UNIVERSITY INSTITUTE OF APPLIED MANAGEMENT

SCIENCES
FINANCIAL MANAGEMENT
S U B M I T TO - D R . M O N I K A
AG G A RWA L

S U B M I T BY- TA N I A

A N K I TA S H A R M A

YA S H L E E N
 INTRODUCTION
According to J. Hampton the term
finance can be defined as the
management of the flows of money
through an organization, whether it
will be a corporation, school, bank or
government agency.
 FINANCIAL MANAGEMENT

Financial management means planning,

organizing, directing and controlling the
financial activities such as procurement and
utilization of funds of the enterprise. It means
applying general management principles to
financial resources of the enterprise.
SCOPE OF FINANCIAL
MANAGEMENT
The scope of financial management refers to the various activities and functions that involve planning,
organizing, controlling, and monitoring the financial resources of an organization to achieve its financial
goals.
Financial Planning
Investment Decisions
Financing Decisions
Financial Control
Dividend Decisions
Risk Management
Cost Management
Tax Management
 FUNCTIONS OF FINANCE
Capital Allocation and Investment
Funding and Capital Raising
Risk Management
Budgeting and Planning
Financial Reporting and Control
Profit Maximization and Value Creation
Liquidity Management
Wealth and Asset Management
 FINANCIAL GOALS
Financial goals are specific objectives that individuals or organizations set to achieve a
desired financial outcome within a certain timeframe.
Profit maximization
Profit maximization refers to the goal of increasing a company’s short-term profits. The objective is to maximize the
difference between total revenue and total cost in the shortest period possible.
Focus on
Short term profits
Emphasizes the immediate financial gain for the company
Wealth maximization
Wealth maximization, also known as value maximization, is the goal of increasing the market value of the company and
the wealth of its shareholders. It focuses on long-term growth, sustainability, and the creation of value.
Focus on
Long term wealth creation
Aims to maximise the shareholder wealth by increasing the value of the company stock price and dividend payouts
 COMPARISON OF BOTH
GOALS
Profit maximization is an inappropriate goal because it's short term in nature and focus more on what
earnings are generated rather than value maximization which comply to shareholders wealth maximization.
Critics have given following arguments against profit maximization approach:
•Profit is a vague term
•Overlook Social welfare
•Ignores time value of money
•Narrow outlook
•Short term achievement
•Ignores Risk
Wealth maximization overcomes all the limitations that profit maximization possesses.
 AGENCY
PROBLEM
The agency problem in financial
management arises when there is a conflict
of interest between the principals (owners
or shareholders) and the agents (managers
or executives) who are hired to manage
and run the business on behalf of the
principals. This problem occurs because the
agents may not always act in the best
interests of the principals, leading to
inefficiencies and potential losses for the
owners.
 Types of Agency Problems
Shareholder vs. Management

o Profit Maximization vs. Managerial Interests: Managers might pursue personal goals like empire-
building (expanding the company beyond optimal size for personal benefits, such as higher salary or
status) or seeking less risky strategies to preserve their jobs, which may not maximize shareholder
wealth.
o Risk Aversion: Managers may be more risk-averse compared to shareholders, who might prefer riskier
investments to maximize returns. Managers may avoid taking risks (e.g., avoiding high-return, high-risk
projects) because their compensation and job security are tied to the company's stability.

Debt Holders vs. Shareholders:

o Shareholders may have an incentive to take on higher-risk projects or increase leverage (borrow more)
because the potential upside belongs to them. However, the downside (in case of losses or bankruptcy)
impacts debt holders more, leading to a conflict between shareholders and creditors.
 Relationship of finance with
accounts and economics
Finance, accounting, and economics are closely related disciplines, each playing a crucial role in understanding and managing
money, resources, and markets. Here’s how they interconnect:
1. Finance and Accounting
• Finance focuses on the management of funds, investment decisions, risk assessment, and maximizing wealth.
• Accounting records, reports, and analyzes financial transactions to provide an accurate picture of a company's financial
health.
• Relationship: Finance relies on accounting data (such as balance sheets, income statements, and cash flow statements) to
make informed investment and business decisions.
2. Finance and Economics
• Finance applies economic principles to real-world financial decision-making, such as stock market analysis, interest rate
determination, and risk management.
• Economics studies how individuals, businesses, and governments allocate resources efficiently.
• Relationship: Economics provides the theoretical foundation for financial principles, such as supply and demand, inflation,
and economic growth, which influence financial markets and policies.
3. Accounting and Economics
• Accounting provides detailed financial data that economists use to analyze economic trends, such as GDP growth and
market stability.
• Economics helps accountants understand the macroeconomic and microeconomic factors that influence financial reporting,
taxation, and corporate strategies.
Features:
• Specified Loan Amount
• Fixed Repayment Schedule
• Collateral Requirement

