Foundations of Finance:- * 1. Nature and Scope of Finance:- * Finance is the lifeblood of any business.

It deals with the management, creation, and study of money, banking, credit, investments, assets, and liabilities. The primary goal of finance is to ensure the
efficient allocation of resources under conditions of risk and uncertainty.
Nature of Finance:- * Decision-Making Oriented: Finance involves critical decisions such as investment, financing, and dividend distribution.* Future-Oriented: Financial decisions are made considering future cash flows and risks.* Quantitative and Analytical:
Finance relies heavily on mathematics, statistics, and accounting for data analysis.* Integrative Function: It integrates with other business functions like marketing, operations, and HR.
Scope of Finance:- * 1. Investment Decisions: Capital budgeting and asset selection for long-term benefits.* 2. Financing Decisions: Identifying sources of funds and capital structure management.* 3. Dividend Decisions: Deciding the proportion of profits to be
distributed as dividends or retained.* 4. Working Capital Management: Managing current assets and liabilities for day-to-day operations.* 5. Risk Management: Identifying and mitigating financial risks.* 6. Financial Planning and Forecasting: Budgeting and
forecasting future financial performance.
2. Organization of Financial Functions:- * In modern business, financial functions are systematically organized under the leadership of the Chief Financial Officer (CFO) or Finance Director. These professionals ensure optimal financial health and compliance
with legal and regulatory requirements.* Key Departments in Financial Management:* Treasury: Manages liquidity, investments, and currency exchange.* Controller: Handles accounting, budgeting, and financial reporting. Internal Audit: Ensures internal control
and risk management.* Taxation: Manages compliance with local and international tax laws.* Investor Relations: Manages communication with shareholders and stakeholders.* Proper organization allows for efficiency, control, and strategic alignment of financial
policies.
3. Emerging Role of Financial Managers (FMs) in India and Global Context:-
In India:- * Financial managers have transitioned from mere accountants to strategic decision-makers.* The liberalization of the Indian economy has increased the demand for sophisticated financial skills.* FMs now deal with financial modeling, regulatory
compliance, corporate restructuring, environmental, social, and governance (ESG) integration, and risk analysis.* Digital finance and fintech innovations are reshaping roles in areas like mobile banking, blockchain, and digital lending.
Globally:- * FMs manage operations across countries, dealing with foreign exchange risk, international tax laws, and cross-border investments.* The focus is on global capital markets, international mergers and acquisitions, sustainability finance, and cyber risk
management.* FMs also play key roles in aligning corporate strategy with shareholder value in volatile global environments.* In both contexts, financial managers are now seen as value creators rather than just caretakers of funds.
4. Financial Goal:- * The ultimate financial objective of any business is maximization of shareholder wealth, as reflected in the market value of the firm's shares.* Profit Maximization vs. Wealth Maximization:- * Profit Maximization focuses on short-term gains and
ignores risk, time value, and long-term sustainability.* Wealth Maximization accounts for the risk and timing of returns, aiming for sustainable long-term growth and shareholder satisfaction.* Thus, wealth maximization is a superior and comprehensive goal.
5. Agency Problems:- * The agency problem arises due to the separation of ownership and management in corporations. While shareholders (principals) own the company, managers (agents) control day-to-day operations.*Types of Agency Problems:- * Manager
vs. Shareholder Conflict: Managers may prioritize personal benefits over shareholder wealth.* Shareholder vs. Creditor Conflict: Risky decisions by shareholders may harm creditors.* Solutions:- * Incentive Schemes: Stock options and performance-based
bonuses.* Board Oversight: Active and independent board of directors. * Auditing: External and internal audits ensure accountability.* Corporate Governance: Adherence to ethical practices and transparency.* Agency problems can reduce the firm’s value if not
properly managed.
6. Time Value of Money (TVM):- * The Time Value of Money is a foundational principle in finance. It states that a sum of money today is worth more than the sa me sum in the future because of its earning potential.* Reasons for TVM:- * Opportunity Cost: Money
today can be invested to earn returns.* Inflation: Reduces the purchasing power of money over time.* Risk and Uncertainty: Future payments are less certain than current ones.* TVM is used in investment analysis, capital budgeting, loan amortization, and
financial planning.
