FUNDAMENTALS OF FINANCIAL MANAGEMENT

UNIT 1
Introduction And Basic Concept
Q1:WHAT DO YOU MEAN BY BUSINESS FINANCE AND ITS TYPES?
Defining Business Finance
Wheeler defines business finance as "that business activity which is concerned with the
acquisition and conservation of capital funds in meeting the financial needs and overall
objectives of business enterprise." Guthmann and Dougall further expand on this by
describing business finance as the activity concerned with planning, raising, controlling,
and administering the funds used in business. Prather and Wert emphasize that business
finance deals primarily with raising, administering, and disbursing funds by privately
owned business units in non-financial industries.

Classification of Business Finance

Business finance can be classified into three main categories based on the form of
business organization:

1. Sole Proprietorship Finance: In this form of business, a single individual promotes,

finances, controls, and manages the enterprise. The individual bears the entire risk and
enjoys the profits alone.
2. Partnership Firm Finance: A partnership involves two or more persons who agree to
share the profits and losses of a business. Partners collectively share the business's
risks and responsibilities, and their liability is unlimited.
3. Corporation or Company Finance: A corporation is an association of individuals who
contribute money or money's worth to a common stock and employ it in some trade or
business. Chief Justice Marshall describes a corporation as an artificial being created by
law, possessing properties conferred by its charter. Corporations have limited liability,
perpetual succession, and a common seal, making them distinct from their owners. The
assets and liabilities of the corporation are separate from those of its members.

Q2:DEFINE FINANCIAL MANAGEMENT. NATURE AND SCOPE AND OBJECTIVES OF

FINANCIAL MANAGEMENT.
Definition:
Financial management refers to the part of management activity focused on the planning,
raising, and controlling of a firm's financial resources. It involves identifying suitable and
economical sources for raising funds and ensuring their appropriate use to meet business
needs. As a managerial activity, it integrates theoretical concepts from Economics.

Nature:

1. Specialized Branch of General Management:

Financial management is a specialized branch of general management, concerned
with the planning and controlling of a firm's financial resources.
2. Integral Part of Management:
It is pervasive throughout the organization and occupies a central position as all
activities involve finance.
3. Both an Art and a Science:
Financial management combines well-defined principles and methods with the skills
and decision-making abilities of financial managers.
4. Growing as a Profession:
 Emerging as a separate discipline, financial management offers various services like
planning, acquisition, and effective utilization of financial resources.
5. Multidisciplinary Approach:
It incorporates knowledge from other fields such as economics and accounting,
making it multidisciplinary in nature.

Scope:

1. Estimating Financial Requirements:

Assessing both short-term and long-term financial needs to ensure adequate funds
for purchasing assets and working capital, avoiding both inadequacy and excess.
2. Deciding Capital Structure:
Determining the mix of different types of securities (e.g., shares, debentures) to
raise the required funds cost-effectively, influencing financial planning.
3. Selecting a Source of Finance:
Choosing appropriate sources (e.g., banks, public deposits, share capital) based on
the need, purpose, and cost, while considering ownership dilution and asset security.
4. Selecting Investment Patterns:
Allocating funds to different assets (fixed and working capital) using decision-making
techniques like Capital Budgeting to balance safety, profitability, and liquidity.
5. Proper Cash Management:
Managing cash inflows and outflows efficiently to meet various business needs and
avoid shortages or idle cash, enhancing creditworthiness and utility of cash
resources.

Objectives:

1. Profit Maximization:
Aims to ensure that a business earns enough profit to cover costs and fund growth,
serving as a measure of efficiency and a buffer against risks.
2. Wealth Maximization or Value Maximization:
Focuses on increasing stockholder wealth by maximizing the firm's stock price,
reflecting the firm's financial health and management performance.
3. Long-Term Perspective:
Emphasizes achieving the maximum stock price over the long term, accounting for
normal market fluctuations and reflecting the firm's sustained performance.
4. Financial Decision-Making:
Requires evaluating financial decisions based on their benefits relative to costs,
ensuring that actions contribute to wealth maximization.
5. Value Creation:
Aims to increase the firm's value by making decisions that enhance the current stock
price and overall shareholder wealth in the long run.

Q3. IN WHAT WAYS IS THE WEALTH MAXIMISATION OBJECTIVE SUPERIOR TO THE

PROFIT MAXIMAISATION OBJECTIVE? EXPLAIN.

The wealth maximization objective is generally considered superior to the profit

maximization objective for several reasons:

1. Long-Term Focus: Wealth maximization prioritizes long-term growth and

sustainability, unlike profit maximization, which often emphasizes short-term gains.
2. Risk Consideration: It accounts for both expected returns and associated risks,
ensuring balanced decisions, while profit maximization may neglect risks.
 3. Shareholder Value: Wealth maximization aligns with shareholder interests by
increasing market value, unlike profit maximization, which may not always enhance
shareholder wealth.
4. Broader Stakeholder Impact: It considers the impact on all stakeholders,
promoting ethical practices, whereas profit maximization might prioritize financial
gain over social responsibility.
5. Cash Flow Focus: Wealth maximization emphasizes cash flows, reflecting the firm’s
true financial health, unlike profit maximization, which focuses on accounting profits.
6. Market Value Reflection: It reflects in the firm’s market value, capturing
profitability and growth potential, unlike profit maximization, which may not indicate
true value.
7. Reduction of Conflicts: Wealth maximization aligns management and shareholder
goals, reducing conflicts, while profit maximization may create short-term vs. long-
term interest conflicts.
Time Value of Money
Q4. CONCEPT OF TIME VALUE OF MONEY. REASONS FOR TIME PREFERENCE OF
MONEY. TECHNIQUES OF TIME VALUE OF MONEY.

