UNIT 1

Meaning of Finance and Financial Management:

● Finance encompasses the management of funds and assets, including how
individuals, businesses, and governments acquire, allocate, and utilize money and other
financial resources. It involves activities such as investing, borrowing, budgeting, saving,
and risk management.
● Financial management, on the other hand, is the process of planning, organizing,
directing, and controlling an organization's financial activities to achieve its financial
objectives. It includes decisions related to investment in assets, financing of operations,
and distribution of profits.

Types of Finance:
● Personal finance involves managing individual financial affairs such as budgeting,
saving, investing, insurance planning, and retirement planning.
● Corporate finance deals with the financial decisions made by corporations, including
capital budgeting (investment decisions), capital structure (financing decisions), and
dividend policy.
● Public finance focuses on the financial activities of governments and public sector
entities, including taxation, public expenditure, borrowing, and debt management.
● - International finance involves financial transactions and decisions between countries,
such as foreign exchange trading, international investment, and global trade finance.

Scope of Financial Management:

● Financial management encompasses various functions, including financial planning,
acquisition and allocation of funds, investment decisions, financing decisions
(determining the optimal capital structure), dividend decisions, risk management, and
financial control (monitoring and evaluating financial performance).

Approaches to Finance:
● Traditional approaches to finance emphasize achieving objectives such as profitability,
liquidity, and stability.
● Modern approaches, influenced by shareholder value theory and agency theory, focus
on maximizing shareholder wealth by making decisions that increase the value of the
firm's stock.

Function Relationship of Finance with Other Business Functions:

● Finance is interconnected with other business functions:
● Marketing: Finance provides funding for marketing campaigns and assesses the
financial viability of marketing strategies.
● Operations: Finance allocates funds for production facilities, inventory management,
and supply chain operations.
● Human Resources: Finance manages payroll, employee benefits, and compensation
strategies.
Objectives of Financial Management:
● Profit maximization seeks to maximize the net income or profit of the organization.
● Wealth maximization aims to increase the value of the firm and maximize shareholders'
wealth over time by focusing on the long-term sustainability and growth of the company.

Merits and Criticisms of Financial Management Objectives:

Merits: Profit maximization provides a clear objective for decision-making and aligns with the
goal of maximizing shareholder wealth in the short term. Wealth maximization considers the
time value of money and encourages decisions that benefit shareholders in the long term.
Criticisms: Profit maximization may encourage short-termism and sacrifice long-term
sustainability for immediate gains. Wealth maximization may prioritize the interests of
shareholders over other stakeholders, leading to ethical concerns.

Financial Decisions:
● Investment decisions involve allocating funds to long-term assets or projects that are
expected to generate returns in the future.
● Financing decisions determine how to raise funds to finance investments, including
decisions about debt vs. equity financing.
● Dividend decisions involve determining how much of the company's profits should be
distributed to shareholders as dividends.

Internal Relation of Financial Decisions:

Financial decisions are interrelated, meaning that one decision affects others. For example,
investment decisions influence the financing requirements of the company, which in turn impact
dividend decisions.

Factors Influencing Financial Decisions:

● Internal factors include the company's financial goals, risk tolerance, capital structure,
and availability of internal funds.
● External factors include economic conditions, interest rates, regulatory environment,
market competition, and investor sentiment.

Functional Areas of Financial Management

● Financial planning and analysis involve forecasting future financial performance and
developing strategies to achieve financial goals.
● Capital budgeting focuses on evaluating and selecting investment projects that maximize
shareholder value.
● Capital structure management involves determining the optimal mix of debt and equity
financing to minimize the cost of capital and maximize firm value.
● Working capital management involves managing short-term assets and liabilities to
ensure liquidity and operational efficiency.
 ● Risk management involves identifying, assessing, and mitigating financial risks that
could impact the organization's financial performance.
● Financial reporting involves preparing and presenting financial information to internal
and external stakeholders in accordance with accounting standards and regulations.

