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Financial Management 14MBA22

Subject Code: 14MBA22 IA Marks: 50


Total Number of Lecture Hours: 56 Exam Hours: 03
No. of Lecture Hours / Week: 04 Exam Marks: 100
Practical Component: 01 Hour / Week

Syllabus
Module 1: (10 Hours)
Financial management – Introduction to financial management, objectives of financial
management – profit maximization and wealth maximization. Changing role of finance managers.
Interface of Financial Management with other functional areas.
Indian financial system – Primary market, Secondary market – stocks & commodities market,
Money market, Forex markets. (Theory Only)
Sources of Financing: Shares, Debentures, Term loans, Lease financing, Hybrid financing,
Venture Capital, Angel investing and private equity, Warrants and convertibles (Theory only)

Module 2: (10 Hours)


Time value of money –Future value of single cash flow & annuity, present value of single cash
flow, annuity & perpetuity. Simple interest & Compound interest, Capital recovery & loan
amortization.

Module 3: (8 Hours)
Cost of Capital Cost of capital – basic concepts. Cost of debenture capital, cost of preferential
capital, cost of term loans, cost of equity capital (Dividend discounting and CAPM model). Cost
of retained earnings. Determination of Weighted average cost of capital (WACC) and Marginal
cost of capital.

Module 4: (10 Hours)


Investment decisions -– Investment evaluation techniques – Net present value, Internal rate of
return, Modified internal rate of return, Profitability index, Payback period, discounted payback
period, accounting rate of return. Estimation of cash flow for new project, replacement projects.

Module 5: (6 Hours)
Working capital management – Factors influencing working capital requirements. Current asset
policy and current asset finance policy. Determination of operating cycle and cash cycle.
Estimation of working capital requirements of a firm (Does not include Cash, Inventory &
Receivables Management)

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Financial Management 14MBA22

Module 6: (8 Hours)

Capital structure and dividend decisions – Planning the capital structure. (No capital structure
theories to be covered) Leverages – Determination of operating leverage, financial leverage and
total leverage. Dividend policy – Factors affecting the dividend policy - dividend policies- stable
dividend, stable payout. (No dividend theories to be covered).

Module 7: (4 Hours)

Emerging Issues in Financial management: Derivatives, Mergers and Acquisitions, Behavioral


Finance, Financial Modelling, Financial engineering, risk management. (Theory only).

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Table of content
Modules Content Page
Numbers

1 Introduction to Financial 4-18


management

2 Time value of money 19-23

3 Cost of Capital 24-29

4 Investment decisions 30-32

5 Working capital management 33-43

6 Capital structure and dividend 44-49


decisions

7 Emerging Issues in Financial 50-53


management:

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Financial Management 14MBA22

Module 1
Financial management
Introduction to Financial Management

Meaning of Financial Management

Financial Management means planning, organizing, directing and controlling the financial
activities such as procurement and utilization of funds of the enterprise. It means applying general
management principles to financial resources of the enterprise.

Scope/Elements

1. Investment decisions includes investment in fixed assets (called as capital budgeting).


Investment in current assets are also a part of investment decisions called as working capital
decisions.

2. Financial decisions - They relate to the raising of finance from various resources which will
depend upon decision on type of source, period of financing, cost of financing and the returns
thereby.

Dividend decision - The finance manager has to take decision with regards to the net profit
distribution. Net profits are generally divided into two:

a. Dividend for shareholders- Dividend and the rate of it has to be decided.

b. Retained profits- Amount of retained profits has to be finalized which will depend upon
expansion and diversification plans of the enterprise.

Objectives of Financial Management

The financial management is generally concerned with procurement, allocation and control of
financial resources of a concern. The objectives can be-

1. To ensure regular and adequate supply of funds to the concern.

2. To ensure adequate returns to the shareholders this will depend upon the earning capacity,
market price of the share, expectations of the shareholders.

3. To ensure optimum funds utilization. Once the funds are procured, they should be utilized in
maximum possible way at least cost.

4. To ensure safety on investment, i.e, funds should be invested in safe ventures so that adequate
rate of return can be achieved.

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5. To plan a sound capital structure-There should be sound and fair composition of capital so that
a balance is maintained between debt and equity capital.

Functions of Financial Management

1. Estimation of capital requirements: A finance manager has to make estimation with regards to
capital requirements of the company. This will depend upon expected costs and profits and future
programmers and policies of a concern. Estimations have to be made in an adequate manner which
increases earning capacity of enterprise.

2. Determination of capital composition: Once the estimation have been made, the capital structure
have to be decided. This involves short- term and long- term debt equity analysis. This will depend
upon the proportion of equity capital a company is possessing and additional funds which have to
be raised from outside parties.

3. Choice of sources of funds: For additional funds to be procured, a company has many choices
like-

a. Issue of shares and debentures

b. Loans to be taken from banks and financial institutions

c. Public deposits to be drawn like in form of bonds.

Choice of factor will depend on relative merits and demerits of each source and period of financing.

4. Investment of funds: The finance manager has to decide to allocate funds into profitable ventures
so that there is safety on investment and regular returns is possible.

5. Disposal of surplus: The net profits decision have to be made by the finance manager. This can
be done in two ways:

a. Dividend declaration - It includes identifying the rate of dividends and other benefits like bonus.

b. Retained profits - The volume has to be decided which will depend upon expansion,
innovational, diversification plans of the company.

6. Management of cash: Finance manager has to make decisions with regards to cash management.
Cash is required for many purposes like payment of wages and salaries, payment of electricity and
water bills, payment to creditors, meeting current liabilities, maintenance of enough stock,
purchase of raw materials, etc.

7. Financial controls: The finance manager has not only to plan, procure and utilize the funds but
he also has to exercise control over finances. This can be done through many techniques like ratio
analysis, financial forecasting, cost and profit control, etc.

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Role of a Financial Manager

Financial activities of a firm is one of the most important and complex activities of a firm.
Therefore in order to take care of these activities a financial manager performs all the requisite
financial activities. A financial manager is a person who takes care of all the important financial
functions of an organization. The person in charge should maintain a far sightedness in order to
ensure that the funds are utilized in the most efficient manner. His actions directly affect the
Profitability, growth and goodwill of the firm.

Following are the main functions of a Financial Manager:

1. Raising of Funds In order to meet the obligation of the business it is important to have enough
cash and liquidity. A firm can raise funds by the way of equity and debt. It is the responsibility of
a financial manager to decide the ratio between debt and equity. It is important to maintain a good
balance between equity and debt.

2. Allocation of Funds Once the funds are raised through different channels the next important
function is to allocate the funds. The funds should be allocated in such a manner that they are
optimally used. In order to allocate funds in the best possible manner the following point must be
considered

its growth capability

term

These financial decisions directly and indirectly influence other managerial activities. Hence
formation of a good asset mix and proper allocation of funds is one of the most important
activities.

3. Profit Planning Profit earning is one of the prime functions of any business organization. Profit
earning is important for survival and sustenance of any organization. Profit planning refers to
proper usage of the profit generated by the firm. Profit arises due to many factors such as pricing,
industry competition, state of the economy, mechanism of demand and supply, cost and output. A
healthy mix of variable and fixed factors of production can lead to an increase in the profitability
of the firm. Fixed costs are incurred by the use of fixed factors of production such as land and
machinery. In order to maintain a tandem it is important to continuously value the depreciation
cost of fixed cost of production. An opportunity cost must be calculated in order to replace those
factors of production which has gone thrown wear and tear. If this is not noted then these fixed
cost can cause huge fluctuations in profit.

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4. Understanding Capital Markets Shares of a company are traded on stock exchange and there is
a continuous sale and purchase of securities. Hence a clear understanding of capital market is an
important function of a financial manager. When securities are traded on stock market there
involves a huge amount of risk involved. Therefore a financial manger understands and calculates
the risk involved in this trading of shares and debentures. Its on the discretion of a financial
manager as to how distribute the profits. Many investors do not like the firm to distribute the profits
amongst shareholders as dividend instead invest in the business itself to enhance growth. The
practices of a financial manager directly impact the operation in capital market.

Financial Goals

 Profit maximization (profit after tax)


 Maximizing Earnings per Share
 Shareholder’s Wealth Maximization

Profit Maximization

 Maximizing the Rupee Income of Firm o Resources are efficiently utilized o


Appropriate measure of firm performance o Serves interest of society also

Objections to Profit Maximization

 It is Vague o It Ignores the Timing of Returns o It Ignores Risk o Assumes Perfect


Competition o In new business environment profit maximization is regarded as
Unrealistic, Difficult, Inappropriate ,Immoral

Maximizing EPS

EPS will not result in highest price


for company's shares

be invested at positive rate of return—such a policy may not always work

Shareholders’ Wealth Maximization

maximizes the net present value of a course of action to shareholders.

—maximize the market value of the firm’s shares.

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Risk-return Trade-off

 Risk and expected return move in tandem; the greater the risk, the greater the expected
return.
 Financial decisions of the firm are guided by the risk-return trade-off.
 The return and risk relationship: Return = Risk-free rate + Risk premium o Risk-free
rate is a compensation for time and risk premium for risk.