Concept of Time Value of Money (TVM)

The Time Value of Money (TVM) is a financial concept that states money available today is
worth more than the same amount in the future due to its potential earning capacity. This
principle emphasizes that money can grow over time if invested, hence, the sooner it is
received, the greater its value.
Reasons for Time Preference of Money
1. Opportunity Cost: Money today can be invested to earn returns, making it more
valuable than the same amount received in the future.
2. Inflation: Over time, inflation erodes the purchasing power of money, making
current money more valuable than future money.
3. Risk and Uncertainty: There is always uncertainty about future events, so having
money now reduces the risk of future financial instability.
4. Consumption Preference: People generally prefer to consume goods and services
now rather than later, adding to the preference for money today.
Techniques of Time Value of Money
A. Compounding Techniques
1. Future Value (FV) of a Single Sum: Calculates how much a present sum will grow
over time by applying interest, showing the future value of the investment.
2. Future Value of an Annuity: Determines the total future value of a series of equal
payments made at regular intervals, compounded over time.
B. Discounting (Present Value) Techniques
1. Present Value (PV) of a Single Sum: Finds the current worth of a future sum by
discounting it using a specific interest rate, reflecting its value today.
2. Present Value of an Annuity: Calculates the present value of a series of future
payments, showing their total worth in today's terms.
Risk-Relationship Relationship
Q5. WHAT DO YOU MEAN BY RISK? WHAT ARE THE TYPES OF RISKS INVOLVED IN
AN INVESTMENT? ANALYSE THE RISK AND RETURN RELATIONSHIP IN TAKING
INVESTMENT DECISIONS.
What is Risk?
Risk refers to the possibility of loss or the uncertainty regarding the outcome of an
investment. It represents exposure to adverse situations that can lead to financial losses
due to future uncertainties. The concept of risk encompasses both the probability of
negative outcomes and the magnitude of those outcomes.
Types of Risks Involved in an Investment
1. Systematic Risk:
o Market Risk: Caused by economic, social, and political changes that affect all
securities in the market.
o Interest Rate Risk: Inverse relationship between interest rates and security
prices, impacting the value of investments.
o Purchasing Power Risk: Risk due to inflation, affecting the future purchasing
power of money received from investments.
2. Unsystematic Risk:
o Business Risk: Arises from factors unique to a firm, such as product mix,
management issues, or industry-specific problems.
o Financial Risk: Linked to a company’s capital structure, particularly its use of
debt financing.
o Credit or Default Risk: The possibility that a borrower will default on a loan
or payment, leading to losses for the lender.
o Other Risks: Includes risks associated with foreign investments, such as
currency risk and political instability.
Risk-Return Relationship in Investment Decisions
The risk-return relationship is a fundamental principle in investment decisions. It states
that the potential return on any investment is directly related to the amount of risk the
investor is willing to take. Higher risk is generally associated with the potential for higher
returns, while lower risk typically yields lower returns. Investors aim to maximize returns
while minimizing risk, often through diversification to reduce unsystematic risk. However,
systematic risk cannot be eliminated and must be managed through careful investment
strategies.
This relationship guides investors in balancing their portfolios to align with their risk
tolerance and return expectations, ensuring that they achieve their financial goals while
managing the inherent risks in the investment landscape.

Q6. DISTINGUISH BETWEEN SYSTEMATIC AND UNSYSTEMATIC RISK?

Q7. WHAT IS FINANCIAL RISK? HOW CAN A RISK OF AN ASSET BE CALCULATED?
WHAT IS RISK-RETURN TRADE OFF.

Financial Risk
Financial Risk refers to the possibility of a loss or reduction in financial performance due to
various factors. It is associated with the potential variability in returns on an investment
and can arise from several sources, including market fluctuations, interest rate changes,
and credit defaults.
Calculation of Risk of an Asset
1. Sensitivity or Range Analysis:
o Definition: Measures the risk by evaluating the range between the highest
and lowest possible returns. A larger range indicates higher risk.
o Example: If an asset has a potential return range from 5% to 15%, the range is
10%, which reflects the variability in returns.
2. Probability Distribution:
o Definition: Probability distribution assigns weights to different outcomes for a
detailed risk assessment, unlike range analysis. Outcomes must be mutually
exclusive and collectively exhaustive, with each probability between 0 and 1,
summing to 1. Probabilities cannot be negative, with certain outcomes at 1 and
impossible outcomes at 0.
o Calculation of Expected Return;
The expected rate of return for an asset is calculated by weighting each
possible return by its probability. This provides a measure of the average
return expected over time.
Formula:
  E(R): Expected return
 n: Number of possible outcomes
 P_i: Probability of outcome iii
 R_i: Rate of return for outcome iii

3. Standard Deviation:
o Definition: Quantifies the dispersion of returns around the expected return,
with higher values indicating greater risk.
o Formula:

4. Coefficient of Variation (CV):

o Definition: Measures risk per unit of return, providing a relative risk measure.
o Formula:

Risk-Return Trade-Off

The Risk-Return Trade-Off is a fundamental principle in investment that posits that

potential return on an investment is directly related to the level of risk taken. Investors
must balance the desire for higher returns with the acceptance of higher risk. Higher risk
investments usually offer the potential for higher returns, whereas lower risk investments
tend to provide lower returns. Investors aim to optimize their portfolios to achieve the
highest possible return for a given level of risk or the lowest risk for a given level of return.