Functions of a Finance Manager:

● Financial planning involves setting financial goals, developing budgets, and forecasting
future financial performance.
● Financial analysis involves analyzing financial data to assess the financial health of the
organization and make informed decisions.
● Investment analysis involves evaluating investment opportunities and making
recommendations on capital allocation.
● Fundraising involves sourcing and securing funds from external sources such as banks,
investors, and capital markets.
● Risk management involves identifying financial risks and implementing strategies to
mitigate them.
● Financial reporting involves preparing financial statements, regulatory filings, and
management reports to communicate financial information to stakeholders.

Agency Cost:
Agency costs arise from conflicts of interest between different stakeholders in a company, such
as shareholders and management. These costs include monitoring costs, bonding costs, and
residual loss.

Definition of Ethics and Importance of Ethics in Finance:

● Ethics refers to principles of right and wrong conduct that guide individual and
organizational behavior.
● In finance, ethical behavior involves honesty, integrity, transparency, and fairness in
financial transactions and decision-making.
● Ethical conduct is important in finance to maintain trust and confidence in financial
markets, protect the interests of investors and stakeholders, ensure compliance with
laws and regulations, and promote the long-term sustainability and reputation of the
organization.

UNIT 2

Ownership securities:
Equity shares:
● Equity shares, also known as ordinary shares or common shares, represent the basic
ownership units in a company. When individuals or entities purchase equity shares, they
become partial owners of the company, entitling them to certain rights and privileges.
 ● As owners, equity shareholders have the right to participate in the company's
decision-making processes through voting rights. Each share typically carries one vote,
allowing shareholders to elect the board of directors and vote on significant corporate
matters during shareholder meetings.
● Another key feature of equity shares is their potential for capital appreciation. If the
company performs well and generates profits, the value of its equity shares may
increase over time, providing shareholders with the opportunity to sell their shares at a
higher price and realize capital gains.
● Equity shareholders also have the right to receive dividends, which are a portion of the
company's profits distributed to shareholders. However, dividends are not guaranteed
and may vary depending on the company's financial performance and management's
discretion.
● While equity shares offer the potential for higher returns, they also carry higher risk
compared to other types of securities. If the company faces financial difficulties or
experiences a decline in its stock price, equity shareholders may incur losses on their
investment.

Preference shares:
● Preference shares are a type of equity security that combines features of both equity
and debt instruments. Unlike equity shares, which provide ownership rights, preference
shares offer investors preferential treatment in terms of dividends and capital repayment.
● One of the distinguishing characteristics of preference shares is their fixed dividend rate.
Unlike equity dividends, which fluctuate based on the company's profitability, preference
shareholders are entitled to receive a predetermined dividend amount, usually
expressed as a percentage of the face value of the shares.
● Additionally, preference shareholders typically have priority over equity shareholders
when it comes to dividend distributions. In the event of the company's liquidation or
winding up, preference shareholders are entitled to receive their capital back before
equity shareholders.
● However, preference shares often do not carry voting rights or have limited voting rights.
This means that preference shareholders may not have a say in corporate
decision-making processes, such as electing the board of directors or approving
significant transactions.
● Preference shares are considered a hybrid form of financing as they combine elements
of equity and debt. While they provide investors with a steady stream of income through
fixed dividends, they also carry some degree of risk, particularly in terms of their ranking
in the capital structure and potential dilution by future equity issuances.

Creditorship securities:

Debentures:
● Debentures are debt instruments issued by companies to raise funds from investors.
When investors purchase debentures, they are essentially lending money to the issuing
 company in exchange for a promise of regular interest payments and repayment of the
principal amount at maturity.
● Unlike shares, debentures do not confer ownership rights in the company. Instead,
debenture holders are creditors of the company and have a claim on its assets in case of
default.
● Debentures typically have a fixed maturity date, at which point the issuing company is
obligated to repay the principal amount to the debenture holders. In the meantime, the
company pays periodic interest payments to the debenture holders at a predetermined
rate.
● Debentures can be secured or unsecured. Secured debentures are backed by specific
assets of the company, providing an added layer of security for investors. Unsecured
debentures, on the other hand, are not backed by any collateral and rely solely on the
company's creditworthiness.
● Depending on the terms of the issue, debentures may be convertible or non-convertible.
Convertible debentures give holders the option to convert their debt into equity shares at
a predetermined conversion ratio, providing them with potential upside if the company's
stock price rises. Non-convertible debentures cannot be converted into equity shares
and offer fixed returns throughout their tenure.
● Debentures are often considered a relatively safer investment compared to equity
shares since they offer fixed returns and priority repayment in case of bankruptcy.
However, they also tend to offer lower returns than equity investments, reflecting the
lower risk profile.

