Department of Business Managment
CONCEPTS IN FINANCIAL MANAGEMENT
1. Finance.
a.Finance is a simple task of providing the necessary funds (money) required by the business of
entities like companies, firms, individuals and others on the terms that are most favourable to
b.Finance is the procurement (to get, obtain) of funds and effective (properly planned) utilisation
of funds. It also deals with profits that adequately compensate for the cost and risks borne by the
business."
2. Financial decisions:
many kinds of financial management decisions that the firm makes min pursuit of maximizing
shareholder?s wealth, viz., kind of assets to be acquired , pattern of capitalization, distribution of
firm?s income etc. we can classify these decisions into three major groups:
? Investment decisions
? Dividend decisions
3. Investment Decisions:
Investment decision relates to the determination of total amount of assets to be held in the firm,
the composition of these assets and the business risk complexions of the firm as perceived by its
Investment decisions can be classified under two broad groups:
Long?term investment decision and
Short? term investment
4. Wealth maximization ?Definition
objective of bringing in the highest possible return. The wealth maximization strategy generally
involves making sound financial investment decisions which take into consideration any risk
factors that would compromise or outweigh the anticipated benefits.
5. Profit maximization ? Definition
maximize its return. The company will usually adjust influential factors such as production costs,
sale prices, and output levels as a way of reaching its profit goal. There are two main profit
maximization methods used, and they are Marginal Cost?Marginal Revenue Method and Total
Cost?Total Revenue Method. Profit maximization is a good thing for a company, but can be a
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Department of Business Managment
CONCEPTS IN FINANCIAL MANAGEMENT
1. Finance.
entities like companies, firms, individuals and others on the terms that are most favourable to
achieve their economic objectives."
b.Finance is the procurement (to get, obtain) of funds and effective (properly planned) utilisation
of funds. It also deals with profits that adequately compensate for the cost and risks borne by the
2. Financial decisions:
Financial decisions refers to decisions concerning financial matters of a business firm. There are
many kinds of financial management decisions that the firm makes min pursuit of maximizing
shareholder?s wealth, viz., kind of assets to be acquired , pattern of capitalization, distribution of
? Investment decisions
? Financing decisions
? Dividend decisions
3. Investment Decisions:
the composition of these assets and the business risk complexions of the firm as perceived by its
investors.
Investment decisions can be classified under two broad groups:
Long?term investment decision and
4. Wealth maximization ?Definition
A process that increases the current net value of business or shareholder capital gains, with the
objective of bringing in the highest possible return. The wealth maximization strategy generally
involves making sound financial investment decisions which take into consideration any risk
5. Profit maximization ? Definition
A process that companies undergo to determine the best output and price levels in order to
maximize its return. The company will usually adjust influential factors such as production costs,
sale prices, and output levels as a way of reaching its profit goal. There are two main profit
Cost?Total Revenue Method. Profit maximization is a good thing for a company, but can be a
bad thing for consumers if the company starts to use cheaper products or decides to raise prices.
6. Time value of money:
The recognition of the time value of money is extremely vital in financial decision making. If the
objectives of maximizing the owner?s welfare. The welfare of the owners would be maximised,
when net wealth or net present worth is created from making a financial decision.
7. Compound Value: Interest that is paid both on the initial principal as also on the interest
earned on the initial principal in previous period/s. The interest earned in one period becomes a
8. Present value:
The present value of current cash inflow or outflow is the amount of current cash that is of
equivalent desirability, to the decision maker, to a specified amount of cash to be received or
paid at a future date.
Three reasons may be attributed to the individual?s time preference for money:
? Risk
? Preference for consumption
? Investment opportunities
10. Annuity: A series of receipts or payments of a fixed amount for a specified number of years.
Alternatively, a pattern of cash flows that is equal in each year, i.e. equal annual cash flows.
11. Capital budgeting: The process of determining which potential long?term projects are worth
undertaking, by comparing their expected discounted cash flows with their internal rates of
12. Capital Budgeting techniques: The following are the capital?budgetingtechniques:
Non ?Discounted cash flow (DCF) criteria?
? Pay back period (PBP)
? Accounting Rate of return
? Net present value (NPV)
? Profitability Index (PI)
? Internal rate of return (IRR)
13. Payback Period: The length of time required to recover the cost of an investment. The
undertake the position or project, as longer payback periods are typically not desirable for
investment positions.
Calculated as: Cost of Project
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CONCEPTS IN FINANCIAL MANAGEMENT
1. Finance.
a.Finance is a simple task of providing the necessary funds (money) required by the business of
entities like companies, firms, individuals and others on the terms that are most favourable to
b.Finance is the procurement (to get, obtain) of funds and effective (properly planned) utilisation
of funds. It also deals with profits that adequately compensate for the cost and risks borne by the
business."
2. Financial decisions:
many kinds of financial management decisions that the firm makes min pursuit of maximizing
shareholder?s wealth, viz., kind of assets to be acquired , pattern of capitalization, distribution of
firm?s income etc. we can classify these decisions into three major groups:
? Investment decisions
? Dividend decisions
3. Investment Decisions:
Investment decision relates to the determination of total amount of assets to be held in the firm,
the composition of these assets and the business risk complexions of the firm as perceived by its
Investment decisions can be classified under two broad groups:
Long?term investment decision and
Short? term investment
4. Wealth maximization ?Definition
objective of bringing in the highest possible return. The wealth maximization strategy generally
involves making sound financial investment decisions which take into consideration any risk
factors that would compromise or outweigh the anticipated benefits.
5. Profit maximization ? Definition
maximize its return. The company will usually adjust influential factors such as production costs,
sale prices, and output levels as a way of reaching its profit goal. There are two main profit
maximization methods used, and they are Marginal Cost?Marginal Revenue Method and Total
Cost?Total Revenue Method. Profit maximization is a good thing for a company, but can be a
6. Time value of money:
The recognition of the time value of money is extremely vital in financial decision making. If the
timing of cash flows is not considered the firm may make decisions which may faulter its
objectives of maximizing the owner?s welfare. The welfare of the owners would be maximised,
7. Compound Value: Interest that is paid both on the initial principal as also on the interest
earned on the initial principal in previous period/s. The interest earned in one period becomes a
part of the principal in the succeeding period.
8. Present value:
equivalent desirability, to the decision maker, to a specified amount of cash to be received or
paid at a future date.
9. Reasons for Time value of money:
Three reasons may be attributed to the individual?s time preference for money:
? Preference for consumption
? Investment opportunities
S
10. Annuity: A series of receipts or payments of a fixed amount for a specified number of years.
11. Capital budgeting: The process of determining which potential long?term projects are worth
undertaking, by comparing their expected discounted cash flows with their internal rates of
return.