Managers versus Shareholders’ Goals

-holders, consumers, suppliers,


government and society.

stakeholders’ view of managers’ role may compromise with the objective of SWM.

and create satisfactory wealth for shareholders than the maximum.

to maximize shareholders’ wealth. Such ―satisfying‖ behaviour of managers will frustrate the
objective of SWM as a normative guide.

Financial Goals and Firm’s Mission and Objectives

operational terms, they


focus on the satisfaction of its customers through the production of goods and services needed by
them

rather than an objective or a


goal.

-level criterion ensuring that the decision


meets the minimum standard of the economic performance.

-making, the judgement of management plays the crucial role. The wealth
maximization criterion would simply indicate whether an action is economically viable or not.

Organisation of the Finance Functions

placing the finance functions in the hands of top management

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 Financial decisions are crucial for the survival of the firm.


 The financial actions determine solvency of the firm
 Centralisation of the finance functions can result in a number of economies to the firm.

Changing Role of Finance Manager in India

New role of finance manager

- he is in the main line

Interface of Financial Management with other functional areas

Marketing-Finance Interface
There are many decisions, which the Marketing Manager takes which have a significant location,
etc. In all these matters assessment of financial implications is inescapable impact on the
profitability of the firm. For example, he should have a clear understanding of the impact the credit
extended to the customers is going to have on the profits of the company. Otherwise in his
eagerness to meet the sales targets he is liable to extend liberal terms of credit, which is likely to
put the profit plans out of gear. Similarly, he should weigh the benefits of keeping a large inventory
of finished goods in anticipation of sales against the costs of maintaining that inventory. Other key
decisions of the Marketing Manager, which have financial implications, are:

 Pricing
 Product promotion and advertisement
 Choice of product mix
 Distribution policy.

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Economics – Finance Interface


The field of finance is closely related to economics. Financial managers must understand the
economic framework and be alert to the consequences of varying levels of economic activity and
changes in economic policy. They must also be able to use economic theories as guidelines for
efficient business operation. The primary economic principle used in managerial finance is
marginal analysis, the principle that financial decisions should be made and actions taken only
when the added benefits exceed the added costs. Nearly all-financial decisions ultimately come
down to an assessment of their marginal benefits and marginal costs.

Accounting – Finance Interface


The firm’s finance (treasurer) and accounting (controller) activities are typically within the control
of the financial vice president (CFO). These functions are closely related and generally overlap;
indeed, managerial finance and accounting are often not easily distinguishable. In small firms the
controller often carries out the finance function, and in large firms many accountants are closely
involved in various finance activities. However, there are two basic differences between finance
and accounting; one relates to the emphasis on cash flows and the other to decision making.

INDIAN FINANCIAL SYSTEM

The economic development of a nation is reflected by the progress of the various economic units,
broadly classified into corporate sector, government and household sector. While performing their
activities these units will be placed in a surplus/deficit/balanced budgetary situations.

There are areas or people with surplus funds and there are those with a deficit. A financial system
or financial sector functions as an intermediary and facilitates the flow of funds from the areas of
surplus to the areas of deficit. A Financial System is a composition of various institutions, markets,
regulations and laws, practices, money manager, analysts, transactions and claims and liabilities.

Financial System;

The word "system", in the term "financial system", implies a set of complex and closely connected
or interlined institutions, agents, practices, markets, transactions, claims, and liabilities in the
economy. The financial system is concerned about money, credit and finance-the three terms are
intimately related yet are somewhat different from each other. Indian financial system consists of
financial market, financial instruments and financial intermediation. These are briefly discussed
below;

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Constituents of a Financial System

Markets

In economics, a financial market is a mechanism that allows people to buy and sell (trade) financial
securities (such as stocks and bonds), commodities (such as precious metals or agricultural goods),
and other fungible items of value at low transaction costs and at prices that reflect the efficient-
market hypothesis. In finance, financial markets facilitate:

Capital Market

A capital market is a market for securities (debt or equity), where business enterprises (companies)
and governments can raise long-term funds. It is defined as a market in which money is provided
for periods longer than a year, as the raising of short-term funds takes place on other markets (e.g.,
the money market). The capital market includes the stock market (equity securities) and the bond
market (debt).

Financial regulators, such as the UK's Financial Services Authority (FSA) or the U.S. Securities
and Exchange Commission (SEC), oversee the capital markets in their designated jurisdictions to
ensure that investors are protected against fraud, among other duties. In India SEBI does the similar
role. Capital markets may be classified as primary markets and secondary markets

a) Primary Market: The primary market is that part of the capital markets that deals with the
issuance of new securities. Companies, governments or public sector institutions can obtain
funding through the sale of a new stock or bond issue. This is typically done through a syndicate
of securities dealers. The process of selling new issues to investors is called underwriting. In the
case of a new stock issue, this sale is an initial public offering (IPO). Dealers earn a commission
that is built into the price of the security offering, though it can be found in the prospectus. Primary
markets create long term instruments through which corporate entities borrow from capital market.

Features of primary markets are:

 This is the market for new long term equity capital. The primary market is the market
where the securities are sold for the first time. Therefore it is also called the new issue
market (NIM).
 In a primary issue, the securities are issued by the company directly to investors.
 The company receives the money and issues new security certificates to the investors.
 Primary issues are used by companies for the purpose of setting up new business or for
expanding or modernizing the existing business.
 The primary market performs the crucial function of facilitating capital formation in the
economy.

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 The new issue market does not include certain other sources of new long term external
finance, such as loans from financial institutions. Borrowers in the new issue market may
be raising capital for converting private capital into public capital; this is known as
"going public."

Methods of Issuing Securities in the Primary Market:

There are three methods through which securities can be issued in the primary market:

 Rights Issue,
 Initial Public Offer (IPO), and
 Preferential issue.

Secondary Market:

The secondary market, also called aftermarket, is the financial market where previously issued
securities and financial instruments such as stock, bonds, options, and futures are bought and sold.
In the secondary market, securities are sold by and transferred from one investor to another. It is
therefore important that the secondary market be highly liquid (originally, the only way to create
this liquidity was for investors and speculators to meet at a fixed place regularly; this is how stock
exchanges originated).

The secondary market for a variety of assets can vary from loans to stocks, from fragmented to
centralized, and from illiquid to very liquid. The major stock exchanges are the most visible
example of liquid secondary markets - in this case, for stocks of publicly traded companies.
Exchanges such as the BSE, NYSE and NASDAQ provide a centralized, liquid secondary market
for the investors who own stocks that trade on those exchanges .

Commodity market refers to markets that trade in primary rather than manufactured
products. Soft commodities are agricultural products such as wheat, coffee,cocoa and sugar. Hard
commodities are mined, such as (gold, rubber and oil). Investors access about 50 major commodity
markets worldwide with purely financial transactions increasingly outnumbering physical trades
in which goods are delivered. Futures contracts are the oldest way of investing in commodities.
Futures are secured by physical assets. Commodity markets can include physical trading and
derivatives trading using spot prices, forwards, futures, and optionson futures. Farmers have used
a simple form of derivative trading in the commodity market for centuries for price risk
management.
Money Markets : The money market is a component of the financial markets for assets involved
in short-term borrowing and lending with original maturities of one year or shorter time frames.
Trading in the money markets involves Treasury bills, commercial paper, bankers' acceptances,

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certificates of deposit, federal funds, and short-lived mortgage- and asset-backed securities. It
provides liquidity funding for the global financial system. Types of Money Market Instruments in
India Money market instruments provide for borrowers' short-term needs and gives needed
liquidity to lenders. The types of money market instruments are treasury bills, repurchase
agreements, commercial papers, certificate of deposit, and bankers acceptance.

a) Treasury Bills (T-Bills): Treasury bills began being issued by the Indian government in 1917.
They are short-term instruments issued by the Reserve Bank of India. They are one of the safest
money market instruments because they are risk free, but the returns from this instrument are not
very large. The primary as well as the secondary markets circulates this instrument. They have 3-
month, 6-month and 1-year maturity periods. T-bills are issued with a separate price from their
face value. The face value is achieved upon maturity, as is the interest earned on the buy value.
The buy value is set by a bidding process in auctions.

b) Repurchase Agreements: Repurchase agreements are also known as repos. They are short-term
loans that buyers and sellers agree to sell and repurchase. As of 1992, repo transactions are allowed
only between RBI-approved securities such as state and central government securities, T-bills,
PSU bonds, FI bonds and corporate bonds. Repurchase agreements are sold by sellers with a
promise of purchasing them back at a given price and on a given date in the future. The buyer will
also purchase the securities and other instruments in the repurchase agreement with a promise of
selling them back to the seller.

c) Commercial Papers: Commercial papers are promissory notes that are unsecured and issued by
companies and financial institutions. They are issued at a discounted rate of their face value. They
have a fixed maturity of 1 to 270 days. They are issued for financing of inventories, accounts
receivables, and settling short-term liabilities or loans. Commercial papers yield higher returns
than T- bills. They are usually issued by companies with strong credit ratings, as these instruments
are not backed by collateral. They are usually issued by corporations to raise working capital and
are actively traded in the secondary market. Commercial papers were first issued in the Indian
money market in 1990.

d) Certificate of Deposit: A certificate or deposit is a short-term borrowing note, like a promissory


note, in the form of a certificate. It enables the bearer to receive interest. It has a maturity date, a
fixed rate of interest and a fixed value. It usually has a term between 3 months and 5 years. The
funds cannot be withdrawn on demand, but it can be liquidated on payment of a penalty. The
returns are higher than T- bills as the risk is higher. Returns are based on an annual percentage
yield (APY) or annual percentage rate (APR). In APY, interest is gained by compounded interest
calculation, whereas in APR simple interest calculation is done to calculate the return. The
certificate of deposit was first introduced to the money market of India in 1989.

e) Banker's Acceptance: A banker's acceptance is a short-term investment plan created by a


company or firm with a guarantee from a bank. It is a guarantee from the bank that a buyer will

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pay the seller at a future date. A good credit rating is required by the company or firm drawing the
bill. The terms for these instruments are usually 90 days, but this period can vary between 30 and
180 days. Companies use the acceptance as a time draft for financing imports, exports and other
trade .

