FUNDAMENTALS OF FINANCIAL

MANAGEMENT
LONG QUESTIONS
1. Define Financial Management. Discuss its nature and
functions of Financial Management.
Financial Management is the discipline concerned with
managing an organization's finances effectively and efficiently. It
involves making strategic decisions about how to allocate
resources, manage risks, and ensure the financial health and
growth of the business.
Nature of Financial Management:
 Decision-Oriented: Financial management revolves around
making critical decisions related to investment, financing,
and dividend policy.
 Future-Oriented: Financial decisions have long-term
implications for the organization's future success.
 Risk-Averse: Financial managers strive to minimize risks
associated with financial decisions.
 Value-Maximizing: The ultimate goal of financial
management is to maximize the wealth of the organization's
shareholders.
Functions of Financial Management:
1. Financial Planning: Developing financial goals, strategies,
and budgets for the organization.
2. Investment Decisions: Evaluating and selecting
investment opportunities that will generate the highest
returns.
3. Financing Decisions: Determining the optimal mix of debt
and equity financing to fund operations and growth.
4. Dividend Policy Decisions: Deciding how much of the
company's profits to distribute to shareholders as dividends
and how much to retain for reinvestment.
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5. Working Capital Management: Managing the
organization's short-term assets and liabilities to ensure
liquidity and efficient operations.
6. Risk Management: Identifying and mitigating financial
risks that could impact the organization's performance.
2. Briefly explain how is wealth Maximization Objective
better than the Profit Maximization Objective.
The wealth maximization objective is generally considered
superior to profit maximization for several reasons:
 Time Value of Money: Wealth maximization considers the
time value of money, recognizing that a dollar received
today is worth more than a dollar received in the future.
Profit maximization, on the other hand, often focuses on
current profits without considering their timing.
 Risk Consideration: Wealth maximization explicitly takes
into account the risk associated with different investment
and financing decisions. Profit maximization may lead to
short-term gains but could expose the organization to
significant risks in the long run.
 Stakeholder Focus: Wealth maximization considers the
interests of all stakeholders, including shareholders,
employees, customers, and the community. Profit
maximization tends to focus solely on maximizing profits for
shareholders.
 Long-Term Perspective: Wealth maximization is a long-
term objective that aims to increase the organization's value
over time. Profit maximization may lead to short-term gains
but could harm the organization's long-term prospects.
3. What is risk? Briefly explain the types of risk involved in
an investment.
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Risk in the context of investment refers to the uncertainty or
variability of expected returns. It is the possibility that the actual
outcome of an investment will differ from the expected outcome.
Types of Risk:
 Systematic Risk (Market Risk): This type of risk affects
the entire market or a large segment of it. Examples include
economic recessions, interest rate changes, and political
instability.
 Unsystematic Risk (Company-Specific Risk): This risk is
unique to a particular company or industry. Examples include
changes in management, competition, technological
advancements, and legal issues.
 Credit Risk: The risk that a borrower may default on their
debt obligations.
 Liquidity Risk: The risk that an investment cannot be easily
bought or sold in the market without significant price
fluctuations.
 Inflation Risk: The risk that inflation will erode the
purchasing power of future returns.
 Currency Risk: The risk of losses due to fluctuations in
exchange rates.
 Country Risk: The risk associated with investing in a
particular country, including political instability, economic
uncertainty, and legal risks.
4. What is Cost of Capital? What are the different methods
of computing the cost of equity capital?
Cost of Capital represents the minimum return that an
investment must generate to compensate investors for the risk
they are taking. It is the opportunity cost of capital, reflecting the
return investors could earn on comparable investments
elsewhere.
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MANAGEMENT
Methods of Computing the Cost of Equity Capital:
 Capital Asset Pricing Model (CAPM): This model
estimates the cost of equity based on the risk-free rate, the
market risk premium, and the beta of the stock.
 Dividend Discount Model (DDM): This model calculates
the cost of equity based on the expected future dividends
and the current stock price.
 Earnings Capitalization Model: This model estimates the
cost of equity based on the expected future earnings and the
current stock price.
 Bond Yield Plus Risk Premium Model: This model adds a
risk premium to the yield on a comparable risk-free bond to
estimate the cost of equity.
5. What is weighted average cost of capital and marginal
cost of capital? Examine the rationale behind the use of
after-tax weighted average cost of capital?
Weighted Average Cost of Capital (WACC) is the average
cost of all the capital sources used by a company, weighted by
their respective proportions in the capital structure. It is a critical
metric used in capital budgeting decisions.