12. Capital Budgeting techniques: The following are the capital?budgetingtechniques:
? Pay back period (PBP)
? Accounting Rate of return
Discounted Cash flow techniques:
? Net present value (NPV)
? Internal rate of return (IRR)
13. Payback Period: The length of time required to recover the cost of an investment. The
payback period of a given investment or project is an important determinant of whether to
undertake the position or project, as longer payback periods are typically not desirable for
Calculated as: Cost of Project
Annual Cash Inflows
14. Accounting rate of return method: The accounting rate of return also known as the return on
Investment (ROI) Uses accounting information, as revealed by financial statements, to measure
tax profit divided by the average investment. The average investment would be equal to half of
the original investment if it were depreciated constantly. Alternatively, it can be found out by
dividing the total of the investment?s book value after depreciation by the life of the project. The
accounting rate of return, thus, is an average rate and can be determined by the following
ARR= Average Income
Average Investment
15. Net Present Value ? NPV?The difference between the present value of cash inflows and the
present value of cash outflows. NPV is used in capital budgeting to analyze the profitability of an
investment or project will yield.
16. Internal Rate Of Return ? IRR? The IRR of an investment is the discount rate at which the net
present value of costs (negative cash flows) of the investment equals the net present value of the
benefits (positive cash flows) of the investment. The discount rate often used in capital budgeting
17. Profitability Index (P.I.) or Benefit cost ratio: It is the ratio of the present value of future cash
benefits, at the required rate of return to the initial cash flow of the investment?.
Formula: PI. = Present value of cash inflows
Present value of initial cash outlay
project under consideration satisfies the minimum acceptance standard and should be accepted.
19. Capital Rationing: Risk?Return Trade off A situation in which due to financial constraints,
the limited funds are allocated a number of mutually exclusive capital budgeting projects.
20. Definition of Risk: The chance that an investment's actual return will be different than
versions of risk are usually measured by calculating the standard deviation of the historical
returns or average returns of a specific investment. A high standard deviation indicates a high
degree of risk.
21. Risk premium: The difference between expected rate of return on a risky project and the rate
22. Risk?Return Trade?off: The relationship between the risk and the required Rate of return.
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Department of Business Managment
CONCEPTS IN FINANCIAL MANAGEMENT
a.Finance is a simple task of providing the necessary funds (money) required by the business of
entities like companies, firms, individuals and others on the terms that are most favourable to
achieve their economic objectives."
b.Finance is the procurement (to get, obtain) of funds and effective (properly planned) utilisation
business."
2. Financial decisions:
Financial decisions refers to decisions concerning financial matters of a business firm. There are
many kinds of financial management decisions that the firm makes min pursuit of maximizing
firm?s income etc. we can classify these decisions into three major groups:
? Investment decisions
? Financing decisions
? Dividend decisions
Investment decision relates to the determination of total amount of assets to be held in the firm,
the composition of these assets and the business risk complexions of the firm as perceived by its
investors.
Investment decisions can be classified under two broad groups:
Short? term investment
4. Wealth maximization ?Definition
A process that increases the current net value of business or shareholder capital gains, with the
objective of bringing in the highest possible return. The wealth maximization strategy generally
factors that would compromise or outweigh the anticipated benefits.
5. Profit maximization ? Definition
A process that companies undergo to determine the best output and price levels in order to
maximize its return. The company will usually adjust influential factors such as production costs,
maximization methods used, and they are Marginal Cost?Marginal Revenue Method and Total
Cost?Total Revenue Method. Profit maximization is a good thing for a company, but can be a
bad thing for consumers if the company starts to use cheaper products or decides to raise prices.
6. Time value of money:
timing of cash flows is not considered the firm may make decisions which may faulter its
objectives of maximizing the owner?s welfare. The welfare of the owners would be maximised,
when net wealth or net present worth is created from making a financial decision.
7. Compound Value: Interest that is paid both on the initial principal as also on the interest
part of the principal in the succeeding period.
8. Present value:
The present value of current cash inflow or outflow is the amount of current cash that is of
equivalent desirability, to the decision maker, to a specified amount of cash to be received or
9. Reasons for Time value of money:
Three reasons may be attributed to the individual?s time preference for money:
? Risk
? Preference for consumption
S
10. Annuity: A series of receipts or payments of a fixed amount for a specified number of years.
Alternatively, a pattern of cash flows that is equal in each year, i.e. equal annual cash flows.
11. Capital budgeting: The process of determining which potential long?term projects are worth
return.
12. Capital Budgeting techniques: The following are the capital?budgetingtechniques:
Non ?Discounted cash flow (DCF) criteria?
? Pay back period (PBP)
Discounted Cash flow techniques:
? Net present value (NPV)
? Profitability Index (PI)
? Internal rate of return (IRR)
payback period of a given investment or project is an important determinant of whether to
undertake the position or project, as longer payback periods are typically not desirable for
investment positions.
Calculated as: Cost of Project
14. Accounting rate of return method: The accounting rate of return also known as the return on
Investment (ROI) Uses accounting information, as revealed by financial statements, to measure
the profitability of an investment. The accounting rate of return is the ratio of the average after
tax profit divided by the average investment. The average investment would be equal to half of
dividing the total of the investment?s book value after depreciation by the life of the project. The
accounting rate of return, thus, is an average rate and can be determined by the following
equation.
ARR= Average Income
15. Net Present Value ? NPV?The difference between the present value of cash inflows and the
present value of cash outflows. NPV is used in capital budgeting to analyze the profitability of an
investment or project. NPV analysis is sensitive to the reliability of future cash inflows that an
investment or project will yield.
present value of costs (negative cash flows) of the investment equals the net present value of the
benefits (positive cash flows) of the investment. The discount rate often used in capital budgeting
that makes the net present value of all cash flows from a particular project equal to zero.
17. Profitability Index (P.I.) or Benefit cost ratio: It is the ratio of the present value of future cash
Formula: PI. = Present value of cash inflows
Present value of initial cash outlay
18. Accept?Reject criterion: Evaluation of capital budgeting proposals to determine whether the
project under consideration satisfies the minimum acceptance standard and should be accepted.
the limited funds are allocated a number of mutually exclusive capital budgeting projects.
20. Definition of Risk: The chance that an investment's actual return will be different than
expected. Risk includes the possibility of losing some or all of the original investment. Different
versions of risk are usually measured by calculating the standard deviation of the historical
degree of risk.
