Unit 1: Introduction to Financial Management

1.1 Nature and Scope of Financial Management

Nature of Financial Management

Financial Management refers to the planning, organizing, directing, and controlling of financial
activities such as procurement and utilization of funds. It involves financial decision-making to
ensure the financial health of a business.

Scope of Financial Management

Financial Management covers three major areas:

1. Investment Decisions – Involves decisions on capital budgeting, asset acquisition,

and portfolio management.
2. Financing Decisions – Deals with raising funds through equity, debt, or other
financial instruments.
3. Dividend Decisions – Determines how much profit should be distributed to
shareholders and how much should be retained.

1.2 Objectives of Financial Management

1. Profit Maximization – Aims at maximizing profits for business survival and growth.
2. Wealth Maximization – Focuses on increasing the value of shareholders' wealth
over time.
3. Value Maximization – Seeks to enhance the overall value of the firm in terms of
market valuation.

Diagram: Flowchart showing Financial Objectives (Profit Maximization → Wealth

Maximization → Value Maximization).

1.3 Importance of Financial Management

• Ensures proper financial planning and control.

• Helps in efficient utilization of resources.
• Supports business growth and expansion.
 • Reduces financial risks.

Case Study:
A company with poor financial management failed to allocate funds effectively, resulting in high
debt and eventual bankruptcy. A well-managed firm, on the other hand, optimized its funding
sources and thrived.

1.4 Role and Functions of a Finance Manager

Role:

A finance manager is responsible for making strategic financial decisions to ensure profitability,
liquidity, and solvency.

Functions:

1. Financial Planning – Forecasting financial needs.

2. Capital Budgeting – Evaluating investment opportunities.
3. Capital Structure Decision – Determining the right mix of debt and equity.
4. Working Capital Management – Managing short-term assets and liabilities.
5. Dividend Decision – Deciding profit distribution to shareholders.

Diagram: Functions of Financial Management in a circular flow format.

1.5 Risk and Return in Financial Planning

• Risk: The possibility of losing money on an investment or financial decision.

• Return: The expected gains or benefits from an investment.
• Risk-Return Tradeoff: Higher returns generally come with higher risks.

Example:
Investing in government bonds has low risk but lower returns, while stock market investments
have higher risk and potentially higher returns.
Numerical Problems
Problem 1: Risk & Return Calculation

A company invests in two projects:

Find: Expected Return

Solution:

Expected Return = (Return * Probability) of A + (Return * Probability) of B

= (1,50,000 × 0.6) + (2,50,000 × 0.4)

= 90,000 + 1,00,000
= ₹1,90,000

MCQs with Answers

1. Which of the following is NOT a financial management function?

a) Investment Decision
b) Production Planning
c) Dividend Decision
d) Financing Decision
o Answer: (b) Production Planning
2. Which financial objective focuses on long-term growth and shareholder value?
a) Profit Maximization
b) Wealth Maximization
c) Cost Minimization
d) Revenue Optimization
o Answer: (b) Wealth Maximization

Unit 2: Sources of Business Finance

2.1 Concept and Definition of Business Finance
Concept:

Business Finance refers to the funds required for carrying out business activities, such as
purchasing assets, managing operations, and expanding business activities.
Definition:

"Business finance is the process of raising, managing, and utilizing funds for business operations
to maximize efficiency and profitability."

2.2 Importance of Finance in Business

• Ensures smooth business operations.

• Helps in expansion and diversification.
• Supports innovation and technology adoption.
• Maintains liquidity and solvency.

Example:
A startup needs finance to invest in research, production, and marketing. Without adequate
funds, it may struggle to compete.

2.3 s Funds and Borrowed Funds

Owner’s Funds:

These are funds contributed by the business owners.

• Equity Capital – Funds raised by issuing shares.

• Retained Earnings – Profits reinvested in the business.
• Venture Capital – Investments made by private investors in startups.

Borrowed Funds:

These are funds obtained from external sources that must be repaid with interest.

• Debentures & Bonds – Long-term borrowing instruments.

• Loans from Banks & Financial Institutions – Borrowed for business expansion.
2.4 Short-Term, Medium-Term, and Long-Term Sources of Finance
Short-Term Sources (Less than 1 Year):

• Trade Credit
• Bank Overdraft
• Commercial Paper

Medium-Term Sources (1 to 5 Years):

• Term Loans
• Hire Purchase
• Leasing

Long-Term Sources (More than 5 Years):

• Equity Shares
• Debentures
• Retained Earnings

Diagram: Classification of Sources of Finance (Short, Medium, and Long-Term).