UNIT 2
Sources of Finance (Long-Term and Short-Term)
Q8. WHAT IS FINANCE? DISCUSS VARIOUS SHORT TERM AND LONG TERM
SOURCES OF CORPORATE FINANCE.
What is Finance?
Finance refers to the management, creation, and study of money, investments, and other
financial instruments. It involves acquiring, managing, and allocating funds to achieve a
firm's objectives, ensuring its growth, profitability, and sustainability. In corporate settings,
finance is crucial for both day-to-day operations and long-term strategic planning.
Short-Term Sources of Corporate Finance
Short-term sources typically cover working capital needs and are used for less than a year:
1. Trade Credit: Suppliers allow companies to buy goods and services on credit,
deferring payment.
 2. Bank Overdraft: Businesses can withdraw more money than they hold in their bank
accounts, up to an agreed limit.
3. Commercial Paper: Unsecured, short-term debt issued by companies to meet
immediate needs, usually for large firms with strong credit.
4. Factoring: Selling accounts receivables to a third party at a discount for immediate
cash.
Long-Term Sources of Corporate Finance
Long-term sources fund investments in fixed assets and strategic expansion:
1. Equity Shares: Issuing shares to raise permanent capital, providing shareholders
with ownership in the company.
2. Debentures: Long-term debt instruments where the company borrows funds and
pays fixed interest over time.
3. Term Loans: Loans from banks or financial institutions with a repayment period
longer than one year, often used for capital expenditures.
4. Retained Earnings: Profits retained in the company rather than distributed as
dividends, reinvested for growth and expansion.
Q9.WHAT DO YOU UNDERSTAND BY RETAINED EARNINGS? DISCUSS THE MERITS
AND DEMERITS OF PLOUGHING BACK THE PROFITS AS A SOURCE OF FINANCE?
What are Retained Earnings?
Retained earnings refer to the portion of a company's net income that is not distributed to
shareholders as dividends but is instead reinvested in the business. This can be used for
various purposes, such as funding new projects, paying off debt, or improving the
company’s financial health. Retained earnings are reported on the balance sheet under
shareholders' equity and reflect the cumulative profits of the company over time.
Merits of Ploughing Back Profits
1. Cost-Effective Source of Finance: Retained earnings do not incur additional costs
like interest or issuance fees, making them a cheaper source of financing compared
to debt or equity.
2. Control Retention: Reinvesting profits allows the company to avoid diluting
ownership through issuing new shares, thus maintaining control among existing
shareholders.
3. Flexibility: The management can decide how and when to use retained earnings for
various projects, allowing for strategic investments based on current needs.
4. Positive Signal to Investors: Reinvestment of profits can signal to the market that
the company is confident in its growth prospects, potentially boosting stock prices.
Demerits of Ploughing Back Profits
1. Opportunity Cost: Retaining earnings may lead to missed opportunities for
investors, as they could potentially earn higher returns from alternative investments
outside the company.
2. Limited Growth Potential: Relying solely on retained earnings might restrict the
company's ability to scale rapidly, especially if the business requires significant
capital for expansion.
3. Risk of Misallocation: Management may misjudge the best use of retained
earnings, leading to poor investment decisions that do not yield the expected
returns.
4. Shareholder Dissatisfaction: If shareholders expect dividends, the decision to
retain earnings can lead to dissatisfaction, especially if they perceive that profits are
not being used effectively.
Q10. WRITE SHORT NOTES ON:
A. VENTURE CAPITAL
B. RIGHT ISSUE
C. SEED CAPITAL
D. CONVERTIABLES
 E. EURO ISSUES
A. Venture Capital

Venture capital refers to a form of private equity financing that is provided to startups and small businesses with
high growth potential. Venture capitalists invest in exchange for equity stakes in the company, often becoming
actively involved in its management and strategic direction. This type of funding is crucial for businesses that may
not have access to traditional financing sources, and it typically supports innovative projects in technology,
biotechnology, and other emerging sectors.

B. Right Issue

A rights issue is a method used by companies to raise additional capital by offering existing shareholders the right
to purchase new shares at a discounted price within a specific period. This approach allows shareholders to
maintain their proportional ownership in the company and provides the company with immediate capital. Rights
issues are often employed during times of financial need or to fund expansion projects.

C. Seed Capital

Seed capital is the initial funding used to start a business, typically in the early stages of development. This
funding is often sought from angel investors, family, friends, or venture capitalists. Seed capital is used to cover
initial expenses such as product development, market research, and establishing a business infrastructure. It is
crucial for turning an idea into a viable business venture.

D. Convertibles

Convertibles, or convertible securities, are financial instruments that can be converted into a predetermined
number of shares of the issuing company's stock. They usually come in the form of convertible bonds or
convertible preferred shares. This flexibility allows investors to benefit from potential stock price appreciation
while providing the issuer with a lower cost of capital. Convertibles can be attractive for both companies and
investors due to their hybrid nature, combining features of both debt and equity.

E. Euro Issues

Euro issues refer to securities that are issued in the Eurocurrency market, typically denominated in a currency
other than that of the country where they are issued. These can include Eurobonds and Euro-denominated stocks.
Euro issues allow companies to access a wider pool of capital and attract international investors while potentially
benefiting from favorable regulatory environments and lower borrowing costs. They are an essential part of global
finance, offering diversification and increased liquidity to both issuers and investors.

Q11. WHAT IS EQUITY SHARE AND ITS CHARACTERSTICS? WHAT IS PREFERENCE

SHARES, ITS TYPES AND ADAVANTAGES?

Equity Shares
Definition: Equity shares, also known as ordinary shares, represent ownership in a
company. Holders of equity shares are known as shareholders and have a claim on the
company's assets and earnings.
Characteristics of Equity Shares:
1. Ownership Stake: Equity shareholders are partial owners of the company and have
voting rights in corporate decisions, such as electing the board of directors.
2. Variable Returns: Returns on equity shares are not fixed and depend on the
company's performance. Shareholders may receive dividends, but these are not
guaranteed and can fluctuate based on profits.
 3. Risk: Equity shares carry higher risk compared to other forms of financing, as
shareholders are last in line to receive any payments in the event of liquidation, after
debt holders and preference shareholders.
4. Capital Gains: Shareholders may benefit from capital gains if the stock price
appreciates over time, providing potential for profit beyond dividends.
5. No Maturity Date: Equity shares do not have a maturity date, meaning they can be
held indefinitely as long as the company remains in operation.

