1 ) Definition and Scope of Financial Management 1 ) Investment Decision Process UNIT 3

1 ) Concept of Cost of Capital

● Definition Identification of Investment Opportunities Definition
Financial management is planning, organizing, directing, and controlling financial ● Recognize potential projects or assets for investment. ● The minimum return a company must earn to satisfy investors.
activities. ● Analyze market trends and business needs carefully. ● Represents the cost of funds used for financing business activities.
It involves acquiring and utilizing funds effectively for organizational goals. ● Select options aligned with company goals and strategy. ● Includes cost of debt, equity, and retained earnings.
Its main aim is maximizing shareholder wealth and financial efficiency.
Evaluation and Analysis of Proposals Importance
● Scope ● Estimate costs, returns, and risks of each opportunity. ● Helps in evaluating the profitability of investment projects.
● Investment Decisions – Concerned with selecting the best assets to invest funds. ● Use techniques like NPV, IRR, and payback period. ● Acts as a benchmark for making financial decisions.
● Financing Decisions – Deals with choosing sources and mix of capital structure. ● Compare alternatives to choose the most profitable option. ● Ensures the company maintains its market value and investor confidence.
● Dividend Decisions – Focuses on profit distribution and retained earnings balance.
● Liquidity Management – Ensures adequate cash flow to meet operational needs. Selection and Implementation Types
● Financial Control – Involves monitoring financial activities using tools like ● Approve the best investment based on analysis results. ● Cost of Debt: Interest paid on borrowed funds after tax.
budgeting. ● Allocate funds and manage resources for execution. ● Cost of Equity: Returns expected by shareholders on their investment.
● Monitor progress and evaluate outcomes regularly. ● Weighted Average Cost of Capital (WACC): Overall cost combining all sources.

2 ) Techniques of Investment Appraisal 2 ) Specific Sources of Capital

2 ) Objectives of Financial Management
Payback Period
● Measures time required to recover initial investment. Equity Capital
Profit and Wealth Maximization
● Simple and easy to calculate but ignores cash flows after payback. ● Funds raised by issuing shares to investors or owners.
● Useful for assessing liquidity and risk of short-term projects. ● Includes common stock, preferred stock, and retained earnings.
● Maximize short-term profits for better returns and growth.
● Enhance shareholder value by increasing market price. ● Provides ownership and voting rights in the company.
Net Present Value (NPV)
● Balance profitability with long-term financial stability goals.
● Calculates present value of cash inflows minus outflows. Debt Capital
● Considers time value of money and profitability of projects. ● Borrowed funds to be repaid with interest over time.
Efficient Fund Utilization
● Positive NPV indicates a worthwhile investment. ● Includes bank loans, bonds, debentures, and commercial papers.
● Ensure proper use of funds without any unnecessary wastage.
● Allocate capital to profitable and strategic business activities. ● Usually has fixed repayment schedules and interest costs.
Internal Rate of Return (IRR)
● Improve efficiency and reduce overall financial operating costs.
● Finds discount rate that makes NPV zero for a project. Hybrid Capital
● Shows expected rate of return from investment. ● Combines features of both debt and equity financing.
Liquidity and Financial Control
● Accept project if IRR exceeds required rate of return. ● Includes convertible debentures and preference shares.
● Maintain enough cash flow to meet all liabilities.
● Ensure smooth business operations through working capital management. ● Offers flexibility in repayment and ownership rights.
● Use budgeting and analysis tools for financial control.