2.5 Foreign Sources of Finance

American Depository Receipts (ADR)

Issued by U.S. banks for foreign companies to raise capital in U.S. stock markets.

Global Depository Receipts (GDR)

Issued for trading company shares in international markets like London and Luxembourg.

Foreign Currency Convertible Bonds (FCCB)

Issued by companies to raise foreign capital with an option to convert bonds into equity shares.
Numerical Problems
Problem 1: Cost of Borrowed Funds

A company raises a ₹10,00,000 loan at 8% annual interest. Find the annual interest cost.

Solution:
Interest Cost = Principal × Interest Rate
= ₹10,00,000 × 8%
= ₹80,000 per year

MCQs with Answers

1. Which of the following is NOT an owner's fund?

a) Equity Capital
b) Debentures
c) Retained Earnings
d) Venture Capital
o Answer: (b) Debentures
2. Which source of finance is used for international capital raising?
a) Bank Overdraft
b) Commercial Paper
c) GDR
d) Trade Credit
o Answer: (c) GDR

Unit 3: Cost of Capital

3.1 Concept of Cost of Capital

The cost of capital refers to the minimum return a company must earn on its investments to
satisfy investors and finance providers. It represents the cost of obtaining funds from different
sources, such as equity, debt, and retained earnings.

Example: If a company raises funds at an interest rate of 10%, it must generate at least a 10%
return to cover its financing cost.
3.2 Factors Affecting the Cost of Capital

1. Risk-Free Rate – Affects the required return for investors.

2. Business Risk – Higher business risk increases the cost of capital.
3. Financial Risk – More debt in capital structure raises financial risk.
4. Market Conditions – Inflation and interest rate fluctuations impact the cost.
5. Capital Structure – The mix of debt and equity affects overall capital cost.

3.3 Measurement of Cost of Capital

1. Cost of Equity (Ke)

The cost of equity is the return required by shareholders. It can be calculated using:

a) Dividend Discount Model (DDM)

Ke = \frac{D1}{P0} + g

• = Expected Dividend
• = Current Market Price of Share
• = Growth Rate of Dividends

b) Capital Asset Pricing Model (CAPM)

Ke = Rf + \beta (Rm - Rf)

• = Risk-Free Rate
• = Market Return
• = Systematic Risk Factor

2. Cost of Preference Share Capital (Kp)

Kp = \frac{D}{P}

• = Dividend on Preference Share

• = Issue Price of Share
3. Cost of Debt (Kd)

Kd = \frac{Interest (1 - Tax Rate)}{Market Price of Debt}

Kd = \frac{80 (1 - 0.3)}{1000} = \frac{80 \times 0.7}{1000} = 5.6\%

4. Cost of Retained Earnings (Kr)

Retained earnings are reinvested profits. The cost of retained earnings is similar to the cost of
equity:

Kr = Ke

3.4 Weighted Average Cost of Capital (WACC)

The WACC is the overall cost of capital for a firm, calculated as:

WACC = \left(\frac{E}{V} \times Ke\right) + \left(\frac{D}{V} \times Kd

\times (1 - Tax Rate)\right)

• = Market Value of Equity

• = Market Value of Debt
• = Total Value (E + D)

Numerical Problems
Problem 1: WACC Calculation

A company has:

• ₹50 lakh equity capital (Ke = 12%)

• ₹30 lakh debt capital (Kd = 8%, Tax rate = 30%)

Find WACC.

WACC = \left(\frac{50}{80} \times 12\%\right) + \left(\frac{30}{80} \times

8\% \times (1 - 0.3)\right)

= \left(0.625 \times 12\%\right) + \left(0.375 \times 5.6\%\right)

= 7.5\% + 2.1\% = 9.6\%

Answer: WACC = 9.6%

MCQs with Answers

1. Which factor does NOT affect the cost of capital?

a) Business Risk
b) Inflation Rate
c) Government Regulations
d) Employee Satisfaction
o Answer: (d) Employee Satisfaction
2. Which formula is used to calculate WACC?
a)
b)
c)
d)
o Answer: (b)