7. Compounding and Discounting:- * Compounding:- * The process of calculating the future value (FV) of a present sum using an interest rate over a period.* Formula:* FV = PV × (1 + r)^n* Where:- * PV = Present Value* r = interest rate* n = number of periods*
Discounting:- * The reverse of compounding; it calculates the present value (PV) of a future sum.* Formula:*PV = FV / (1 + r)^n*These concepts are critical in evaluating Net Present Value (NPV) and Internal Rate of Return (IRR) for investment decisions.
8. Short-Term and Long-Term Sources of Funds** Short-Term Sources (for working capital needs):* Trade Credit: Credit from suppliers, usually interest-free.* Bank Overdraft: Allows businesses to withdraw more than their account balance.* Cash Credit: Credit
facility against pledged inventory or receivables.* Commercial Paper: Unsecured promissory notes issued by large firms.* Bill Discounting: Selling of bills of exchange to banks at a discount.
Long-Term Sources (for capital investments):- * Equity Shares: Ownership capital raised from investors.* Preference Shares: Hybrid securities with fixed dividends and lower risk.* Debentures and Bonds: Long-term debt instruments with regular interest
payments.* Term Loans: Loans from banks or financial institutions for fixed periods.* Retained Earnings: Profits reinvested into the business.* Venture Capital: Funds from investors in exchange for equity in startups.* External Commercial Borrowings (ECBs): Loans
from foreign sources.* A proper mix of short-term and long-term funds ensures liquidity and solvency.
1. Investment Decisions:- * Investment decisions, also known as capital budgeting decisions, are long-term decisions regarding the allocation of capital to investment projects. These decisions are crucial as they determine the firm's future growth, profitability,
and risk profile.* Importance of Investment Decisions:* Involves large amounts of capital.* Affects the firm’s long-term strategic direction.* Usually irreversible or costly to reverse.* Direct impact on shareholder wealth.
2. Capital Budgeting** Capital budgeting is the process of evaluating and selecting long-term investments that are in line with the firm's goal of maximizing shareholder wealth.* Features of Capital Budgeting:* Long-term focus: Investments are for several years.*
High cost and risk: Large funds are committed with uncertainty.* Irreversibility: Difficult to reverse decisions once implemented.* Impact on profitability: Affects future earnings and competitiveness.
Types of Capital Budgeting Decisions:- * 1. Expansion Decisions – To increase capacity or add new product lines.* 2. Replacement Decisions – To replace outdated or inefficient assets.* 3. Modernization Decisions – Upgrading technology or processes.* 4.
Diversification Decisions – Entering new markets or products.* 5. Mutually Exclusive Projects – Choosing one among alternatives.* 6. Independent Projects – Projects that can be taken up simultaneously.
Techniques of Capital Budgeting:- * 1. Traditional Methods:* Payback Period: Time required to recover the initial investment.* Simple but ignores time value of money and cash flows af ter payback.* Accounting Rate of Return (ARR): Average annual accounting
profit as a percentage of investment.*Easy to understand but ignores TVM and cash flows.
2. Modern Techniques (Discounted Cash Flow Methods):- * Net Present Value (NPV): Present value of cash inflows minus outflows.* Accept if NPV > 0; best for wealth maximization.* Internal Rate of Return (IRR): Discount rate at which NPV = 0.* Accept if IRR >
cost of capital.* Profitability Index (PI): Ratio of PV of inflows to outflows.* Accept if PI > 1.* Discounted Payback Period: Time to recover investment considering time value.* Modern methods are preferred as they consider the time value of money and overall
profitability.