Advantages:
• Structured Repayments
• Lower Interest Rates
• Flexibility
EquityShares
Features :Ownership Rights: Equity shareholders are partial owners of the
company and have voting rights in corporate decisions.​BYJU'SDividend Entitlement:
Dividends are paid to equity shareholders based on the company's profitability and
discretion.​Residual Claim: In case of liquidation, equity shareholders have a residual claim
on assets after all debts and liabilities are settled.​

Advantages :Potential for High Returns: Equity shareholders may benefit

from capital appreciation and profit-sharing through dividends.​Bajaj BrokingLimited
Liability: Shareholders' liability is limited to the amount invested in shares.​BYJU'S+1Angel
One+1Voting Rights: They have a say in major corporate decisions, influencing the
company's strategic direction.

Limitations
​ :Risk of Capital Loss: The value of equity shares can fluctuate,
leading to potential capital losses.​Bajaj BrokingNo Guaranteed Dividends: Dividends are not
assured and depend on the company's performance and dividend policy.​Dilution of
Control: Issuing more equity shares can dilute existing shareholders' control and earnings
per share.​
Preference Shares
Features:Priority in Dividends: Preference shareholders receive dividends before
equity shareholders, often at a fixed rate.​InvestopediaNo
Voting Rights: Generally, preference shareholders do not possess voting rights in
the company.​Convertible Options: Some preference shares can be converted into equity
shares after a specified period.
Advantages
​ :Fixed Income: They provide a fixed dividend, offering a predictable
income stream.​Priority in Asset Distribution: In liquidation scenarios, preference
shareholders have a higher claim on assets than equity shareholders.​Less Risky: They are
less volatile compared to common shares, appealing to risk-averse investors.​:

Limitations:Limited Upside Potential: Preference shareholders typically do not

benefit from company profits beyond their fixed dividend.​No Voting Rights: Lack of voting
rights means no influence over corporate decisions.​SmartAsset+6Investopedia+6Latest news
& breaking headlines+6Interest Rate Sensitivity: Their market value can be affected by
changes in interest
3. Debentures
Features:Fixed Interest Rate: Debentures carry a predetermined interest rate, payable periodically.​
Debt: Typically, debentures are not backed by physical assets but by the issuer's creditworthiness.​Maturity Date: They have a
specific maturity date when the principal amount is repaid.​

Advantages:Regular Interest Income: Investors receive consistent interest payments, providing a steady income.​
Priority Over Equity:
In liquidation, debenture holders are paid before shareholders.​
No Ownership Dilution: Issuing debentures does not dilute existing shareholders' equity.

Limitations
​ :Credit Risk: As unsecured instruments, debentures depend on the issuer's creditworthiness.​Interest Rate
Risk: Fixed interest payments may become less attractive if market rates rise.
​Repayment Obligation: The company must repay the principal at maturity, which can strain finances.
4. Term Loans
Features:Specified Loan Amount: A lump sum provided upfront for specific purposes.​
Fixed Repayment Schedule: Regular payments over a set period, including principal and interest.​Collateral Requirement:
Often secured against assets to mitigate lender risk

Advantages
.​ :
Structured Repayments: Predictable payment schedules aid in financial planning.​Lower Interest Rates: Generally offer
lower rates compared to unsecured loans.​
Flexibility: Can be tailored to match the borrower's cash flow and project timelines.​Investopedia

Limitations
:Collateral Risk: Failure to repay can lead to loss of secured assets.​Debt Burden: Regular repayments can strain the
company's cash flow.​Prepayment Penalities
.​5. Rights Issue
Features:Existing Shareholder Privilege: Current shareholders are given the right to
purchase additional shares, usually at a discount.​Angel OneProportional Allocation: Shares are
offered in proportion to existing holdings.​
Time-Bound Offer: The rights are available for a specific period, after which they may lapse.​