21. Risk premium: The difference between expected rate of return on a risky project and the rate
of return on a risk less project.
22. Risk?Return Trade?off: The relationship between the risk and the required Rate of return.
measuring how much risk is involved in producing that return, which is generally expressed as a
number or rating. Risk?adjusted returns are applied to individual securities and investment funds
and portfolios.
24. Certainty?Equivalents: The return required with certainty to make investors indifferent
25. Coefficient of variation: A relative measure of the variability of the outcomes associated
with an event. It is calculated by dividing the standard deviation of a distribution by the mean.
26. Sensitivity Analysis: The analysis of the effect of change in certain variable on an outcome,
to estimate the variability of the outcome, or risk associated with a project or a situation.
decision and future events, future decisions and their consequences. The sequence of events is
mapped out over time in a format similar to the branches of a tree.
28. Leverage: A General Dictionary meaning of the term ?Leverage? refers to an increased means
of accomplishing some purpose.? Leverage allows us to accomplish certain things which are
leverage is valid in business also.
In Financial Management, the term ?leverage? is used to describe the firm?s ability to use fixed
cost assets or funds to increase the return to its owners? i.e. equity shareholders. James Home has
defined leverage as ?the employment of an asset or sources of funds for which the firm has to
the changes in volume of output or sales. Thus, the employment of an asset or source of funds for
which the firm has to pay a fixed cost or return has a considerable influence on the earnings
available for equity shareholders.
24. Financial Leverage/Trading on Equity:
share(EPS) . Also known as Trading on Equity.
? To use debt to finance an activity. For example, one usually borrows money in the form
of a mortgage to buy a house. One commonly refers to this as leveraging the house.
Likewise, one leverages when one uses a margin in order to purchase securities.
debt than equity is generally called "highly leveraged." Too much leverage is often
thought to be unhealthy, but many firms use leverage in order to expand operations.
OR
Financial leverage
proportionate changes in earnings after taxes. Financial leverage magnifies increases in earnings
per share during periods of rising operating income but adds significant risks for stockholders
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Department of Business Managment
1. Finance.
a.Finance is a simple task of providing the necessary funds (money) required by the business of
entities like companies, firms, individuals and others on the terms that are most favourable to
achieve their economic objectives."
of funds. It also deals with profits that adequately compensate for the cost and risks borne by the
business."
2. Financial decisions:
Financial decisions refers to decisions concerning financial matters of a business firm. There are
shareholder?s wealth, viz., kind of assets to be acquired , pattern of capitalization, distribution of
firm?s income etc. we can classify these decisions into three major groups:
? Investment decisions
? Financing decisions
3. Investment Decisions:
Investment decision relates to the determination of total amount of assets to be held in the firm,
the composition of these assets and the business risk complexions of the firm as perceived by its
investors.
Long?term investment decision and
Short? term investment
4. Wealth maximization ?Definition
A process that increases the current net value of business or shareholder capital gains, with the
involves making sound financial investment decisions which take into consideration any risk
factors that would compromise or outweigh the anticipated benefits.
5. Profit maximization ? Definition
A process that companies undergo to determine the best output and price levels in order to
sale prices, and output levels as a way of reaching its profit goal. There are two main profit
maximization methods used, and they are Marginal Cost?Marginal Revenue Method and Total
Cost?Total Revenue Method. Profit maximization is a good thing for a company, but can be a
bad thing for consumers if the company starts to use cheaper products or decides to raise prices.
The recognition of the time value of money is extremely vital in financial decision making. If the
timing of cash flows is not considered the firm may make decisions which may faulter its
objectives of maximizing the owner?s welfare. The welfare of the owners would be maximised,
when net wealth or net present worth is created from making a financial decision.
earned on the initial principal in previous period/s. The interest earned in one period becomes a
part of the principal in the succeeding period.
8. Present value:
The present value of current cash inflow or outflow is the amount of current cash that is of
paid at a future date.
9. Reasons for Time value of money:
Three reasons may be attributed to the individual?s time preference for money:
? Risk
? Investment opportunities
S
10. Annuity: A series of receipts or payments of a fixed amount for a specified number of years.
Alternatively, a pattern of cash flows that is equal in each year, i.e. equal annual cash flows.
undertaking, by comparing their expected discounted cash flows with their internal rates of
return.
12. Capital Budgeting techniques: The following are the capital?budgetingtechniques:
Non ?Discounted cash flow (DCF) criteria?
? Accounting Rate of return
Discounted Cash flow techniques:
? Net present value (NPV)
? Profitability Index (PI)
13. Payback Period: The length of time required to recover the cost of an investment. The
payback period of a given investment or project is an important determinant of whether to
undertake the position or project, as longer payback periods are typically not desirable for
investment positions.
Annual Cash Inflows
14. Accounting rate of return method: The accounting rate of return also known as the return on
Investment (ROI) Uses accounting information, as revealed by financial statements, to measure
the profitability of an investment. The accounting rate of return is the ratio of the average after
the original investment if it were depreciated constantly. Alternatively, it can be found out by
dividing the total of the investment?s book value after depreciation by the life of the project. The
accounting rate of return, thus, is an average rate and can be determined by the following
equation.
Average Investment
15. Net Present Value ? NPV?The difference between the present value of cash inflows and the
present value of cash outflows. NPV is used in capital budgeting to analyze the profitability of an
investment or project. NPV analysis is sensitive to the reliability of future cash inflows that an
16. Internal Rate Of Return ? IRR? The IRR of an investment is the discount rate at which the net
present value of costs (negative cash flows) of the investment equals the net present value of the
benefits (positive cash flows) of the investment. The discount rate often used in capital budgeting
that makes the net present value of all cash flows from a particular project equal to zero.
benefits, at the required rate of return to the initial cash flow of the investment?.
Formula: PI. = Present value of cash inflows
Present value of initial cash outlay
18. Accept?Reject criterion: Evaluation of capital budgeting proposals to determine whether the
19. Capital Rationing: Risk?Return Trade off A situation in which due to financial constraints,
the limited funds are allocated a number of mutually exclusive capital budgeting projects.
20. Definition of Risk: The chance that an investment's actual return will be different than
expected. Risk includes the possibility of losing some or all of the original investment. Different
returns or average returns of a specific investment. A high standard deviation indicates a high
degree of risk.
21. Risk premium: The difference between expected rate of return on a risky project and the rate
of return on a risk less project.
23. Definition of Risk?Adjusted Return: A concept that defines an investment's return by
measuring how much risk is involved in producing that return, which is generally expressed as a
number or rating. Risk?adjusted returns are applied to individual securities and investment funds
and portfolios.
between this certain return and a particular uncertain (risky) return.