Zero coupon bonds:

● Zero coupon bonds are a type of debt instrument that does not pay periodic interest
payments like traditional bonds. Instead, they are sold at a discount to their face value
and redeemed at face value upon maturity, providing investors with a return in the form
of capital appreciation.
● Since zero coupon bonds do not pay interest, they are initially priced at a significant
discount to their face value. Investors earn a return by purchasing these bonds at a
discounted price and receiving the full face value when the bond matures.
● Zero coupon bonds are particularly attractive to investors seeking a predictable return
without the need for regular interest income. However, they are also subject to interest
rate risk, meaning their prices may fluctuate in response to changes in interest rates.

Zero interest bonds:

● Zero interest bonds, also known as deep discount bonds, are similar to zero coupon
bonds in that they do not pay periodic interest payments. However, unlike zero coupon
bonds, zero interest bonds are issued at par value and do not trade at a discount.
● Instead of receiving interest payments, investors earn a return through the difference
between the purchase price and the face value of the bond at maturity. This difference
represents the implicit interest earned on the investment.
● Zero interest bonds are often issued by government entities or highly creditworthy
corporations as a means of raising funds at a lower cost. They appeal to investors
 seeking a fixed return over a specified period without the need for regular interest
payments.

Callable bonds:
● Callable bonds are debt instruments that give the issuer the option to redeem the bonds
before their maturity date. This feature allows issuers to take advantage of declining
interest rates by refinancing their debt at a lower cost.
● When a bond is called, the issuer repurchases the bonds from investors at a
predetermined price, usually at a premium to the face value. This can result in a loss for
investors if the bonds are called before they reach maturity, as they may have to reinvest
the proceeds at lower interest rates.
● Callable bonds typically offer higher yields than non-callable bonds to compensate
investors for the risk of early redemption. However, callable bonds carry reinvestment
risk, as investors may struggle to find comparable investment opportunities if their bonds
are called prematurely.

Deep discount bonds:

● Deep discount bonds are debt instruments issued at a significant discount to their face
value, resulting in a low initial purchase price for investors. These bonds do not pay
periodic interest payments like traditional bonds but are redeemed at face value upon
maturity, providing investors with a return in the form of capital appreciation.
● Deep discount bonds are often issued by governments or corporations as a means of
raising funds at a lower cost. They appeal to investors seeking a fixed return over a
specified period without the need for regular interest income.
● While deep discount bonds offer the potential for capital gains, they are also subject to
interest rate risk, as their prices may fluctuate in response to changes in interest rates.
Additionally, investors should be aware of the tax implications of deep discount bonds,
as they may be subject to taxation on the imputed interest accrued over the life of the
bond.

Internal financing or ploughing back of profit:

Internal financing or ploughing back of profit:

