Unit 1 & Unit 2 Β· Simple language Β· Indian examples Β· Exam-ready
Basics of finance, scope of FM, objectives, principles, and the all-important Time Value of Money β explained simply with Indian examples.
Finance is simply about MONEY β how to get it, manage it, invest it, and use it wisely. Without money, a company cannot buy raw materials, pay salaries, or expand. Finance is the backbone of any organisation.
You earn βΉ50,000/month. You spend βΉ30,000 on expenses, save βΉ10,000 in FD, and invest βΉ10,000 in mutual funds. That's personal finance β deciding how to allocate money to meet your goals. The same idea scales up to giant corporations!
"Finance is the art and science of managing money." Involves raising, allocating, managing, and distributing money.
"Concerned with the acquisition, financing, and management of assets with some overall goal in mind."
"Management of the finances of a business enterprise in order to achieve the financial objectives of the enterprise."
Before launching Jio, Reliance had to: (1) Estimate funds needed (~βΉ1.5 lakh crore), (2) Decide how to raise it β internal profits, bank loans, bonds, (3) Decide where to invest β spectrum, towers, data centers, (4) Monitor returns β subscriber growth & revenue. All 4 steps = Financial Management.
Where to invest money? Also called Capital Budgeting. Evaluate projects using NPV, IRR, Payback Period. Invest only in value-creating projects.
From where to get money? Choose the best mix of equity, debt, and retained earnings β called the Capital Structure.
What to do with profits? How much to pay as dividend vs retain for future growth? Affects share price.
Investment: Should we build a new EV factory? (Evaluate NPV) β Financing: Raise βΉ2,000 crore via shares + bonds + bank loans β Dividend: Use this year's profits to pay shareholders or reinvest in R&D? All three decisions happen together!
| Basis | π Profit Maximization | π Wealth Maximization β |
|---|---|---|
| Time Value | Ignores β | Considers (discounts future cash) β |
| Risk | Ignores β | Considers (risky = lower value) β |
| Measurement | Ambiguous β which profit? β | Clear β share market price β |
| Time Horizon | Short-term β | Long-term β |
| Social Goals | Not considered β | Indirectly considered β |
In FY22, Zomato had a net LOSS of βΉ1,222 crore (negative profit!). Yet its market cap was βΉ50,000+ crore. Why? Because investors believed in future profit potential. Share price (= wealth) is based on expected future cash flows β not just today's profit. This proves Wealth Max > Profit Max!
In reality, managers don't maximize β they satisfice. They look for solutions that are "good enough." Why? Because:
Need βΉ100 crore loan. A maximizer would compare 50 banks for the absolute lowest rate. A satisficer gets offers from 3 banks, picks 9.5% (vs 9.8% and 10.5%), and proceeds β saving time and transaction costs. Satisficing is practical and often optimal.
This is the MOST IMPORTANT concept in all of finance. Simply put: βΉ1 today is worth MORE than βΉ1 in the future.
βΉ1 lakh today invested at 10% β βΉ1.1 lakh next year. Future money can't do this!
Movie ticket: βΉ50 in 2000 β βΉ400 in 2024. Same βΉ50 buys less in the future.
βΉ1 lakh today is certain. βΉ1 lakh promised 3 years later may never come. Certainty > uncertainty.
People prefer satisfaction TODAY. "Present bias" means we value present money more.
Future Value (FV) = PV Γ (1 + r)^n
Invest βΉ1,00,000 at 8% for 3 years. FV = 1,00,000 Γ (1.08)Β³ = 1,00,000 Γ 1.2597 = βΉ1,25,971. Your money grew by βΉ25,971!
Present Value (PV) = FV Γ· (1 + r)^n
You receive βΉ1,50,000 after 4 years. Discount rate = 10%. PV = 1,50,000 Γ· (1.10)β΄ = 1,50,000 Γ· 1.4641 = βΉ1,02,452. So βΉ1.5L in 4 years = only βΉ1.02L today!
FV of Annuity = A Γ [(1+r)^n β 1] Γ· r
Deposit βΉ10,000/year for 5 years at 8%. FV = 10,000 Γ [(1.08)β΅ β 1] Γ· 0.08 = 10,000 Γ 5.867 = βΉ58,666. You deposited only βΉ50,000 but get βΉ58,666 β extra βΉ8,666 is interest.
PV of Annuity = A Γ [1 β (1+r)^(βn)] Γ· r
Project gives βΉ20,000/year for 5 years. Discount rate = 10%. PV = 20,000 Γ [1 β (1.10)β»β΅] Γ· 0.10 = 20,000 Γ 3.791 = βΉ75,816. If project costs less than βΉ75,816 β good investment!
