Finan Core Y - - - 4 5 25 75 100

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Learning Objectives
CLO1 Understand the basics of finance and roles of
finance manager
CLO2 Evaluate Capital structure & Cost of capital
CLO3 Evaluate Capital budgeting
CLO4 Assess dividends
CLO5 Appraise Working Capital
UNIT Details No. of Hours Learning Objectives
I Meaning, objectives 15 CLO1
and Importance of
Finance – Sources of
finance – Functions of
financial management
– Role of financial
manager in Financial
Management.
II Capital structures 15 CLO2
planning - Factors
affecting capital
structures –
Determining Debt and
Equity proportion –
Theories of capital
structures – Leverage
concept. Cost of
capital – Cost of
equity – Cost of
preference share
capital – Cost of debt –
Cost of retained
earnings – Weighted
Average (or)
Composite cost of
capital (WACC)
III Capital Budgeting: 15 CLO3
ARR, Pay back period,
Net present value,
IRR, Capital rationing,
simple problems on
capital budgeting
methods.
IV Dividend policies – 15 CLO4
Factors affecting
 dividend payment -
Company Law
provision on dividend
payment –Various
Dividend Models
(Walter‘s Gordon‘s –
M.M. Hypothesis)
V Working capital – 15 C5
Components of
working capital –
operating cycle –
Factors influencing
working capital –
Determining (or)
Forecasting of
working capital
requirements.
Total 75
Course Outcomes
Course Outcomes On Completion of this course, Program Outcomes
the students will
CO1 Understand the basics of PO1, PO5,PO6
finance and roles of finance
manager

Understand the basics of finance and roles of finance manager

Evaluate Capital structure & Cost of
capital
Evaluate Capital budgeting
Assessing dividends
Appraise Working Capital
UNIT 1

Meaning, objectives and Importance of Finance – Sources of finance – Functions of financial

management – Role of financial manager in Financial Management.

Meaning, Objectives, and Importance of Finance

Meaning of Finance: Finance is the science of managing monetary resources, including the
creation, investment, and management of funds. It involves understanding how money is raised
and used, and how financial resources are allocated to achieve organizational goals.

Objectives of Finance:

1. Maximizing Shareholder Wealth: The primary goal of finance in a business context is

to maximize the wealth of the shareholders by increasing the company's value through
strategic investments and efficient management of resources.
2. Profit Maximization: While long-term wealth maximization is preferred, short-term
profit maximization remains crucial for ensuring liquidity and operational stability.
3. Ensuring Financial Stability: Finance aims to maintain financial health through
balanced capital structure, effective risk management, and sufficient liquidity.
4. Growth and Expansion: Facilitating strategic investments and financing for business
expansion and development.

Importance of Finance:

1. Resource Allocation: Effective finance management helps allocate resources optimally

to maximize returns and minimize costs.
2. Investment Decisions: Finance is crucial for making informed decisions about capital
investments and asset management.
3. Risk Management: Identifying and managing financial risks, such as market
fluctuations and credit risks, is essential for business sustainability.
4. Operational Efficiency: Proper financial planning and management enhance the
efficiency of operations and financial stability.
5. Strategic Planning: Finance supports strategic decision-making by providing insights
into financial trends and projections.

Sources of Finance
1. Internal Sources:

 Retained Earnings: Profits that are reinvested into the business rather than distributed as
dividends.
 Depreciation Funds: Funds accumulated through depreciation can be used for
reinvestment.

2. External Sources:

 Equity Financing: Raising capital by selling shares of the company (e.g., through Initial
Public Offerings, or IPOs).
 Debt Financing: Borrowing funds that need to be repaid with interest, including loans,
bonds, and debentures.
 Venture Capital: Investment provided by venture capitalists in exchange for equity,
typically used by startups.
 Trade Credit: Short-term financing extended by suppliers allowing businesses to buy
now and pay later.
 Factoring: Selling receivables to a third party at a discount for immediate cash.