Foreign exchange market

The foreign exchange market (forex, FX, or currency market) is a global decentralized market for
the trading of currencies. The main participants in this market are the larger international banks.
Financial centers around the world function as anchors of trading between a wide range of different
types of buyers and sellers around the clock, with the exception of weekends. Electronic Broking
Services (EBS) and Reuters 3000 Xtraare two main interbank FX trading platforms. The foreign
exchange market determines the relative values of different currencies.
The foreign exchange market works through financial institutions, and it operates on several levels.
Behind the scenes banks turn to a smaller number of financial firms known as “dealers,” who are
actively involved in large quantities of foreign exchange trading. Most foreign exchange dealers
are banks, so this behind-the-scenes market is sometimes called the “interbank market”, although
a few insurance companies and other kinds of financial firms are involved. Trades between foreign
exchange dealers can be very large, involving hundreds of millions of dollars. Because of the
sovereignty issue when involving two currencies, Forex has little (if any) supervisory entity
regulating its actions.
The foreign exchange market assists international trade and investment by enabling currency
conversion. For example, it permits a business in the United States to import goods from
the European Union member states, especially Eurozone members, and pay euros, even though its
income is in United States dollars. It also supports direct speculation in the value of currencies,
and the carry trade, speculation based on the interest rate differential between two currencies

HYBRID FINANCING

It can be defined as a combined face of equity and debt. This means that the characteristics of both
equity and bond can be found in Hybrid Financing. Financial instruments that carry both
characteristics of common stock and Long Term debt.

. There is a future common stock


conversion

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HYBRID FINANCING INCLUDES

hybrid financing form

WARRANTS

A warrant is a certificate issued by a company which gives the warrant holder the right to buy a
stated number of 'shares of the company's stock at a specified price for some specified length of
time.

• Such warrants are called long-term call options, because they offer investors the opportunity to
buy the firm's common stock at a fixed price, regardless of how high the stock may climb.

• This option offsets a low interest rate on a bond and can make a low-yield bond/warrant package
more appealing to investors.

• In the case that the price of the security rises to above that of the warrant's exercise price, then
the investor can buy the security at the warrant's exercise price and resell it for a profit.

• Otherwise, the warrant will simply expire or remain unused.

• Warrants are listed on options exchanges and trade independently of the security with which it
was issued.

CONVERTIBLES

• Convertible notes, which may be converted to ordinary shares.

• Both preferred stock and bonds that under certain conditions can be exchanged in common stock

• Conversion ratio; number of common shares received for a bond/preferred stock

• The conversion price is typically 20-30% above the market price at issue (as the warrant)

• If the common stock will be traded below conversion level the conversion level will be adjusted
(legal)

• If the stock follow a stock split all calculations will be adjusted accordingly…

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PRIVATE EQUITY

• Private equity - Money invested in firms which have not 'gone public' and therefore are not listed
on any stock exchange.

• Private equity is highly illiquid because sellers of private stocks (called private securities) must
first locate willing buyers.

• Investors in private equity are generally compensated when: – (1) the firm goes public, – (2) it
is sold or merges with another firm, or – (3) it is recapitalized

VENTURE FUNDS

• Venture capital (VC) is funding invested, or available for investment, in an enterprise that offers
the probability of profit along with the possibility of loss.

• Indeed, venture capital was once known also as risk capital, but that term has fallen out of usage,
probably because investors don't like to see the words "risk" and "capital" in close conjunction.

• Venture capitalists often don't tend to think that their investments involve an element of risk, but
are assured a successful return by virtue of the investor's knowledge and business sense.

ANGEL FINANCING

• An angel investor or angel (also known as a business angel or informal investor) is an affluent
individual who provides capital for a business start-up, usually in exchange for convertible debt or
ownership equity.

• A small but increasing number of angel investors organize themselves into angel groups or angel
networks to share research and pool their investment capital.

Term loans

institution

principal and interest are paid off in installments over life of loan)

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Bond

- government, public sector enterprises


and financial institutions.

Various features of a bond are:


interest rate is generally fixed

Some of the types of bonds that a company can issue are:

redeemable bonds

Lease Financing

• Many businesses lease assets as an alternative to owning them. – Business has the use of the asset
and incurs an obligation either to pay off loan or meet monthly lease payment. – At the end of
lease term, residual value of asset belongs to lessee. – Leasing is a form of debt financing. • FASB
13 (governing lease accounting): defines difference between capital lease and operating lease

Capital leases meet any one of these four conditions: – Title is transferred to lessee at end of lease
term. – Lease contains bargain purchase option (an option to buy asset at very low price). – Term
of lease is greater than or equal to 75% of estimated economic life of asset. Present value of
minimum lease payment is greater than or equal to 90% of fair value of leased property

Capital lease on balance sheet: – Asset: ―capital lease asset‖ – Liability: ―obligation under
capital lease‖ – Amount of asset and liability equals present value of minimum future lease
payments • Leasing does not provide source of off-balance-sheet financing • Operating leases –
More like true rentals rather than means to finance long-term use of asset – For substantially less
than expected useful life of asset and provide for both financing and maintenance – Contain
cancellation clauses so that lessee is not locked into long-term agreement. – No asset and
associated liability are created • Tax benefits are the major motivation that firms prefer leasing to
owning.

– Lessor is entitled to tax benefits from depreciation. – Lessor’s after-tax return is higher than it
would be under straight debt arrangement. – Lessor prices lease payments at lower rate of return
than would otherwise be charged the lessee on straight loan arrangement. – Equity Shares

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Common stock or ordinary shares are most commonly known as equity shares.

any divided into small units of equal value.

 Capital appreciation
 Limited liability
 Hedge against inflation

Preference Stock

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Module 2
Time value of money
Time Value of Money

Introduction

Time Value of Money (TVM) is an important concept in financial management. It can be used to
compare investment alternatives and to solve problems involving loans, mortgages, leases,
savings, and annuities.

TVM is based on the concept that a dollar that you have today is worth more than the promise or
expectation that you will receive a dollar in the future. Money that you hold today is worth more
because you can invest it and earn interest. After all, you should receive some compensation for
foregoing spending. For instance, you can invest your dollar for one year at a 6% annual interest
rate and accumulate $1.06 at the end of the year. You can say that the future value of the dollar is
$1.06 given a 6% interest rate and a one-year period. It follows that the present value of the $1.06
you expect to receive in one year is only $1.

A key concept of TVM is that a single sum of money or a series of equal, evenly-spaced payments
or receipts promised in the future can be converted to an equivalent value today. Conversely, you
can determine the value to which a single sum or a series of future payments will grow to at some
future date.

Interest

Interest is the cost of borrowing money. An interest rate is the cost stated as a percent of the
amount borrowed per period of time, usually one year. The prevailing market rate is composed of:

1. The Real Rate of Interest that compensates lenders for postponing their own spending during
the term of the loan.

2. An Inflation Premium to offset the possibility that inflation may erode the value of the money
during the term of the loan. A unit of money (dollar, peso, etc) will purchase progressively fewer
goods and services during a period of inflation, so the lender must increase the interest rate to
compensate for that loss.

3. Various Risk Premiums to compensate the lender for risky loans such as those that are
unsecured, made to borrowers with questionable credit ratings, or illiquid loans that the lender may
not be able to readily resell.

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Present Value

Present Value of a Single Amount

Present Value is an amount today that is equivalent to a future payment, or series of payments, that
has been discounted by an appropriate interest rate. Since money has time value, the present value
of a promised future amount is worth less the longer you have to wait to receive it. The difference
between the two depends on the number of compounding periods involved and the interest
(discount) rate.

The relationship between the present value and future value can be expressed as:

PV = FV [ 1 / (1 + i)n ]

Where:

PV = Present Value

FV = Future Value

i = Interest Rate per Period

n = Number of Compounding Periods

Present Value of Annuities

An annuity is a series of equal payments or receipts that occur at evenly spaced intervals. Leases
and rental payments are examples. The payments or receipts occur at the end of each period for
an ordinary annuity while they occur at the beginning of each period for an annuity due.