PV of Perpetuity = A Γ· r
Preference share pays βΉ500/year forever. Required return = 10%. PV = 500 Γ· 0.10 = βΉ5,000. Pay no more than βΉ5,000 for this share!
NPV = PV of Cash Inflows β Initial Investment
NPV > 0 β ACCEPT (project creates value) | NPV < 0 β REJECT (project destroys value) | NPV = 0 β Indifferent
Project cost = βΉ90,000. PV of all future cash flows = βΉ97,897. NPV = 97,897 β 90,000 = βΉ7,897 (Positive). Since NPV > 0 β ACCEPT. The project creates βΉ7,897 of value for shareholders!
Sources of Finance β Cost of each component β WACC β Operating & Financial Leverage β DCL. Full calculations with step-by-step examples.
Before studying the cost of capital, we must know where a company gets its money from. Every company needs funds for starting up, day-to-day operations, and future expansion.
For fixed assets: land, machinery, buildings. Examples: Equity shares, Debentures, Long-term bank loans, Retained earnings, Venture capital.
For semi-permanent assets. Examples: Term loans, Hire purchase, Leasing, NCDs (3β5 years), SIDBI/NABARD loans.
For working capital β raw materials, wages. Examples: Bank overdraft, Trade credit, Commercial paper, Factoring.
| Instrument | Who holds it? | Return | Risk Level | Tax on Return? |
|---|---|---|---|---|
| Equity Shares | Owners / Shareholders | Variable Dividend + Capital Gain | Highest π΄ | No deduction |
| Preference Shares | Preference Shareholders | Fixed Dividend | Medium π‘ | No deduction |
| Debentures/Bonds | Creditors/Lenders | Fixed Interest | Low π’ | β Tax deductible! |
| Retained Earnings | Company itself | Opportunity cost = Ke | No external risk | Already taxed profit |
Amul needs to pay βΉ50 crore to milk farmers every week. It uses a Bank Overdraft β draws more than available in account, repays once distributor collections come in. This is classic short-term working capital finance.
Cost of Capital = the minimum rate of return a company must earn on its investments to satisfy all its investors. It is the "price" paid for using capital.
You borrow βΉ10 lakh at 12%. If your business earns only 8%, you CANNOT pay back 12% interest. So 12% is your minimum β your cost of capital. Earn more than 12% β create value. Earn less β destroy value.
Interest on debt is tax-deductible. Government shares the interest burden through tax savings β debt is cheaper after tax.
Kd (After Tax) = Pre-tax rate Γ (1 β Tax Rate)
10% interest. Tax rate = 30%.3%. So government pays 3% of your interest!7%Preference dividends are NOT tax-deductible (paid from after-tax profit). So no tax adjustment here!
Kp (Irredeemable) = Annual Dividend Γ· Net Proceeds
Kp (Redeemable) = [Dp + (RVβNP)/n] Γ· [(RV+NP)/2]
βΉ99.47%Ke = (D1 Γ· P0) + g
D1=next dividend, P0=current price, g=growth rate
Ke = Rf + Ξ²(Rm β Rf)
Rf=risk-free rate, Ξ²=Beta, Rm=market return
Ke (Gordon) = (D1 Γ· P0) + g
βΉ31.80βΉ1,5008.12%Ke (CAPM) = Rf + Ξ² Γ (Rm β Rf)
6%11.8%22%Retained earnings are NOT free! They have an opportunity cost β if distributed as dividends, shareholders could invest elsewhere.
Kr = Ke Γ (1 β Personal Tax Rate on Dividends)
Kr = (D1 Γ· P0) + g [same as Ke but NO flotation cost]
WACC is the overall cost of capital β the weighted average of all financing sources. It is the minimum return the company must earn overall to satisfy ALL investors.
WACC = (WdΓKd) + (WpΓKp) + (WeΓKe) + (WrΓKr)
5.2%| Source | Amount (βΉL) | Weight | Cost | Weighted Cost |
|---|---|---|---|---|
| Equity Shares | 40 | 0.40 | 14.00% | 5.60% |
| Retained Earnings | 10 | 0.10 | 12.00% | 1.20% |
| Preference Shares (10%) | 20 | 0.20 | 10.50% | 2.10% |
| Debentures (8%), Tax 35% | 30 | 0.30 | 5.20% | 1.56% |
| WACC = Sum of Weighted Costs | 10.46% | |||
The company must earn at least 10.46% on its total investments. Any project returning more than 10.46% adds value. Any project returning less destroys value.
Leverage = using fixed costs to magnify returns to equity shareholders. Like a lever in physics β small input creates large output. But it magnifies LOSSES too!
