FINANCIAL MANAGEMENT Notes, Amrutha M .docx

Amrutha M
Assistant Professor
SRM Institute of Science and Technology Ramapuram

1. FINANCIAL MANAGEMENT
UNIT I INTRODUCTION
Meaning
Financial management refers to the process of planning, organizing, directing, and controlling
an organization's financial activities, such as procurement and utilization of funds, to achieve
its objectives.
Objectives of Financial Management
1. Profit Maximization: Ensure the organization earns maximum profits.
2. Wealth Maximization: Maximize shareholder value.
3. Liquidity Management: Ensure sufficient liquidity to meet financial obligations.
4. Risk Management: Minimize financial risks.
5. Financial Planning: Plan and control financial activities effectively.
Functions of Financial Management
1. Financial Planning: Determine financial goals and develop plans to achieve them.
2. Financial Decision Making: Make decisions on investments, financing, and dividend
payments.
3. Financial Control: Monitor and control financial activities to ensure they align with plans.
4. Raising Funds: Identify and secure necessary funding sources.
5. Allocating Funds: Allocate funds to various activities and projects.
6. Managing Risk: Identify and manage financial risks.
Meaning of finance
Finance refers to the management of money and other financial resources, including activities
such as investing, borrowing, lending, budgeting, saving, and forecasting. It involves the
allocation of resources over time, often under conditions of risk and uncertainty.
Importance of finance
1. Business Growth: Enables businesses to invest, expand, and innovate.
2. Economic Development: Contributes to a country's economic growth and stability.

2. 3. Personal Wealth: Helps individuals manage resources, achieve financial goals, and secure
their future.
4. Resource Allocation: Facilitates efficient allocation of resources in the economy.
5. Risk Management: Provides tools and mechanisms to manage financial risks.
Sources of Finance
Debt Financing
Loans: Borrowed money from banks or financial institutions, repaid with interest.
Bonds: Debt securities issued to raise capital, with a promise to repay with interest.
Debentures: Long-term debt instruments, often unsecured.
Equity Financing
Shares: Ownership stakes sold to investors, representing a claim on company assets
and profits.
Venture Capital: Investment in startups or early-stage companies with high growth
potential.
Short-term Sources
Trade Credit: Credit extended by suppliers for goods or services.
Bank Overdrafts: Temporary borrowing facility from banks.
Commercial Paper: Short-term debt instrument issued by companies.
Role of Financial Manager in financial management
1. Financial Planning: Develop financial plans and forecasts.
2. Investment Decisions: Evaluate and decide on investment opportunities.
3. Financing Decisions: Determine optimal capital structure and financing sources.
4. Risk Management: Identify and manage financial risks.
5. Financial Control: Monitor financial performance and ensure compliance.
6. Working Capital Management: Manage cash, inventory, accounts receivable, and payable.
UNIT II CAPITAL STRUCTURE
Meaning
Capital structure refers to the mix of debt and equity financing used by a company to fund its
operations and growth. It represents the proportion of debt (borrowed money) and equity
(owner's funds) in the company's total capital.