● Internal financing, also known as ploughing back of profits, refers to the practice of
using a company's retained earnings to fund its growth and expansion activities instead
of seeking external sources of financing.
● When a company generates profits, it has the option to distribute those profits to
shareholders in the form of dividends or retain them within the business for reinvestment
in various projects, acquisitions, research and development, or other growth initiatives.
● Ploughing back of profits allows a company to maintain control over its operations and
avoid the costs and obligations associated with external financing, such as interest
payments and dilution of ownership.
 ● By reinvesting profits internally, companies can capitalize on their own resources and
capabilities to fuel growth, enhance competitiveness, and create long-term value for
shareholders.
● However, the decision to plough back profits depends on various factors, including the
company's growth opportunities, capital requirements, risk tolerance, and financial
position.
● Factors affecting ploughing back of profits:
● Growth opportunities: Companies with high growth potential may choose to reinvest
profits to capitalize on expansion opportunities, develop new products or markets, or
invest in research and development.
● Capital requirements: The amount of capital needed to fund growth initiatives or support
ongoing operations influences the decision to plough back profits. Companies with
substantial capital needs may rely on internal financing to avoid overleveraging or
diluting existing shareholders' equity.
● Financial position: The financial health and liquidity of the company play a crucial role in
its ability to plough back profits. Companies with strong cash flows and healthy balance
sheets are better positioned to reinvest profits for growth.
● Shareholder preferences: The company's dividend policy and shareholders' expectations
regarding dividend payments versus reinvestment opportunities influence the decision to
plough back profits. Companies may balance the interests of shareholders by adopting a
dividend reinvestment plan or offering share buybacks.
● Tax considerations: Tax implications, such as corporate tax rates and tax incentives for
reinvestment, can affect the attractiveness of ploughing back profits compared to
distributing dividends.
Merits of ploughing back of profits:
● Cost-effective: Internal financing does not involve transaction costs or interest expenses
associated with external financing, making it a cost-effective source of capital.
● Retained control: By retaining earnings within the company, shareholders maintain
control over decision-making and avoid dilution of ownership.
● returns on investment and sustainable long-term growth, enhancing shareholder value.
● Demerits of ploughing back of profits:
● Opportunity cost: By not distributing profits to shareholders as dividends, the company
foregoes the opportunity for shareholders to allocate capital according to their
preferences and risk profiles.
● Risk concentration: Relying solely on internal financing may limit the company's ability to
diversify risk and access external sources of capital during periods of financial distress or
economic uncertainty.
● Shareholder expectations: Failure to meet shareholders' expectations for dividend
payments or capital appreciation may lead to dissatisfaction and potential loss of
investor confidence.
Loan financing - short term and long term sources:
Loan financing:
● Loan financing involves borrowing funds from external sources, such as banks, financial
institutions, or private lenders, to finance business operations, investments, or capital
expenditures.
● Loans provide companies with access to capital to support growth, expand operations,
bridge short-term cash flow gaps, or fund specific projects.
● Loan financing can be categorized into short-term and long-term sources based on the
duration of the loan and the purpose of the financing.

Short-term sources:
● Short-term loans are typically used to meet immediate financing needs, cover short-term
liabilities, or finance working capital requirements.
● Common short-term sources of loan financing include:
● Bank overdrafts: Allows companies to withdraw funds exceeding their account balance
up to a predetermined limit, providing flexibility to manage cash flow fluctuations.
● Trade credit: Suppliers may extend credit terms to customers, allowing them to purchase
goods or services on credit and defer payment for a specified period.
● Commercial paper: Short-term debt instruments issued by corporations to raise funds for
short-term financing needs, usually with maturities ranging from a few days to a year.
● Revolving credit facilities: Lines of credit that provide borrowers with access to a
predetermined amount of funds, which can be borrowed, repaid, and borrowed again
within the specified limit.

Long-term sources:
● Long-term loans are used to finance capital investments, acquisitions, or projects with
longer-term horizons, typically exceeding one year.
● Common long-term sources of loan financing include:
● Term loans: Fixed-term loans with predetermined repayment schedules, usually used to
finance capital expenditures, acquisitions, or long-term investments.
● Bonds: Debt securities issued by corporations or governments to raise funds from
investors, typically with maturities ranging from several years to decades.
● Mortgage loans: Loans secured by real estate assets, such as property or equipment,
used to finance property acquisitions, expansions, or development projects.
● Private placements: Direct placements of debt securities with institutional investors or
accredited investors, bypassing public markets, and offering more flexibility in terms of
terms and conditions.
Startup finance - Bootstrapping, Series Funding:

Startup finance:
Startup finance refers to the process of raising capital to fund the development, launch, and
growth of a new business venture.

Bootstrapping:
● Bootstrapping, also known as self-funding, involves financing a startup using personal
savings, revenue generated by the business, or resources obtained from friends and
family.
● Bootstrapping allows entrepreneurs to maintain full control over their business, avoid
dilution of equity, and minimize reliance on external financing sources.
● While bootstrapping can be cost-effective and provide autonomy, it may limit the scale
and pace of growth due to resource constraints.