Preference Shares
Definition: Preference shares, or preferred stock, are a class of equity that has preferential
rights over common equity shares. Preference shareholders typically receive fixed
dividends before any dividends are paid to equity shareholders.
Types of Preference Shares:
1. Cumulative Preference Shares: Dividends accumulate if they are not paid in a
given year. These dividends must be paid before any dividends can be distributed to
equity shareholders.
2. Non-Cumulative Preference Shares: Dividends do not accumulate if not declared
in a particular year. Shareholders do not have the right to claim unpaid dividends.
3. Convertible Preference Shares: These can be converted into equity shares at a
predetermined ratio, allowing shareholders to take advantage of potential equity
upside.
4. Redeemable Preference Shares: These can be redeemed by the company at a
specified price after a certain period, providing liquidity to investors.
5. Participating Preference Shares: These allow shareholders to participate in
additional earnings beyond the fixed dividend, typically in the event of liquidation or
profit-sharing.
Advantages of Preference Shares:
1. Fixed Dividend: Preference shares offer a fixed dividend, providing more
predictable income compared to equity shares.
2. Priority over Equity: In the event of liquidation, preference shareholders have a
higher claim on assets than equity shareholders, reducing their risk.
3. No Voting Rights: Preference shareholders usually do not have voting rights,
allowing companies to raise capital without diluting control among equity
shareholders.
4. Convertible Options: Many preference shares come with conversion features,
allowing investors to convert their shares into equity if they believe the company's
prospects are improving.
5. Attractive to Risk-Averse Investors: Due to fixed dividends and reduced risk in
liquidation, preference shares can be appealing to conservative investors seeking
income without the volatility of common stocks.
 Cost of Capital
Q12. WHAT IS COST OF CAPITAL? ITS SIGNIFICANCE ?WHAT ARE THE DIFFERENT
METHODS OF COMPUTING THE COST OF EQUITY CAPITAL?
Meaning of Cost of Capital
The cost of capital refers to the minimum rate of return that a company must earn on its
investments to maintain its market value and satisfy its investors. It is essentially the
opportunity cost of using capital and represents the required return for both equity and
debt holders. The cost of capital is a weighted average of the costs of various sources of
finance, including debt, preference capital, retained earnings, and equity shares.

Significance of Cost of Capital

1. Acceptance Criterion in Capital Budgeting:
Cost of capital acts as the benchmark for accepting projects. A project is accepted if
its expected returns, discounted at the cost of capital, exceed the investment cost.
2. Determining Capital Mix in Capital Structure Decisions:
It aids in designing an optimal balance between debt and equity to minimize
financing costs while maximizing the firm's value through effective capital structure
decisions.
3. Evaluating Financial Performance:
By comparing a project's actual returns with its cost of capital, management can
assess whether the performance meets or exceeds expectations, indicating
satisfactory results.
4. Basis for Other Financial Decisions:
Cost of capital guides decisions on dividends, profit capitalization, issuing rights
shares, and managing working capital to align with the firm’s financial strategy.

Methods of Computing the Cost of Equity Capital

The cost of equity is the rate of return required by shareholders. Here are the methods
used to compute the cost of equity capital:
Q13. MARGINAL COST OF CAPITAL?
Marginal Cost of Capital (MCC)
Marginal Cost of Capital (MCC) is the weighted average cost of raising additional
funds for a firm. It is calculated using marginal weights, which represent the proportions
of new sources of finance (debt, equity, etc.). The MCC differs from the firm’s existing
Weighted Average Cost of Capital (WACC) if the proportion of capital or the cost of new
financing changes.

Q14. COST OF DEBT INCLUDING REDEEMABLE NAD IRREDEEMABLE DEBTS.

Cost of Debt: Redeemable and Irredeemable Debts
Debt can be classified into two types:
1. Perpetual or Irredeemable Debt – No fixed redemption period.
2. Redeemable Debt – Debt that is repaid after a specific time.
Q15. COST OF RETAINED EARNING ?
Cost of Retained Earnings
Retained earnings represent profits that are not distributed as dividends but reinvested in
the firm. Although the firm doesn't pay out cash for retained earnings, there is an
opportunity cost because shareholders forgo dividends they could invest elsewhere.

Q16. WEIGHTED AVERAGE COST OF CAPITAL.

Computation of Weighted Average Cost of Capital (WACC)
The Weighted Average Cost of Capital (WACC), also known as the composite cost of capital,
represents the average cost of various sources of finance, weighted according to their
proportions in the overall capital structure. WACC can be computed using either market
value weights or book value weights.
The choice between market value and book value weights can significantly impact the
WACC calculation:
 Using market values may lead to an overstated or understated WACC, depending on
how the market perceives the firm’s capital.
 Book value weights, while more stable, might result in a less precise assessment of
the firm’s cost of capital.
Q17. COMPONENTS OF COST OF CAPITAL/ DISCUSS THE DIFFERENT APPROCHES
TO CALCULATE COST OF CAPITAL.

Q18.DIFFERENCE BETWEEN EXPLICIT AND IMPLICIT COST.