Option A (No Leverage): Pay βΉ50L cash for a house. House price rises to βΉ60L β gain βΉ10L on βΉ50L = 20% return.
Option B (With Leverage): Pay βΉ10L own + βΉ40L loan. Same house rises to βΉ60L β gain βΉ10L on βΉ10L own money = 100% return!
This is the MAGIC of leverage. Same gain β but 5Γ higher return on YOUR money.
Combined Leverage = Operating Leverage Γ Financial Leverage (Sales β EPS directly)
Operating Leverage comes from fixed operating costs (rent, depreciation, permanent salaries). When sales increase, fixed costs stay same β EBIT grows FASTER than sales.
DOL = Contribution Γ· EBITContribution = Sales β Variable CostsEBIT = Contribution β Fixed CostsβΉ4LβΉ2L2IndiGo has huge fixed costs β aircraft leases, airport fees, permanent crew salaries. These costs exist whether planes are full or half-empty. When flights fill up, profit explodes (high DOL). During COVID, flights stopped β SAME fixed costs continued β massive losses. This is the double-edged sword of high operating leverage.
Financial Leverage comes from fixed financial costs (interest on debt, preference dividends). When EBIT increases, interest stays fixed β EPS grows FASTER than EBIT.
DFL = EBIT Γ· EBT [when no preference dividend]DFL = EBIT Γ· (EBIT β Interest β Pd/(1βT))βΉ3L1.67Using borrowed funds to earn more than the interest cost β surplus goes to equity shareholders, magnifying their returns.
Same EBIT, but debt financing gives equity shareholders 50% higher EPS! That's Trading on Equity.
Combined = Operating Γ Financial. Shows the TOTAL effect on EPS for a change in SALES.
DCL = DOL Γ DFLDCL = Contribution Γ· EBT% Change in EPS = DCL Γ % Change in SalesGiven: Selling Price = βΉ100/unit, Variable Cost = βΉ60/unit, Units Sold = 5,000, Fixed Operating Costs = βΉ1,20,000, Interest = βΉ40,000, Tax = 40%
βΉ5,00,000βΉ3,00,000βΉ2,00,000βΉ80,000βΉ40,0002.52.05.0| Basis | Operating Leverage | Financial Leverage | Combined |
|---|---|---|---|
| Fixed Cost | Fixed Operating Costs | Interest / Pref. Dividend | Both |
| Measures | EBIT sensitivity to Sales | EPS sensitivity to EBIT | EPS sensitivity to Sales |
| Formula | Contribution Γ· EBIT | EBIT Γ· EBT | DOL Γ DFL |
| Risk Type | Business Risk | Financial Risk | Total Risk |
| Indian Example | Airlines, Hotels, Pharma | Real Estate, Infrastructure | SpiceJet β both high! |
FV = PV Γ (1+r)^n
PV = FV Γ· (1+r)^n
FV Annuity = AΓ[(1+r)^nβ1]Γ·r
PV Annuity = AΓ[1β(1+r)^βn]Γ·r
PV Perpetuity = A Γ· r
NPV = PV Inflows β Investment
Kd = Rate Γ (1 β Tax)
Kp = Dp Γ· NP
Ke (Gordon) = D1/P0 + g
Ke (CAPM) = Rf + Ξ²(RmβRf)
Kr β Ke (no flotation cost)
Ranking: Kd < Kp < Kr < Ke
WACC = Ξ£(Weight Γ Cost)
Use after-tax Kd in WACC
Market value weights preferred
WACC = Hurdle Rate for projects
Project return > WACC β Accept
Project return < WACC β Reject
DOL = Contribution Γ· EBIT
DFL = EBIT Γ· EBT
DCL = DOL Γ DFL
DCL = Contribution Γ· EBT
%ΞEBIT = DOL Γ %ΞSales
%ΞEPS = DCL Γ %ΞSales
Goal = Wealth Maximization
(NOT profit maximization)
Satisficing = "good enough"
(Herbert Simon β Bounded Rationality)
Agency Problem = Mgr vs Owner
Solved by ESOPs, Bonuses
Khan & Jain β FM definitions
Prasanna Chandra β Cost of Capital
I.M. Pandey β Leverage, FM
Brealey & Myers β CAPM, Principles
Ezra Solomon β Wealth Max goal
Herbert Simon β Satisficing
1οΈβ£ WACC calculation (always with a table β 10 marks) | 2οΈβ£ Profit Max vs Wealth Max (comparison β 5 marks) | 3οΈβ£ DOL + DFL + DCL from one income statement β 10 marks | 4οΈβ£ TVM β Present/Future Value (4β6 marks) | 5οΈβ£ CAPM vs Gordon's Model for cost of equity (5 marks)