Series Funding:
● Series funding refers to the process of raising capital from external investors in multiple
rounds, or series, as the startup progresses through various stages of growth and
development.
● Common types of series funding rounds include:
● Seed round: Initial funding round used to validate the startup's concept, develop a
prototype, or conduct market research. Seed funding is often provided by angel
investors, venture capital firms, or accelerators.
● Series A round: Early-stage funding round aimed at scaling the business, expanding
operations, or acquiring customers. Series A funding is typically provided by venture
capital firms in exchange for equity stakes in the company.
● Series B, C, D, etc.: Successive funding rounds conducted as the startup achieves
milestones, demonstrates growth potential, and prepares for further expansion. Each
series funding round typically involves larger investment amounts and higher valuations
as the startup matures.
● Series funding allows startups to access capital at different stages of their growth
journey, attract strategic investors, and fuel expansion plans. However, it also involves
dilution of ownership and may subject the startup to increased scrutiny and performance
expectations from investors.

UNIT 3
Meaning of capitalization:
Capitalization:
● Capitalization refers to the process of determining the total value of a company's equity
and debt securities by combining its outstanding shares of stock and long-term debt.
● It represents the total amount of capital invested in the company by its shareholders and
creditors and reflects the company's overall financial structure and stability.
Theories of capitalization:

Cost theory:
● Cost theory of capitalization suggests that the total capitalization of a company is
determined by the cost of its assets and the rate of return required by investors.
● According to this theory, the value of a company's capitalization is influenced by the cost
of acquiring its assets, including land, buildings, machinery, and equipment.
● Additionally, investors' required rate of return on the company's securities, such as equity
and debt, also affects its capitalization. Higher required rates of return lead to lower
capitalization values, while lower required rates of return result in higher capitalization
values.

Earnings theory:
● Earnings theory of capitalization posits that the total capitalization of a company is
determined by its earnings or profitability.
● According to this theory, investors are willing to pay a multiple of a company's earnings
to acquire its shares, reflecting their expectations of future earnings growth and
profitability.
● Companies with higher earnings potential and growth prospects tend to have higher
capitalization values, as investors are willing to pay more for their shares to participate in
future earnings growth.

Overcapitalization and undercapitalization (Theory):

Overcapitalization:
● Overcapitalization occurs when a company's total capitalization exceeds the value of its
productive assets or earning capacity.
● Causes of overcapitalization may include excessive debt financing, inflated asset
values, overestimation of future earnings, or poor capital budgeting decisions.
● Effects of overcapitalization may include reduced profitability, lower returns on
investment, financial distress, and loss of investor confidence.
● Remedies for overcapitalization may involve restructuring the company's capital,
reducing debt levels, selling non-core assets, or improving operational efficiency to
enhance profitability.

Undercapitalization:
● Undercapitalization occurs when a company's total capitalization is insufficient to
support its operating needs and growth opportunities.
● Causes of undercapitalization may include inadequate equity financing, conservative
capital structure policies, underestimation of capital requirements, or rapid expansion
without adequate funding.
● Effects of undercapitalization may include liquidity problems, inability to seize growth
opportunities, reduced competitiveness, and increased financial risk.
 ● Remedies for undercapitalization may involve raising additional equity capital,
restructuring debt obligations, renegotiating financing terms, or divesting non-performing
assets to improve financial stability.

Watered stock, Overtrading, and Undertrading:

Watered stock:
● Watered stock refers to shares of stock that are issued with a par value or market price
higher than the true value of the company's assets or earning capacity.
● Watered stock may result from overvaluation of assets, manipulation of financial
statements, or fraudulent practices aimed at inflating the company's stock price.
● Investors who purchase watered stock may suffer losses when the true value of the
company is revealed, leading to declines in stock prices and erosion of shareholder
value.

Overtrading:
● Overtrading occurs when a company engages in excessive trading or expansion
activities beyond its financial capacity or market demand.
● Overtrading may result from aggressive growth strategies, inadequate capitalization, or
poor management decisions, leading to liquidity problems and financial distress.
● Effects of overtrading may include cash flow shortages, increased debt levels, reduced
profitability, and operational inefficiencies.

