FUNDAMENTALS OF FINANCIAL MANAGEMENT

LONG QUESTIONS
1. Define Financial Management. Discuss its nature and functions of
Financial Management.
Financial Management is the discipline concerned with managing an
organization's finances effectively and efficiently. It involves making strategic
decisions about how to allocate resources, manage risks, and ensure the
financial health and growth of the business.
Nature of Financial Management:
• Decision-Oriented: Financial management revolves around making
critical decisions related to investment, financing, and dividend policy.
• Future-Oriented: Financial decisions have long-term implications for
the organization's future success.
• Risk-Averse: Financial managers strive to minimize risks associated
with financial decisions.
• Value-Maximizing: The ultimate goal of financial management is to
maximize the wealth of the organization's shareholders.
Functions of Financial Management:
1. Financial Planning: Developing financial goals, strategies, and budgets
for the organization.
2. Investment Decisions: Evaluating and selecting investment
opportunities that will generate the highest returns.
3. Financing Decisions: Determining the optimal mix of debt and equity
financing to fund operations and growth.
4. Dividend Policy Decisions: Deciding how much of the company's
profits to distribute to shareholders as dividends and how much to
retain for reinvestment.
5. Working Capital Management: Managing the organization's short-term
assets and liabilities to ensure liquidity and efficient operations.
 FUNDAMENTALS OF FINANCIAL MANAGEMENT
6. Risk Management: Identifying and mitigating financial risks that could
impact the organization's performance.
2. Briefly explain how is wealth Maximization Objective better than the
Profit Maximization Objective.
The wealth maximization objective is generally considered superior to profit
maximization for several reasons:
• Time Value of Money: Wealth maximization considers the time value of
money, recognizing that a dollar received today is worth more than a
dollar received in the future. Profit maximization, on the other hand,
often focuses on current profits without considering their timing.
• Risk Consideration: Wealth maximization explicitly takes into account
the risk associated with different investment and financing decisions.
Profit maximization may lead to short-term gains but could expose the
organization to significant risks in the long run.
• Stakeholder Focus: Wealth maximization considers the interests of all
stakeholders, including shareholders, employees, customers, and the
community. Profit maximization tends to focus solely on maximizing
profits for shareholders.
• Long-Term Perspective: Wealth maximization is a long-term objective
that aims to increase the organization's value over time. Profit
maximization may lead to short-term gains but could harm the
organization's long-term prospects.
3. What is risk? Briefly explain the types of risk involved in an investment.
Risk in the context of investment refers to the uncertainty or variability of
expected returns. It is the possibility that the actual outcome of an investment
will differ from the expected outcome.
Types of Risk:
• Systematic Risk (Market Risk): This type of risk affects the entire
market or a large segment of it. Examples include economic recessions,
interest rate changes, and political instability.
 FUNDAMENTALS OF FINANCIAL MANAGEMENT
• Unsystematic Risk (Company-Specific Risk): This risk is unique to a
particular company or industry. Examples include changes in
management, competition, technological advancements, and legal
issues.
• Credit Risk: The risk that a borrower may default on their debt
obligations.
• Liquidity Risk: The risk that an investment cannot be easily bought or
sold in the market without significant price fluctuations.
• Inflation Risk: The risk that inflation will erode the purchasing power of
future returns.
• Currency Risk: The risk of losses due to fluctuations in exchange rates.
• Country Risk: The risk associated with investing in a particular country,
including political instability, economic uncertainty, and legal risks.
4. What is Cost of Capital? What are the different methods of computing
the cost of equity capital?
Cost of Capital represents the minimum return that an investment must
generate to compensate investors for the risk they are taking. It is the
opportunity cost of capital, reflecting the return investors could earn on
comparable investments elsewhere.
Methods of Computing the Cost of Equity Capital:
• Capital Asset Pricing Model (CAPM): This model estimates the cost of
equity based on the risk-free rate, the market risk premium, and the
beta of the stock.
• Dividend Discount Model (DDM): This model calculates the cost of
equity based on the expected future dividends and the current stock
price.
• Earnings Capitalization Model: This model estimates the cost of equity
based on the expected future earnings and the current stock price.
 FUNDAMENTALS OF FINANCIAL MANAGEMENT
• Bond Yield Plus Risk Premium Model: This model adds a risk premium
to the yield on a comparable risk-free bond to estimate the cost of
equity.
5. What is weighted average cost of capital and marginal cost of capital?
Examine the rationale behind the use of after-tax weighted average cost of
capital?
Weighted Average Cost of Capital (WACC) is the average cost of all the
capital sources used by a company, weighted by their respective proportions
in the capital structure. It is a critical metric used in capital budgeting
decisions.