25. Coefficient of variation: A relative measure of the variability of the outcomes associated
with an event. It is calculated by dividing the standard deviation of a distribution by the mean.
26. Sensitivity Analysis: The analysis of the effect of change in certain variable on an outcome,
27. Decision Tree: A decision tree is a graphic display of the relationship between a present
decision and future events, future decisions and their consequences. The sequence of events is
mapped out over time in a format similar to the branches of a tree.
28. Leverage: A General Dictionary meaning of the term ?Leverage? refers to an increased means
otherwise not possible, viz? Lifting of heavy objects with the help of leverage. The concept of
leverage is valid in business also.
In Financial Management, the term ?leverage? is used to describe the firm?s ability to use fixed
cost assets or funds to increase the return to its owners? i.e. equity shareholders. James Home has
pay a fixed cost or fixed return?. The fixed cost and fixed return remain constant irrespective of
the changes in volume of output or sales. Thus, the employment of an asset or source of funds for
which the firm has to pay a fixed cost or return has a considerable influence on the earnings
available for equity shareholders.
The ability of fixed financial charges magnify the effect of changes in EBIT on the earnings per
share(EPS) . Also known as Trading on Equity.
? To use debt to finance an activity. For example, one usually borrows money in the form
of a mortgage to buy a house. One commonly refers to this as leveraging the house.
? The amount of debt that has been used to finance activities. A company with much more
debt than equity is generally called "highly leveraged." Too much leverage is often
thought to be unhealthy, but many firms use leverage in order to expand operations.
OR
The extent to which interest on debt magnifies changes in operating income into even greater
proportionate changes in earnings after taxes. Financial leverage magnifies increases in earnings
per share during periods of rising operating income but adds significant risks for stockholders
and creditors because of added interest obligations.
A measurement of the degree to which a firm or project incurs a combination of fixed and
variable costs.
? A business that makes few sales, with each sale providing a very high gross margin,
is said to be highly leveraged. A business that makes many sales, with each sale
in a business increases, each new sale contributes less to fixed costs and more to
profitability.
? A business that has a higher proportion of fixed costs and a lower proportion of
variable costs is said to have used more operating leverage. Those businesses with
26. Capital structure: Capital structure of a company means the composition of long ?term
sources of funds. Such as ordinary shares, preference shares, debentures, bonds, long?term debts
etc. It refers to the kind and proportion of securities for raising long?term funds. It implies the
determination of form or makeup of a company?s capitalization.
that combination of debt and equity that attains the stated managerial goal in the most relevant
manner? the maximization of the firm?s market value and the minimization of the firm?s cost of
capital. The Optimal capital structure is concerned with the two important variables at one time ?
The minimization of cost as well as maximization of worth.
It is the rate of return that could have been earned by putting the same money into a different
investment with equal risk. Thus, the cost of capital is the rate of return required to persuade the
investor to make a given investment.
29. Definition of 'Weighted Average Cost Of Capital ? WACC'
weighted. All capital sources ? common stock, preferred stock, bonds and any other long?term
debt ? are included in a WACC calculation. All else equal, the WACC of a firm increases as the
beta and rate of return on equity increases, as an increase in WACC notes a decrease in valuation
and a higher risk.
Income for this income statement item, but finance people usually refer to it as EBIT
(pronounced as it is spelled ? E.B.I. T). Either way, on an income statement, it is the amount of
income that a company has after subtracting operating expenses from sales (hence the term net
operating income). Another way of looking at it is that this is the income that the company has
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Department of Business Managment
CONCEPTS IN FINANCIAL MANAGEMENT
1. Finance.
entities like companies, firms, individuals and others on the terms that are most favourable to
achieve their economic objectives."
b.Finance is the procurement (to get, obtain) of funds and effective (properly planned) utilisation
of funds. It also deals with profits that adequately compensate for the cost and risks borne by the
2. Financial decisions:
Financial decisions refers to decisions concerning financial matters of a business firm. There are
many kinds of financial management decisions that the firm makes min pursuit of maximizing
shareholder?s wealth, viz., kind of assets to be acquired , pattern of capitalization, distribution of
? Investment decisions
? Financing decisions
? Dividend decisions
3. Investment Decisions:
the composition of these assets and the business risk complexions of the firm as perceived by its
investors.
Investment decisions can be classified under two broad groups:
Long?term investment decision and
4. Wealth maximization ?Definition
A process that increases the current net value of business or shareholder capital gains, with the
objective of bringing in the highest possible return. The wealth maximization strategy generally
involves making sound financial investment decisions which take into consideration any risk
5. Profit maximization ? Definition
A process that companies undergo to determine the best output and price levels in order to
maximize its return. The company will usually adjust influential factors such as production costs,
sale prices, and output levels as a way of reaching its profit goal. There are two main profit
Cost?Total Revenue Method. Profit maximization is a good thing for a company, but can be a
bad thing for consumers if the company starts to use cheaper products or decides to raise prices.
6. Time value of money:
The recognition of the time value of money is extremely vital in financial decision making. If the
objectives of maximizing the owner?s welfare. The welfare of the owners would be maximised,
when net wealth or net present worth is created from making a financial decision.
7. Compound Value: Interest that is paid both on the initial principal as also on the interest
earned on the initial principal in previous period/s. The interest earned in one period becomes a
8. Present value:
The present value of current cash inflow or outflow is the amount of current cash that is of
equivalent desirability, to the decision maker, to a specified amount of cash to be received or
paid at a future date.
Three reasons may be attributed to the individual?s time preference for money:
? Risk
? Preference for consumption
? Investment opportunities
10. Annuity: A series of receipts or payments of a fixed amount for a specified number of years.
Alternatively, a pattern of cash flows that is equal in each year, i.e. equal annual cash flows.
11. Capital budgeting: The process of determining which potential long?term projects are worth
undertaking, by comparing their expected discounted cash flows with their internal rates of
12. Capital Budgeting techniques: The following are the capital?budgetingtechniques:
Non ?Discounted cash flow (DCF) criteria?
? Pay back period (PBP)
? Accounting Rate of return
? Net present value (NPV)
? Profitability Index (PI)
? Internal rate of return (IRR)
13. Payback Period: The length of time required to recover the cost of an investment. The
undertake the position or project, as longer payback periods are typically not desirable for
investment positions.
Calculated as: Cost of Project
Annual Cash Inflows
Investment (ROI) Uses accounting information, as revealed by financial statements, to measure
the profitability of an investment. The accounting rate of return is the ratio of the average after
tax profit divided by the average investment. The average investment would be equal to half of
the original investment if it were depreciated constantly. Alternatively, it can be found out by
accounting rate of return, thus, is an average rate and can be determined by the following
equation.