3 ) Risk Analysis in Capital Budgeting 3 ) Cost of Equity Capital

Definition
3 ) Functions and Role of Finance Manager Identification of Risks
● Recognize possible uncertainties affecting project outcomes. ● The return required by shareholders for investing in a company.
Financial Planning and Forecasting ● Reflects the risk of investing in the company’s equity shares.
● Includes market, financial, operational, and environmental risks.
● Prepare budgets to estimate future financial needs. ● Is a component of the overall cost of capital.
● Helps prepare for potential challenges in investment decisions.
● Forecast revenues, expenses, and capital requirements.
● Align financial plans with organizational goals and strategies. Calculation Methods
Measurement and Evaluation of Risks
● Use techniques like sensitivity, scenario, and simulation analysis. ● Dividend Discount Model: Uses expected dividends and growth rate.
Fund Procurement and Allocation ● Capital Asset Pricing Model (CAPM): Based on risk-free rate and market risk
● Assess impact of variable changes on project’s cash flows.
● Identify and arrange sources of funds like equity or loans. premium.
● Quantify risk to compare projects effectively.
● Decide optimal capital structure to minimize cost of capital. ● Earnings Capitalization Ratio: Uses expected earnings and market price.
● Allocate funds efficiently among various projects and departments.
Risk Management and Mitigation
● Develop strategies to reduce or control identified risks. Importance
Financial Control and Risk Management ● Helps in valuing the company’s equity and investment decisions.
● Include diversification, insurance, and contingency planning.
● Monitor financial performance using budgets and reports. ● Used to determine the hurdle rate for equity-financed projects.
● Aim to protect investment and ensure project success.
● Implement controls to prevent fraud and misuse of funds. ● Influences dividend policies and capital structure decisions.
● Manage financial risks through diversification and insurance.
4 ) Digital Currency and Cryptocurrency and Their Differences
4 ) Cost of Retained Earnings
Digital Currency
4 ) Sources of Finance ● Electronic form of money used for online transactions. Definition
● Issued and regulated by central banks or governments. ● The opportunity cost of reinvesting profits back into the business.
Internal Sources
● Includes e-money, mobile money, and central bank digital currency. ● Represents the return shareholders expect instead of receiving dividends.
● Retained earnings generated from company’s profits.
● Considered a source of internal equity financing.
● Sale of assets that are no longer needed.
● Reduction in working capital by managing inventory and receivables. Cryptocurrency
● A decentralized digital asset secured by cryptography. Calculation
External Sources
● Operates on blockchain technology without central authority. ● Often assumed equal to the cost of equity capital.
● Borrowing from banks, financial institutions, or bond issuance.
● Examples include Bitcoin, Ethereum, and other altcoins. ● Can be estimated using Dividend Discount Model or CAPM.
● Issuing equity shares to raise capital from investors.
Differences ● Adjusted for taxes since retained earnings avoid dividend taxes.
● Trade credit and leasing from suppliers and lessors.
Short-term and Long-term Sources ● Digital currency is centralized; cryptocurrency is decentralized.
● Digital currency backed by government; cryptocurrency relies on trust. Importance
● Short-term: Bank overdraft, trade credit, and commercial paper.
● Cryptocurrency transactions are anonymous; digital currency transactions are ● Helps evaluate whether to reinvest profits or distribute as dividends.
● Long-term: Equity shares, debentures, and term loans.
traceable. ● Influences decisions on funding new projects internally.
● Choice depends on purpose, cost, and repayment capacity.
● Affects the company’s overall cost of capital and growth strategy.

5 ) Financial Modeling and Hurdle Rate

Financial Modeling
● A process of creating a mathematical representation of financial performance.
● Helps forecast future revenues, costs, and cash flows for decision-making.
● Used for valuation, budgeting, and assessing investment opportunities.

Hurdle Rate

5 ) Financial Market ● The minimum acceptable rate of return required on an investment. 5 ) EBIT-EPS Analysis
● Acts as a benchmark to decide whether to proceed with a project.
● Reflects risk level and cost of capital in financial models. Definition
Capital Market Relationship ● Examines the relationship between Earnings Before Interest and Taxes (EBIT) and
● Deals with long-term funds for investment in assets. ● Hurdle rate is used within financial models to evaluate projects. Earnings Per Share (EPS).
● Includes stock markets and bond markets for securities trading. ● Projects with expected returns above hurdle rate are considered viable. ● Helps assess the impact of different financing options on shareholder earnings.
● Helps companies raise equity and debt for growth projects. ● Used to choose between debt and equity financing.

Money Market Purpose

● Handles short-term funds with maturity less than one year. ● To find the EBIT level where EPS is the same for different financing plans.
● Includes treasury bills, commercial papers, and call money. ● Helps identify the break-even EBIT or indifference point.
● Provides liquidity to businesses and government for daily needs. ● Assists in understanding financial leverage effects on EPS.