Functions of Financial Management

1. Investment Decisions: Determining where and how to invest the company's funds to
achieve the best returns.
2. Financing Decisions: Choosing the appropriate sources of funds, balancing debt and
equity to support business activities and growth.
3. Dividend Decisions: Deciding the portion of profits to be distributed as dividends versus
reinvested in the business.
4. Working Capital Management: Managing day-to-day financial operations, including
inventory, receivables, and payables to ensure liquidity.
5. Financial Planning and Analysis: Forecasting future financial conditions, preparing
budgets, and analyzing financial performance.

Role of Financial Manager in Financial Management

1. Financial Planning: Developing long-term financial strategies and short-term financial

plans to ensure the company’s financial health.
2. Capital Budgeting: Evaluating and selecting investment opportunities to allocate capital
efficiently.
3. Financial Control: Monitoring financial performance against budgets and standards, and
implementing corrective actions if needed.
4. Risk Management: Identifying, assessing, and mitigating financial risks to protect the
company's assets and earnings.
5. Liquidity Management: Ensuring the company has enough cash flow to meet its short-
term obligations and operational needs.
6. Cost Management: Overseeing and controlling costs to improve profitability and
operational efficiency.
 7. Communication with Stakeholders: Providing financial information and reports to
shareholders, investors, and other stakeholders to support transparency and trust.

The financial manager plays a crucial role in balancing the various aspects of financial
management to achieve the organization’s financial objectives and ensure its overall success.

UNIT II

Capital structures planning - Factors affecting capital structures – Determining Debt and Equity
proportion – Theories of capital structures – Leverage concept. Cost of capital – Cost of equity –
Cost of preference share capital – Cost of debt – Cost of retained earnings – Weighted Average (or)
Composite cost of capital (WACC)

Capital Structure Planning

Capital Structure Planning involves determining the optimal mix of debt and equity financing
to minimize the overall cost of capital and maximize the value of the company. The goal is to
balance risk and return in a way that supports the company's growth and financial stability.

Factors Affecting Capital Structure

1. Business Risk: Companies with higher business risk typically use less debt to avoid
financial distress. Industries with stable earnings can handle more debt.
2. Cost of Debt: The cost of debt, including interest rates and terms, influences the
decision. Higher interest rates make debt more expensive.
3. Financial Flexibility: The ability to access funds when needed affects capital structure.
Companies with higher financial flexibility may use more debt.
4. Profitability: More profitable companies can afford higher levels of debt due to their
ability to service interest payments.
5. Tax Considerations: Interest on debt is tax-deductible, which can make debt financing
attractive. However, too much debt increases financial risk.
6. Control: Issuing new equity may dilute existing shareholders' control, affecting the
decision between debt and equity.
7. Market Conditions: Economic conditions and market sentiment can influence the choice
between debt and equity financing.
8. Regulatory Environment: Regulations and industry standards can impact capital
structure decisions.

Determining Debt and Equity Proportion

Determining the optimal debt-to-equity ratio involves evaluating the balance between risk and
return:

1. Debt Proportion: Includes all forms of borrowings such as bonds, loans, and debentures.
Higher debt can amplify returns but also increases financial risk.
2. Equity Proportion: Includes common stock, preferred stock, and retained earnings.
Equity provides a cushion against financial distress but can dilute ownership and control.

Theories of Capital Structures

1. Modigliani-Miller Theorem: Initially proposed in a world without taxes, it states that

under certain conditions (no taxes, no bankruptcy costs), the value of a firm is unaffected
by its capital structure. With taxes, the theorem suggests that leverage increases firm
value due to the tax shield on interest payments.
2. Trade-Off Theory: This theory suggests that companies balance the benefits of debt (tax
shields) against the costs (bankruptcy risks). The optimal capital structure is achieved
when the marginal benefit of debt equals the marginal cost.
3. Pecking Order Theory: Proposes that firms prefer internal financing first, then debt, and
issue equity only as a last resort. This hierarchy is driven by information asymmetry
between managers and investors.
4. Agency Theory: Focuses on conflicts between managers and shareholders, and between
shareholders and debt holders. High levels of debt might mitigate agency costs by
imposing discipline but could also create conflicts with shareholders.