ARR= Average Income
Average Investment
present value of cash outflows. NPV is used in capital budgeting to analyze the profitability of an
investment or project. NPV analysis is sensitive to the reliability of future cash inflows that an
investment or project will yield.
16. Internal Rate Of Return ? IRR? The IRR of an investment is the discount rate at which the net
benefits (positive cash flows) of the investment. The discount rate often used in capital budgeting
that makes the net present value of all cash flows from a particular project equal to zero.
17. Profitability Index (P.I.) or Benefit cost ratio: It is the ratio of the present value of future cash
benefits, at the required rate of return to the initial cash flow of the investment?.
Present value of initial cash outlay
18. Accept?Reject criterion: Evaluation of capital budgeting proposals to determine whether the
project under consideration satisfies the minimum acceptance standard and should be accepted.
19. Capital Rationing: Risk?Return Trade off A situation in which due to financial constraints,
20. Definition of Risk: The chance that an investment's actual return will be different than
expected. Risk includes the possibility of losing some or all of the original investment. Different
versions of risk are usually measured by calculating the standard deviation of the historical
returns or average returns of a specific investment. A high standard deviation indicates a high
21. Risk premium: The difference between expected rate of return on a risky project and the rate
of return on a risk less project.
22. Risk?Return Trade?off: The relationship between the risk and the required Rate of return.
23. Definition of Risk?Adjusted Return: A concept that defines an investment's return by
number or rating. Risk?adjusted returns are applied to individual securities and investment funds
and portfolios.
24. Certainty?Equivalents: The return required with certainty to make investors indifferent
between this certain return and a particular uncertain (risky) return.
with an event. It is calculated by dividing the standard deviation of a distribution by the mean.
26. Sensitivity Analysis: The analysis of the effect of change in certain variable on an outcome,
to estimate the variability of the outcome, or risk associated with a project or a situation.
27. Decision Tree: A decision tree is a graphic display of the relationship between a present
mapped out over time in a format similar to the branches of a tree.
28. Leverage: A General Dictionary meaning of the term ?Leverage? refers to an increased means
of accomplishing some purpose.? Leverage allows us to accomplish certain things which are
otherwise not possible, viz? Lifting of heavy objects with the help of leverage. The concept of
In Financial Management, the term ?leverage? is used to describe the firm?s ability to use fixed
cost assets or funds to increase the return to its owners? i.e. equity shareholders. James Home has
defined leverage as ?the employment of an asset or sources of funds for which the firm has to
pay a fixed cost or fixed return?. The fixed cost and fixed return remain constant irrespective of
which the firm has to pay a fixed cost or return has a considerable influence on the earnings
available for equity shareholders.
24. Financial Leverage/Trading on Equity:
The ability of fixed financial charges magnify the effect of changes in EBIT on the earnings per
? To use debt to finance an activity. For example, one usually borrows money in the form
of a mortgage to buy a house. One commonly refers to this as leveraging the house.
Likewise, one leverages when one uses a margin in order to purchase securities.
? The amount of debt that has been used to finance activities. A company with much more
thought to be unhealthy, but many firms use leverage in order to expand operations.
OR
Financial leverage
The extent to which interest on debt magnifies changes in operating income into even greater
per share during periods of rising operating income but adds significant risks for stockholders
and creditors because of added interest obligations.
25. Definition of 'Operating Leverage'
A measurement of the degree to which a firm or project incurs a combination of fixed and
? A business that makes few sales, with each sale providing a very high gross margin,
is said to be highly leveraged. A business that makes many sales, with each sale
contributing a very slight margin, is said to be less leveraged. As the volume of sales
in a business increases, each new sale contributes less to fixed costs and more to
? A business that has a higher proportion of fixed costs and a lower proportion of
variable costs is said to have used more operating leverage. Those businesses with
lower fixed costs and higher variable costs are said to employ less operating leverage.
26. Capital structure: Capital structure of a company means the composition of long ?term
etc. It refers to the kind and proportion of securities for raising long?term funds. It implies the
determination of form or makeup of a company?s capitalization.
27. Optimum capital structure: An optimal or sound capital structure can be properly defined as
that combination of debt and equity that attains the stated managerial goal in the most relevant
capital. The Optimal capital structure is concerned with the two important variables at one time ?
The minimization of cost as well as maximization of worth.
28. Cost of capital: Cost of capital refers to the opportunity cost of making a specific investment.
It is the rate of return that could have been earned by putting the same money into a different
investor to make a given investment.
29. Definition of 'Weighted Average Cost Of Capital ? WACC'
A calculation of a firm's cost of capital in which each category of capital is proportionately
weighted. All capital sources ? common stock, preferred stock, bonds and any other long?term
beta and rate of return on equity increases, as an increase in WACC notes a decrease in valuation
and a higher risk.
30. EBIT ? Earnings Before Interest and Taxes. Accountants like to use the term Net Operating
Income for this income statement item, but finance people usually refer to it as EBIT
income that a company has after subtracting operating expenses from sales (hence the term net
operating income). Another way of looking at it is that this is the income that the company has
before subtracting interest and taxes (hence, EBIT) .
31. EAT ? Earnings After Taxes. Accountants call this Net Income or Net Profit After Taxes, but
32. EPS ? Earnings Per Share. This is the amount of income that the common stockholders are
entitled to receive (per share of stock owned). This income may be paid out in the form of
dividends, retained and reinvested by the company, or a combination of both. (It is pronounced
E. P. S).
A firm. The book value of ordinary shares is equal to the paid?up capital plus retained earnings
i.e. net worth.
34. Par value: The stated or face nominal) value of a security.
35. Market value: It is determined on the basis of the stock market quotations of the company?s
36. Flotation costs: Costs incurred in issuing securities, e.g., underwriting and brokerage costs,
printing, legal, publicity and so on.
37. Equity share capital: Long term funds provided by the owners of a firm and consist of
ordinary share capital and retained earnings.
shareholders as dividends.
39. Preference shares: Preference shares have a fixed percentage dividend before any dividend is
paid to the ordinary shareholders. As with ordinary shares a preference dividend can only be paid
if sufficient distributable profits are available, although with 'cumulative' preference shares the
cumulative preference shares must be paid before any dividend is paid to the ordinary
shareholders.