Present Value of an Ordinary Annuity

The Present Value of an Ordinary Annuity (PVoa) is the value of a stream of expected or promised
future payments that have been discounted to a single equivalent value today. It is extremely
useful for comparing two separate cash flows that differ in some way.

PV-oa can also be thought of as the amount you must invest today at a specific interest rate so that
when you withdraw an equal amount each period, the original principal and all accumulated
interest will be completely exhausted at the end of the annuity.

The Present Value of an Ordinary Annuity could be solved by calculating the present value of each
payment in the series using the present value formula and then summing the results. A more direct
formula is:

PVoa = PMT [(1 - (1 / (1 + i)n)) / i]

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Where:

PVoa = Present Value of an Ordinary Annuity

PMT = Amount of each payment

i = Discount Rate Per Period

n = Number of Periods

Future Value

Future Value Of A Single Amount

Future Value is the amount of money that an investment made today (the present value) will grow
to by some future date. Since money has time value, we naturally expect the future value to be
greater than the present value. The difference between the two depends on the number of
compounding periods involved and the going interest rate.

The relationship between the future value and present value can be expressed as:

FV = PV (1 + i)n

Where:

FV = Future Value

PV = Present Value

i = Interest Rate Per Period

n = Number of Compounding Periods

Future Value of Annuities

An annuity is a series of equal payments or receipts that occur at evenly spaced intervals. Leases
and rental payments are examples. The payments or receipts occur at the end of each period for
an ordinary annuity while they occur at the beginning of each period. For an annuity due.

Future Value of an Ordinary Annuity

The Future Value of an Ordinary Annuity (FVoa) is the value that a stream of expected or promised
future payments will grow to after a given number of periods at a specific compounded interest.

The Future Value of an Ordinary Annuity could be solved by calculating the future value of each
individual payment in the series using the future value formula and then summing the results. A
more direct formula is:

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FVoa = PMT [((1 + i)n - 1) / i]

Where:

FVoa = Future Value of an Ordinary Annuity

PMT = Amount of each payment

i = Interest Rate Per Period

n = Number of Periods

Loan Amortization

Amortization

Amortization is a method for repaying a loan in equal installments. Part of each payment goes
toward interest due for the period and the remainder is used to reduce the principal (the loan
balance). As the balance of the loan is gradually reduced, a progressively larger portion of each
payment goes toward reducing principal.

Simple Interest
Interest is the cost of borrowing money, or is the amount you receive from lending money. To
calculate, you take the amount of the loan, known as the principal, and multiply it by the rate,
which is the annual percentage being charged. Multiply the result by the time to maturity.

Simple Interest = (Principal x Rate) x Time

Compound Interest

Compound interest occurs in most instances, and is generated from the ability of reinvested
earnings (or the remaining principal) to earn interest on interest.
Let's consider a similar example. Say you deposited $100,000 in the bank at 5% annual interest.
After a year, you would have $105,000, but you cannot just tack on another 5% every year. For
Year 2 you would have to calculate what 5% of $105,000 is, and add that on, then for Year 3,
figure out what 5% of the Year 2 figure is and add that to the mix.

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Capital recovery

1. The earning back of the initial funds put into an investment. Capital recovery must occur before
a company can earn a profit on its investment.

2. A euphemism for debt collection. Capital recovery companies obtain overdue payments from
individuals and businesses that have not paid their bills. Upon obtaining payment and remitting it
to the company to which it is owed, the capital recovery company earns a fee for its services.

Amortized Loan

A loan with scheduled periodic payments of both principal and interest. This is opposed to loans
with interest-only payment features, balloon payment features and even negatively amortizing
payment features.

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Module 3
Cost of Capital

The Cost of Capital

Introduction

The project’s cost of capital is the minimum required rate of return on funds committed to the
project, which depends on the riskiness of its cash flows.

The firm’s cost of capital will be the overall, or average, required rate of return on the aggregate
of investment projects

Significance of the Cost of Capital

Evaluating investment decisions,

Designing a firm’s debt policy, and

Appraising the financial performance of top management.

The Concept of the Opportunity Cost of Capital

The opportunity cost is the rate of return foregone on the next best alternative investment
opportunity of comparable risk.

General Formula for the Opportunity Cost of Capital

Opportunity cost of capital is given by the following formula:

Where Io is the capital supplied by investors in period 0 (it represents a net cash inflow to the
firm), Ct are returns expected by investors (they represent cash outflows to the firm) and k is the
required rate of return or the cost of capital.

The opportunity cost of retained earnings is the rate of return, which the ordinary shareholders
would have earned on these funds if they had been distributed as dividends to them.

Weighted Average Cost of Capital Vs. Specific Costs of Capital

capital.

the investment decisions is the future cost or the marginal cost.

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now, or in the near future.

sing capital is not relevant in financial


decision-making.

Cost of Debt

 Cost of perpetual debt:

The coupon interest rate or the market yield on debt can be said to represent an approximation of
cost of debt.

The bonds or debentures can be issued at Par, discount or premium.

The after tax cost of perpetual cost of debt can be calculated as

 Cost Of redeemable debt

The cost redeemable debt can be calculated by using yield to maturity also called trial and error
method.

The cost of redeemable debt can also be calculated using the short cut method

Cost preference capital

Cost of preference capital may be defined as the dividend expected by the preference
shareholders.

There are two types of preference shares

Cost of Perpetual preference shares

Cost of Redeemable preference shares

Cost Term Loan:


A loan from a bank for a specific amount that has a specified repayment schedule and a floating
interest rate. Term loans almost always mature between one and 10 years.

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Cost of equity capital

It is the rate at which investors discount the expected dividends of the firm to determine its share
value.

Cost of equity capital may be defined as the minimum rate of return that a firm must earn on the
equity financed portion of an investment project in order to leave unchanged the market price of
the shares.

There are three possible approaches that can be employed to compute cost of equity capital

Dividend approach

 One approach to calculate the cost of equity capital is based on the dividend valuation
model.
 The model assumes that the value of a share equals the present value of all future dividends
that it is expected to provide over an indefinite period.
 Using this model cost of equity can be calculated using the following equation

Capital asset pricing model

As per the CAPM, the required rate of return on equity is given by the following relationship:

Equation requires the following three parameters to estimate a firm’s cost of equity:

- (Rm –

Cost of Equity: CAPM vs. Dividend—Growth Model

The dividend-growth approach has limited application in practice

ected
dividend growth rate, g, should be less than the cost of equity, ke, to arrive at the simple growth
–growth approach also fails to deal with risk directly.

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CAPM has a wider application although it is based on restrictive assumptions:

data, they are common to all companies.

f beta is determined in an objective manner by using sound statistical methods. One


practical problem with the use of beta, however, is that it does not probably remain stable over
time.

Earnings- Price Ratio approach

According to this approach cost of equity is equal to

Cost of Retained earnings

issue of additional share


used as Kr but the latter would be lower than the former due to differences in floatation cost

The Weighted Average Cost of Capital

The following steps are involved for calculating the firm’s WACC:

proportion in the capital structure.

WACC is in fact the weighted marginal cost of capital (WMCC); that is, the weighted average
cost of new capital given the firm’s target capital structure.

Book Value versus Market Value Weights

Managers prefer the book value weights for calculating WACC:

—equity
ratios are analysed by investors to evaluate the risk of the firms in practice.

The use of the book-value weights can be seriously questioned on theoretical grounds:

weights should also be market- k-value weights are based on

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arbitrary accounting policies that are used to calculate retained earnings and value of assets.
Thus, they do not reflect economic values.

Market-value weights are theoretically superior to book-value weights:

consistent with the market-determined component costs.

The difficulty in using market-value weights:

arket value based


target capital structure means that the amounts of debt and equity are continuously adjusted as
the value of the firm changes.

Flotation Costs, Cost of Capital and Investment Analysis

A new issue of debt or shares will invariably involve flotation costs in the form of legal fees,
administrative expenses, brokerage or underwriting commission.

a correct procedure. Flotation costs are not annual costs; they are one-time costs incurred when the
investment project is undertaken and financed. If the cost of capital is adjusted for the flotation
costs and used as the discount rate, the effect of the flotation costs will be compounded over the

flotation costs and use the weighted average cost of capital, unadjusted for the flotation costs, as
the discount rate.

The Cost of Capital for Projects

WACC (upwards or downwards), and use the adjusted WACC to evaluate the investment project.
corporating the project risk
differences. One approach is to divide projects into broad risk classes, and use different discount
rates based on the decision-

Low risk projects

discount rate < the firm’s WACC Medium risk projects

discount rate = the firm’s WACC High risk projects

discount rate > the firm’s WACC

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Marginal Cost of Capital

Marginal Cost of Capital (MCC) Schedule is a graph that relates the firm’s weighted average cost
of each dollar of capital to the total amount of new capital raised.
The WACC is the minimum rate of return allowable, and still meeting financial obligationts such
as debt, interest payments, dividends etc... Therefore, the WACC averages the required returns
from all long-term financing sources (Debt and Equity).
The WACC is based on cash flows, which are after-tax. By the same notion then, the WACC
should be calculated on an after-tax basis.