Leverage Concept

Leverage refers to the use of borrowed funds to increase the potential return on investment. It
can be categorized into:

1. Operating Leverage: Involves fixed costs in operations. High operating leverage means
small changes in sales can lead to large changes in operating income.
2. Financial Leverage: Involves the use of debt. High financial leverage means a small
change in operating income can lead to large changes in earnings per share (EPS).

Total Leverage: Combines both operating and financial leverage to measure the impact of
changes in sales on net income.

Cost of Capital

1. Cost of Equity:

 Formula (CAPM): Cost of Equity=Rf+β×(Rm−Rf)\text{Cost of Equity} = R_f + \beta \

times (R_m - R_f)Cost of Equity=Rf+β×(Rm−Rf)
o RfR_fRf: Risk-free rate
o β\betaβ: Beta coefficient (risk relative to the market)
o RmR_mRm: Expected market return
2. Cost of Preference Share Capital:

 Formula: Cost of Preference Shares=DpPp\text{Cost of Preference Shares} = \

frac{D_p}{P_p}Cost of Preference Shares=PpDp
o DpD_pDp: Annual dividend per preference share
o PpP_pPp: Market price of preference share

3. Cost of Debt:

 Formula: Cost of Debt=IPd×(1−T)\text{Cost of Debt} = \frac{I}{P_d} \times (1 -

T)Cost of Debt=PdI×(1−T)
o III: Interest expense
o PdP_dPd: Net proceeds from debt
o TTT: Tax rate (interest is tax-deductible)

4. Cost of Retained Earnings:

 Typically assumed to be the same as the cost of equity because retained earnings are an
internal source of equity financing.

5. Weighted Average Cost of Capital (WACC):

 Formula: WACC=EV×Re+PV×Rp+DV×Rd×(1−T)\text{WACC} = \frac{E}{V} \times

R_e + \frac{P}{V} \times R_p + \frac{D}{V} \times R_d \times (1 - T)WACC=VE×Re
+VP×Rp+VD×Rd×(1−T)
o EEE: Market value of equity
o PPP: Market value of preference shares
o DDD: Market value of debt
o VVV: Total value (E + P + D)
o ReR_eRe: Cost of equity
o RpR_pRp: Cost of preference shares
o RdR_dRd: Cost of debt
o TTT: Tax rate

The WACC represents the average rate of return a company needs to provide to its security
holders (debt holders, equity investors, and preferred shareholders) to maintain its current value.
It is used in financial modeling and valuation to determine the discount rate for future cash
flows.

Effective capital structure planning and cost of capital management are crucial for maximizing
shareholder value and ensuring long-term financial stability.
UNIT III

Capital Budgeting: ARR, Pay back period, Net present value, IRR, Capital rationing, simple
problems on capital budgeting methods.

Capital Budgeting

Capital Budgeting is the process of evaluating and selecting long-term investments or projects
that are in line with the firm's strategic objectives. The goal is to allocate resources to
investments that will maximize the company's value. Several methods are used to assess the
attractiveness of investment projects:

1. Accounting Rate of Return (ARR)

ARR measures the return on an investment based on accounting information rather than cash
flow. It is calculated as:

ARR=Average Annual ProfitInitial Investment\text{ARR} = \frac{\text{Average Annual

Profit}}{\text{Initial Investment}}ARR=Initial InvestmentAverage Annual Profit

Where:

 Average Annual Profit is the average profit the project is expected to generate annually.
 Initial Investment is the total amount invested in the project.

Decision Rule:

 Accept the project if the ARR is greater than the required rate of return or target rate.

Example: A project requires an initial investment of $100,000 and is expected to generate an

average annual profit of $20,000.

ARR=20,000100,000=0.20 or 20%\text{ARR} = \frac{20,000}{100,000} = 0.20 \text{ or }

20\%ARR=100,00020,000=0.20 or 20%

2. Payback Period
The Payback Period measures the time required to recover the initial investment from the
project's cash flows. It is calculated as:

Payback Period=Initial InvestmentAnnual Cash Inflows\text{Payback Period} = \frac{\

text{Initial Investment}}{\text{Annual Cash
Inflows}}Payback Period=Annual Cash InflowsInitial Investment

Decision Rule:

 Accept the project if the payback period is less than or equal to the maximum acceptable
payback period.

