Financial Management
Unit 1 & Unit 2

Finance simply means everything to do with money — getting money, spending money, saving money, and investing money. Every person does finance daily when deciding how to spend their salary or pocket money. Companies also do finance, but on a much bigger scale.

Financial Management means applying management skills to handle the money of a company properly. The Finance Manager decides: Where should we get money from? Where should we invest it? What should we do with profits?

"Scope" means — what areas does FM cover? The scope has changed from a narrow traditional view to a broad modern view.

The finance manager's job was only to arrange money when the company needed it. He was treated like a cashier — just collecting money from banks and giving it to departments. No focus on how to invest wisely or manage finances day-to-day.

• Only focused on raising funds (from banks, public, investors)
• No attention to investment decisions or working capital
• Finance manager had no role in planning or strategy
• Very narrow and outdated — not useful for modern companies

The modern view says Financial Management covers THREE big decisions every company must make:

Financial Management does not work in isolation. It is closely connected to other subjects. These connections help make better decisions.

Economics is the parent subject of finance. FM borrows many concepts from economics.

• Macroeconomics: GDP growth, inflation, and RBI interest rate changes directly affect company borrowing costs and investment decisions
• Microeconomics: Demand-supply forces affect pricing, which affects revenue and profit
• Marginal Analysis: Compare extra benefit vs extra cost — used in every capital budgeting decision

Finance and Accounting use the same data but for different purposes:

• Marketing creates demand and sales — but needs a budget to run campaigns and promotions
• Finance provides the budget and then evaluates: "Did our ₹500 crore ad spend by HUL actually increase sales proportionally?"
• Finance also uses sales forecasts from marketing to plan cash flows

• Salaries, bonuses, training costs, and manpower planning all require financial budgeting
• ESOPs (Employee Stock Option Plans) — a financial tool — are used by IT companies like Infosys to retain talent
• Finance allocates funds for recruitment, training, and performance incentives

• Production needs capital for buying machinery and equipment (capital expenditure)
• Day-to-day production needs working capital for raw materials and wages
• Finance decides: Buy new machine or repair old? Finance evaluates using cost-benefit analysis

Every financial decision is guided by fundamental principles. Brealey & Myers (textbook authors) identified 7 core principles that govern all sound financial decisions.

Higher the risk, higher the expected return. You cannot earn high returns without taking some risk. This is the most fundamental law in all of finance — there is no free lunch.

₹1 today is worth MORE than ₹1 one year later. Why? Because today's ₹1 can be invested to earn returns. Future money cannot be invested today. Also, inflation reduces purchasing power over time.

Financial decisions should be based on actual CASH FLOWS, not accounting profit. A company can show profit on paper but go bankrupt if customers don't pay on time.

Decisions should be based on INCREMENTAL (extra/additional) cash flows — only the new cash flows created by this decision, not existing ones.

The investment decision (which project to invest in) and the financing decision (how to fund that project) should be made SEPARATELY. First decide if the project is good, then decide how to finance it.

Financial decisions send SIGNALS to investors and the market. A dividend increase signals confidence in future profits. A company buying back shares signals that management thinks shares are undervalued.

Shareholders (owners) hire managers (agents) to run the company. Managers should act in the BEST INTEREST of shareholders. But sometimes managers act for their own benefit — this conflict is called the Agency Problem.

• Manager may choose safe, low-risk projects (to protect their job) even when shareholders want higher-return risky projects
• Manager may spend company money on personal perks, luxury offices
• Solutions: ESOPs (managers become shareholders), performance-linked bonuses, strong Board of Directors, transparent audits

Every company needs a clear goal. In financial management, there are two main schools of thought about what the ultimate objective should be.

Meaning: Earn as much accounting profit as possible in every period. Maximize rupee profit.