Undertrading:
● Undertrading refers to a situation where a company fails to fully utilize its resources or
exploit growth opportunities due to conservative financial policies or risk aversion.
● Undertrading may result from insufficient investment in marketing, research and
development, or capital expenditures, leading to missed growth opportunities and
stagnation.
● Effects of undertrading may include slower revenue growth, loss of market share,
reduced competitiveness, and diminished shareholder value.

Meaning of capital structure and financial structure:

Capital structure:
● Capital structure refers to the mix of equity and debt financing used by a company to
fund its operations and investments.
● It represents the proportion of long-term debt, preferred equity, and common equity in
the company's capitalization and influences its financial risk and cost of capital.

Financial structure:
● Financial structure refers to the composition of a company's total liabilities, including
both short-term and long-term debt, as well as equity capital.
 ● It reflects the company's overall financial health, leverage levels, and ability to meet its
financial obligations.

Principles of capital structure:

Principle of optimum capital structure:
● The principle of optimum capital structure states that a company should maintain a
balance between debt and equity financing to minimize its cost of capital and maximize
shareholder value.
● Optimum capital structure is achieved when the company balances the benefits of debt,
such as tax shields and leverage, with the costs of debt, such as interest payments and
financial risk.
● Companies should consider factors such as business risk, financial flexibility, growth
prospects, and investor preferences when determining their optimal capital structure.

Optimum Capital Structure:

Optimum capital structure:

● Optimum capital structure refers to the ideal mix of debt and equity financing that
maximizes a company's value and minimizes its cost of capital.
● It represents the balance between the benefits of debt, such as tax advantages and
leverage, and the costs of debt, such as interest payments and financial risk.
● Achieving optimum capital structure involves considering various factors, including
business risk, financial flexibility, growth prospects, and investor preferences, to
determine the most efficient mix of financing sources.

Determinants of capital structure:

● Financial risk tolerance: Companies with higher risk tolerance may opt for higher levels
of debt financing to leverage their returns and enhance shareholder value.
● Cost of debt and equity: The cost of debt and equity financing influences a company's
capital structure decisions. Lower borrowing costs may incentivize higher debt levels,
while higher equity costs may favor equity financing.
● Business risk: The level of business risk inherent in the company's operations affects
its capital structure decisions. Companies with stable cash flows and predictable
earnings may tolerate higher debt levels, while those with volatile earnings may prefer a
more conservative capital structure.
● Tax considerations: Tax implications, such as interest deductibility and tax shields,
influence the attractiveness of debt financing compared to equity financing. Companies
may leverage tax advantages to optimize their capital structure and minimize their cost
of capital.
● Market conditions: Economic and market conditions, including interest rates, investor
sentiment, and capital market liquidity, impact a company's access to debt and equity
financing. Companies must consider market dynamics when determining their capital
structure.
 ● Regulatory environment: Regulatory constraints and capital market regulations may
influence a company's capital structure decisions. Compliance with regulatory
requirements, such as debt covenants and leverage ratios, affects the choice between

UNIT 4

Meaning of cost of capital:

Cost of capital:
● Cost of capital refers to the cost incurred by a company to finance its operations and
investments through various sources of capital, including equity and debt.
● It represents the minimum rate of return that investors expect to earn on their
investments in the company's securities to compensate them for the risk of investing in
the company.
● Cost of capital serves as a benchmark for evaluating the profitability of investment
projects and determining the optimal capital structure for the company.

Significance of cost of capital:

Significance:
● Cost of capital is a critical financial metric used by companies to make investment
decisions, such as capital budgeting and project evaluation.
● It helps companies determine the minimum return required from investment projects to
create value for shareholders and meet their cost of capital.
● Cost of capital also influences the company's capital structure decisions, as it provides
insights into the relative costs of equity and debt financing and helps optimize the capital
mix to minimize the overall cost of capital.
● Additionally, cost of capital is used as a discount rate in discounted cash flow (DCF)
analysis to calculate the present value of future cash flows and assess the economic
viability of investment opportunities.