Example: A project requires an initial investment of $50,000 and is expected to generate annual
cash inflows of $10,000.

Payback Period=50,00010,000=5 years\text{Payback Period} = \frac{50,000}{10,000} = 5 \

text{ years}Payback Period=10,00050,000=5 years

3. Net Present Value (NPV)

NPV calculates the present value of future cash flows generated by a project, minus the initial
investment. It is calculated using:

NPV=∑Ct(1+r)t−C0\text{NPV} = \sum \frac{C_t}{(1 + r)^t} - C_0NPV=∑(1+r)tCt−C0

Where:

 CtC_tCt = Cash flow at time ttt

 rrr = Discount rate
 C0C_0C0 = Initial investment

Decision Rule:

 Accept the project if NPV is positive, indicating the project is expected to add value.

Example: A project requires an initial investment of $80,000 and is expected to generate the
following cash flows: $30,000 in Year 1, $40,000 in Year 2, and $50,000 in Year 3. The discount
rate is 10%.

NPV=30,000(1+0.10)1+40,000(1+0.10)2+50,000(1+0.10)3−80,000\text{NPV} = \frac{30,000}
{(1 + 0.10)^1} + \frac{40,000}{(1 + 0.10)^2} + \frac{50,000}{(1 + 0.10)^3} -
80,000NPV=(1+0.10)130,000+(1+0.10)240,000+(1+0.10)350,000−80,000

NPV=27,273+24,793+22,539−80,000=−5,395\text{NPV} = 27,273 + 24,793 + 22,539 - 80,000

= -5,395NPV=27,273+24,793+22,539−80,000=−5,395
Since the NPV is negative, the project is not acceptable.

4. Internal Rate of Return (IRR)

IRR is the discount rate that makes the NPV of a project equal to zero. It is found using:

NPV=∑Ct(1+IRR)t−C0=0\text{NPV} = \sum \frac{C_t}{(1 + \text{IRR})^t} - C_0 =

0NPV=∑(1+IRR)tCt−C0=0

Decision Rule:

 Accept the project if the IRR is greater than the required rate of return.

Example: Using the same cash flows and initial investment as in the NPV example, suppose the
IRR is found to be approximately 8%.

Since the IRR (8%) is less than the discount rate (10%), the project is not acceptable.

5. Capital Rationing

Capital Rationing occurs when a firm has limited resources and must choose among various
projects. It involves selecting the combination of projects that offers the highest total NPV or
IRR within the budget constraints.

Steps:

1. List all potential projects with their NPVs or IRRs.

2. Rank projects by their profitability.
3. Select projects that fit within the capital budget and provide the highest combined return.

Example: Suppose a company has a budget of $200,000 and has the following projects:

 Project A: NPV = $60,000, Cost = $80,000

 Project B: NPV = $50,000, Cost = $70,000
 Project C: NPV = $40,000, Cost = $50,000

To maximize returns, the company should choose Projects A and B (total cost = $150,000, total
NPV = $110,000) and use the remaining budget for other investments or reserve it.

Summary of Capital Budgeting Methods

1. ARR: Focuses on profitability but ignores the time value of money.

2. Payback Period: Measures liquidity risk but does not consider the time value of money.
3. NPV: Considers the time value of money and provides a direct measure of added value.
4. IRR: Provides the rate of return expected from the project but can be misleading with
unconventional cash flows.
 5. Capital Rationing: Helps in selecting the most profitable combination of projects when
resources are limited.

These methods each have their strengths and weaknesses, and a combination is often used to
make the most informed investment decisions.