Criticisms — Why this is WRONG:

• Ignores Time Value of Money: ₹10 lakh profit today and ₹10 lakh profit after 5 years are treated the same — but they're NOT equal. Today's ₹10L is worth more.
• Ignores Risk: A safe project and a very risky project both earning the same profit are treated equally. That is wrong — risk should be penalized.
• Promotes Short-term Thinking: Manager may cut R&D, training, and quality control to boost this year's profit — which damages the company's long-term future.
• Ambiguous Measurement: Which profit? Gross profit? Net profit? Before tax? After tax? EPS? The measure is unclear.
• No Social Concern: Ignores impact on employees, environment, and society.

Meaning: Maximize the market price of equity shares = maximize present value of all future expected cash flows for shareholders.

Shareholders' Wealth = Number of Shares × Market Price per Share

Why Wealth Maximization is BETTER:

• Considers Time Value: Future cash flows are discounted — ₹10L today is valued higher than ₹10L after 5 years.
• Considers Risk: Higher risk = higher discount rate = lower present value. Risk is automatically accounted for.
• Clear, Objective Measure: Share price in the stock market is publicly observable. No ambiguity.
• Long-term Focus: Companies that cut quality or R&D to save costs get punished by falling share prices.
• Social Alignment: A company creating long-term wealth also benefits its employees, customers, and community.

This topic asks: In theory we say managers should MAXIMIZE wealth — but do they actually do that in real life?

Meaning: Decision makers always try to find the BEST possible option from all available alternatives. In finance, this means: choose the project with highest NPV, financing with lowest cost, dividend policy that maximizes share price — always the absolute best choice.

Assumption: The manager has perfect information, unlimited time, and perfect analytical ability to evaluate every single option.

Nobel laureate Herbert Simon argued that in REALITY, managers do NOT maximize. Instead, they "satisfice" — a word combining satisfy and suffice. They look for options that are "good enough" rather than the absolute best.

Why Satisficing Happens in Real Life:

• Managers never have complete, perfect information about all options
• Analysing every possible option is too expensive and too time-consuming
• Organizational politics and approval processes slow decision-making
• Human brain has limited capacity to process complex data
• In fast-moving markets, a "good enough" decision made quickly is better than a "perfect" decision made too late

Before studying the COST of capital, we must understand WHERE a company gets money from. These are called Sources of Finance.

Long-Term Finance (More than 5 years): Used to buy permanent fixed assets — land, buildings, heavy machinery. Since these assets will be used for many years, long-term money is needed.

• Equity Shares — permanent capital; shareholders become part-owners of the company
• Preference Shares — fixed dividend, paid before equity shareholders
• Debentures / Bonds — borrowed money; company pays fixed interest and repays principal at maturity
• Long-term bank loans and term loans from financial institutions (IDBI, NABARD)
• Retained Earnings — past profits kept by company for reinvestment

Medium-Term Finance (1 to 5 years): Used for semi-permanent assets or medium-duration projects.

• Term loans from commercial banks (SBI, HDFC, ICICI)
• Hire Purchase — use the asset immediately, pay in installments over time
• Leasing — use an asset without owning it; pay periodic lease rent
• Loans from SIDBI (for small industries) and NABARD (for agriculture)

Short-Term Finance (Less than 1 year): Used for working capital — daily operations like buying raw materials and paying wages.

• Bank Overdraft — withdraw more than your account balance; repay quickly
• Cash Credit — revolving credit facility against stock or debtors
• Trade Credit — suppliers give 30–90 days credit; buy now, pay later
• Commercial Paper — large companies issue short-term promissory notes to borrow from the market
• Factoring — sell your unpaid invoices to a factoring company to get immediate cash

Equity Shares: Buying equity shares makes you a part-owner. You get dividends when the company makes profit and can vote at company meetings. Highest risk but highest potential return. Example: Buying TCS shares makes you a tiny part-owner of TCS.