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Module 4
Investment decisions
Investment Decision

Capital budgeting is a required managerial tool. One duty of a financial manager is to choose
investments with satisfactory cash flows and rates of return. Therefore, a financial manager must
be able to decide whether an investment is worth undertaking and be able to choose intelligently
between two or more alternatives. To do this, a sound procedure to evaluate, compare, and select
projects is needed. This procedure is called capital budgeting.

II. Basic Steps of Capital Budgeting

1. Estimate the cash flows

2. Assess the riskiness of the cash flows.

3. Determine the appropriate discount rate.

4. Find the PV of the expected cash flows.

5. Accept the project if PV of inflows > costs. IRR > Hurdle Rate and/or payback < policy

III. Evaluation Techniques

A. Payback period

B. Net present value (NPV)

C. Internal rate of return (IRR)

D. Modified internal rate of return (MIRR)

E. Profitability index

A. PAYBACK PERIOD

Payback period = Expected number of years required to recover a project’s cost.

Weaknesses of Payback:

1. Ignores the time value of money. This weakness is eliminated with the discounted payback
method. 2. Ignores cash flows occurring after the payback period.

Discounted Cash Flow (DCF) Technique NPV, IRR and PI are the discounted cash flow (DCF)
criteria for appraising the worth of an investment project.

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Net Present Value (NPV): method is a process of calculating the present value of the project’s
cash flows, using the opportunity cost of capital as the discount rate, and finding out the net present
value by subtracting the initial investment from the present value of cash flows. Under the NPV
method, the investment project is accepted if its net present value is positive (NPV > 0). The market
value of the firm’s share is expected to increase by the project’s positive NPV. Between the
mutually exclusive projects, the one with the highest NPV will be chosen. NPV methods account
for the time value of money and are generally consistent with the wealth maximisation objective.

Internal Rate of Return (IRR): is that discount rate at which the project’s net present value is
zero. Under the IRR rule, the project will be accepted when its internal rate of return is higher than
the opportunity cost of capital (IRR > k).

IRR methods account for the time value of money and are generally consistent with the wealth
maximisation objective.

NPV and IRR NPV and IRR give same accept-reject results in case of conventional independent
projects. Under a number of situations, the IRR rule can give a misleading signal for mutually
exclusive projects. The IRR rule also yields multiple rates of return for non-conventional projects
and fails to work under varying cost of capital conditions. Since the IRR violates the value-
additively principle; since it may fail to maximise wealth under certain conditions; and since it is
cumbersome, the use of the NPV rule is recommended.

Profitability index (PI): is the ratio of the present value of cash inflows to initial cash outlay. It
is a variation of the NPV rule. PI specifies that the project should be accepted when it has a
profitability index greater than one (PI > 1.0) since this implies a positive NPV.

NPV and PI A conflict of ranking can arise between the NPV and PI rules in case of mutually
exclusive projects. Under such a situation, the NPV rule should be preferred since it is consistent
with the wealth maximisation principle.

Payback: is the number of years required to recoup the initial cash outlay of an investment project.
The project would be accepted if its payback is less than the standard payback. The greatest
limitations of this method are that it does not consider the time value of money, and does not
consider cash flows after the payback period.

Discounted Payback: considers the time value of money, but like the simple payback it also
ignores cash flows after the payback period. Under the conditions of constant cash flows and a
long life of the project, the reciprocal of payback can be a good approximation of the project’s rate
of return.

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Accounting Rate of Return: is found out by dividing the average profit after- tax by the average
amount of investment. A project is accepted if its ARR is greater than a cut off rate (arbitrarily
selected). This method is based on accounting flows rather than cash flows; therefore, it does not
account for the time value of money. Like PB, it is also not consistent with the objective of the
shareholders’ wealth maximisation. Following table provides a summary of the features of various
investment criteria.

Estimate Cash Flow of a Project


Initial Cash Outlay
When estimating the cash flow of a project, first consider the initial cash outlay. This refers to the
amount of all the cash inflows and outflows that occur when the project starts. When starting a
project, there are initial costs involved, such as purchasing equipment, labor costs and the costs of
other utilities necessary to kick start the project. Adding up all the costs involved to create the
project enables you to have a clear mind of the expenses.
Working Capital
When undertaking the project, consider the fact that the needs of the operating working capital
change over different phases of the project. For instance, when the current assets are more than the
current liabilities, the working capital increases and this represents a cash outflow. Similarly, if
the current liabilities are more than the current assets, the net working capital is likely to become
negative and this is a cash inflow. Therefore, when estimating a projects’ cash flow, consider the
working capital and discount it appropriately.
Overhead Costs
Overhead costs will be incurred in starting and running the project. Overhead costs include rent
payments, employee benefits, legal expenses and other administrative costs incurred. Always
determine whether the overhead expenses are incremental cash flows affiliated to your project. To
make your project remain viable, ensure that the cost you are paying for your overheads does not
exceed the cash inflow.
Depreciation Expenses
To start a project, you typically need to purchase assets that will enable you to run the project. The
purchase of assets results to negative cash outflow, but you should not record it at once. Do it
progressively as a depreciating expense throughout the life of the asset. Depreciation is not a cash
flow but it affects income, which has an impact on cash flow. Therefore, when calculating the cash
flows of a project, add the depreciation back.

Replacement projects

 The cash flow analysis must take all cash flow components into account, such as
opportunity costs and depreciation and maintenance expense.
 The replacement project's cash flows are the additional inflows and outflows to be provided
by the prospective replacement project.
 The comparison between the replacement and the current project informs the decision
whether to undertake the replacement and, if applicable, at what point replacement should
occur.

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Module 5
Working capital management
Working Capital management

Introduction

One of the vital aspects of the company’s financial management is to manage its current assets and
the current liabilities in such a way that a satisfactory level of working capital is maintained.
Working capital management means administration of working capital i.e. current assets and
current liabilities. Firm has to manage its property in order to attain its goal of wealth
maximization.

Every business needs funds for two purposes- for its establishment and to carry out its day to day
operations. Long term funds are required to create production facilities through purchase of fixed
assets such as plant and machinery, land and building etc. funds also needed for short term
purposes for the purchase of raw materials, payment of wages and other day to day expenses.
These funds are known as working capital.

Meaning

In accounting ―working capital is the difference between the inflow and outflow of funds in other
words it is net cash flow‖.

Working capital is that part of total capital which is used for carrying out routine business
operations, in simple terms, working capital is the capital with which business of the company is
worked over. It is the life blood of the business and it is the controlling system of every business.

The working capital management is concerned with the problems that arise in attempting to
manage the current liabilities ant the interrelationships exist between them. This tries to evolve
how much funds to be invested in each type of current assets and what should be the proportion of
long term funds and which are the sources that are ideal for financing current assets.

Working Capital = Current Assets – Current Liabilities

Importance of working capital:

It is considered as a central nervous system of a firm. The importance of working capital


management is reflected in the fact that financial managers spend most of their times in managing
current assets and current liabilities.

Working capital management includes a number of aspects that makes it has importance phase of
financial management in a firm.

Working capital policy concerned with the following factors:

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Factors influencing working capital requirements

1. Size of Business

Working capital requirement of a firm is directly influenced by the size of its business
operation. Big business organizations require more working capital than the small business
organization. Therefore, the size of organization is one of the major determinants of working
capital.

2. Nature of Business

Working capital requirement depends upon the nature of business carried by the firm. Normally,
manufacturing industries and trading organizations need more working capital than in the service
business organizations. A service sector does not require any amount of stock of goods. In service
enterprises, there are less credit transactions. But in the manufacturing or trading firm, credit sales
and advance related transactions are in large amount. So, they need more working capital.

3. Storage Time or Processing Period

Time needed for keeping the stock in store is called storage period. The amount of working capital
is influenced by the storage period. If storage period is high, a firm should keep more quantity of
goods in store and hence requires more working capital. Similarly, if the processing time is more,
then more stock of goods must be held in store as work-in-progress.

4. Credit Period

Credit period allowed to customers is also one of the major factors which influence the requirement
of working capital. Longer credit period requires more investment in debtors and hence more
working capital is needed. But, the firm which allows less credit period to customers’ needs less
working capital.

5. Seasonal Requirement

In certain business, raw material is not available throughout the year. Such business organizations
have to buy raw material in bulk during the season to ensure an uninterrupted flow and process
them during the entire year. Thus, a huge amount is blocked in the form of raw material inventories
which gives rise to more working capital requirements.

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6. Potential Growth or Expansion Of Business

If the business is to be extended in future, more working capital is required. More amount of
working capital is required to meet the expansion need of business.

7. Changes in Price Level

Change in price level also affects the working capital requirements. Generally, the rise in price
will require the firm to maintain large amount of working capital as more funds will be required
to maintain the sale level of current assets.

g the individual
components of current assets.