40. Definition of 'Dividend Policy': The policy a company uses to decide how much it will pay
out to shareholders in dividends.
dividend policies almost always affect the value of the firm. His model, one of the earlier
theoretical works shows the importance of the relationship between the firm?s rate of return, r
and its cost of capital, k in determining the dividend policy that will maximize the wealth of
shareholders.
Miller (MM), under a perfect market situation, the dividend policy of a firm is irrelevant, as it
does not affect the value of the firm. They argue that the value of the firm depends on the firm?s
earnings that result from its investment policy.
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CONCEPTS IN FINANCIAL MANAGEMENT
1. Finance.
a.Finance is a simple task of providing the necessary funds (money) required by the business of
entities like companies, firms, individuals and others on the terms that are most favourable to
b.Finance is the procurement (to get, obtain) of funds and effective (properly planned) utilisation
of funds. It also deals with profits that adequately compensate for the cost and risks borne by the
business."
2. Financial decisions:
many kinds of financial management decisions that the firm makes min pursuit of maximizing
shareholder?s wealth, viz., kind of assets to be acquired , pattern of capitalization, distribution of
firm?s income etc. we can classify these decisions into three major groups:
? Investment decisions
? Dividend decisions
3. Investment Decisions:
Investment decision relates to the determination of total amount of assets to be held in the firm,
the composition of these assets and the business risk complexions of the firm as perceived by its
Investment decisions can be classified under two broad groups:
Long?term investment decision and
Short? term investment
4. Wealth maximization ?Definition
objective of bringing in the highest possible return. The wealth maximization strategy generally
involves making sound financial investment decisions which take into consideration any risk
factors that would compromise or outweigh the anticipated benefits.
5. Profit maximization ? Definition
maximize its return. The company will usually adjust influential factors such as production costs,
sale prices, and output levels as a way of reaching its profit goal. There are two main profit
maximization methods used, and they are Marginal Cost?Marginal Revenue Method and Total
Cost?Total Revenue Method. Profit maximization is a good thing for a company, but can be a
6. Time value of money:
The recognition of the time value of money is extremely vital in financial decision making. If the
timing of cash flows is not considered the firm may make decisions which may faulter its
objectives of maximizing the owner?s welfare. The welfare of the owners would be maximised,
7. Compound Value: Interest that is paid both on the initial principal as also on the interest
earned on the initial principal in previous period/s. The interest earned in one period becomes a
part of the principal in the succeeding period.
8. Present value:
equivalent desirability, to the decision maker, to a specified amount of cash to be received or
paid at a future date.
9. Reasons for Time value of money:
Three reasons may be attributed to the individual?s time preference for money:
? Preference for consumption
? Investment opportunities
S
10. Annuity: A series of receipts or payments of a fixed amount for a specified number of years.
11. Capital budgeting: The process of determining which potential long?term projects are worth
undertaking, by comparing their expected discounted cash flows with their internal rates of
return.
12. Capital Budgeting techniques: The following are the capital?budgetingtechniques:
? Pay back period (PBP)
? Accounting Rate of return
Discounted Cash flow techniques:
? Net present value (NPV)
? Internal rate of return (IRR)
13. Payback Period: The length of time required to recover the cost of an investment. The
payback period of a given investment or project is an important determinant of whether to
undertake the position or project, as longer payback periods are typically not desirable for
Calculated as: Cost of Project
Annual Cash Inflows
14. Accounting rate of return method: The accounting rate of return also known as the return on
Investment (ROI) Uses accounting information, as revealed by financial statements, to measure
tax profit divided by the average investment. The average investment would be equal to half of
the original investment if it were depreciated constantly. Alternatively, it can be found out by
dividing the total of the investment?s book value after depreciation by the life of the project. The
accounting rate of return, thus, is an average rate and can be determined by the following
ARR= Average Income
Average Investment
15. Net Present Value ? NPV?The difference between the present value of cash inflows and the
present value of cash outflows. NPV is used in capital budgeting to analyze the profitability of an
investment or project will yield.
16. Internal Rate Of Return ? IRR? The IRR of an investment is the discount rate at which the net
present value of costs (negative cash flows) of the investment equals the net present value of the
benefits (positive cash flows) of the investment. The discount rate often used in capital budgeting
17. Profitability Index (P.I.) or Benefit cost ratio: It is the ratio of the present value of future cash
benefits, at the required rate of return to the initial cash flow of the investment?.
Formula: PI. = Present value of cash inflows
Present value of initial cash outlay
project under consideration satisfies the minimum acceptance standard and should be accepted.
19. Capital Rationing: Risk?Return Trade off A situation in which due to financial constraints,
the limited funds are allocated a number of mutually exclusive capital budgeting projects.
20. Definition of Risk: The chance that an investment's actual return will be different than
versions of risk are usually measured by calculating the standard deviation of the historical
returns or average returns of a specific investment. A high standard deviation indicates a high
degree of risk.
21. Risk premium: The difference between expected rate of return on a risky project and the rate
22. Risk?Return Trade?off: The relationship between the risk and the required Rate of return.
23. Definition of Risk?Adjusted Return: A concept that defines an investment's return by
measuring how much risk is involved in producing that return, which is generally expressed as a
number or rating. Risk?adjusted returns are applied to individual securities and investment funds
24. Certainty?Equivalents: The return required with certainty to make investors indifferent
between this certain return and a particular uncertain (risky) return.
25. Coefficient of variation: A relative measure of the variability of the outcomes associated
with an event. It is calculated by dividing the standard deviation of a distribution by the mean.
to estimate the variability of the outcome, or risk associated with a project or a situation.
27. Decision Tree: A decision tree is a graphic display of the relationship between a present
decision and future events, future decisions and their consequences. The sequence of events is
mapped out over time in a format similar to the branches of a tree.
of accomplishing some purpose.? Leverage allows us to accomplish certain things which are
otherwise not possible, viz? Lifting of heavy objects with the help of leverage. The concept of
leverage is valid in business also.
In Financial Management, the term ?leverage? is used to describe the firm?s ability to use fixed
defined leverage as ?the employment of an asset or sources of funds for which the firm has to
pay a fixed cost or fixed return?. The fixed cost and fixed return remain constant irrespective of
the changes in volume of output or sales. Thus, the employment of an asset or source of funds for
which the firm has to pay a fixed cost or return has a considerable influence on the earnings
24. Financial Leverage/Trading on Equity:
The ability of fixed financial charges magnify the effect of changes in EBIT on the earnings per
share(EPS) . Also known as Trading on Equity.
? To use debt to finance an activity. For example, one usually borrows money in the form
Likewise, one leverages when one uses a margin in order to purchase securities.