Preference Shares: Like a middle ground between equity and debt. Preference shareholders get a FIXED dividend every year BEFORE equity shareholders get anything. They get preference in payment. No voting rights normally. Example: 9% Preference Share of ₹100 = ₹9 every year, fixed.

Debentures/Bonds: The company borrows money from the public and gives a written promise to pay fixed interest every year and return the principal at maturity. Investor is a LENDER, not owner. Interest is tax-deductible for the company. Example: NTPC 7.5% Bond = ₹75 interest per year on ₹1,000 face value.

Retained Earnings: Profit kept by the company instead of distributing as dividend. Used for future growth. NOT free money — has an opportunity cost equal to what shareholders could have earned by investing that money elsewhere.

Cost of Capital is the minimum rate of return that a company must earn on its investments to satisfy all its investors and maintain the market value of its shares. If the company earns less than this, value is destroyed.

• Hurdle Rate for Projects: Every project must earn at least the cost of capital to be accepted. Projects earning less destroy value and should be rejected.
• Capital Budgeting Decision: Used as the discount rate in NPV method. A project with positive NPV (at WACC discount rate) adds value.
• Capital Structure Optimisation: Companies try to find the mix of debt and equity that MINIMIZES WACC. Lower WACC = more investment opportunities = higher firm value.
• Performance Evaluation: If a business division earns less than the cost of capital, it is destroying shareholder wealth even if it shows profit.
• Dividend Policy: Cost of retained earnings influences the decision to retain profits vs distribute dividends.
• Lease vs Buy Decisions: Compare which option costs less in present value terms using cost of capital as the discount rate.
• Firm Valuation: Lower WACC → higher present value of future cash flows → higher company value → higher share price.

Cost of Debt (Kd) is the effective rate of interest the company pays on its borrowed money — AFTER accounting for the income tax savings on interest payments.

Reason 1 — Lower Risk for the Lender: A lender (debenture holder or bank) gets fixed interest regardless of company profit or loss. If the company goes bankrupt, lenders get paid FIRST before shareholders. Because they take less risk, they accept a lower return — making debt cheaper for the company.

Reason 2 — Tax Shield (Most Important!): Interest paid on debt is a business expense. It is deducted from profit BEFORE calculating income tax. This means every rupee of interest saves the company some tax. The government effectively shares the interest cost with the company.

Simple formula (irredeemable / perpetual debt):

Kd = Interest Rate × (1 – Tax Rate)

Example: Interest rate = 12%, Tax = 35%. Kd = 12% × (1 – 0.35) = 12% × 0.65 = 7.8%

Redeemable debt formula:

Kd = [I(1–T) + (RV–NP)/n] ÷ [(RV+NP)/2]

• I = Annual interest amount (face value × rate)
• T = Tax rate in decimal (30% = 0.30)
• RV = Redemption Value (amount paid back at maturity)
• NP = Net Proceeds (money received when issuing debenture, after flotation costs)
• n = Number of years to maturity

Cost of Preference Shares (Kp) is the annual rate of return that preference shareholders expect, which becomes the cost to the company of using preference share capital.

Interest on debt is paid BEFORE tax → reduces taxable income → tax shield available → effective cost is lower.

But preference dividends are paid from AFTER-TAX profits. Tax has already been paid before the dividend is declared. The government does NOT allow preference dividends as a tax deduction. No tax shield = effective cost equals the full dividend rate.

Irredeemable Preference Shares (never repaid):

Kp = Annual Preference Dividend ÷ Net Proceeds (NP)

Redeemable Preference Shares (repaid after n years):

Kp = [Dp + (RV–NP)/n] ÷ [(RV+NP)/2]

• Dp = Annual preference dividend
• RV = Redemption value (amount paid back at maturity)
• NP = Net proceeds received when shares were issued
• n = Years to redemption

Cost of Equity (Ke) is the minimum return that equity shareholders expect from the company. Unlike debt (fixed interest) or preference (fixed dividend), equity shareholders have NO contractual payment. We must ESTIMATE their expected return.