3. Cost of Capital:- *The cost of capital is the rate of return that a firm must earn on its investment projects to maintain the market value of its shares and attract funds.* Types of Cost of Capital:*Cost of Equity: Return expected by shareholders.* Can be
calculated using the Dividend Discount Model (DDM) or Capital Asset Pricing Model (CAPM).* Cost of Debt: Interest paid on borrowed funds, adjusted for tax savings.* Cost of Preference Shares: Fixed dividend expected by preference shareholders.* Weighted
Average Cost of Capital (WACC): Average cost of all sources of capital, weighted by their proportion in the capital structure.* Importance:- * Acts as a benchmark for investment decisions.* Affects valuation, profitability, and financing strategy.
4. Financing Decision* The financing decision involves determining the optimal capital structure — the mix of debt and equity — to finance the firm's operations and investments.
Operating Leverage* * Meaning:- * Operating leverage refers to the extent to which a company uses fixed operating costs in its cost structure. These are costs that do not change with the level of production or sales, such as rent, salaries of permanent staff,
insurance, and depreciation. A business with high operating leverage will see greater changes in operating income (EBIT) with changes in sales revenue. * Explanation:- * In businesses with high fixed costs and low variable costs, an increase in sales leads to a
relatively higher increase in profits because the fixed costs have already been covered. However, if sales fall, the losses a re magnified for the same reason—fixed costs remain constant regardless of output.* Formula:* The Degree of Operating Leverage (DOL) is
calculated as:- * \text{DOL} = \frac{\text{Percentage Change in EBIT}}{\text{Percentage Change in Sales}}* \text{DOL} = \frac{\text{Contribution Margin}}{\text{EBIT}}.* Where:- * Contribution Margin = Sales – Variable Costs* EBIT = Earnings Before Interest and Taxes
* Implications:- * High DOL means the firm is more sensitive to changes in sales. Profitability increases rapidly with higher sales, but losses also deepen quickly when sales decline. * Low DOL indicates that a business has lower fixed costs and is less sensitive to
sales changes. * Example:* Consider two companies, A and B.* Company A has high fixed costs but low variable costs (e.g., a software firm).* Company B has low fixed costs and high variable costs (e.g., a bakery).* If both experience a 10% increase in sales,
Company A will likely see a much greater increase in operating income due to high operating leverage.
Financial Leverage:- * Meaning:- * Financial leverage refers to the use of debt in a company’s capital structure. Companies borrow funds to invest in business activities with the goal of increasing shareholder returns. However, borrowing introduces fixed financial
costs in the form of interest payments.* Explanation:- * A firm that uses a higher proportion of debt relative to equity is said to have high financial leverage. When a firm earns more from its investments than the cost of debt, leverage enhances returns. However, if
earnings fall below the cost of debt, it magnifies losses and can lead to financial distress.* Formula:- * The Degree of Financial Leverage (DFL) is calculated as:* \text{DFL} = \frac{\text{Percentage Change in EPS}}{\text{Percentage Change in EBIT}}
M* \text{DFL} = \frac{\text{EBIT}}{\text{EBIT} - \text{Interest Expense}}* Implications:- * High DFL increases the potential return to shareholders but also raises the risk of insolvency during poor performance.* Low DFL indicates more conservative financing with less
debt, reducing risk but also potential returns.* Example:- * Company X and Company Y both earn an EBIT of $100,000.* Company X has no debt.* Company Y has $50,000 in interest expenses.* If EBIT increases by 20%, Company Y’s net income (after interest) will
rise more sharply than Company X’s, due to leverage. But if EBIT falls, Company Y will suffer more due to fixed interest obligations.
Combined Levera** Definition:- * Combined or Total Leverage takes into account both operating and financial leverage. It measures the sensitivity of net income or EPS to changes in sales.* Formula:- * \text{Degree of Combined Leverage (DCL)} = \text{DOL}
\times \text{DFL}* Implications:- * Companies with high combined leverage are highly sensitive to changes in sales—both their operating income and net income can fluctuate significantly.* While this can result in high returns during growth periods, it also
increases vulnerability during downturns.* 5. Capital Structure – Theory and Policy* Capital structure refers to the proportion of debt and equity in the firm’s total capital.