Marginal Cost of Capital (MCC) represents the cost of raising
an additional dollar of capital. It is the cost of the next dollar of
capital raised by the company.
Rationale behind using After-Tax WACC:
 Tax Shield: Interest payments on debt are tax-deductible,
reducing the company's tax liability. The after-tax cost of
debt reflects this tax benefit.
 True Cost of Capital: The after-tax WACC represents the
true cost of capital to the company, as it takes into account
the tax benefits of debt financing.
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MANAGEMENT
 Decision Making: The after-tax WACC is used in capital
budgeting decisions to evaluate the profitability of potential
investments.
6. What do you mean by dividend policy? Explain the
various theories of dividend policy.
Dividend Policy refers to the decisions made by a company
regarding the distribution of its profits to shareholders as
dividends. It involves determining the optimal dividend payout
ratio and dividend growth rate.
Theories of Dividend Policy:
 Dividend Irrelevance Theory (Modigliani and Miller):
This theory argues that dividend policy is irrelevant to the
value of a firm under certain assumptions, such as perfect
capital markets and no taxes.
 Dividend Relevance Theory: This theory suggests that
dividend policy can affect the value of a firm. It includes
theories such as the bird-in-the-hand argument, the
signaling hypothesis, and the clientele effect.
 Residual Dividend Theory: This theory suggests that
dividends should be paid only after all profitable investment
opportunities have been funded with retained earnings.
7. Critically examine Walter's relevance theory of
dividend.
Walter's Relevance Theory suggests that the optimal dividend
policy depends on the relationship between the company's
internal rate of return (IRR) on investments and the cost of equity
capital.
Key Points of Walter's Theory:
 If IRR > Cost of Equity: The company should retain all
earnings for reinvestment, as the return on investment
exceeds the cost of capital.
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MANAGEMENT
 If IRR < Cost of Equity: The company should distribute all
earnings as dividends, as the cost of capital exceeds the
return on investment.
 If IRR = Cost of Equity: The dividend policy is irrelevant, as
the return on investment is equal to the cost of capital.
Criticisms of Walter's Theory:
 Assumes Constant Cost of Equity: The theory assumes
that the cost of equity remains constant regardless of the
dividend payout ratio, which may not be realistic.
 Assumes Constant IRR: The theory assumes that the
company's IRR on investments remains constant, which is
also unrealistic.
 Ignores Taxes and Other Factors: The theory does not
consider the impact of taxes, transaction costs, and other
factors that can influence dividend policy decisions.
8. What is working capital? Discuss the factors that can be
considered while estimating working capital requirements
of a business firm.
Working Capital is the difference between a company's current
assets and current liabilities. It represents the funds available for
the day-to-day operations of the business.
Factors Affecting Working Capital Requirements:
 Nature of Business: The working capital requirements vary
depending on the nature of the business. For example,
manufacturing businesses typically require more working
capital than service businesses.
 Scale of Operations: Larger businesses generally require
more working capital than smaller ones.
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MANAGEMENT
 Business Cycle: Working capital requirements fluctuate
with the business cycle. During periods of growth, working
capital needs tend to increase.
 Credit Policy: A more lenient credit policy can lead to
higher accounts receivable and increased working capital
requirements.
 Inventory Levels: Higher inventory levels require more
working capital to finance the cost of goods.
 Production Cycle: The longer the production cycle, the
higher the working capital requirements.
 Growth Prospects: Growing businesses typically require
more working capital to support expansion.
 Inflation: Inflation can increase the cost of raw materials
and other inputs, leading to higher working capital needs.
 Financial Policies: The company's financial policies, such
as dividend policy and debt-equity ratio, can also affect
working capital requirements.

3 MARKS QUESTIONS
1. Write a note on profit maximization vs wealth maximization.
Profit maximization focuses on maximizing a company's current
earnings, often neglecting long-term implications and risk. Wealth
maximization, on the other hand, aims to increase the overall
value of the company over time by considering factors like risk,
time value of money, and stakeholder interests.
2. How is present value of an annuity is calculated?
The present value of an annuity is calculated using the formula:
PV = PMT * [(1 - (1 + r)^-n) / r]
where:
 FUNDAMENTALS OF FINANCIAL
MANAGEMENT
 PV = Present value
 PMT = Periodic payment
 r = Discount rate
 n = Number of periods
3. How is Weighted Average Cost of Capital (WACC) calculated?
WACC is calculated by weighting the cost of each capital source
(debt and equity) by its proportion in the capital structure. The
formula is:
WACC = (Weight of Debt * Cost of Debt) * (1 - Tax Rate) + (Weight
of Equity * Cost of Equity)
4. Define the Cost of Equity Capital.
The cost of equity capital is the minimum return that a company
must offer to its equity investors to compensate them for the risk
they are taking. It represents the opportunity cost of investing in
the company's stock.