If the company doesn't deliver this expected return, shareholders sell their shares → share price falls → wealth is destroyed. So Ke = minimum return to keep shareholders satisfied and share price stable.

Equity shareholders expect two things: (1) dividends today, and (2) growth in those dividends in the future. Together these form the total expected return.

Ke = (D1 ÷ P0) + g

• D1 = Expected dividend NEXT year = Current dividend D0 × (1 + g)
• P0 = Current market price of the share (or NP for new issue)
• g = Constant annual growth rate of dividends (in decimal form)
• If issuing NEW shares with flotation costs: use NP (net proceeds) instead of P0

Developed by William Sharpe (Nobel Prize winner). CAPM says the return investors demand depends on how RISKY the company's stock is compared to the overall market.

Ke = Rf + β × (Rm – Rf)

• Rf = Risk-free rate = return on safe government bonds (e.g., 10-year G-Sec yield ≈ 7%)
• β (Beta) = Systematic risk. How much the stock moves compared to the whole market.
• Rm = Expected market return (long-run Sensex/Nifty average ≈ 12–14%)
• (Rm – Rf) = Market Risk Premium = extra return investors demand for taking market risk

Understanding Beta (β):

Many students think retained earnings are FREE because no payment is made to anyone. This is WRONG! Retained earnings carry an OPPORTUNITY COST.

Meaning: When a company retains profits instead of distributing dividends, shareholders lose the chance to invest that money themselves. The "cost" = what shareholders could have earned by investing it elsewhere. This is the opportunity cost.

Kr = (D1 ÷ P0) + g [same as Ke but WITHOUT flotation cost]

WACC is the overall cost of capital of a company. A company uses multiple sources of money — equity, debt, preference shares, retained earnings. Each has a different cost. WACC combines all these into ONE single number using their proportions (weights) in the capital structure.

WACC = (Wd × Kd) + (Wp × Kp) + (We × Ke) + (Wr × Kr)

Where W = Weight (proportion) of each source in total capital. Always use AFTER-TAX Kd.

Book Value Weights: Use the values shown in the Balance Sheet (historical cost). Simple to calculate. Available directly from financial statements. However, these are historical values and may not reflect current market reality.

Market Value Weights (Preferred by scholars): Use current market values — current share price × number of shares for equity; current market price for bonds. More accurate because it reflects what investors currently value the company at. Recommended by Brealey & Myers and most modern finance textbooks.

Marginal Weights: Use the proportion of each source in the NEW capital being raised right now for a specific project. Used only when a company is planning to raise additional funds.

• Hurdle Rate for Investment Decisions: Every project must earn at least WACC. Project return > WACC → Accept. Project return < WACC → Reject. This is the most important use.
• Discount Rate in NPV Method: Used to calculate present value of future cash flows. Lower WACC → higher NPV for all projects → more investments qualify.
• Optimal Capital Structure: The mix of debt and equity that gives the LOWEST WACC is the optimal capital structure for that company.
• Firm Valuation: WACC is used in DCF (Discounted Cash Flow) models to value an entire company. Lower WACC → higher company value.
• Performance Measurement: If a business division earns less than WACC, it destroys value even if it earns accounting profit.

The word "leverage" comes from physics. A lever allows you to lift a very heavy rock using very little effort — it MULTIPLIES your force. In finance, leverage means using fixed costs to MAGNIFY the effect of a small change in sales into a large change in profit or EPS.

• Magnifies Returns: During profitable times, leverage creates much higher returns for shareholders than would be possible without fixed costs
• Risk Measurement: Higher leverage = higher risk. Banks, investors, and credit rating agencies use leverage ratios to assess risk
• Capital Structure Planning: DFL helps decide how much debt is optimal in the capital structure
• Profit Planning / Forecasting: DOL helps management predict exactly how EBIT will change if sales increase or decrease by a given percentage
• Trading on Equity: Financial leverage enables equity shareholders to earn higher EPS by using cheaper borrowed funds

Operating Leverage arises from the presence of Fixed Operating Costs — costs that stay the same regardless of how much you produce or sell. Examples: factory rent, depreciation of machinery, permanent staff salaries, insurance premiums.

