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Semester 3: Financial Management
Meaning, objectives and Importance of Finance, Sources of finance, Functions of financial management, Role of financial manager
Financial Management
Meaning of Finance
Finance refers to the management of monetary resources, including the raising, allocation, and management of cash and investments. It encompasses various activities such as budgeting, forecasting, and investing to achieve financial goals.
Objectives of Finance
The main objectives of finance include maximizing shareholder wealth, ensuring liquidity, achieving financial stability, and supporting business growth. The efficient use of financial resources is vital for sustainability and profitability.
Importance of Finance
Finance plays a critical role in business operations, aiding in decision-making, investment planning, and risk management. It ensures that the enterprise can meet its operational and strategic goals.
Sources of Finance
Sources of finance can be classified into internal and external sources. Internal sources include retained earnings, while external sources encompass loans, equity financing, and grants. Each source has its own implications for control and risk.
Functions of Financial Management
The main functions of financial management include financial planning, investment management, risk management, and performance evaluation. These functions ensure effective allocation and management of resources.
Role of Financial Manager
The financial manager oversees the organization's financial health. Responsibilities include financial analysis, budgeting, forecasting, risk assessment, and guiding investment decisions. A financial manager plays a vital role in aligning financial strategies with the overall goals of the organization.
Capital structures planning: Factors affecting capital structures, Determining Debt and Equity proportion, Theories of capital structures, Leverage concept, Cost of capital (equity, preference share, debt, retained earnings), Weighted Average or Composite cost of capital (WACC)
Capital structures planning
Factors affecting capital structures
Key factors include business risk, financial flexibility, tax considerations, market conditions, and the overall capital market environment.
Determining Debt and Equity proportion
Capital structure is determined by analyzing the trade-off between the cost of debt versus equity and the company's risk profile, growth prospects, and shareholder expectations.
Theories of capital structures
Various theories exist such as Modigliani-Miller theorem, Trade-off theory, Pecking order theory, and Market timing theory, each providing different insights into capital structure decisions.
Leverage concept
Leverage refers to the use of debt to acquire additional assets. It can amplify returns but also increases risk. Types include operating leverage and financial leverage.
Cost of capital
Includes the cost of equity, preference shares, debt, and retained earnings. Each component has its own method of calculation and influences decisions on financing.
Weighted Average or Composite cost of capital (WACC)
WACC represents the average rate of return a company is expected to pay to its security holders to finance its assets. It is a crucial factor in investment decisions and capital structure assessment.
Capital Budgeting: ARR, Payback period, Net present value, IRR, Capital rationing, simple problems on capital budgeting methods
Capital Budgeting
Average Rate of Return (ARR)
ARR is a financial metric used to evaluate the profitability of an investment. It is calculated by dividing the average annual profit by the initial investment. It helps investors understand how much return they can expect relative to their investment.
Payback Period
The Payback Period is the time it takes for an investment to generate an amount of income equal to the cost of the investment. It is a simple metric that helps assess risk by determining how quickly an investment can recover its costs.
Net Present Value (NPV)
NPV is the difference between the present value of cash inflows and outflows over a period of time. A positive NPV indicates that the projected earnings (in present dollars) exceed the anticipated costs, which suggests that the investment may be worthwhile.
Internal Rate of Return (IRR)
IRR is the discount rate at which the net present value of an investment equals zero. It is used to compare the profitability of different investments. A higher IRR indicates a more attractive investment opportunity.
Capital Rationing
Capital Rationing refers to the limitation of available funds for investment projects, necessitating the selection of the most beneficial projects. This often involves prioritizing projects based on their returns and risks due to limited resources.
Simple Problems on Capital Budgeting Methods
Example problems involve calculating ARR, Payback Period, NPV, and IRR for hypothetical investments to illustrate the application of these methods. Problems often include projects with various cash inflows over time, allowing for comparison of methods.
Dividend policies: Factors affecting dividend payment, Company Law provision on dividend payment, Various Dividend Models (Walter‘s, Gordon‘s, M.M. Hypothesis)
Dividend policies
Factors affecting dividend payment
Factors such as company's earning stability, cash flow situation, retained earnings, taxation policy, access to capital markets, and shareholder expectations influence a company's dividend decisions. Moreover, the company's current and future projects can determine how much capital will be retained.
Company Law provision on dividend payment
Company law typically requires that dividends can only be paid out of profits. The legal framework ensures that companies maintain a certain level of reserves and do not distribute dividends that may compromise their financial stability.
Walter's Model
Walter's model posits that the value of a firm is affected by its dividend policy. The model suggests that the internal rate of return (IRR) and cost of equity should dictate the dividend payout. It argues that firms with high IRR should pay higher dividends.
Gordon's Model
Gordon's model, or the Gordon Growth Model, states that the price of a stock is equal to the sum of future dividends discounted back to their present value. The model implies that a company with a steady dividend growth rate will have a stable stock price.
M.M. Hypothesis
The Modigliani-Miller hypothesis claims that in a perfect market, dividend policy does not affect the firm's value. They assert that investors are indifferent to dividend payouts as they can create their own cash flow by selling shares if needed.
Working capital: Components, operating cycle, Factors influencing working capital, Determining or Forecasting working capital requirements
Working capital
Components of Working Capital
Working capital is the difference between current assets and current liabilities. Key components include cash, accounts receivable, inventory, and accounts payable. Each component plays a crucial role in maintaining the liquidity of a business.
Operating Cycle
The operating cycle represents the time taken from the purchase of inventory to the collection of cash from sales. It includes the inventory period and the receivables period. A shorter operating cycle indicates more efficient management of working capital.
Factors Influencing Working Capital
Several factors influence working capital management, including the nature of the business, sales volume, credit policy, seasonality, and operational efficiency. Businesses must consider these factors to ensure optimal working capital.
Determining or Forecasting Working Capital Requirements
Forecasting working capital needs involves estimating future sales, collecting historical data, and considering market trends. Businesses often use financial ratios, cash flow projections, and inventory turnover rates for accurate forecasting.