UNIT IV

Dividend policies – Factors affecting dividend payment - Company Law provision on dividend
payment –Various Dividend Models (Walter‘s Gordon‘s –M.M. Hypothesis)

Dividend Policies

1. Factors Affecting Dividend Payment:

 Profitability: Companies usually pay dividends out of their profits. High profitability can
lead to higher dividend payments, while lower profits may restrict dividends.
 Cash Flow: Even if a company is profitable, it needs sufficient cash flow to pay
dividends. Companies with strong cash flows are better positioned to distribute
dividends.
 Debt Levels: Companies with high levels of debt may prioritize paying off interest and
principal over paying dividends to avoid financial strain.
 Growth Opportunities: Firms with significant growth opportunities may reinvest
earnings into projects rather than paying dividends. High-growth companies often prefer
to use retained earnings for expansion.
 Tax Considerations: Tax policies can influence dividend decisions. For instance, some
jurisdictions may tax dividends at higher rates than capital gains, affecting a company's
dividend strategy.
 Shareholder Preferences: Companies may consider the preferences of their
shareholders. Some investors prefer regular dividends, while others may prefer capital
gains.
 Economic Conditions: Broader economic conditions, such as recessions or booms, can
impact dividend policies. During economic downturns, companies may cut dividends to
conserve cash.

2. Company Law Provisions on Dividend Payment:

 Legal Framework: Company laws vary by jurisdiction, but they typically include
provisions on how and when dividends can be paid. These laws ensure that dividends are
only paid out of profits and not in a manner that could jeopardize the company's financial
stability.
  Restrictions: There may be restrictions on dividends if a company has negative retained
earnings or if paying dividends would reduce its capital below a certain threshold.
 Declaration: Dividends usually need to be declared by the board of directors.
Shareholders generally do not have the right to dividends until they are officially
declared.
 Payment: Once declared, dividends must be paid to shareholders according to the terms
specified, such as the dividend rate and payment date.

Dividend Models

1. Walter’s Model:

 Concept: Walter's Model is a dividend policy model that emphasizes the relationship
between a company's internal rate of return (IRR) and its cost of capital.
 Theory: The model suggests that the value of the company depends on whether the
company's internal rate of return is higher or lower than the cost of equity. If the IRR is
higher than the cost of equity, paying dividends will reduce the company's value because
it would be better off reinvesting the profits. Conversely, if the IRR is lower, paying
dividends is beneficial as reinvestment would yield lower returns.
 Implication: Walter’s Model is more applicable to companies with stable earnings and
growth rates.

2. Gordon’s Model (Dividend Discount Model - DDM):

 Concept: Gordon’s Model, also known as the Gordon Growth Model, evaluates a
company’s stock price based on the present value of expected future dividends.
 Formula: The model is represented as P0=D0(1+g)r−gP_0 = \frac{D_0 (1+g)}{r - g}P0
=r−gD0(1+g), where P0P_0P0 is the current stock price, D0D_0D0 is the dividend just
paid, ggg is the growth rate of dividends, and rrr is the required rate of return.
 Theory: The model assumes that dividends will grow at a constant rate indefinitely. The
value of a stock is essentially the sum of the present value of all future dividends.
 Implication: Gordon’s Model is useful for companies with a stable and predictable
dividend growth rate.

3. Modigliani-Miller Hypothesis (M&M Hypothesis):

 Concept: The Modigliani-Miller Hypothesis, proposed by Franco Modigliani and Merton

Miller, states that under certain conditions, a company's dividend policy is irrelevant to
its valuation.
 Theory: According to this hypothesis, in a world with no taxes, bankruptcy costs, or
asymmetric information, and with efficient capital markets, the value of a company is
determined by its earning power and investment decisions, not by its dividend policy.
This is because shareholders can create their own dividend policy by selling or buying
shares.
 Implication: In real-world scenarios, taxes, transaction costs, and market imperfections
make dividend policies relevant, but the M&M hypothesis provides a baseline
 understanding that dividends do not inherently affect company value if the assumptions
hold.

These models and laws help in understanding how dividend policies are crafted and their
implications for both companies and investors. Each model provides a different perspective, and
real-world applications often involve considerations beyond the idealized conditions of these
models.

UNIT V

Working capital – Components of working capital –operating cycle – Factors influencing working
capital – Determining (or) Forecasting of working capital requirements.

Working Capital is a critical aspect of financial management that refers to the capital a
company uses in its day-to-day operations. It is calculated as the difference between a company’s
current assets and current liabilities. Efficient management of working capital ensures that a
company can maintain its operations and meet its short-term obligations.