When sales increase, variable costs increase proportionally. But fixed costs DO NOT CHANGE. So the difference between sales and variable costs (called Contribution) increases, while fixed costs stay constant. This means EBIT rises FASTER than sales. That "faster-than-proportional" rise in EBIT is Operating Leverage.

• Contribution = Sales – Variable Costs (the money left after covering variable costs, to meet fixed costs and profit)
• EBIT = Contribution – Fixed Operating Costs (Earnings Before Interest and Tax)
• DOL = Contribution ÷ EBIT (Degree of Operating Leverage)
• Meaning: DOL = 3 means if Sales rise by 10%, EBIT rises by 30% (10% × 3). If Sales fall by 10%, EBIT falls by 30%.

Financial Leverage arises from the use of Fixed Financial Costs — mainly interest on debt and preference dividends — which must be paid regardless of the level of EBIT.

When EBIT increases, interest stays fixed. So EBT (Earnings Before Tax) increases FASTER than EBIT. Since EPS depends on EBT, EPS also rises faster. This magnification of EPS changes relative to EBIT changes is Financial Leverage.

• EBT = EBIT – Interest (Earnings Before Tax)
• DFL = EBIT ÷ EBT (Degree of Financial Leverage)
• Meaning: DFL = 2 means if EBIT rises by 10%, EPS rises by 20% (10% × 2). If EBIT falls by 10%, EPS falls by 20%.

"Trading on Equity" means: using borrowed money (which has a fixed, lower interest cost) to invest and earn a higher return. The surplus earned ABOVE the interest cost goes entirely to equity shareholders, multiplying their EPS and wealth.

The level of EBIT at which EPS is the SAME under two different financing plans (e.g., all-equity vs debt+equity plan). At this EBIT level, both plans give equal EPS. Above this point, the debt plan gives higher EPS (leverage works in favour). Below this point, the all-equity plan gives higher EPS.

Combined Leverage (also called Total Leverage) combines both Operating and Financial Leverage. It shows the total magnification effect — how much EPS changes when Sales change, considering BOTH fixed operating costs AND fixed financial costs together.

• DCL = DOL × DFL
• DCL = Contribution ÷ EBT (shortcut — most useful in exams, verify with this)
• % Change in EPS = DCL × % Change in Sales

The three leverages work in a chain. Understanding this chain helps you visualise the full picture:

SALES → ×DOL → EBIT → ×DFL → EPS    |    OR DIRECTLY: SALES → ×DCL → EPS

• A 1% change in Sales creates a DOL% change in EBIT
• That EBIT change then creates a DFL% change in EPS
• Combined effect: 1% sales change creates a DCL% change in EPS

• Financial Management: Planning, organising, directing, and controlling financial resources to achieve organisational goals
• Wealth Maximization: Maximising the market price of equity shares = present value of all future expected cash flows
• Satisficing: Finding a "good enough" solution rather than searching for the absolute best (Herbert Simon)
• Cost of Capital: Minimum rate of return a company must earn on investments to maintain market value of shares
• Tax Shield: Tax saving on interest payments that reduces the effective cost of debt — making debt cheaper
• WACC: Weighted average of costs of all capital components using their proportions in capital structure as weights
• Operating Leverage: Use of fixed operating costs to magnify the effect of sales changes on EBIT
• Financial Leverage: Use of fixed financial costs (interest) to magnify the effect of EBIT changes on EPS
• Combined Leverage: DOL × DFL — total sensitivity of EPS to sales changes
• Trading on Equity: Using borrowed money to earn more than its interest cost, with surplus going to equity shareholders