Theories of Capital Structure:* 1. Net Income Approach (NI):* Assumes cost of debt is less than equity.* More debt leads to higher firm value and lower WACC.* 2. Net Operating Income Approach (NOI):- * Firm’s value is unaffected by capital structure.* WACC
remains constant.* 3. Modigliani and Miller (MM) Theory (without taxes):- Capital structure is irrelevant in a perfect market.* Value depends on earnings and risk, not financing.* 4. MM Theory (with taxes):- * Debt adds value due to tax shield on interest.*
Encourages use of debt.* 5. Trade-Off Theory:* Balances tax benefits of debt against bankruptcy costs.* 6. Pecking Order Theory:* Firms prefer internal financing first, then debt, then equity.* 7. Agency Theory:* Focuses on conflicts between stakeholders due to
leverage.
Capital Structure Policy:- * Should aim to minimize WACC.* Must consider risk, control, flexibility, and market conditions.* Firms must strike a balance between debt and equity to maintain financial health.
6. Dividend Decision:- * Dividend decision refers to the choice of how much profit to return to shareholders and how much to retain for reinvestment.
Theories of Dividend:- * 1. Walter’s Model:* If return on investment > cost of capital, retain earnings.*Implies dividend policy affects firm value.* 2. Gordon’s Model:- * Favors dividend payments due to the bird-in-hand argument.* Investors prefer certain dividends
over uncertain capital gains.* 3. Modigliani and Miller (MM) Hypothesis:* In perfect markets, dividend policy is irrelevant.* Value of firm is based on earnings, not dividend distribution.
Dividend Policy Types:- * 1. Stable Dividend Policy:- * Fixed dividend per share or a consistent payout ratio.* 2. Residual Dividend Policy:- * Pay dividends only after funding all acceptable investment opportunities.* 3. Constant Payout Ratio:- * Pay a fixed
percentage of earnings as dividends.* 4. Irregular Dividend Policy:- * Varies based on earnings and cash availability.* Factors Affecting Dividend Policy:* Earnings stability* Liquidity position* Investment opportunities* Tax considerations* Shareholder preferences*
Legal and contractual constraints
Current Assets Management :- 1. Introduction** Current assets are assets expected to be realized or consumed within the normal operating cycle or within one year. These include cash, accounts receivables, inventory, marketable securities, and
prepaid expenses. Effective management of these assets is vital to a firm’s financial health, as it directly impacts liquidity, profitability, and risk.* Working Capital Management is essentially the management of current assets and current liabilities. It ensures
that a firm has sufficient short-term resources to continue its operations and meet its short-term obligations.
2. Working Capital: Concepts and Types** 2.1. Definitions:- * Gross Working Capital: The total value of a firm’s current assets.* Net Working Capital: The difference between current assets and current liabilities.
Net WC = Current Assets – Current Liabilities * 2.2. Types of Working Capital:- * Permanent Working Capital: The minimum level of current assets required at all times.* Temporary Working Capital: Extra WC needed to meet seasonal or special demands.*
2.3. Importance of Working Capital Management:- * Ensures liquidity for day-to-day operations.* Helps maintain solvency and improves creditworthiness.* Optimizes resource utilization.* Reduces financing costs and increases profitability.
3. Working Capital Policies** 3.1. Conservative Policy* Maintains high current assets relative to liabilities.* Ensures high liquidity, low risk.* Lower returns due to higher idle resources.* 3.2. Aggressive Policy:- * Keeps current assets at a minimum level.* Higher
risk of liquidity crunch but higher profitability.* 3.3. Hedging or Matching Policy* Matches asset life with liability maturity.* Moderate risk and return.
4. Estimation of Working Capital** 4.1. Techniques:- * Operating Cycle Approach: Determines WC needs based on the time taken to convert raw material into cash.* Cash Cost Approach: Focuses only on cash-based costs.* Percentage of Sales Method: WC
estimated as a fixed percentage of projected sales.* Balance Sheet Method: Based on projected balance sheet figures.* 4.2. Components of Operating Cycle:* Raw Materials Period* Work-in-Progress Period* Finished Goods Holding Period* Receivables
Collection Period* Payables Deferral Period* Operating Cycle = Inventory Period + Receivables Period – Payables Period
5. Factors Affecting Working Capital Requirements* * Nature of Business: Manufacturing needs more WC than service industries.* Business Cycle: During a boom, firms need more WC.* Production Cycle: Longer cycles increase WC demand.* Credit Policy:
Liberal policies increase receivables and WC.* Growth Prospects: Expansion requires more WC.* Profitability: Higher profits may reduce external WC needs.* Operational Efficiency: Efficient use of assets reduces WC needs.