Concepts of Working Capital

There are two concepts of working capital, they are

Balance sheet concept

There are two interpretations of working capital under the balance sheet concept:

Gross working capital: It is the amount of funds invested in the various components of current
assets.

Net working capital: It is the difference between current assets and the current liabilities. The
concept of net working capital determines how much amount is left for operational requirements.

GWC focuses on

• Optimization of investment in current

• Financing of current assets NWC focuses on

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• Liquidity position of the firm

• Judicious mix of short-term and long-term financing CURRENT ASSETS

Current assets are cash and other assets reasonably expected to be (1) realized in cash, or (2) sold
or consumed, during the longer of one year or the company’s operating cycle

Current assets include:

1. Cash -- ultimate liquid asset

2. Cash equivalents -- temporary investments of excess cash

3. Marketable securities -- debt or equity securities held as s-t investments

4. Accounts receivable -- amounts due from credit sales

5. Inventories -- items held for sale in the normal course of business

6. Prepaid expenses -- advance payments for services and supplies CURRENT LIABILITIES

Current liabilities are obligations expected to be satisfied within a relatively short period of time,
usually one year

Current liabilities include:

• Accounts payable

• Notes payable

• Short-term bank loans

• Tax payable

• Accrued expenses

• Current portion of long-term debt

Operating Cycle of Working Capital:

Maximization of shareholder’s wealth of a firm is possible only when there is sufficient return
from their operations. But profit can be earned will naturally depend among other things upon the
magnitude of sales.

It is essential that the operating cycle should be kept up continuously.

The operating cycle consists of following events:

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onversion of work-in-progress into finished goods

Classification of Working Capital:

 Initial working capital


 Special working capital Seasonal working capital
 Permanent working capital Gross working capital

On the basis of Concepts On the basis of Time

 Variable working capital


 Regular working capital
 Net working capital

WORKING CAPITAL

Determinants of Working Capital:

The following are the factors generally influence the working capital requirements:

and the industry to which it belongs. A public utility concern, for example, mostly employs fixed
assets in its operations, while merchandising department depends generally on inventory and
receivables.

with larger scale of operation will need more working capital than the small firm.

quirements of
working capital and vice versa.

higher sales but will need more working capital as compared to a firm enforcing strict credit terms.

ycle: It refers to the alternate expansion and contraction in general business activity.
In the period of boom i.e., when the business is prosperous, there is need for larger working capital
due to increase in sales, raise in prices. In the time of depression i.e., when there is a down swing
of the cycle, the business contracts, sales decline.

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volume of the business and in the working capital of the business, yet it may be concluded that for
a normal rate of expansion in the volume of the business, we may have retained profits to provide
for more working capital.

with realization of cash from the sale of finished products. The speed with which the working
capital completes one cycle determines the requirements of working capital- longer the period of
the cycle larger are the requirement of working capital.

l changes: Changes in price level also affect the working capital requirements. The
rising prices require the firm to maintain larger amount of working capital as more funds. The
effect of rising

is not available throughout the year. They


have to buy the raw material in bulk during the season to ensure an uninterrupted flow and process
them, during the entire year.

editors influence
considerably the requirements of working capital. A concern that purchases its requirements on
credit and sells its products on cash requires lesser amount of working capital.

working capacity than others


due to quality of their products, monopoly conditions, etc. Such firms with high earning capacity
may generate cash profits from operations and contribute to their working capital. The dividend
policy of a concern also influences the requirements of its working capital. A firm that maintains
a steady rate of cash dividend irrespective of its generation of profits needs more working capital.

Advantages and Disadvantages of working capital

Advantages of Working Capital:

protects a business from the adverse effects of shrinkage in the values of current assets.

take advantage of cash discounts.

losses or decreased retained earnings.


-operating or extra-ordinary losses.

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Disadvantages of Working Capital:

company may not be able to take advantage of cash discount facilities.

company will not be able to pay its dividends because of the non-availability of funds.

undant working capital gives rise to speculative transactions.

Estimation of Working Capital

The most appropriate methods for estimating working capital needs are enumerated hereunder:

1. Operating cycle concept: In this method, the estimates of working capital requirements on the
basis of average holding period of current assets and relating them to costs based on company’s
expectations and experiences. This value of total current assets is known as gross working capital.
From gross working capital, the expected current liabilities like sundry creditors for raw materials,
expenses, etc., are deducted to find net working capital.

2. Current assets holding period method: This method is based on operating cycle period. Here,
the working capital requirement equals to gross working capital requirement.

3. Ratio to sales method: The working capital requirements are estimated as a ratio of sales for
each component of working capital.

4. Ratio of fixed investment method: The working capital is estimated as a percentage of fixed
investment

TYPES OF WORKING CAPITAL

1. Permanent or fixed working capital

A minimum level of current assets, which is continuously required by a firm to carry on its business
operations, is referred to as permanent or fixed working capital.

2. Fluctuating or variable working capital

The extra working capital needed to support the changing production and sales activities of the
firm is referred to as fluctuating or variable working capital.

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TYPES OF WORKING CAPITAL

DETERMINATION OF LEVEL OF CURRENT ASSETS

To maximize the wealth of shareholders Firm requires FA and CA to support particular level of
output Firm can have different level of CA Level of CA can be measured by relating CA to FA

This may be

Conservative policy

Aggressive Policy

Moderate policy or Trade off

1. CONSERVATIVE POLICY

2. AGGRESSIVE POLICY

3. MODERATE / TRADE OFF POLICY

n average level of current

COMPARISION OF THERE APPROACHES

Approach Degree of Risk Degree of Liquidity

Conservative Lowest Highest

Trade off Moderate Moderate

Aggressive Highest Lowest

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COMPARISION OF THERE APPROACHES

In the above diagram, alternative A indicates the most conservative policy, where CA/FA ratio is
greatest at every level of output. In the same way, Alternative C is the most aggressive policy &
alternative C lies between the conservative & the aggressive and is the average one. Cost involved
in maintaining a level of current assets

Costs of liquidity: if the firm’s level of current assets is very high, it has excessive liquidity. Its
return on assets will be low as funds ties up in idle cash and stocks earn nothing & high level of
debtors produces nothing.

Costs of illiquidity: is the cost of holding insufficient current assets. The firm will not be able to
honor its obligations if it carries too little cash. This may force firm to borrow at high rate of
interest.

THE COST TRADE OFF

In determining the optimum level of current assets, the firm should balance the profitability-
solvency tangle by minimizing total costs-cost of liquidity & cost of illiquidity. This is shown in
the diagram below:

As you can see in the diagram, with the level of current assets, the cost of liquidity increases while
the cost of illiquidity decreases. & Vice-a-versa. The firm should maintain its current assets at that
level where the sum of these two costs is minimized.

Current asset policy

Operating current assets financing policies are necessary to maintain productive operations.

Sources of funds:

1. Bank Loans
2. Credit from suppliers (accounts payable)
3. Accrued Liabilities
4. Long-term debt
5. Common equity

Things that affect current assets:

1. Seasonal fluctuation
2. Economic fluctuations
3. Position of the business in the business cycle

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Maturity matching (self-liquidating) Approach:

Maturity Matching is considered a moderate current asset financing policy.

Matching asset and liability maturities, fixed assets and permanent current assets are financed with
long-term debt while temporary current assets are financed with short term debt. A 30 day bank
loan is used to finance inventory that is expected to be sold within 30 days.

The problem with maturity matching is that the lives of assets are sometimes unpredictable, such
as when inventory is expected to sell. Also some assets have no maturity and therefor it does not
make sense to use the Maturity matching approach.

Aggressive Approach

Companies who finance permanent assets with short-term debt use an aggressive current asset
financing approach. There can be different degrees of aggressiveness, because some companies
finance only a portion of their permanent assets with short-term debt.

Some advantages to an aggressive policy are that short-term debt is usually cheaper and an upward
sloping yield curve.

An aggressive policy is very risky, as many companies have found out during the 2009 financial
crisis.

Conservative Approach

A conservative approach is using long-term capital to finance all permanent assets and meet some
or all of its seasonal needs. A small amount of short-term credit is sometimes used during the busy
season.

Determining which approach to use depends on a firms specific conditions. Short term debt usually
has a lower interest rate, however, rates do flexuate and if the rates increase to the point that the
firms ratios are show the inability to repay its current debt it may become very difficult to obtain
additional financing.

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Determination of operating cycle and cash cycle

THE OPERATING CYCLE

There are several things to notice in our example. First, the entire cycle, from the time we acquire
some inventory to the time we collect the cash, takes 105 days. This is called the operating cycle
The time between the acquisition of inventory and the collection of cash from receivables. .

As we illustrate, the operating cycle is the length of time it takes to acquire inventory, sell it and
collect the payment. This cycle has two distinct components. The first part is the time it takes to
acquire and sell the inventory. This period, a sixty-day span in our example, is called the inventory
period The time it takes to acquire and sell inventory. The second part is the time it takes to collect
on the sale, forty-five days in our example. This is called the accounts receivable period The time
between sale of inventory and collection of the receivable. , or, simply, the receivables period.