5. Differentiate between Money Market and Capital Market.
The money market deals with short-term debt instruments (less
than 1 year), such as treasury bills and commercial paper, while
the capital market deals with long-term debt instruments (more
than 1 year) and equity securities, such as bonds and stocks.
6. Differentiate between cash flows from operating activities and
investing activities.
Cash flows from operating activities are the cash flows generated
from a company's core business operations, such as sales
revenue, cost of goods sold, and operating expenses. Cash flows
from investing activities are the cash flows related to the
purchase and sale of long-term assets, such as property, plant,
and equipment.
7. Differentiate between Systematic Risk and Unsystematic Risk.
 FUNDAMENTALS OF FINANCIAL
MANAGEMENT
Systematic risk is market-wide risk that affects all assets in the
market, such as economic recessions or interest rate changes.
Unsystematic risk is specific to a particular company or industry,
such as changes in management or competition.
8. Differentiate between NPV and IRR in Fundamentals of Financial
Management.
Net Present Value (NPV) is the difference between the present
value of cash inflows and the present value of cash outflows.
Internal Rate of Return (IRR) is the discount rate at which the NPV
of an investment becomes zero.
9. Write down the different kinds of Working Capital.
Working capital can be categorized into:
 Gross Working Capital: Current assets minus current
liabilities.
 Net Working Capital: Current assets minus current liabilities,
excluding cash and marketable securities.
 Operating Working Capital: Current assets minus current
liabilities, excluding cash, marketable securities, and short-
term debt.

2 MARKS QUESTIONS
1. What is Financial Management?
Financial Management is the process of managing an
organization's finances effectively and efficiently. It involves
making strategic decisions about how to allocate resources,
manage risks, and ensure the financial health and growth of the
business.
2. What do you mean by the Time Value of Money?
 FUNDAMENTALS OF FINANCIAL
MANAGEMENT
The time value of money is the concept that a sum of money
received today is worth more than the same sum received in the
future due to its potential earning capacity. This principle is
fundamental in financial decision-making.
3. What do you mean by Systematic Risk?
Systematic risk is the market-wide risk that affects all assets in
the market, such as economic recessions or interest rate changes.
It cannot be diversified away through portfolio diversification.
4. What is Finance Function?
The finance function is responsible for managing an organization's
finances, including planning, budgeting, investing, financing, and
risk management. It plays a crucial role in ensuring the financial
health and sustainability of the business.
5. What is Operating Cycle?
The operating cycle is the length of time it takes for a business to
convert its inventory into cash. It starts with the purchase of raw
materials, followed by production, sale of finished goods, and
collection of accounts receivable.
6. What is meant by Dividend Payout Ratio?
The dividend payout ratio is the proportion of a company's net
income that is distributed to shareholders as dividends. It
indicates how much of the company's profits are returned to
investors.
7. What is Leasing?
Leasing is an arrangement where an asset is rented or leased
from an owner by a lessee for a defined period. It allows
businesses to use assets without incurring the cost of outright
purchase.
8. What is Payback Period?
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The payback period is the length of time it takes for an
investment to generate enough cash flow to recover its initial
cost. It is a simple capital budgeting technique used to assess the
risk and liquidity of an investment.
9. Define Cost of Retained Earnings.
The cost of retained earnings is the opportunity cost of using
retained earnings for reinvestment within the company rather
than distributing them as dividends to shareholders. It represents
the return that shareholders could expect to earn on comparable
investments.
10. What is Profitability Index?
The profitability index is a capital budgeting technique that
measures the profitability of an investment by dividing the
present value of future cash inflows by the initial investment cost.
A profitability index greater than 1 indicates a positive net present
value.
11. Write any two characteristics of Short-term Finance.
Two characteristics of short-term finance are:
 Short Maturity: Short-term finance refers to borrowing or
raising funds for a period of less than one year.
 Flexibility: Short-term financing sources are generally more
flexible than long-term sources, allowing businesses to adapt
to changing needs.
12. Give the meaning of Trade Credit.
Trade credit is the credit extended by suppliers to their customers,
allowing them to purchase goods or services on credit and pay
later. It is a common form of short-term financing for businesses.
13. What is Aggressive Working Capital?
Aggressive working capital management involves minimizing
investment in current assets and maximizing the use of short-
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term debt. It is a strategy that aims to maximize profitability but
carries higher risk due to potential liquidity problems.