Components of cost of capital:

Components:
● Cost of equity: Cost of equity represents the rate of return required by equity investors to
compensate them for the risk of investing in the company's stock. It is calculated using
models such as the Capital Asset Pricing Model (CAPM) or the Dividend Growth Model.
● Cost of debt: Cost of debt refers to the effective interest rate paid by the company on its
debt obligations, taking into account factors such as coupon payments, maturity, and tax
benefits. It is typically calculated using the yield to maturity (YTM) or the cost of debt
formula.
● Weighted Average Cost of Capital (WACC): WACC represents the weighted average of
the cost of equity and the cost of debt, adjusted for the company's capital structure. It
 reflects the overall cost of capital for the company and is used as the discount rate for
evaluating investment projects.

UNIT 5

Meaning of Capital Budgeting:

Capital Budgeting:
● Capital budgeting is the process of planning, evaluating, and selecting long-term
investment projects or capital expenditures that involve significant outlays of funds.
● It involves analyzing various investment opportunities to determine which projects are
most likely to generate positive returns and contribute to the company's strategic
objectives.
● Capital budgeting decisions typically involve investments in fixed assets, such as
property, plant, and equipment, as well as research and development projects,
acquisitions, and expansions.

Importance and Need of Capital Budgeting:

Importance:
● Strategic planning: Capital budgeting helps companies align their investment decisions
with their strategic objectives and long-term goals.
● Resource allocation: It enables companies to allocate scarce resources efficiently to
projects that offer the highest potential returns and create the most value for
shareholders.
● Risk management: Capital budgeting allows companies to assess the risks associated
with investment projects and make informed decisions to mitigate risks and
uncertainties.
● Performance evaluation: It provides a framework for evaluating the performance of
investment projects and comparing actual results with initial projections to learn from
past experiences and improve future decision-making.

Need:
● Long-term perspective: Capital budgeting helps companies evaluate investment
opportunities from a long-term perspective, considering their impact on future cash flows
and profitability.
● Resource constraints: Limited financial resources necessitate careful evaluation and
prioritization of investment projects to ensure optimal allocation of funds.
● Strategic alignment: Companies need to align their investment decisions with their
overall business strategy and objectives to maximize shareholder value and maintain
competitiveness.
● Risk management: Assessing the risks and uncertainties associated with investment
projects is essential for managing financial risk and ensuring the sustainability of the
business.
Capital budgeting process:

Capital budgeting process:

● Identification of investment opportunities: The first step involves identifying potential
investment projects that align with the company's strategic objectives and growth plans.
● Evaluation of investment proposals: Investment proposals are evaluated based on their
expected cash flows, risks, time horizons, and other relevant factors using quantitative
and qualitative analysis techniques.
● Selection of projects: Investment projects are prioritized and selected based on their net
present value (NPV), internal rate of return (IRR), profitability index (PI), payback period,
and other criteria to maximize shareholder value.
● Implementation and monitoring: Selected projects are implemented, and their
performance is monitored regularly to ensure that they achieve their expected returns
and contribute to the company's overall objectives.
●

UNIT 6

Bonus shares:

Meaning:
● Bonus shares, also known as scrip dividends or capitalization issues, are additional
shares distributed by a company to its existing shareholders free of charge, typically in
proportion to their current shareholdings.
● Unlike dividends, which involve cash payments to shareholders, bonus shares represent
capitalization of the company's retained earnings or reserves, converting them into
additional equity capital.

Kinds:
● Bonus shares can be classified into two types:
● Capitalization of reserves: Bonus shares issued by converting accumulated reserves,
such as retained earnings or surplus capital, into additional equity capital.
● Capitalization of profits: Bonus shares issued by capitalizing profits generated by the
company, either from operations or asset sales, and converting them into additional
shares for distribution to shareholders.

Merits:
● Conservation of cash: Bonus shares enable companies to conserve cash by capitalizing
retained earnings or reserves instead of paying cash dividends, thereby retaining funds
for reinvestment in growth initiatives.
● Enhanced liquidity: By increasing the number of shares outstanding, bonus shares
enhance the liquidity of the company's stock, making it more attractive to investors and
potentially increasing trading volumes.
 ● Improved shareholder value: Bonus shares demonstrate the company's confidence in its
future prospects and commitment to rewarding shareholders, leading to positive market
sentiment and potentially higher stock prices.