What the operating cycle describes is how a product moves through the current asset accounts. It
begins life as inventory; it is converted to a receivable when it is sold; and it is finally converted
to cash when we collect from the sale. Notice that, at each step, the asset is moving closer to cash.

THE CASH CYCLE

The second thing to notice is that the cash flows and other events that occur are not synchronised.
For example, we do not actually pay for the inventory until thirty days after we acquire it. The
intervening thirty-day period is called the accounts payable periodThe time between receipt of
inventory and payment for it.. Next, we spend cash on Day 30, but we do not collect until Day
105. Somehow, we have to arrange to finance the $1000 for 105 − 30 = 75 days. This period is
called the cash cycle The time between cash disbursement and cash collection..

The cash cycle, therefore, is the number of days that pass until we collect the cash from a sale,
measured from when we actually pay for the inventory. Notice that, based on our definitions, the
cash cycle is the difference between the operating cycle and the accounts payable period

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Module 6
Capital structure and dividend decisions
Capital Structure Theory and Policy

Debt-equity Mix and the Value of the Firm

Meaning of Capital Structure

Capital Structure is referred to as the ratio of different kinds of securities raised by a firm as long-
term finance. The capital structure involves two decisions-

a. Type of securities to be issued is equity shares, preference shares and long term borrowings
(Debentures).

b. Relative ratio of securities can be determined by process of capital gearing. On this basis, the
companies are divided into two-

a. Highly geared companies - Those companies whose proportion of equity capitalization is small.

c. Low geared companies - Those companies whose equity capital dominates total capitalization

Factors Determining Capital Structure

1. Trading on Equity- The word ―equity‖ denotes the ownership of the company. Trading on
equity means taking advantage of equity share capital to borrowed funds on reasonable basis. It
refers to additional profits that equity shareholders earn because of issuance of debentures and
preference shares. It is based on the thought that if the rate of dividend on preference capital and
the rate of interest on borrowed capital is lower than the general rate of company’s earnings, equity
shareholders are at advantage which means a company should go for a judicious blend of
preference shares, equity shares as well as debentures. Trading on equity becomes more important
when expectations of shareholders are high.

2. Degree of control- In a company, it is the directors who are so called elected representatives of
equity shareholders. These members have got maximum voting rights in a concern as compared to
the preference shareholders and debenture holders. Preference shareholders have reasonably less
voting rights while debenture holders have no voting rights. If the company’s management policies
are such that they want to retain their voting rights in their hands, the capital structure consists of
debenture holders and loans rather than equity shares.

3. Flexibility of financial plan- In an enterprise, the capital structure should be such that there is
both contractions as well as relaxation in plans. Debentures and loans can be refunded back as the
time requires. While equity capital cannot be refunded at any point which provides rigidity to
plans. Therefore,

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4. Choice of investors- The company’s policy generally is to have different categories of investors
for securities. Therefore, a capital structure should give enough choice to all kind of investors to
invest. Bold and adventurous investors generally go for equity shares and loans and debentures are
generally raised keeping into mind conscious investors.

5. Capital market condition- In the lifetime of the company, the market price of the shares has got
an important influence. During the depression period, the company’s capital structure generally
consists of debentures and loans. While in period of boons and inflation, the company’s capital
should consist of share capital generally equity shares.

6. Period of financing- When company wants to raise finance for short period, it goes for loans
from banks and other institutions; while for long period it goes for issue of shares and debentures.

7. Cost of financing- In a capital structure, the company has to look to the factor of cost when
securities are raised. It is seen that debentures at the time of profit earning of company prove to be
a cheaper source of finance as compared to equity shares where equity shareholders demand an
extra share in profits.

8. Stability of sales- An established business which has a growing market and high sales turnover,
the company is in position to meet fixed commitments. Interest on debentures has to be paid
regardless of profit. Therefore, when sales are high, thereby the profits are high and company is in
better position to meet such fixed commitments like interest on debentures and dividends on
preference shares. If company is having unstable sales, then the company is not in position to meet
fixed obligations. So, equity capital proves to be safe in such cases.

9. Sizes of a company- Small size business firms capital structure generally consists of loans from
banks and retained profits. While on the other hand, big companies having goodwill, stability and
an established profit can easily go for issuance of shares and debentures as well as loans and
borrowings from financial institutions. The bigger the size, the wider is total capitalization.

Optimum Capital Structure: Trade-off Theory

The optimum capital structure is a function of:

o Agency costs associated with debt o The costs of financial distress o Interest tax shield

Features of an Appropriate Capital Structure

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Approaches to Establish Appropriate Capital Structure

—EPS approach for analyzing the impact of debt on EPS.

ty to service debt.

Financial and Operating Leverage

Meaning of Financial Leverage

The use of the fixed-charges sources of funds, such as debt and preference capital along with the
owners’ equity in the capital structure, is described as financial leverage or gearing or trading on
equity.

The financial leverage employed by a company is intended to earn more return on the fixed- charge
funds than their costs. The surplus (or deficit) will increase (or decrease) the return on the owners’
equity. The rate of return on the owners’ equity is levered above or below the rate of return on
total assets

Measures of Financial Leverage

–equity ratio

The first two measures of financial leverage can be expressed either in terms of book values or
market values. These two measures are also known as measures of capital gearing.

The third measure of financial leverage, commonly known as coverage ratio. The reciprocal of
interest coverage is a measure of the firm’s income gearing.

Financial Leverage and the Shareholders’ Return

return under favourable economic conditions. The role of financial leverage in magnifying the
return of the shareholders’ is based on the assumptions that the fixed- charges funds (such as the

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Financial Management 14MBA22

loan from financial institutions and banks or debentures) can be obtained at a cost lower than the
firm’s rate of return on net assets (ROA or ROI).

analyzing the impact of financial leverage.

EPS and ROE Calculations

For calculating ROE either the book value or the market value equity may be used.

Operating Leverage

Operating leverage affects a firm’s operating profit (EBIT).

The degree of operating leverage (DOL) is defined as the percentage change in the earnings before
interest and taxes relative to a given percentage change in sales.

Combining Financial and Operating Leverages

Operating leverage affects a firm’s operating profit (EBIT), while financial leverage affects profit
after tax or the earnings per share.

The degrees of operating and financial leverages are combined to see the effect of total leverage
on EPS associated with a given change in sales.

Financial Leverage and the Shareholders’ Risk

The variability of EBIT and EPS distinguish between two types of risk—operating risk and
financial risk.

Operating risk can be defined as the variability of EBIT (or return on total assets). The
environment—internal and external—in which a firm operates determines the variability of EBIT

The variability of EBIT has two components:

The variability of EPS caused by the use of financial leverage is called financial risk.

Dividend Policy

Dividend policy is concerned with taking a decision regarding paying cash dividend in the present
or paying an increased dividend at a later stage. The firm could also pay in the form of stock
dividends which unlike cash dividends do not provide liquidity to the investors; however, it ensures
capital gains to the stockholders. The expectations of dividends by shareholders helps them

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determine the share value, therefore, dividend policy is a significant decision taken by the financial
managers of any company.

Factors Influencing Dividend policy

The following factors generally influence the dividend policy of the firm.

1. Shareholders’ expectations: Shareholders’ expectation relating to dividends or capital gains


depends on their economic status, effect of differential tax system, need for regular income, etc.

2. Firm’s financial needs: Financial needs of the company to finance the profitable investment
opportunities.

3. Legal restrictions: Legal restrictions like dividend to be paid out of current or past profits do
influence dividend policy of a firm.

4. Liquidity: The overall liquidity of a company has an effect on the dividend decision of a firm.
In the absence of sufficient cash, a firm may be unable to pay dividends even if it has profits.

5. Firm’s financial condition: The financial condition or capability of a firm depends on its use of
borrowings and interest charges payable. A high levered firm is expected to retain more profits
and distribute lesser dividends in order to strengthen its equity base.

6. Capital market accessibility: Accessibility by firm to the capital market becomes an important
factor to declare dividends. For example, a fast growing company which has a tight liquidity
position will not face any difficulty in paying dividends if it has access to the capital markets.

7. Institutional lenders: Lenders of funds like financial institutions and banks may generally put
restrictions on dividend payments to protect their interests when the firm is experiencing low
liquidity or low profitability, etc.

Stable Dividend policy

Stable dividend policy means regularity in paying some dividend annually, even though the
amount of dividend may fluctuate over years, and may not be related with earnings. Precisely,
stability of dividends refers to the amount paid out regularly. This policy should be followed,
because by and large, shareholders favour this policy and value stable dividends higher than the
fluctuating ones. The stable dividend may have a positive impact as the market price of the share.
This policy resolves uncertainty in the minds of investors about future earnings, and satisfies the
desire of many investors, such as old, retired persons, etc. If the companies change from the stable
dividend policy to an irregular or fluctuating dividend policy, it gives an unfavourable signal to
shareholders about the stability of the firm’s operations.

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Dividend Payout

Three distinct forms of dividend payout methods are (1) constant dividend per share; (2) constant
dividend payout ratio; and (3) constant dividend per share plus extra dividend.