6. Sources of Financing Working Capital** 6.1. Short-Term Sources:- Trade Credit* Bank Overdraft/Cash Credit* Commercial Papers* Factoring and Bill Discounting* Customer Advances* Public Deposits* 6.2. Long-Term Sources:- * Equity and
Preference Shares* Debentures and Bonds* Term Loans* Retained Earnings* The firm should balance the cost and risk of using each source.
7. Management of Cash:- * 7.1. Objectives of Cash Management:* Maintain optimum cash levels.* Avoid cash shortages and surpluses.* Ensure timely payments and take advantage of discounts.* Invest surplus cash profitably.* 7.2. Cash Budget:- * A cash
budget forecasts future cash inflows and outflows over a specific period.* 7.3. Techniques to Manage Collections and Disbursements:* Speeding up collections: Discounts, electronic payment systems.* Delaying disbursements: Use float, schedule
payments smartly. * 7.4. Investment of Surplus Cash:- * Idle cash can be invested in * Treasury Bills * Commercial Papers * Money Market Mutual Funds * Certificates of Deposit * Investment must ensure safety, liquidity, and return.
8. Management of Receivables:- * Receivables are amounts owed by customers due to credit sales. Efficient receivable management boosts sales while controlling bad debts.* 8.1. Objectives:- * improve sales via credit extension.* Reduce bad debts and
collection cost.* Maintain optimal investment in receivables.* 8.2. Terms of Credit:- * Credit Period: Time allowed for payment.* Discounts: Incentivize early payment.* Credit Limits: Restrict exposure to individual customers.* 8.3. Credit Policy Decisions: *
Liberal Credit Policy* Increases sales.* Higher risk of bad debts.* Strict Credit Policy* controls risk.* May reduce sales.* 8.4. Credit Evaluation and Collection:* Use 5 Cs: Character, Capacity, Capital, Conditions, Collateral.* Monitor aging schedules.* Use
collection agencies or legal means when needed.
9. Management of Inventory* Inventory refers to raw materials, WIP, and finished goods. It is a major part of working capital.* 9.1. Objectives:- * Avoid stockouts and overstocking.* Maintain production and sales flow.* Minimize holding and ordering costs.* 9.2.
Types of Inventory:- * Raw Materials* Work-in-Progress* Finished Goods* Maintenance and Spare Parts* 9.3. Inventory Control Techniques:- * a) Economic Order Quantity (EOQ):- * The optimal order size that minimizes the sum of ordering and holding
costs.* b) ABC Analysis:- * A: High value, tight control.* B: Medium value. C: Low value, minimal control.* c) Just-in-Time (JIT):- * Raw materials ordered just before use.* Reduces inventory carrying costs.* d) Reorder Level:- * Stock level at which a new order
should be placed.* Reorder Level = Daily Usage × Lead Time* e) Safety Stock:- * Extra stock to guard against uncertainties in demand/supply.* f) Inventory Turnover Ratio:- * ITR = Cost of Goods Sold / Average Inventory
Measures how efficiently inventory is managed.
10. Integrated Working Capital Management:- * Firms must integrate the management of cash, receivables, and inventory to optimize overall working capital. * Strategies Include:- * Synchronize cash inflows with outflows.* Improve receivables turnover
through credit control.* Reduce inventory through better planning and demand forecasting.
11. Consequences of Poor Working Capital Management:- * Liquidity Crisis: Inability to pay obligations.* Idle Funds: Excess cash or stock affects profitability.* High Interest Costs: Due to short-term borrowing.* Production Bottlenecks: Due to stock-outs. *
Lost Sales: Poor customer satisfaction.