? The amount of debt that has been used to finance activities. A company with much more
debt than equity is generally called "highly leveraged." Too much leverage is often
thought to be unhealthy, but many firms use leverage in order to expand operations.
Financial leverage
The extent to which interest on debt magnifies changes in operating income into even greater
proportionate changes in earnings after taxes. Financial leverage magnifies increases in earnings
per share during periods of rising operating income but adds significant risks for stockholders
25. Definition of 'Operating Leverage'
A measurement of the degree to which a firm or project incurs a combination of fixed and
variable costs.
? A business that makes few sales, with each sale providing a very high gross margin,
contributing a very slight margin, is said to be less leveraged. As the volume of sales
in a business increases, each new sale contributes less to fixed costs and more to
profitability.
? A business that has a higher proportion of fixed costs and a lower proportion of
lower fixed costs and higher variable costs are said to employ less operating leverage.
26. Capital structure: Capital structure of a company means the composition of long ?term
sources of funds. Such as ordinary shares, preference shares, debentures, bonds, long?term debts
etc. It refers to the kind and proportion of securities for raising long?term funds. It implies the
27. Optimum capital structure: An optimal or sound capital structure can be properly defined as
that combination of debt and equity that attains the stated managerial goal in the most relevant
manner? the maximization of the firm?s market value and the minimization of the firm?s cost of
capital. The Optimal capital structure is concerned with the two important variables at one time ?
28. Cost of capital: Cost of capital refers to the opportunity cost of making a specific investment.
It is the rate of return that could have been earned by putting the same money into a different
investment with equal risk. Thus, the cost of capital is the rate of return required to persuade the
investor to make a given investment.
A calculation of a firm's cost of capital in which each category of capital is proportionately
weighted. All capital sources ? common stock, preferred stock, bonds and any other long?term
debt ? are included in a WACC calculation. All else equal, the WACC of a firm increases as the
beta and rate of return on equity increases, as an increase in WACC notes a decrease in valuation
30. EBIT ? Earnings Before Interest and Taxes. Accountants like to use the term Net Operating
Income for this income statement item, but finance people usually refer to it as EBIT
(pronounced as it is spelled ? E.B.I. T). Either way, on an income statement, it is the amount of
income that a company has after subtracting operating expenses from sales (hence the term net
before subtracting interest and taxes (hence, EBIT) .
31. EAT ? Earnings After Taxes. Accountants call this Net Income or Net Profit After Taxes, but
finance people usually refer to it as EAT (pronounced E. A. T) .
32. EPS ? Earnings Per Share. This is the amount of income that the common stockholders are
dividends, retained and reinvested by the company, or a combination of both. (It is pronounced
E. P. S).
33. Book value: The value of an asset, a liability or equity, as recorded in the accounts of
A firm. The book value of ordinary shares is equal to the paid?up capital plus retained earnings
34. Par value: The stated or face nominal) value of a security.
35. Market value: It is determined on the basis of the stock market quotations of the company?s
securities.
36. Flotation costs: Costs incurred in issuing securities, e.g., underwriting and brokerage costs,
37. Equity share capital: Long term funds provided by the owners of a firm and consist of
ordinary share capital and retained earnings.
38. Retained Earnings: The portion of the after?tax profits that are not paid out to the
shareholders as dividends.
paid to the ordinary shareholders. As with ordinary shares a preference dividend can only be paid
if sufficient distributable profits are available, although with 'cumulative' preference shares the
right to an unpaid dividend is carried forward to later years. The arrears of dividend on
cumulative preference shares must be paid before any dividend is paid to the ordinary
40. Definition of 'Dividend Policy': The policy a company uses to decide how much it will pay
out to shareholders in dividends.
41. Dividend Relevance: Walter?s Models: Professor James E. Walter argues that the choice of
dividend policies almost always affect the value of the firm. His model, one of the earlier
and its cost of capital, k in determining the dividend policy that will maximize the wealth of
shareholders.
42. Dividend Irrelevance: The Miller Modgiliani (MM) approach: According to Modgiliani and
Miller (MM), under a perfect market situation, the dividend policy of a firm is irrelevant, as it
earnings that result from its investment policy.
43. Gordon Model: A valuation model in which the value of a firm is equal to the present value
of all future dividends expected over the life of the firm.
44. Inventory management: Definition: Activities employed in maintaining the optimum number
uninterrupted production, sales, and/or customer?service levels at the minimum cost. Since for
many companies inventory is the largest item in the current assets category, inventory problems
can and do contribute to losses or even business failures.
45. Economic Order Quantity: The optimum quantity of inventory to order or to produce based
46. Accounts Receivable Management: The term receivables is defined as debt owed to the firm
by customers arising from sale of goods or services in the ordinary course of business.
47. Receivables management: Receivables Management means planning, organising, directing
and controlling of receivables.
The average period taken to collect receivables. It is equal to the average credit sales divided by
the number of days in a year.
49. Definition of Cash Management: The corporate process of collecting, managing and (short?
term) investing cash. A key component of ensuring a company's financial stability and
management.
50. Cash management: Successful cash management involves not only avoiding insolvency (and
therefore bankruptcy), but also reducing days in account receivables (AR), increasing collection
rates, selecting appropriate short?term investment vehicles, and increasing days cash on hand all
51. Cash cycle: The length of time from the point a firm purchases raw materials to the point
when cash is collected from the sale of the resulting finished goods. In other words, it represents
the time during which cash is tied up in operations.
52. Liquidity/Solvency: Abilityof a firm to meet its obligations when they become due.
54. Current liabilities: Liabilities hat are payable within a year.
55. Cash Budget: A Cash budget is an estimate of cash receipts and disbursements of cash during
a future period of time. In the words of Solomon Ezra, a cash budget is ?an analysis of flow of
cash in a business over a future, short or long period of time. It is a forecast of expected cash
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Department of Business Managment
CONCEPTS IN FINANCIAL MANAGEMENT
1. Finance.
entities like companies, firms, individuals and others on the terms that are most favourable to
achieve their economic objectives."
b.Finance is the procurement (to get, obtain) of funds and effective (properly planned) utilisation
of funds. It also deals with profits that adequately compensate for the cost and risks borne by the
2. Financial decisions:
Financial decisions refers to decisions concerning financial matters of a business firm. There are
many kinds of financial management decisions that the firm makes min pursuit of maximizing
shareholder?s wealth, viz., kind of assets to be acquired , pattern of capitalization, distribution of
? Investment decisions
? Financing decisions
? Dividend decisions
3. Investment Decisions:
the composition of these assets and the business risk complexions of the firm as perceived by its
investors.