Advantages:Capital Raising: Enables companies to raise funds without

incurring debt.​Cost-Effective: Avoids underwriting fees associated with public offerings.​
Shareholder Value: Allows shareholders to maintain their ownership percentage.​
BYJU'Slimitations

Dilution
: Risk: If not all shareholders participate, their ownership may be diluted.​
Market Perception:
Frequent rights issues may signal financial instability.​Angel OneLimited Capital: The amount
raised is dependent on shareholder participation
6. Venture Capital
Features:Equity Financing: Provides capital in exchange for equity, often in early-stage
companies.​The HartfordActive Involvement: Venture capitalists may participate in management
and strategic decisions.​High Risk and Return: Focuses on businesses with high growth potential
and corresponding risks.
​Advantages:Access to Capital: Provides funding when traditional financing
Cost of capital

Introduction
The cost of capital is a critical concept in financial management, representing the cost incurred by a
company to raise funds from various sources such as equity, debt, and retained earnings. It serves
as a benchmark for evaluating investment decisions and determining the financial viability of projects.

Meaning of Cost of Capital

Cost of capital is the return expected by the providers of capital (i.e., shareholders, lenders, and
debt-holders) to the business as compensation for their investment. It is expressed as a rate used to
discount/compound the cash flow or stream of cash flows. Cost of capital is also known as ‘cut-off’
rate, ‘hurdle rate’, ‘minimum rate of return,’ etc.
Components of cost of capital
Significance of the Cost of Capital.
The cost of capital is important to arrive at a correct amount and helps the management or an
investor make an appropriate decision. The correct cost of capital helps in the following decision-
making:
(i) Evaluation of investment options: The estimated benefits (future cash flows) from available
investment opportunities (business or project) are converted into the present value of benefits by
discounting them with the relevant cost of capital. Here it is pertinent to mention that every
investment option may have a different cost of capital hence it is very important to use the cost of
capital which is relevant to the options available. Here Internal Rate of Return (IRR) is treated as
the cost of capital for the evaluation of two options (projects).
(ii) Performance Appraisal: Cost of capital is used to appraise the performance of a particular
project or business. The performance of a project or business is compared against the cost of
capital, which is known here as the cut-off rate or hurdle rate.
(iii) Designing of optimum credit policy: While appraising the credit period to be allowed to the
customers, the cost of allowing credit period is compared against the benefit/profit earned by
providing credit to customer of the segment of customers. Here cost of capital is used to arrive at
the present value of cost and benefits received
1) COST OF DEBT CAPITAL
Cost of Debt
External borrowings or debt instruments do not confer ownership to the providers of finance. The providers of the debt fund
do not participate in the affairs of the company but enjoy the charge on the profit before taxes. Long-term debt includes long-
term loans from financial institutions, capital from issuing debentures, or bonds, etc.
Features of Debentures or Bonds:
(i) Face Value: Debentures or Bonds are denominated with some value; this denominated value is called the face value of
the debenture. Interest is calculated on the face value of the debentures.
(ii) Interest (Coupon) Rate: Each debenture bears a fixed interest (coupon) rate (except Zero coupon bond and Deep
discount bond). The interest (coupon) rate is applied to the face value of the debenture to calculate interest, which is payable
to the holders of debentures periodically.
(iii) Maturity period: Debentures or Bonds have a fixed maturity period for redemption. However, in the case of irredeemable
debentures, the maturity period is not defined and it is taken as infinite.
(iv) Redemption Value: Redeemable debentures or bonds are redeemed on their specified maturity date. Based on the debt
covenants, the redemption value is determined. The redemption value may vary from the face value of the debenture.
(v) Benefit of tax shield: The payment of interest to the debenture holders is allowed as expenses for the purpose of
corporate tax determination. Hence, interest paid to the debenture holders saves the tax liability of the company.
Based on redemption (repayment of principal) on maturity, the debts can be categorized into two types:
(i) Irredeemable debts
(ii) Redeemable debts
Cost of Irredeemable Debentures
The cost of debentures that are not redeemed by the issuer of the debenture is known as irredeemable debentures. Cost of
debentures not redeemable during the lifetime of the company is calculated as below:
Cost of Irredeemable Debenture (Kd) = I/NP(1-t)
Where :
Kd= cost of debt after tax
I = annual interest payment
NP= net proceeds of debentures or current market price
t = tax rate .
Example:
A company issues 1,000, 15% debentures of the face value of ₹100 each at a discount of ₹5. Suppose further that the underwriting
and other costs are ₹5,000 for the total issue. Thus, ₹90,000 is actually realized, i.e., ₹1,00,000 minus ₹5,000 as a discount and
₹5,000 as underwriting expenses. The interest per annum of ₹15,000 is therefore the cost of ₹90,000 actually received by the
company. This is because interest is a charge on profit, and every year the company will save ₹7,500 as tax, assuming that the
income tax rate is 50%. Hence, the after-tax cost of ₹90,000 is ₹7,500, which comes to 8.33%.
Cost of Redeemable Debentures (using approximation method)
The cost of redeemable debentures will be calculated as below:
Cost of Redeemable Debenture
Where:
I = Interest payment
NP = Net proceeds from debentures in case of new issue of debt or Current market price in case of
existing debt.
RV = Redemption value of debentures
t = Tax rate applicable to the company
n = Life of debentures.
Example:
A company issued 10,000, 10% debentures of ₹100 each at a premium of 10% on 1.4.2020 to be
matured on 1.4.2025. The debentures will be redeemed on maturity. Compute the cost of
debentures assuming 35% as the tax rate.
Solution:
I=Interest on debenture=10% of ₹100= ₹10
NP=Net Proceeds=110% of ₹100=₹110
RV=Redemption value=₹100
n=Period of debenture=5 years
t=Tax rate=35% or 0.35
PREFERRENCE CAPITAL