Marginal Cost of Capital (MCC) represents the cost of raising an additional
dollar of capital. It is the cost of the next dollar of capital raised by the
company.
Rationale behind using After-Tax WACC:
• Tax Shield: Interest payments on debt are tax-deductible, reducing the
company's tax liability. The after-tax cost of debt reflects this tax
benefit.
• True Cost of Capital: The after-tax WACC represents the true cost of
capital to the company, as it takes into account the tax benefits of debt
financing.
• Decision Making: The after-tax WACC is used in capital budgeting
decisions to evaluate the profitability of potential investments.
6. What do you mean by dividend policy? Explain the various theories of
dividend policy.
Dividend Policy refers to the decisions made by a company regarding the
distribution of its profits to shareholders as dividends. It involves determining
the optimal dividend payout ratio and dividend growth rate.
Theories of Dividend Policy:
 FUNDAMENTALS OF FINANCIAL MANAGEMENT
• Dividend Irrelevance Theory (Modigliani and Miller): This theory
argues that dividend policy is irrelevant to the value of a firm under
certain assumptions, such as perfect capital markets and no taxes.
• Dividend Relevance Theory: This theory suggests that dividend policy
can affect the value of a firm. It includes theories such as the bird-in-
the-hand argument, the signaling hypothesis, and the clientele effect.
• Residual Dividend Theory: This theory suggests that dividends should
be paid only after all profitable investment opportunities have been
funded with retained earnings.
7. Critically examine Walter's relevance theory of dividend.
Walter's Relevance Theory suggests that the optimal dividend policy
depends on the relationship between the company's internal rate of return
(IRR) on investments and the cost of equity capital.
Key Points of Walter's Theory:
• If IRR > Cost of Equity: The company should retain all earnings for
reinvestment, as the return on investment exceeds the cost of capital.
• If IRR < Cost of Equity: The company should distribute all earnings as
dividends, as the cost of capital exceeds the return on investment.
• If IRR = Cost of Equity: The dividend policy is irrelevant, as the return on
investment is equal to the cost of capital.
Criticisms of Walter's Theory:
• Assumes Constant Cost of Equity: The theory assumes that the cost
of equity remains constant regardless of the dividend payout ratio,
which may not be realistic.
• Assumes Constant IRR: The theory assumes that the company's IRR
on investments remains constant, which is also unrealistic.
• Ignores Taxes and Other Factors: The theory does not consider the
impact of taxes, transaction costs, and other factors that can influence
dividend policy decisions.
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8. What is working capital? Discuss the factors that can be considered
while estimating working capital requirements of a business firm.
Working Capital is the difference between a company's current assets and
current liabilities. It represents the funds available for the day-to-day
operations of the business.
Factors Affecting Working Capital Requirements:
• Nature of Business: The working capital requirements vary depending
on the nature of the business. For example, manufacturing businesses
typically require more working capital than service businesses.
• Scale of Operations: Larger businesses generally require more working
capital than smaller ones.
• Business Cycle: Working capital requirements fluctuate with the
business cycle. During periods of growth, working capital needs tend to
increase.
• Credit Policy: A more lenient credit policy can lead to higher accounts
receivable and increased working capital requirements.
• Inventory Levels: Higher inventory levels require more working capital
to finance the cost of goods.
• Production Cycle: The longer the production cycle, the higher the
working capital requirements.
• Growth Prospects: Growing businesses typically require more working
capital to support expansion.
• Inflation: Inflation can increase the cost of raw materials and other
inputs, leading to higher working capital needs.
• Financial Policies: The company's financial policies, such as dividend
policy and debt-equity ratio, can also affect working capital
requirements.

3 MARKS QUESTIONS
 FUNDAMENTALS OF FINANCIAL MANAGEMENT
1. Write a note on profit maximization vs wealth maximization.
Profit maximization focuses on maximizing a company's current earnings,
often neglecting long-term implications and risk. Wealth maximization, on the
other hand, aims to increase the overall value of the company over time by
considering factors like risk, time value of money, and stakeholder interests.
2. How is present value of an annuity is calculated?
The present value of an annuity is calculated using the formula:
PV = PMT * [(1 - (1 + r)^-n) / r]
where:
• PV = Present value
• PMT = Periodic payment
• r = Discount rate
• n = Number of periods
3. How is Weighted Average Cost of Capital (WACC) calculated?
WACC is calculated by weighting the cost of each capital source (debt and
equity) by its proportion in the capital structure. The formula is:
WACC = (Weight of Debt * Cost of Debt) * (1 - Tax Rate) + (Weight of Equity *
Cost of Equity)
4. Define the Cost of Equity Capital.
The cost of equity capital is the minimum return that a company must offer to
its equity investors to compensate them for the risk they are taking. It
represents the opportunity cost of investing in the company's stock.