 UNIT-3
Capital Budgeting
Q19.WHAT IS CAPITAL BUDGETING ? DISCUSS THE PROCESS OF CAPITAL
BUDGETING.DISCUSS THE TYPES OF CAPITALBUDGETING DECISIONS.
Capital Budgeting:
Capital budgeting is the process that businesses use to evaluate and prioritize long-term
investment opportunities or projects. It helps in determining whether a project or
investment is worth pursuing based on its potential to generate future returns.
Process of Capital Budgeting:
1. Identification of Investment Opportunities:
o Identify potential projects or investments that align with the company’s
strategic objectives.
o This can include expansion plans, new product development, or machinery
upgrades.
2. Estimation of Cash Flows:
o Estimate the expected inflows and outflows associated with the project.
o This includes both initial costs and projected revenues over time.
3. Evaluation of Investment Risks:
o Assess the risks involved with each project, including market risks, operational
risks, and financial risks.
o Consider factors like economic conditions, technological changes, and
competitive forces.
4. Selection of an Appropriate Evaluation Technique:
o Choose methods to evaluate projects, such as Net Present Value (NPV),
Internal Rate of Return (IRR), Payback Period, or Profitability Index
(PI).
o These techniques help assess the project’s profitability and feasibility.
5. Project Decision:
o Based on the evaluation, decide whether to accept or reject the project.
o The project is chosen if it meets or exceeds the company’s required rate of
return.
6. Implementation of the Project:
o Once approved, allocate resources and begin the project implementation.
o Ensure that the project is executed according to the plan, with close monitoring
of timelines and costs.
7. Performance Review and Post-Audit:
 o After completion, review the actual performance of the project against
projections.
o Conduct a post-audit to learn from the outcome, identifying areas of
improvement for future projects.
Types of Capital Budgeting Decisions:
1. Expansion Decisions: These involve investments in new projects or the expansion
of existing operations to increase production or market reach.
2. Replacement Decisions: Investments aimed at replacing old or obsolete assets to
maintain operational efficiency.
3. Diversification Decisions: When a company invests in new products, markets, or
industries to reduce dependence on its core business.
4. Mutually Exclusive Decisions: When the selection of one project excludes the
possibility of investing in another project, companies must choose the most
profitable option.
5. Contingent Decisions: Investments that are dependent on the acceptance or
rejection of another project, often linked to interrelated projects.

Q20.WHAT IS NPV? HOW IT IS DIFFERENT FROM IRR METHOD? WHY MIGHT THESE
TECHNIQUES LEAD TO CONFLICT IN PROJECT RANKING? MERITS AND DEMERITS
OF IRR.
What is NPV?
Net Present Value (NPV) is a financial metric used to evaluate the profitability of an
investment or project. It calculates the difference between the present value of cash
inflows and the present value of cash outflows over a specific period. A positive NPV
indicates that the projected earnings (in present dollars) exceed the anticipated costs,
making the project potentially worthwhile.
Conflict in Project Ranking:
NPV and IRR can sometimes lead to conflicting project rankings due to several factors:
1. Different Cash Flow Patterns: Projects with different cash flow patterns can yield
different IRR and NPV results. For instance, a project may have high early cash
inflows (high IRR) but lower total cash inflow (lower NPV) over its lifespan.
2. Scale of Investment: NPV considers the absolute dollar value of a project, while IRR
provides a relative return. A project with a smaller scale may have a high IRR but
lower NPV compared to a larger project with a lower IRR.
3. Reinvestment Rate Assumption: IRR assumes that cash flows are reinvested at
the IRR itself, which may be unrealistic. In contrast, NPV assumes reinvestment at
the firm’s cost of capital,
leading to differing evaluations.

Merits of IRR:
1. Ease of Interpretation: Provides a clear percentage for expected return, facilitating
easy comparison with the cost of capital.
2. Time Value of Money: Accounts for the time value of money, allowing for a more
accurate profitability assessment.
3. Decision-Making Tool: Useful benchmark for investment evaluation; projects with
IRR > cost of capital are generally considered good investments.
Demerits of IRR:
1. Multiple IRRs: Non-conventional cash flows can result in multiple IRR values,
causing confusion in decision-making.
2. Reinvestment Rate Assumption: Assumes reinvestment of cash flows at the IRR
rate, which may not be realistic and can overestimate returns.
3. Inconsistent Ranking: May lead to conflicting project rankings compared to other
methods like NPV, potentially misallocating capital.
Q21. DEFINE THE FOLLOWING:
A. Accounting Rate of Return (ARR)
 The Accounting Rate of Return (ARR) measures the expected annual profit from
an investment as a percentage of the initial investment cost. It is calculated using
the formula:
ARR=(Average Annual ProfitInitial Investment)×100\text{ARR} = \left( \frac{\
text{Average Annual Profit}}{\text{Initial Investment}} \right) \times
100ARR=(Initial InvestmentAverage Annual Profit)×100
ARR helps evaluate the profitability of a project over its lifespan based on accounting
income rather than cash flow.

B. Payback Period
The Payback Period is the time required for an investment to generate cash flows
sufficient to recover its initial cost. It is calculated as:
Payback Period=Time taken to recover initial investment\text{Payback Period} = \
text{Time taken to recover initial
investment}Payback Period=Time taken to recover initial investment
This metric provides a simple way to assess liquidity and risk by indicating how
quickly an investment can be expected to return its initial outlay.

C. Capital Rationing
Capital Rationing refers to the situation where a company has limited funds
available for investment and must prioritize its projects. It involves selecting the
most profitable projects within the constraints of the available capital. This can lead
to a situation where not all profitable projects are undertaken, affecting overall
growth potential.

D. Profitability Index (PI)

The Profitability Index (PI) is a ratio that measures the relationship between the
present value of cash inflows and the initial investment cost. Formula for
Profitability Index:

PI=Present Value of Cash InflowsInitial Investment\text{PI} = \frac{\text{Present

Value of Cash Inflows}}{\text{Initial
Investment}}PI=Initial InvestmentPresent Value of Cash Inflows
Calculation Steps:
1. Estimate Future Cash Flows: Determine the expected future cash inflows
generated by the project over its lifespan.
2. Select a Discount Rate: Choose an appropriate discount rate, typically the
company's cost of capital.
3. Calculate Present Value of Cash Inflows:
 E. Conventional and Non-Conventional Cash Flows
 Conventional Cash Flows: Cash flows that typically involve an initial cash outflow
followed by a series of cash inflows. For example, an investment in machinery that
costs $10,000 initially and generates $2,000 annually for five years.
 Non-Conventional Cash Flows: Cash flows that may have multiple sign changes,
such as an initial outflow followed by inflows and subsequent outflows. For example,
an investment that requires an additional investment after a few years or involves
fluctuating cash flows.

