

Unit IV: Leverage

Operating Leverage: Operating leverage measures the proportion of fixed costs in a

company's cost structure. High operating leverage indicates that a small change in sales can
lead to a significant change in operating income, increasing business risk.

Degree of Operating Leverage (DOL) or Its Automotive Division: The Degree of Operating
Leverage (DOL) quantifies the sensitivity of operating income to changes in sales. It is
calculated as the percentage change in operating income divided by the percentage change
in sales.

Financial Leverage: Financial leverage involves using debt to finance a firm's operations and
investments. It magnifies the potential return to shareholders but also increases the risk of
financial distress.

Analysis Degree of Financial Leverage (DFL): The Degree of Financial Leverage (DFL)
measures the sensitivity of a firm's earnings per share (EPS) to changes in operating income
due to the use of debt. It is calculated as the percentage change in EPS divided by the
percentage change in operating income.

Total Leverage Degree of Total Leverage (DTL): The Degree of Total Leverage (DTL)
combines operating and financial leverage to measure the sensitivity of EPS to changes in
sales. It is calculated as the product of DOL and DFL, indicating the total risk faced by
shareholders.

DTL and Total Firm Risk: The Degree of Total Leverage (DTL) helps in assessing the overall
risk faced by the firm due to its cost structure and financing decisions. Higher DTL indicates
greater sensitivity of EPS to changes in sales, implying higher risk.

Cash-Flow Ability to Service Debt Coverage Ratios or Probability of Cash Insolvency: Debt
coverage ratios, such as the interest coverage ratio and debt service coverage ratio,
measure a firm's ability to meet its debt obligations. A higher ratio indicates better ability to
service debt and lower probability of cash insolvency.

Unit V: Break-Even Analysis

EBIT-EPS Break-Even: EBIT-EPS break-even analysis determines the level of earnings

before interest and taxes (EBIT) at which the earnings per share (EPS) are the same under
different financing options. It helps in comparing the impact of debt and equity financing on
shareholder returns.

Break-Even Chart (Selection of the Approach): A break-even chart graphically represents the
relationship between costs, revenues, and profits at different levels of output. It helps in
identifying the break-even point and analyzing the impact of changes in cost and revenue on
profitability.

Output Measurement: Output measurement in break-even analysis involves determining the

level of production or sales needed to cover all fixed and variable costs. It is crucial for
assessing the feasibility and profitability of business operations.

Total Cost Curve: The total cost curve represents the sum of fixed and variable costs at
different levels of output. It helps in understanding the cost structure of the business and
identifying the break-even point.

Total Revenue Curve: The total revenue curve shows the total revenue generated at different
levels of output. It helps in analyzing the relationship between sales volume, price, and
revenue.

Break-Even Point: The break-even point is the level of output or sales at which total revenue
equals total costs, resulting in zero profit. It is a critical metric for assessing the minimum
performance required to avoid losses.

Margin of Safety: The margin of safety represents the difference between actual sales and
break-even sales. It measures the risk of a decline in sales before the firm incurs a loss. A
higher margin of safety indicates lower business risk.
Calculation of Margin of Safety: The margin of safety is calculated as the difference between
actual sales and break-even sales, divided by actual sales, and multiplied by 100 to express
it as a percentage.

BEP in Terms of Sales Value: The break-even point can also be expressed in terms of sales
value, indicating the total revenue required to cover all costs. It helps in setting sales targets
and pricing strategies.

Types of Break-Even Point: Different types of break-even points include cash break-even,
accounting break-even, and financial break-even. Each type considers different costs and
helps in analyzing the firm's financial health from various perspectives.

Managerial Uses of Break-Even Analysis: Break-even analysis helps managers in decision-

making related to pricing, cost control, production planning, and financial forecasting. It
provides insights into the impact of changes in cost, price, and volume on profitability.

Multiple Product Firms and Break Even Point: For firms with multiple products, the break-
even point is determined by considering the weighted average contribution margin of all
products. It helps in assessing the overall performance and profitability of the product mix.

Unit VI: Dividend Decision

Forms of Dividend: Dividends can be paid in various forms, including cash dividends, stock
dividends, and property dividends. Cash dividends are the most common, while stock
dividends involve issuing additional shares to shareholders.

Concept of Retained Earnings and Plough Back of Profit: Retained earnings are the portion
of net income that is not distributed as dividends but reinvested in the business. Ploughing
back profits helps in financing growth and expansion without raising external capital.

Dividend Theories and Dividend Policy: Dividend theories, such as the dividend irrelevance
theory, bird-in-hand theory, and signaling theory, provide different perspectives on the impact
of dividend policy on firm value. Dividend policy involves deciding the amount and timing of
dividends to maximize shareholder value.

Walter Model: The Walter model suggests that the choice of dividend policy depends on the
firm’s internal rate of return and cost of capital. If the internal rate of return is higher than the
cost of capital, the firm should retain earnings; otherwise, it should pay dividends.

Gordon's Model and Modigliani Miller Model: Gordon’s model emphasizes the importance of
dividends in determining stock value, suggesting that higher dividends lead to higher stock
prices. The Modigliani-Miller model, on the other hand, argues that dividend policy does not
affect the firm’s value or cost of capital.

Factors Affecting Dividend Decision: Factors influencing dividend decisions include the firm’s
profitability, cash flow position, growth opportunities, shareholder preferences, tax
considerations, market conditions, and legal constraints. These factors determine the amount
and frequency of dividends paid.

Overview of Working Capital Management: Working capital management involves managing

the short-term assets and liabilities of a company to ensure sufficient liquidity to meet
operational needs. It includes managing cash, inventory, accounts receivable, and accounts
payable.

Management of Cash, Inventory, and Receivables: Effective cash management ensures that
the firm has adequate cash to meet its obligations. Inventory management aims to optimize
inventory levels to minimize costs while meeting demand. Receivables management focuses
on collecting payments from customers promptly to maintain cash flow.

Introduction to Working Capital Financing: Working capital financing involves securing short-
term funding to cover day-to-day operational expenses. This can include trade credit, bank
loans, commercial paper, and factoring. Effective working capital financing ensures the firm
can meet its short-term obligations and maintain smooth operations.