5. Differentiate between Money Market and Capital Market.
The money market deals with short-term debt instruments (less than 1 year),
such as treasury bills and commercial paper, while the capital market deals
with long-term debt instruments (more than 1 year) and equity securities,
such as bonds and stocks.
 FUNDAMENTALS OF FINANCIAL MANAGEMENT
6. Differentiate between cash flows from operating activities and investing
activities.
Cash flows from operating activities are the cash flows generated from a
company's core business operations, such as sales revenue, cost of goods
sold, and operating expenses. Cash flows from investing activities are the
cash flows related to the purchase and sale of long-term assets, such as
property, plant, and equipment.
7. Differentiate between Systematic Risk and Unsystematic Risk.
Systematic risk is market-wide risk that affects all assets in the market, such
as economic recessions or interest rate changes. Unsystematic risk is specific
to a particular company or industry, such as changes in management or
competition.
8. Differentiate between NPV and IRR in Fundamentals of Financial
Management.
Net Present Value (NPV) is the difference between the present value of cash
inflows and the present value of cash outflows. Internal Rate of Return (IRR) is
the discount rate at which the NPV of an investment becomes zero.
9. Write down the different kinds of Working Capital.
Working capital can be categorized into:
• Gross Working Capital: Current assets minus current liabilities.
• Net Working Capital: Current assets minus current liabilities, excluding
cash and marketable securities.
• Operating Working Capital: Current assets minus current liabilities,
excluding cash, marketable securities, and short-term debt.

2 MARKS QUESTIONS
1. What is Financial Management?
 FUNDAMENTALS OF FINANCIAL MANAGEMENT
Financial Management is the process of managing an organization's finances
effectively and efficiently. It involves making strategic decisions about how to
allocate resources, manage risks, and ensure the financial health and growth
of the business.
2. What do you mean by the Time Value of Money?
The time value of money is the concept that a sum of money received today is
worth more than the same sum received in the future due to its potential
earning capacity. This principle is fundamental in financial decision-making.
3. What do you mean by Systematic Risk?
Systematic risk is the market-wide risk that affects all assets in the market,
such as economic recessions or interest rate changes. It cannot be diversified
away through portfolio diversification.
4. What is Finance Function?
The finance function is responsible for managing an organization's finances,
including planning, budgeting, investing, financing, and risk management. It
plays a crucial role in ensuring the financial health and sustainability of the
business.
5. What is Operating Cycle?
The operating cycle is the length of time it takes for a business to convert its
inventory into cash. It starts with the purchase of raw materials, followed by
production, sale of finished goods, and collection of accounts receivable.
6. What is meant by Dividend Payout Ratio?
The dividend payout ratio is the proportion of a company's net income that is
distributed to shareholders as dividends. It indicates how much of the
company's profits are returned to investors.
7. What is Leasing?
Leasing is an arrangement where an asset is rented or leased from an owner
by a lessee for a defined period. It allows businesses to use assets without
incurring the cost of outright purchase.
 FUNDAMENTALS OF FINANCIAL MANAGEMENT
8. What is Payback Period?
The payback period is the length of time it takes for an investment to generate
enough cash flow to recover its initial cost. It is a simple capital budgeting
technique used to assess the risk and liquidity of an investment.
9. Define Cost of Retained Earnings.
The cost of retained earnings is the opportunity cost of using retained earnings
for reinvestment within the company rather than distributing them as
dividends to shareholders. It represents the return that shareholders could
expect to earn on comparable investments.
10. What is Profitability Index?
The profitability index is a capital budgeting technique that measures the
profitability of an investment by dividing the present value of future cash
inflows by the initial investment cost. A profitability index greater than 1
indicates a positive net present value.
11. Write any two characteristics of Short-term Finance.
Two characteristics of short-term finance are:
• Short Maturity: Short-term finance refers to borrowing or raising funds
for a period of less than one year.
• Flexibility: Short-term financing sources are generally more flexible than
long-term sources, allowing businesses to adapt to changing needs.
12. Give the meaning of Trade Credit.
Trade credit is the credit extended by suppliers to their customers, allowing
them to purchase goods or services on credit and pay later. It is a common
form of short-term financing for businesses.
13. What is Aggressive Working Capital?
Aggressive working capital management involves minimizing investment in
current assets and maximizing the use of short-term debt. It is a strategy that
aims to maximize profitability but carries higher risk due to potential liquidity
problems.
FUNDAMENTALS OF FINANCIAL MANAGEMENT