F. Internal Rate of Return (IRR)

The Internal Rate of Return (IRR) is the discount rate that makes the net present
value (NPV) of an investment equal to zero. It represents the expected annual rate of
return on the investment and is calculated through iterative methods. The IRR helps
evaluate the profitability and feasibility of projects.

G. Capital Expenditure (CapEx)

Capital Expenditure (CapEx) refers to the funds used by a company to acquire,
upgrade, or maintain physical assets such as property, buildings, technology, or
equipment. These expenditures are made to enhance the productive capacity of the
business and are typically long-term investments that are capitalized on the balance
sheet.
Dividends Theories, Policy and Decisions
Q22.EXPLAIN THE THEORY OF RELEVANCE EXAMINING WALTER’S AND GORDAN’S
APPROACH ON DIVIDEND DECISIONS? DIFFERENCES AND SIMILARITIES BETWEEN
THEM.
The Theory of Relevance in dividend policy suggests that a company's dividend
decisions can significantly impact its stock price and overall valuation.
1. Walter’s Approach
Concept: Walter’s model emphasizes the relationship between the firm’s return on
investment (ROI) and its cost of equity (r). According to Walter, dividends play a crucial role
in influencing the firm’s value and, consequently, its market price.
Key Points:
 Retention Ratio: The proportion of earnings retained for reinvestment. The higher
the retention ratio, the more funds are available for growth.
 Return on Investment: If ROI exceeds the cost of equity (r), retaining earnings is
beneficial, and the firm should reinvest rather than pay dividends. Conversely, if ROI
is less than r, paying out dividends is preferred.
Formula: The value of a firm (V) can be expressed as:

2. Gordon’s Approach
Concept: Gordon’s model, also known as the Gordon Growth Model (GGM), asserts that
dividends are the primary source of value for shareholders and that investors value stocks
based on expected future dividends. The model highlights the constant growth of
dividends.
Key Points:
 Constant Growth Assumption: Dividends are expected to grow at a constant rate
(g) over time, making dividend payments predictable for investors.
 Dividend Valuation: The value of a share is determined by the present value of
future dividends. If dividends are expected to grow at a constant rate, the formula for
valuing the stock is:
Similarities between Walter’s and Gordon’s approaches to dividend decisions:
1. Dividend Significance: Both approaches emphasize the importance of dividends in
determining a firm's value, indicating that dividend policy directly impacts stock
prices and shareholder wealth.
2. Focus on Returns: Each model considers the relationship between returns (ROI in
Walter’s model and required rate of return in Gordon’s model) and how they
influence dividend decisions and firm valuation.
3. Shareholder Perspective: Both approaches acknowledge that shareholders prefer
dividends, viewing them as a crucial component of their overall returns, thereby
influencing their investment decisions and perceptions of the company’s financial
health.
Q23.WHAT DO YOU MEAN BY DIVIDEND POLICY? EXPLAIN THE
DETERMINANTS/FACTORS OF DIVIDEND POLICY?

Dividend Policy
Definition: Dividend policy refers to the strategy a company uses to decide how much of
its earnings will be distributed to shareholders as dividends versus how much will be
retained for reinvestment in the business.

Determinants/Factors of Dividend Policy:

1. Earnings Stability: Companies with stable and predictable earnings are more likely
to pay consistent dividends, while those with volatile earnings may opt for lower or
irregular payouts.
2. Cash Flow: Adequate cash flow is essential for dividend payments; companies must
ensure they have sufficient liquid resources to meet their dividend obligations
without compromising operational needs.
3. Profitability: Higher profitability allows a company to pay larger dividends, whereas
low or negative earnings may lead to reduced or suspended dividends to maintain
financial health.
4. Debt Levels: Companies with high debt levels may prioritize debt repayment over
dividends, as servicing debt can take precedence to maintain financial stability and
creditworthiness.
5. Growth Opportunities: Firms with significant growth prospects may retain earnings
to reinvest in expansion rather than pay dividends, as they seek to maximize long-
term shareholder value.
 6. Tax Considerations: The tax treatment of dividends versus capital gains can
influence a company’s dividend policy; firms may choose to pay dividends that are
more tax-efficient for shareholders.
7. Market Conditions: Economic and market conditions can impact dividend policy; in
uncertain environments, companies may prefer to conserve cash and reduce
dividends to ensure financial flexibility.
Q24.DEFINE THE FOLLOWING:
a) Dividend Pay-Out Ratio
The Dividend Pay-Out Ratio is the percentage of earnings distributed to shareholders in
the form of dividends. It is calculated using the formula:

A higher ratio indicates a larger portion of earnings is being returned to shareholders, while
a lower ratio suggests more earnings are being retained for reinvestment.

b) Scrip Dividend
A Scrip Dividend is a type of dividend payment made in the form of additional shares of
stock instead of cash. This allows shareholders to increase their equity in the company
without the company having to disburse cash, often used when cash flow is limited.

c) Bonus Issue
A Bonus Issue, also known as a Stock Dividend, is when a company issues additional
shares to existing shareholders at no extra cost, typically in proportion to their current
holdings. This is a way to reward shareholders while retaining cash within the company.