Cost of Preference Share Capital

The preference shares are those shares that enjoy priority in payments of dividend and return of
capital over equity shares. Preference shareholders have a preferential right to claim dividend at a
fixed rate before any dividend is paid to equity shareholders. The preference shares do not carry
voting rights. The preference shares can be of two types (a) Redeemable Preference shares (b)
Irredeemable Preference shares.
Where:
PD = Preference dividend
NP = Net proceeds of preference share
Example:
A company issues 1,000 10% preference shares of ₹100 each at a premium of 5%. The cost of
issue is ₹5,000. Calculate the cost of preference shares.
Solution:
Preference dividend = 10% of ₹100 = ₹10
Net proceeds = ₹(100+5) – (5,000/1,000) = ₹100
Cost of preference shares = 10/100 = 10%
Cost of Equity
Equity shareholders are the real owners of the company. Equity capital is a permanent source of funds, which
cannot be redeemed except in the event of liquidation. Equity shareholders have a right to control the affairs
of the company.
Approaches for Computation of Cost of Equity Capital:
(i) Dividend Yield Method
(ii) Dividend Yield plus Growth Method
(iii) Earning Yield Method
(iv) Realized Yield Method
(v) Capital Asset Pricing Model (CAPM)
Dividend Yield Method:
Where,
Ke = Cost of equity capital
D = Current dividend per share
P0 = Market price per share (ex-dividend)
Example: The equity shares of a company are quoted at ₹110 and the expected dividend per share is ₹11.
Calculate the cost of equity capital.
Solution: Cost of equity capital = 11/110 = 10%
Dividend Yield plus Growth Method:
The method is based on the assumption that equity shares are held for an indefinite period and
dividend income from them is expected to grow at a constant rate (g).
Where:
Ke = Cost of equity
D1 = Expected dividend next year
P0= Current market price per share
g = Growth rate
Example: The equity shares of a company are quoted at ₹150 and the expected dividend per
share is ₹15. The dividend is expected to grow at the rate of 7%. Calculate the cost of equity
capital.
Solution:
Cost of equity capital = (15/150) + 0.07 = 0.10 + 0.07 = 17%
Earning Yield Method
The logic of this method is that if the company does not distribute profits as dividends and retains
them, the shareholders would have earned some return on their investment.
Where,
EPS = Earning per share
P0 = Market price per share
Example: The EPS of a company is ₹20 and the market price per share is ₹200. Calculate the
cost of equity capital.
Solution:
Cost of equity capital = 20/200 = 10%
Capital Asset Pricing Model (CAPM)
CAPM explains the relationship between the expected return and risk for assets. CAPM is widely
used throughout finance for pricing risky securities and generating estimates of the expected
returns of assets considering the risk.
Where,
Ke = Cost of Equity
Rf= Risk-free rate of return
β = Beta of the security
Rm = Market rate of return
Example: The risk-free rate of return is 6%, the beta of the security is 1.5 and the market rate of
return is 12%. Calculate the cost of equity capital.
Solution:
Cost of equity capital = 6% + 1.5 (12% - 6%) = 6% + 1.5 (6%) = 6% + 9% = 15%
Cost of Retained Earnings
Retained earnings are an internal source of funds and are available to the company at no cost.
However, this does not mean that the cost of retained earnings is zero. The shareholders expect a
return on their investment, and the company must earn at least that much on the retained
earnings. The cost of retained earnings is the opportunity cost of not distributing the earnings to
the shareholders as dividends.
Therefore, the cost of retained earnings may be taken as the cost of equity capital.
Weighted Average Cost of Capital (WACC)
Weighted Average Cost of Capital (WACC) is the average cost of all sources of finance used by a
company, weighted by their proportion in the total capital structure.
Where:
wi= Weightage for each source
Ki = Cost associated with each source
Where:
wi= Weightage for each source
Ki = Cost associated with each source
Example:
A company has the following capital structure:
Debt: ₹500,000 at 10% cost
Preference Shares: ₹200,000 at 12% cost
Equity Shares: ₹300,000 at 15% cost
Case Studies: Companies Using Cost of Capital
Apple Inc.