Application
6 ) (i) Microfinance ● Compare EPS under various capital structures at different EBIT levels.
● Provides small loans to low-income individuals or groups. ● Choose financing that maximizes EPS based on expected EBIT.
● Supports entrepreneurship and poverty alleviation in communities. ● Important for financial planning and capital structure decisions.
● Often offered by NGOs, cooperatives, or specialized banks.
6 ) Operating and Financial Leverage

(ii) Financial Information Systems Operating Leverage

● Measures the impact of fixed costs on operating income.
● Use technology to collect, process, and report financial data.
● Higher fixed costs increase sensitivity of EBIT to sales changes.
● Help in budgeting, forecasting, and decision-making processes.
● Helps assess business risk related to production and sales.
● Improve accuracy and speed of financial management tasks.
Financial Leverage
● Measures the effect of debt financing on net income.
● Higher debt increases sensitivity of EPS to changes in EBIT.
(iii) Behavioral Finance ● Indicates risk related to fixed interest obligations.
● Studies how psychological factors affect financial decisions.
● Explains biases like overconfidence and herd behavior. Combined Leverage
● Helps improve investment strategies by understanding human errors. ● Shows total risk by combining operating and financial leverage.
● Amplifies the effect of sales changes on EPS.
● Useful for overall risk and profitability analysis.
UNIT 4 7 ) Traditional Approach 3 ) Working Capital Policies
1 ) Concept of Capital Structure Definition Conservative Policy
● Suggests an optimal capital structure exists between debt and equity.
Definition ● Cost of capital decreases to a certain point with increased debt. ● Maintains high level of current assets for safety and liquidity.
● The mix of debt and equity used to finance a company’s operations. ● Beyond optimum, cost of capital rises due to financial risk. ● Reduces risk of shortage but lowers profitability.
● Determines how a firm raises funds for growth and activities. ● Combines features of both NI and NOI approaches. ● Excess funds kept idle or in low-return assets.
● Affects the company’s risk, cost of capital, and financial flexibility. ● Suitable for risk-averse firms prioritizing stability.
Assumptions
Importance ● Moderate debt usage lowers overall capital cost initially. Aggressive Policy
● Influences the overall value and stability of the business. ● Cost of debt is cheaper but increases with high leverage. ● Minimizes investment in current assets to boost returns.
● Balances risk and return for shareholders and creditors. ● Cost of equity rises gradually as debt level increases. ● Relies more on short-term borrowings for financing.
● Helps optimize the cost of capital to maximize firm value. ● Bankruptcy costs become significant after a certain debt level. ● Increases risk of liquidity issues and default.
● Aims to maximize profitability with higher financial risk.
Factors Affecting Capital Structure Implications
● Business risk, tax considerations, and market conditions. ● Firms should maintain a balanced mix of debt and equity. Moderate Policy
● Company's growth prospects and management preferences. ● Optimal capital structure minimizes weighted average cost of capital. ● Balances between risk and return with stable asset levels.
● Availability and cost of different financing sources. ● Excessive debt increases financial distress risk and cost of capital. ● Uses mix of short-term and long-term funds wisely.
● Helps managers decide appropriate leverage to maximize firm value. ● Maintains adequate liquidity without excessive idle assets.
2 ) Factors Influencing Capital Structure ● Most commonly followed for steady operations and control.
8 ) Dividend and Dividend Policy
Business Risk Dividend 4 ) Financial Analysis
● Higher business risk leads to lower debt usage to avoid financial distress.
● Stable industries can support more debt due to predictable earnings. ● Portion of company’s profits distributed to shareholders regularly. Definition
● Riskier firms prefer equity to reduce fixed obligations. ● Can be paid in cash, shares, or other property forms. ● Process of evaluating financial statements to assess performance.
● Reflects company’s financial health and profit distribution approach. ● Helps understand profitability, liquidity, solvency, and efficiency.
Financial Flexibility ● Provides income to shareholders alongside potential capital gains. ● Involves comparing current and past data systematically.
● Ability to raise funds under adverse conditions affects debt levels. ● Supports stakeholders in making informed decisions.
● Firms with good credit ratings can use more debt. Dividend Policy
● Flexibility helps manage unexpected expenses or opportunities. ● Guidelines a company follows to decide dividend payments. Objectives
● Balances between retaining earnings and distributing profits. ● Assess firm’s financial health and operational effectiveness.
Tax Considerations ● Aims to maintain stable dividends to satisfy investor expectations. ● Identify strengths, weaknesses, risks, and growth opportunities.
● Interest on debt is tax-deductible, encouraging debt financing. ● Influenced by earnings stability, cash flow, and growth opportunities. ● Aid management in planning and strategic decision-making.
● Tax benefits reduce the overall cost of debt. ● Help investors and creditors evaluate financial stability.
● Companies consider tax laws when deciding debt-equity mix. Importance
● Signals company’s profitability and future prospects to investors. Techniques Used
● Affects share price and investor confidence in the company. ● Ratio analysis for profitability, liquidity, and solvency.
● Helps in managing company’s liquidity and financing needs. ● Trend analysis to study financial patterns over years.
● Comparative and common-size statements for better insights.
● Cash flow analysis to track fund movement and usage.