d) Types of Dividend
1. Cash Dividend: Paid out in cash to shareholders, providing immediate liquidity.
2. Stock Dividend: Paid in the form of additional shares, increasing the number of
shares held by shareholders.
3. Scrip Dividend: Paid in shares instead of cash, allowing shareholders to receive
more stock without cash outflow for the company.
4. Bonus Issue: Similar to stock dividends, where additional shares are issued at no
cost to shareholders.
5. Property Dividend: Paid in the form of assets other than cash or stock, such as real
estate or products.

e) Main Theories of Dividend

1. Walter’s Model: Suggests that dividends are relevant and can affect a firm's value
based on the relationship between ROI and the cost of equity.
2. Gordon’s Model: Emphasizes the importance of stable and predictable dividends,
asserting that dividend growth impacts stock price and investor perceptions.
3. Miller and Modigliani Theory: Argues that under perfect market conditions,
dividend policy is irrelevant to firm value; investors can create their desired dividend
streams through buying and selling shares.
g) Retention Ratio
The Retention Ratio is the percentage of earnings retained in the business after
dividends are paid out. It is calculated as:

A higher retention ratio indicates a focus on reinvesting profits for growth rather than
distributing them as dividends.

h) Final Dividend
The Final Dividend is the dividend declared by a company after the conclusion of its
financial year, which is typically recommended by the board and approved by shareholders
at the annual general meeting (AGM). This is in addition to any interim dividends paid
during the year.

i) Dividend and Significance of Stable Dividend

A dividend is a portion of a company’s earnings distributed to its shareholders, typically in
cash or stock. The significance of a stable dividend lies in its ability to attract and retain
investors by providing predictable returns, signaling financial health and stability, and
fostering investor confidence. Consistent dividends also reflect the company's commitment
to returning value to shareholders, thereby enhancing its reputation in the market.
UNIT-4
Working Capital Management and Finance - I
Q24.DEFINE THE TERM WORKING CAPITAL? DESCRIBE THE NEED AND
DETERMINANTS OF WORKING CAPITAL IN A BUSINESS. DISCUSS THE VARIOUS
SOURCES OF FINANCE TO MEET THE WORKING CAPITAL REQUIREMENTS OF FIRM.
WHICH SOURCE IS SUITABLE FOR FIXED WORKING CAPITAL FINANCING ?
Working Capital is the capital required for the day-to-day operations of a business. It
represents the difference between a company’s current assets (like cash, inventory, and
receivables) and current liabilities (such as accounts payable). It is essentially the funds
available for short-term expenses and is crucial for maintaining liquidity and ensuring that
the company can meet its operational expenses.

Need for Working Capital in a Business

 1. Smooth Business Operations: Ensures that a business can continue its daily
activities without interruption, covering expenses like payroll, rent, and utility bills.
2. Meeting Short-Term Obligations: Helps a company manage and settle its
immediate liabilities, like supplier payments and loan interest, without impacting
long-term funds.
3. Operational Flexibility: Provides the ability to take advantage of market
opportunities, like purchasing raw materials in bulk at discounted rates.
4. Maintaining Inventory Levels: Adequate working capital allows a business to
maintain sufficient inventory to meet customer demand, avoiding stockouts and lost
sales.
Determinants of Working Capital
1. Nature of Business: Manufacturing firms often require more working capital than
service-based companies due to the need for inventory and production processes.
2. Business Cycle: Seasonal businesses may need higher working capital during peak
periods to handle increased sales volume and inventory demands.
3. Operating Cycle: The length of the production cycle influences working capital
needs. Businesses with longer cycles need more working capital.

4. Growth and Expansion: Expanding businesses need additional working capital to

cover new locations, inventory, and other resources.
5. Economic Conditions: During economic booms, companies often increase
production, requiring higher working capital. In contrast, recessions may decrease
the demand for working capital.

Various sources of finance can be used to meet a firm's working capital requirements,
depending on whether the need is short-term or long-term.

Short-Term Working Capital Sources

1. Trade Credit: Suppliers allow delayed payments, offering short-term relief.
2. Bank Overdraft: Flexible borrowing, where a bank allows withdrawals beyond the
account balance.
3. Short-Term Loans: Banks provide loans repayable within a year, suitable for
seasonal working capital needs.
4. Factoring: Selling receivables to a financial company for immediate cash flow.
5. Commercial Paper: A low-cost, unsecured promissory note issued by large firms.
Long-Term (Fixed) Working Capital Sources
For fixed working capital, long-term financing options are more suitable because they
provide stability and a lasting source of funds.
1. Equity Financing: Issuing shares provides a permanent capital source without
repayment.
2. Long-Term Loans: Banks offer loans that can be repaid over several years, suitable
for permanent working capital.
3. Retained Earnings: Profits reinvested in the business provide a cost-effective
source for continuous capital.
Of these, long-term loans and equity financing are most suitable for fixed working
capital, as they ensure consistent availability of funds.

Q25. WRITE SHORT NOTE ON :

a) Hedging Approach
The hedging approach involves matching the maturities of assets and liabilities to reduce
the risk of financial instability. In working capital management, short-term assets are
funded by short-term liabilities, while long-term assets use long-term funds. This approach
reduces liquidity risk and aligns cash flows with liabilities.
b) Risk-Return Trade-Off
The risk-return trade-off suggests a balance between the potential returns of an
investment and its associated risks. Higher returns usually involve greater risk, while lower-
risk investments generally yield lower returns. Firms weigh this trade-off to optimize
financial decisions.
c) Commercial Paper as Working Capital Finance
Commercial paper is a short-term, unsecured debt instrument issued by large corporations
to meet immediate working capital needs. It is cost-effective with low interest rates but is
only accessible to companies with strong credit ratings.