Apple uses WACC to evaluate investments in product development and

technology innovation, ensuring that returns exceed its cost benchmarks.
Benefits:
Efficient allocation of resources.
Strategic investments in innovation maintain competitive advantage.
Detailed Application:
Apple uses its WACC to assess the financial viability of new product lines.
For example, when considering the development of the Apple Watch, the
company would have projected the expected cash flows from sales and
then discounted those cash flows back to their present value using Apple’s
WACC. If the present value of the expected cash flows exceeded the
initial investment required to develop and produce the Apple Watch, the
project would be deemed financially attractive
Tesla

Tesla applies cost-of-capital concepts to decide on manufacturing plants and renewable energy
projects like Gigafactories.
Benefits:
Sustainable growth through renewable energy projects.
Optimized capital structure for profitability.
Detailed Application:
When Tesla decides to invest in a new Gigafactory, they evaluate whether the projected future
revenues and cost savings from increased battery production will provide a return that is greater
than the cost of the capital required for the massive investment. This involves estimating future
production volumes, pricing, and operational efficiencies, then discounting the projected cash flows
using Tesla's WACC to ensure that the project enhances shareholder value.
Amazon

Amazon utilizes WACC in logistics optimization and warehouse expansions to ensure infrastructure
investments meet profitability benchmarks.
Benefits:
Operational efficiency improvements.
Enhanced shareholder value through strategic growth initiatives.
Detailed Application:
Amazon continuously evaluates expanding its network of warehouses and optimizing its logistics. To
determine whether to invest in a new fulfillment center, Amazon projects the incremental revenue that
the new center will generate through faster delivery times and increased sales. They then discount
these cash flows using the company's WACC to assess if the investment will yield a return higher
than its cost of capital, supporting its growth and efficiency strategies.
Reliance Industries

Reliance employs cost-of-capital calculations for large-scale refinery projects and telecom
ventures like Jio.
Benefits:
Diversification into new sectors supported by accurate financial planning.
Ensures financial viability before committing resources.
Detailed Application:
Reliance Industries evaluates major capital expenditures, such as refinery expansions or
investments in telecom infrastructure (e.g., Jio), by using the cost of capital to determine if the
projects will generate adequate returns. By calculating the present value of the future cash flows
(revenues, cost savings) and comparing it to the initial investment, Reliance ensures that these
large projects meet their financial goals and create value for shareholders.
Conclusion
The cost of capital is an indispensable
tool for businesses, guiding them in
making informed decisions about
funding sources, investment
strategies, and project evaluations. By
understanding and applying this
concept effectively, companies can
achieve sustainable growth and
maximize shareholder value.