3 ) Optimal Capital Structure 9 ) Sources Available for Dividend

Current Profits
Definition 5 ) Cash Management
● Best mix of debt and equity minimizing overall capital cost. ● Dividends are primarily paid out from the company’s current earnings. ● Ensures sufficient cash is available for daily business needs.
● Maximizes company’s market value and shareholder wealth. ● Reflects the profits generated during the latest accounting period. ● Involves planning, controlling, and monitoring cash inflows and outflows.
● Balances financial risk and expected return carefully. ● Indicates company’s ability to reward shareholders regularly. ● Prevents both cash shortages and excess idle funds.
● Guides firms in choosing appropriate financing sources. ● Preferred source for consistent and sustainable dividend payments. ● Helps maintain liquidity and meet short-term obligations effectively.

Characteristics Retained Earnings 6 ) Receivable Management

● Minimizes weighted average cost of capital (WACC) effectively. ● Accumulated past profits not distributed as dividends earlier. ● Controls the credit extended to customers and collection process.
● Maintains adequate financial flexibility for future needs. ● Provides a reserve to support dividend payments in lean periods. ● Aims to reduce bad debts and improve cash inflow timing.
● Ensures firm’s solvency and ability to meet obligations. ● Helps maintain dividend stability despite fluctuating current profits. ● Involves setting credit terms, limits, and follow-up procedures.
● Reflects company’s risk tolerance and market environment. ● Used when current earnings are insufficient to pay dividends. ● Balances between increasing sales and minimizing credit risk.

Importance Capital Profits 7 ) Inventory Management

● Supports sustainable growth and long-term profitability goals. ● Gains from sale of fixed assets, investments, or non-operating activities. ● Maintains optimal stock levels to avoid overstocking or shortages.
● Reduces chances of financial distress or bankruptcy risks. ● Generally not recommended as a regular dividend source. ● Ensures smooth production and sales without interruption.
● Helps managers make informed financing and investment decisions. ● Sometimes used for special or bonus dividends. ● Includes ordering, storing, and controlling inventory effectively.
● Enhances investor confidence and improves company reputation. ● Considered non-recurring and affects capital structure if used. ● Reduces carrying costs and maximizes operational efficiency.

4 ) Capital Structure Theories 10 ) Determinants of Dividend Policy 8 )Credit Policy Management

Profitability ● Sets rules for granting credit to customers efficiently.
Net Income (NI) Approach ● Includes credit terms, limits, and collection policies.
● Suggests lowering cost of capital by increasing debt in capital mix. ● Higher profits enable regular and higher dividend payments. ● Affects sales volume, customer loyalty, and working capital.
● Assumes cost of debt is cheaper than cost of equity. ● Stable earnings encourage consistent dividend distribution. ● Balances between profit growth and credit risk control.
● More debt reduces overall cost and increases firm value. ● Companies with fluctuating profits may retain earnings.
● Assumes no change in cost of debt or equity with leverage. ● Profit levels influence dividend payout ratios and policies.