Constant dividend per share: The policy of a company to pay fixed amount per share or fixed rate
on paid-up capital as dividend every year, irrespective of fluctuations in the earnings. Those
investors who have dividends as the only source of their income may prefer this method. They do
not accord much importance to the changes in the share price.

Constant payout: The ratio of dividend to earnings is known as payout ratio. With this policy, the
amount of dividend will fluctuate in direct proportion to earnings. Internal financing with retained
earnings is automatic when this policy is followed.

Constant dividend per share plus extra dividend: The policy to pay a minimum dividend per share
with step-up feature is desirable. The small amount of dividend is fixed to reduce the possibility
of ever missing a dividend payment. The extra dividend may be paid as an interim dividend in
periods of prosperity. Certain shareholders like this policy because of the certain cash flow in the
form of the regular dividend and the option of earning extra dividend occasionally

Bonus Shares

Bonus share means distribution of free shares to the existing shareholders. This is known as stock
dividend in the USA. This has the effect of increasing the number of ordinary shares of the
company by capitalization of retained earnings. In India, bonus shares cannot be issued in lieu of
cash dividend. The earnings per share and market price per share will fall proportionately to the
bonus issue, but the total net worth of the firm is not affected by the bonus issues.

Advantages

• The shareholders are benefited as bonus shares are not taxable as income. They interpret it as an
indication of higher profitability of the firm. If the company is following the constant dividend
policy, then total cash dividend of the shareholders will increase in future. Some of the
shareholders can sell bonus shares to make capital recovery.

• The company is able to retain the earnings and at the same time satisfy the desires of shareholders
to receive dividend. It is the only way for firm to pay dividend under financial difficulty and
contractual restrictions, and maintain the impression of firm in shareholders’ mind intact.

Disadvantages

• Bonus share have no effect on share value. From the company’s point of view, they are more
costly to administer than cash dividend.

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Financial Management 14MBA22

Module 7
Emerging Issues in Financial management

Derivative
A derivative is a financial contract which derives its value from the performance of another entity
such as an asset, index, or interest rate, called the "underlying".[1][2] Derivatives are one of the three
main categories of financial instruments, the other two being equities (i.e. stocks) and debt (i.e.
bonds and mortgages). Derivatives include a variety of financial contracts, including futures,
forwards, swaps, options, and variations of these such as caps, floors, collars, and credit default
swaps. Most derivatives are traded over-the-counter (off-exchange) or on an exchange such as the
Chicago Mercantile Exchange, while most insurance contracts have developed into a separate
industry.

Financial Modeling

In simple words, Financial Modelling is creating a complete program/ structure, which helps you
in coming to a decision regarding investment in a project/ company. To be more specific, Financial
Modeling refers to the process of building a structure that integrates the Balance Sheet, Income
Statement, Cash Flow Statement and supporting schedules to enable decision making in areas like,
Business Planning and Forecasting, Equity Valuation, Credit Analysis/Appraisal,
Merger/acquisition analysis, Project Appraisal etc. In each of the above areas, success of the
deliverable to a large extent depends on the quality of the Financial Model.

Financial modelling supports management in making important business decisions. It involves the
quantification of the potential impact of decisions on the profit and loss account, balance sheet and
cash flow statements. Through financial models, managers can determine the outcome of a
proposal before even its execution and rely on a rational and comprehensive justification for their
decisions. Moreover, these models enable managers to study different options and scenarios
without imposing any risk on the business. To avoid the common pitfalls related to financial
modelling, designers should follow five basic principles. They should make sure that the model
satisfies its objectives, maintain model flexibility, take inflation into consideration, present the
model clearly and interestingly, and measure outcome

Financial Modelling is a key skill with application in several areas within banking and finance
industry as well as within corporations. In financial modelling you learn to gather historical
information on companies and analyze company / industry performance on various financial
parameters. This analysis is then used to build a company’s financial model, which in turn is key
to projecting a future financial performance. Based on this model companies investors can arrive
at a suitable evaluation for the companies.

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Financial Engineering

The financial risk faced by companies has increased tremendously over the last two decades and
the payoffs of managing risk successfully are very high. In response to this increased risk and the
incentive to manage it, older instruments of risk management such as forwards and futures have
been expanded in scope, and many new instruments devised. The process of adaptation of existing
financial instruments and processes to develop new ones, in order that financial market participants
can effectively cope with the changing situation, is known as financial engineering.

Financial engineering has been defined as "the design, the development, and the implementation
of innovative financial instruments and processes, and the formulation of creative solutions to
problems in finance‖. This is a very broad definition, but the primary objective of financial
engineering (FE) is to meet the needs of risk management. FE takes a building block approach to
the building of new instruments. This approach was first demonstrated by Black and Scholes
(1973) in considering a call option as "a continuously adjusting portfolio of two securities: (1)
forward contracts on the underlying asset and (2) riskless securities" (Smith,1990:50). Most of the
hedges can be constructed from futures, forwards, options, and swaps, which are now known as
the building blocks of financial engineering. By combining forwards, options, futures and swaps,
with the underlying cash position, a firm's risk exposure can be manipulated in a practically infinite
variety of ways.

Corporate Restructuring

Corporate restructuring can be defined as any change in the business capacity or portfolio that is
carried out by an inorganic route or
Any change in the capital structure of a company that is not a part of its ordinary course of business
or Any change in the ownership of or control over the management of the company or a
combination of any two or all of the above
Major Forms of Corporate Restructuring

-back of Securities

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Mergers:

Merger is defined as combination of two or more companies into a single company where
one survives and the others lose their corporate existence. The survivor acquires all the assets as
well as liabilities of the merged company or companies. Generally, the surviving company is the
buyer, which retains its identity and the dissolved company is the seller. The main objective of
merger is to facilitate efficient use of human, managerial, financial and other resources and to
protect the interests of the shareholders. Mergers refer to aspects of corporate strategy, corporate
finance and management dealing with the buying, selling and combining of different companies
that can aid, finance or help a growing company in a given industry without having to create
another business activity. Merger is when two companies combine together to form a new
company altogether. An acquisition may be private or public, depending on whether the merging
company is or is not listed in public markets.

Acquisition

It is acquiring the ownership in the property. When one company acquires and the latter
ceases to exist and one company takes controlling interest in the other company. In the context of
business combinations, an acquisition is the purchase by one company of a controlling interest in
the share capital of another existing company. An acquisition, also known as a takeover or a
buyout, is the buying of one company (the target) by another. An acquisition may be friendly or
hostile. Whether a purchase is perceived as a friendly or hostile depends on how it is communicated
to and received by the target company's board of directors, employees and shareholders. In the
case of a friendly transaction, the companies cooperate in negotiations and in the case of a hostile
deal, the takeover target is unwilling to be bought or the target's board has no prior knowledge of
the offer. Hostile acquisitions can and often do, turn friendly at the end, as the acquirer secures the
endorsement of the transaction from the board of the merging company. This usually requires an
improvement in the terms of the offer. Acquisition usually refers to a purchase of a smaller firm
by a larger one. Sometimes, however, a smaller firm will acquire management control of a larger
or longer established company and keep its name for the combined entity. This is known as a
reverse takeover. Another type of acquisition is reverse merger a deal that enables a private
company to get publicly listed in a short time period.

Amalgamation is the fusion or blending of two or more existing companies. All assets,
liabilities and the stock of one company stand transferred to the transferee company in
consideration of payment in the form of equity shares in the transferee company, debentures in the
transferee company, cash or a mix of the above modes. Amalgamations are governed by sections
390 to 394 of Indian Companies Act, 1956.

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A takeover is acquisition and both the terms are used interchangeably. Takeover differs
from merger in approach to business combinations i.e. the process of takeover, transaction
involved in takeover, determination of share exchange or cash price and the fulfillment of goals of
combination all are different in takeovers than in mergers. Takeovers are governed by SEBI
Regulation for Substantial acquisition of shares and Takeover (1997).

Behavioral Finance,
A field of finance that proposes psychology-based theories to explain stock market
anomalies. Within behavioral finance, it is assumed that the information structure and the
characteristics of market participants systematically influence individuals' investment decisions as
well as market outcomes.
There have been many studies that have documented long-term historical phenomena in securities
markets that contradict the efficient market hypothesis and cannot be captured plausibly in models
based on perfect investor rationality. Behavioral finance attempts to fill the void.

Risk management

Risk management is the identification, assessment, and prioritization of risks (defined in


ISO 31000 as the effect of uncertainty on objectives, whether positive or negative) followed by
coordinated and economical application of resources to minimize, monitor, and control the
probability and/or impact of unfortunate events[1] or to maximize the realization of opportunities.
Risks can come from uncertainty in financial markets, threats from project failures (at any phase
in design, development, production, or sustainment life-cycles), legal liabilities, credit risk,
accidents, natural causes and disasters as well as deliberate attack from an adversary, or events of
uncertain or unpredictable root-cause. Several risk management standards have been developed
including the Project Management Institute, the National Institute of Standards and Technology,
actuarial societies, and ISO standards

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