WHAT ARE THE DANGERS OF

a) EXCESSIVE WORKING CAPITAL
b) INADEQUATE WORKING CAPITAL

Dangers of Excessive Working Capital

 Idle Resources: Excess cash leads to inefficiencies, as funds are not optimally
invested.
 Lower Profitability: Excessive working capital ties up funds that could be earning
higher returns elsewhere.
Dangers of Inadequate Working Capital
 Operational Disruptions: Insufficient capital can cause interruptions in daily
operations, impacting sales and customer satisfaction.
 Creditworthiness Decline: A lack of liquidity can harm the firm’s credit rating,
making future borrowing difficult.
Q26.GIVE THREE OBJECTIVES OF HOLDING INVENTORIES. WHAT ARE THRE
FACTIRS AFFECTING THE SIZE OF RECEIVABLES? NAME VARIOUS TOOLS OF
INVENTORY MANANGEMENT. EXPLAIN DANGER LEVEL OF INVENTORIES.
Objectives of Holding Inventories
Holding inventories is essential for businesses to manage the flow of goods and ensure
that operations run smoothly. The main objectives of holding inventories include:
1. Ensuring Smooth Production and Operations:
o Maintaining inventories helps businesses avoid disruptions in production due to
a shortage of raw materials or finished goods. It ensures a continuous flow of
work, preventing delays and stoppages.
2. Meeting Customer Demand:
o By holding adequate inventory, businesses can promptly meet customer
demands and ensure timely delivery of products. This helps in maintaining
customer satisfaction and loyalty.
3. Taking Advantage of Economies of Scale:
o Purchasing in bulk and holding inventories helps firms take advantage of
discounts or price reductions, which can lead to cost savings. This is
particularly beneficial in industries where purchasing volumes or stockpiling
can lead to lower per-unit costs.

Factors Affecting the Size of Receivables

The size of receivables is influenced by several internal and external factors:
1. Credit Policy:
 o The company’s credit policy, including the terms of credit (e.g., payment
periods, credit limits), directly impacts the volume of receivables. A lenient
policy can lead to higher receivables, while a stricter policy may limit them.
2. Sales Volume and Customer Demand:
o Higher sales volumes, especially on credit, can lead to a greater accumulation
of receivables. Demand for products or services also influences how much
customers are willing to purchase on credit.
3. Customer Creditworthiness:
o The financial stability and creditworthiness of customers play a key role in the
size of receivables. Companies tend to extend higher credit limits to customers
with strong financial backgrounds.

Various Tools of Inventory Management

Inventory management involves using various tools and techniques to optimize inventory
levels, reduce costs, and meet demand efficiently. Some common tools of inventory
management include:
1. Economic Order Quantity (EOQ):
o EOQ is a formula used to determine the ideal order quantity that minimizes
total inventory costs, including ordering and holding costs.
o EOQ Formula:

o EOQ=
o Where:
 D = Demand rate
 S = Ordering cost
 H = Holding cost per unit per period
2. Just-in-Time (JIT):
o JIT inventory management aims to reduce inventory levels by ordering and
receiving goods only when needed in the production process, thus minimizing
holding costs.
3. ABC Analysis:
o This technique divides inventory into three categories (A, B, and C) based on
their value and importance.
 A items: High-value, low-quantity items.
 B items: Moderate-value items.
 C items: Low-value, high-quantity items.
o Focus is placed on managing A items more closely to optimize costs and
inventory control.
4. FIFO (First-In-First-Out):
o FIFO assumes that the first items to be purchased or produced are the first to
be sold. This method is beneficial in industries where products have a shelf life
or become obsolete quickly.

Danger Level of Inventories

The danger level of inventory refers to a situation where stock levels become excessive,
potentially leading to several issues such as:
1. Increased Holding Costs:
o When inventory levels exceed the optimal amount, companies incur higher
holding costs, including warehousing, insurance, and deterioration costs.
2. Obsolescence:
 o Holding excessive inventory, especially for products with short life cycles (e.g.,
technology, fashion items), increases the risk of inventory becoming obsolete
or unsellable.
3. Cash Flow Problems:
o Large amounts of capital tied up in excess inventory can create cash flow
issues, limiting a company's ability to invest in other areas like production or
marketing.
4. Waste and Damage:
o Storing excessive inventory can lead to increased spoilage, damage, or theft,
especially in industries like food, pharmaceuticals, and perishable goods.
Q27. WRITE NOTES ON PAYABLES MANAGEMENT AND MOTIVES FOR HOLDING
CASH.
Payables Management
Payables management involves efficiently managing a company’s obligations to its
creditors and suppliers to ensure smooth operations and optimal cash flow. The key
objectives are:
1. Timely Payments: Ensuring that payments are made on time to avoid late fees and
maintain strong supplier relationships.
2. Negotiating Payment Terms: Companies can negotiate discounts for early
payments or extended payment periods to optimize cash flow and reduce costs.
3. Cash Flow Management: Balancing the timing of cash inflows and outflows to
maintain liquidity and meet operational expenses.
4. Automation: Using automated systems to track invoices and due dates, improving
efficiency and reducing the risk of errors.
Effective management of payables allows a company to preserve its liquidity, maintain
favorable supplier relationships, and ensure that operations continue without financial
disruption.

Motives for Holding Cash

Holding cash is essential for businesses to meet operational needs, prepare for
uncertainties, and take advantage of opportunities. The main motives for holding cash are:
1. Transaction Motive: To cover everyday expenses such as salaries, inventory, and
operating costs, ensuring smooth operations.
2. Precautionary Motive: To maintain a buffer for unexpected expenses or economic
downturns, providing financial security.
3. Speculative Motive: To capitalize on investment opportunities, such as acquiring
assets or taking advantage of market fluctuations.
4. Control Motive: To maintain financial independence, avoiding reliance on external
financing and enabling strategic decision-making.
Holding sufficient cash allows businesses to manage operations, weather economic
uncertainty, and seize growth opportunities while maintaining control over their financial
decisions.