Net Operating Income (NOI) Approach Liquidity

● Claims capital structure does not affect overall cost of capital. ● Availability of cash affects the ability to pay dividends.
● Cost of equity rises with more debt, offsetting cheaper debt. ● Sufficient liquid assets ensure timely dividend payments.
● Firm value remains constant regardless of debt-equity mix. ● Illiquid firms may delay or reduce dividend distributions.
● Assumes perfect capital markets without taxes or bankruptcy costs. ● Cash flow management is crucial for dividend decisions.

Modigliani-Miller (M-M) Approach Growth Opportunities

● In a no-tax world, capital structure is irrelevant to firm value. ● Firms with high growth needs may retain earnings for reinvestment.
● With taxes, debt financing provides tax shield benefits. ● Dividend payments may be lower to fund expansion projects.
● Suggests an optimal structure with some debt to maximize value. ● Mature firms with fewer growth prospects often pay higher dividends.
● Recognizes trade-off between tax benefits and bankruptcy costs. ● Balancing reinvestment and shareholder returns is essential.

Trade-Off Theory Tax Considerations

● Balances tax benefits of debt against bankruptcy and financial distress costs. ● Tax rates on dividends and capital gains influence policy decisions.
● Firms choose capital structure optimizing between costs and benefits. ● Investors’ tax preferences may affect dividend expectations.
● Suggests existence of optimal debt level for maximum firm value. ● Companies consider tax efficiency while deciding payout ratios.

5 ) Net Income (NI) Approach UNIT 5

Definition 1 ) Working Capital Management: Definition and Objectives

● Suggests increasing debt lowers overall cost of capital.
● Assumes debt is cheaper than equity financing sources. Definition
● Firm value rises as leverage increases due to low-cost debt. ● Managing the firm’s short-term assets and liabilities efficiently.
● Capital structure directly impacts the firm’s value and cost. ● Ensures smooth day-to-day business operations and liquidity.
● Balances current assets and current liabilities properly.
Assumptions ● Aims to maintain optimum working capital levels.
● Cost of debt remains constant regardless of debt level.
● Cost of equity remains unchanged with changes in leverage. Objectives
● No bankruptcy or financial distress costs exist. ● Maintain adequate liquidity to meet short-term obligations.
● Perfect capital markets with no taxes or transaction costs. ● Optimize the use of current assets to maximize profitability.
● Avoid insolvency by ensuring continuous cash flow.
Implications ● Minimize the cost of holding working capital components.
● Firms should use maximum debt to minimize capital cost.
● Higher leverage increases earnings available to equity holders. 2 ) Factors Affecting Working Capital
● Encourages firms to rely more on debt financing. Nature of Business
● Helps in maximizing market value of the company. ● Manufacturing firms require more working capital than trading firms.
● Service businesses generally need less due to fewer inventory needs.
6 ) Net Operating Income (NOI) Approach ● Seasonal businesses have fluctuating working capital requirements.
Definition ● Type of industry impacts the amount of current assets needed.
● Claims capital structure does not affect overall cost of capital.
● Firm value remains constant regardless of debt-equity mix. Business Cycle
● Cost of equity rises with increase in debt to offset benefits. ● During expansion, working capital needs increase due to higher sales.
● Debt is cheaper but increases risk, balancing overall cost. ● In recession, working capital requirements usually decrease.
● Economic fluctuations affect inventory and receivables levels.
Assumptions ● Firms adjust working capital based on market conditions.
● No taxes, bankruptcy costs, or transaction costs exist.
● Perfect capital markets with symmetric information. Production Cycle
● Investors and firms can borrow at same interest rates. ● Longer production cycles require more working capital investment.
● Cost of debt remains constant despite leverage changes. ● Shorter cycles reduce the need for high current assets.
● Includes time taken for raw materials to finished goods.
Implications ● Impacts the amount of inventory and cash needed.
● Changes in capital structure do not affect firm’s value.
● Overall cost of capital (WACC) remains unchanged with leverage. Credit Policy
● Managers need not focus on debt-equity mix for value maximization. ● Liberal credit policy increases accounts receivable, raising working capital.
● Financial risk shifts from equity holders to debt holders. ● Strict credit policy reduces receivables but may lower sales.
● Credit terms with suppliers affect current liabilities.