3. In other words, capital structure is the way a company finances its assets and activities
through a combination of debt, equity, and other financial instruments.
Factors Affecting Capital Structure
:1. Cost of Capital: Debt is often cheaper than equity, but excessive debt increases risk.
2. Business Risk: Companies with high business risk may prefer less debt.
3. Growth Rate: High-growth companies may prefer equity to avoid fixed debt obligations.
4. Financial Flexibility: Companies may prefer debt for flexibility in repayment.
5. Control: Owners may prefer debt to maintain control, rather than issuing equity.
6. Taxation: Debt interest is tax-deductible, making debt more attractive.
7. Industry Norms: Companies often follow industry norms for capital structure.
Planning of Capital Structure
1. Determine Capital Requirements: Assess the company's financial needs.
2. Evaluate Financing Options: Consider debt, equity, and hybrid instruments.
3. Analyse Cost and Risk: Balance cost of capital with financial risk.
4. Consider Business Objectives: Align capital structure with company goals.
5. Assess Impact on Control: Evaluate impact on ownership and control.
6. Monitor and Adjust: Regularly review and adjust capital structure as needed.
Theories of Capital Structure
1.Net Income Approach
Suggests increasing debt to reduce cost of capital.
Assumption: Cost of debt is less than cost of equity.
Implication: Increase debt to reduce overall cost of capital and increase firm value.
2. Net Operating Income Approach
Argues capital structure doesn't affect firm value.
Assumption: Capital structure doesn't affect firm value.
Implication: Firm value is determined by operating income, not financing mix.
2.Traditional Approach:
Suggests an optimal debt-equity mix minimizes cost of capital.
Assumption: Optimal debt-equity mix minimizes cost of capital.
Implication: Moderate debt levels can maximize firm value.

4. 3.Modigliani-Miller (MM) Theory
Firm value is independent of capital structure
Assumption: Perfect markets, no taxes, no bankruptcy costs.
Implication: Firm value is independent of capital structure.
4.Trade-off Theory
Balances tax benefits of debt with bankruptcy costs.
Assumption: Balance tax benefits of debt with bankruptcy costs.
Implication: Optimal capital structure balances these factors.
5.Pecking Order Theory
Companies prefer internal funds, then debt, and finally equity.
Assumption: Asymmetric information leads to financing hierarchy.
Implication: Companies prefer internal funds, then debt, and finally equity.
Determining Debt and Equity Proportion
1. Financial Goals: Align with company's objectives (growth, stability, etc.).
2. Risk Tolerance: Balance debt (higher risk) and equity (lower risk).
3. Cost of Capital: Compare costs of debt and equity.
4. Cash Flow: Ensure ability to service debt.
5. Industry Norms: Consider typical capital structures in the industry.
6. Growth Stage: Adjust mix based on company's life cycle stage.
Concept of Leverage
Leverage refers to using debt (borrowed funds) to amplify returns on equity. It can increase
potential gains, but also increases risk.
Types of Leverage:1. Operating Leverage: Fixed costs amplify changes in sales.
2. Financial Leverage: Debt amplifies changes in earnings.
3. Combined Leverage: Interaction of operating and financial leverage.
UNIT III COST OF CAPITAL
Definition of cost of capital
Cost of capital is the rate of return that a firm must earn on its project/investments to maintain
its market value and attract funds.
It is also referred to as cut off rate, target rate, hurdle rate, minimum required rate of return,
standard return and so on.

5. It is the minimum rate of return which consists of risk-free return plus premium for risk
associated with the particular business.
Cost of Equity Capital
The cost of equity is the return expected by shareholders for investing in a company,
considering risk and opportunity cost. It's the minimum return a company must earn to satisfy
shareholders.
Cost of Preference Capital
The cost of preference capital is the dividend rate paid to preference shareholders.
The cost of debt
The cost of debt is the effective interest rate a company pays on its borrowings. It's often
calculated after-tax, as interest expenses are tax-deductible.
Cost of Retained Earnings
The cost of retained earnings is the opportunity cost of reinvesting earnings instead of
distributing them as dividends. It's often considered equal to the cost of equity, as it
represents the return shareholders expect.
Weighted Average Cost of Capital (WACC)
WACC is a company's overall cost of capital, weighted by its capital structure.
WACC = (E/V × Ke) + (D/V × Kd × (1 - Tax Rate))
Where:
E = Market value of equity
D = Market value of debt
V = E + D
Ke = Cost of equity
Kd = Cost of debt
(Practice problems related with cost of debt, cost of equity capital, cost of preference
capital, cost of retained earnings and weighted average cost of capital)
UNIT IV DIVIDEND
Meaning of Dividend
A dividend is a portion of a company's profit distributed to shareholders, usually in cash or
additional shares. It's a way for companies to share earnings with investors.