Demerits:
● Dilution of earnings per share (EPS): Since bonus shares increase the number of shares
outstanding without a corresponding increase in earnings, they can dilute the company's
EPS, potentially reducing the attractiveness of the stock to investors.
● Lack of immediate cash benefits: Unlike cash dividends, which provide shareholders with
immediate cash payments, bonus shares do not provide any immediate liquidity or
income to shareholders, as they only increase the number of shares held.
● Market signaling concerns: The issuance of bonus shares may be interpreted by
investors as a signal of undervaluation or inability to sustain cash dividends, potentially
leading to negative market perceptions and stock price declines.

Theories of dividend decisions:

Relevance theory:
● Relevance theory suggests that dividend policy is relevant and affects the value of the
firm. According to this theory, investors prefer dividends over capital gains since
dividends provide certainty of returns and signal the company's financial strength and
stability.
● The relevance theory implies that firms should adopt a dividend policy that balances the
desire for current income with the need for reinvestment to maximize shareholder
wealth.

Irrelevance theory:
● Irrelevance theory, proposed by Modigliani and Miller, argues that dividend policy has no
impact on the firm's value under certain assumptions, such as perfect capital markets,
no taxes, and no transaction costs.
● According to the irrelevance theory, investors are indifferent between dividends and
capital gains since they can replicate cash flows through portfolio adjustments or
homemade dividends.
● Therefore, firms' dividend policies are irrelevant, and shareholders' wealth is determined
solely by the firm's investment decisions and capital structure.

Determinants of dividend policy decisions:

Profitability: The level of profitability influences a company's ability to pay dividends. Higher
profits provide more resources for dividend payments, while lower profits may necessitate
retaining earnings for reinvestment.
Cash flow: The availability of cash flow is crucial for paying dividends. Companies with stable
and predictable cash flows are better positioned to maintain consistent dividend payments.
 ● Investment opportunities: The growth prospects and investment opportunities available
to the company influence its dividend policy. Firms with lucrative growth opportunities
may retain more earnings for reinvestment, while mature firms with fewer growth
prospects may distribute higher dividends.
● Capital structure: The company's capital structure, including its debt levels and financing
preferences, can affect its dividend policy. Highly leveraged firms may prioritize debt
servicing over dividend payments, while firms with excess cash or low debt levels may
have more flexibility to pay dividends.
● Legal and regulatory constraints: Companies must comply with legal requirements and
regulatory guidelines when making dividend decisions. For example, the Companies Act,
2013 in India mandates certain provisions regarding dividend distribution, including the
use of profits for dividend payments and approval processes.
● Shareholder preferences: The preferences and expectations of shareholders also play a
role in shaping dividend policy decisions. Companies may consider factors such as
shareholder demographics, tax considerations, and desired income streams when
determining dividend payout ratios.

Companies Act, 2013 and SEBI Guidelines on Dividend Distribution (Theory only):

Companies Act, 2013:

● The Companies Act, 2013 is the primary legislation governing the incorporation,
management, and operation of companies in India. It contains provisions related to
dividend distribution, including the sources from which dividends can be paid, the
declaration process, and shareholder approval requirements.
● Under the Companies Act, 2013, dividends can only be paid out of profits available for
distribution, subject to certain conditions and restrictions. Companies are required to
follow prescribed procedures for declaring dividends and obtaining shareholder
approval, ensuring transparency and accountability in dividend distribution practices.

SEBI Guidelines on Dividend Distribution:

● The Securities and Exchange Board of India (SEBI) regulates securities markets in India
and issues guidelines to ensure fair and transparent practices by listed companies.
● SEBI has issued guidelines on dividend distribution, including disclosure requirements,
timing of dividend declarations, and restrictions on dividend payments during certain
circumstances, such as financial distress or pending regulatory approvals.
● Listed companies are required to comply with SEBI guidelines on dividend distribution to
protect the interests of investors and maintain the integrity of the capital markets.