Components of Working Capital

1. Current Assets:
o Cash and Cash Equivalents: Money in hand or in bank accounts that can be
readily used for operations.
o Accounts Receivable: Money owed by customers for goods or services already
delivered.
o Inventory: Raw materials, work-in-progress, and finished goods that are held for
sale.
o Prepaid Expenses: Payments made in advance for goods or services to be
received in the future.
2. Current Liabilities:
o Accounts Payable: Money owed to suppliers for goods or services purchased on
credit.
o Short-Term Loans: Loans or debt obligations that are due within one year.
o Accrued Expenses: Expenses that have been incurred but not yet paid (e.g.,
wages, utilities).
o Other Current Liabilities: Any other short-term obligations, such as taxes
payable.

Operating Cycle
The operating cycle is the time it takes for a company to purchase inventory, sell it, and collect
cash from the sale. It can be broken down into several stages:

1. Inventory Period: The time taken to purchase and hold inventory before it is sold.
2. Accounts Receivable Period: The time taken to collect payments from customers after a
sale has been made.
3. Accounts Payable Period: The time taken to pay suppliers after receiving inventory.

The operating cycle is calculated as:

Operating Cycle=Inventory Period+Accounts Receivable Period−Accounts Payable Period\
text{Operating Cycle} = \text{Inventory Period} + \text{Accounts Receivable Period} - \
text{Accounts Payable
Period}Operating Cycle=Inventory Period+Accounts Receivable Period−Accounts Payable Perio
d

Factors Influencing Working Capital

1. Business Cycle: The phase of the business cycle affects working capital needs. During
expansion, more working capital may be required due to increased inventory and
receivables. In a downturn, less working capital may be needed.
2. Nature of Business: Businesses with long production cycles or those dealing in high-
value items might need more working capital compared to businesses with shorter cycles
or lower-value goods.
3. Sales Volume: Higher sales volumes generally increase the need for working capital to
support higher levels of inventory and accounts receivable.
4. Credit Terms: The terms of credit extended to customers and received from suppliers
affect working capital. Longer credit terms from suppliers and shorter credit terms to
customers can reduce working capital needs.
5. Seasonality: Seasonal businesses may need more working capital during peak seasons to
support higher inventory and accounts receivable levels.
6. Operational Efficiency: Efficient management of inventory, receivables, and payables
can reduce the amount of working capital required.
7. Growth and Expansion: Growing businesses may require additional working capital to
fund increased inventory, receivables, and other operational costs.
8. Financial Policies: A company’s financial policies, including dividend policies and
investment decisions, can impact its working capital.

Determining (or) Forecasting Working Capital Requirements

1. Historical Analysis:
o Review past financial statements to analyze trends in working capital components
and operating cycles.
o Identify patterns in sales, inventory, receivables, and payables.
2. Sales Forecasting:
o Forecast future sales to estimate future working capital needs based on expected
changes in inventory and receivables.
 3. Budgeting:
o Develop a detailed budget that includes projections for sales, expenses, inventory,
and other components that impact working capital.
o Consider seasonal variations and growth plans.
4. Ratio Analysis:
o Use ratios such as the current ratio (current assets/current liabilities) and quick
ratio (quick assets/current liabilities) to assess working capital adequacy.
o Analyze the cash conversion cycle, which includes inventory turnover,
receivables turnover, and payables turnover ratios.
5. Cash Flow Projections:
o Prepare cash flow projections to ensure sufficient cash is available to meet short-
term obligations.
o Account for variations in cash flows due to changes in sales and operational
activities.
6. Scenario Analysis:
o Conduct scenario analysis to assess how different business conditions (e.g.,
increased sales, economic downturn) affect working capital requirements.
7. Industry Benchmarks:
o Compare working capital metrics with industry benchmarks to ensure the
company’s working capital management is in line with industry standards.
8. Consultation with Stakeholders:
o Engage with key stakeholders, including sales, production, and finance teams, to
gather insights on working capital needs.

Efficient working capital management ensures that a company can maintain liquidity, support its
operations, and invest in growth opportunities while minimizing financial risks.