6. Dividend policies
A company's approach to distributing dividends to shareholders.
Types of Dividend Policies
1. Stable Dividend Policy: Maintains a consistent dividend payout, even if earnings
fluctuate.
2. Constant Payout Ratio: Pays out a fixed percentage of earnings as dividends.
3. Residual Dividend Policy: Pays dividends only after meeting capital budgeting
requirements.
4. Regular Dividend Plus Extra: Pays regular dividends with occasional extra payouts.
Factors Affecting Dividend Payment
1. Earnings: Availability of profits
2. Cash Flow: Liquidity position
3. Growth Opportunities: Need for retained earnings
4. Debt Obligations: Impact on cash flow
5. Shareholder Expectations: Investor preferences
6. Regulatory Requirements: Legal constraints
7. Tax Implications: Impact on shareholders
Provisions on Dividend Payment in Company Law (India)
1. Section 123: Regulates declaration and payment of dividends, including interim dividends.
2. Section 124: Deals with unpaid/unclaimed dividends.
3. Section 127: Specifies penalties for non-payment of declared dividends.
Companies must follow these provisions and relevant rules under the Companies Act, 2013.
Dividend Model
A dividend model is a theoretical framework explaining how a company's dividend policy
affects its value or stock price. These models analyse relationships between dividends,
earnings, growth, and cost of capital.
Walter's Model
Walter's Model (1956) suggests a firm's dividend policy affects its value. The model assumes:

7. Retained earnings are the only source of finance.
Return on investment (r) and cost of capital (k) are constant.
Formula
P = D + (r/k)(E-D)/k
Where:
P = Market price per share
D = Dividend per share
E = Earnings per share
r = Return on investment
k = Cost of capital
Gordon's Model
Gordon's Model (1959) assumes a firm's value is determined by its dividend stream, growing
at a constant rate.
Formula
P = D1 / (ke - g)
Where:
P = Market price per share
D1 = Expected dividend per share
ke = Cost of equity
g = Constant growth rate of dividends
MM Model (Modigliani-Miller)
The MM Model (1961) argues that in a perfect market, dividend policy is irrelevant to a
firm's value. Shareholder wealth is unaffected by dividend decisions.
Key Points
Value determined by earnings power and investment policy
Dividends are a financing decision, not a value driver
Investors are indifferent between dividends and capital gains
UNIT V WORKING CAPITAL
Meaning of Working Capital
Working capital refers to a company's short-term assets and liabilities, reflecting its liquidity
and operational efficiency.

8. Importance of Working Capital
1. Ensures Liquidity: Meets short-term obligations and operational needs.
2. Supports Growth: Facilitates business expansion and opportunities.
3. Manages Risk: Buffers against financial uncertainties and cash flow fluctuations.
4. Enhances Credibility: Strengthens relationships with suppliers and creditors.
Factors Influencing Working Capital
1. Business Nature: Industry type and operational cycle length.
2. Sales Volume: Higher sales often require more working capital.
3. Credit Policy: Terms of credit affect receivables and payables.
4. Inventory Management: Stock levels impact working capital needs.
5. Seasonality: Seasonal fluctuations affect working capital requirements.
Determining/Forecasting Working Capital Requirements
1. Operating Cycle Method: Estimates working capital based on operating cycle length.
2. Ratio Method: Uses ratios like current ratio or quick ratio.
3. Budgeted Method: Estimates based on projected sales and expenses.
4. Regression Analysis: Statistical method using historical data.
Working Capital Operating Cycle
The operating cycle is the time taken to convert inventory into cash.
Cycle Steps
1. Raw Material Purchase: Procurement
2. Production: Conversion to finished goods
3. Inventory Holding: Storage of finished goods
4. Sales: Credit or cash sales
5. Receivables Collection: Collection from debtors
Cycle Length
Operating Cycle = Inventory Period + Receivables Period - Payables Period