Investment decisions can be classified under two broad groups:
Long?term investment decision and
4. Wealth maximization ?Definition
A process that increases the current net value of business or shareholder capital gains, with the
objective of bringing in the highest possible return. The wealth maximization strategy generally
involves making sound financial investment decisions which take into consideration any risk
5. Profit maximization ? Definition
A process that companies undergo to determine the best output and price levels in order to
maximize its return. The company will usually adjust influential factors such as production costs,
sale prices, and output levels as a way of reaching its profit goal. There are two main profit
Cost?Total Revenue Method. Profit maximization is a good thing for a company, but can be a
bad thing for consumers if the company starts to use cheaper products or decides to raise prices.
6. Time value of money:
The recognition of the time value of money is extremely vital in financial decision making. If the
objectives of maximizing the owner?s welfare. The welfare of the owners would be maximised,
when net wealth or net present worth is created from making a financial decision.
7. Compound Value: Interest that is paid both on the initial principal as also on the interest
earned on the initial principal in previous period/s. The interest earned in one period becomes a
8. Present value:
The present value of current cash inflow or outflow is the amount of current cash that is of
equivalent desirability, to the decision maker, to a specified amount of cash to be received or
paid at a future date.
Three reasons may be attributed to the individual?s time preference for money:
? Risk
? Preference for consumption
? Investment opportunities
10. Annuity: A series of receipts or payments of a fixed amount for a specified number of years.
Alternatively, a pattern of cash flows that is equal in each year, i.e. equal annual cash flows.
11. Capital budgeting: The process of determining which potential long?term projects are worth
undertaking, by comparing their expected discounted cash flows with their internal rates of
12. Capital Budgeting techniques: The following are the capital?budgetingtechniques:
Non ?Discounted cash flow (DCF) criteria?
? Pay back period (PBP)
? Accounting Rate of return
? Net present value (NPV)
? Profitability Index (PI)
? Internal rate of return (IRR)
13. Payback Period: The length of time required to recover the cost of an investment. The
undertake the position or project, as longer payback periods are typically not desirable for
investment positions.
Calculated as: Cost of Project
Annual Cash Inflows
Investment (ROI) Uses accounting information, as revealed by financial statements, to measure
the profitability of an investment. The accounting rate of return is the ratio of the average after
tax profit divided by the average investment. The average investment would be equal to half of
the original investment if it were depreciated constantly. Alternatively, it can be found out by
accounting rate of return, thus, is an average rate and can be determined by the following
equation.
ARR= Average Income
Average Investment
present value of cash outflows. NPV is used in capital budgeting to analyze the profitability of an
investment or project. NPV analysis is sensitive to the reliability of future cash inflows that an
investment or project will yield.
16. Internal Rate Of Return ? IRR? The IRR of an investment is the discount rate at which the net
benefits (positive cash flows) of the investment. The discount rate often used in capital budgeting
that makes the net present value of all cash flows from a particular project equal to zero.
17. Profitability Index (P.I.) or Benefit cost ratio: It is the ratio of the present value of future cash
benefits, at the required rate of return to the initial cash flow of the investment?.
Present value of initial cash outlay
18. Accept?Reject criterion: Evaluation of capital budgeting proposals to determine whether the
project under consideration satisfies the minimum acceptance standard and should be accepted.
19. Capital Rationing: Risk?Return Trade off A situation in which due to financial constraints,
20. Definition of Risk: The chance that an investment's actual return will be different than
expected. Risk includes the possibility of losing some or all of the original investment. Different
versions of risk are usually measured by calculating the standard deviation of the historical
returns or average returns of a specific investment. A high standard deviation indicates a high
21. Risk premium: The difference between expected rate of return on a risky project and the rate
of return on a risk less project.
22. Risk?Return Trade?off: The relationship between the risk and the required Rate of return.
23. Definition of Risk?Adjusted Return: A concept that defines an investment's return by
number or rating. Risk?adjusted returns are applied to individual securities and investment funds
and portfolios.
24. Certainty?Equivalents: The return required with certainty to make investors indifferent
between this certain return and a particular uncertain (risky) return.
with an event. It is calculated by dividing the standard deviation of a distribution by the mean.
26. Sensitivity Analysis: The analysis of the effect of change in certain variable on an outcome,
to estimate the variability of the outcome, or risk associated with a project or a situation.
27. Decision Tree: A decision tree is a graphic display of the relationship between a present
mapped out over time in a format similar to the branches of a tree.
28. Leverage: A General Dictionary meaning of the term ?Leverage? refers to an increased means
of accomplishing some purpose.? Leverage allows us to accomplish certain things which are
otherwise not possible, viz? Lifting of heavy objects with the help of leverage. The concept of
In Financial Management, the term ?leverage? is used to describe the firm?s ability to use fixed
cost assets or funds to increase the return to its owners? i.e. equity shareholders. James Home has
defined leverage as ?the employment of an asset or sources of funds for which the firm has to
pay a fixed cost or fixed return?. The fixed cost and fixed return remain constant irrespective of
which the firm has to pay a fixed cost or return has a considerable influence on the earnings
available for equity shareholders.
24. Financial Leverage/Trading on Equity:
The ability of fixed financial charges magnify the effect of changes in EBIT on the earnings per
? To use debt to finance an activity. For example, one usually borrows money in the form
of a mortgage to buy a house. One commonly refers to this as leveraging the house.
Likewise, one leverages when one uses a margin in order to purchase securities.
? The amount of debt that has been used to finance activities. A company with much more
thought to be unhealthy, but many firms use leverage in order to expand operations.
OR
Financial leverage
The extent to which interest on debt magnifies changes in operating income into even greater
per share during periods of rising operating income but adds significant risks for stockholders
and creditors because of added interest obligations.
25. Definition of 'Operating Leverage'
A measurement of the degree to which a firm or project incurs a combination of fixed and
? A business that makes few sales, with each sale providing a very high gross margin,
is said to be highly leveraged. A business that makes many sales, with each sale
contributing a very slight margin, is said to be less leveraged. As the volume of sales
in a business increases, each new sale contributes less to fixed costs and more to
? A business that has a higher proportion of fixed costs and a lower proportion of
variable costs is said to have used more operating leverage. Those businesses with
lower fixed costs and higher variable costs are said to employ less operating leverage.
26. Capital structure: Capital structure of a company means the composition of long ?term
etc. It refers to the kind and proportion of securities for raising long?term funds. It implies the
determination of form or makeup of a company?s capitalization.
27. Optimum capital structure: An optimal or sound capital structure can be properly defined as
that combination of debt and equity that attains the stated managerial goal in the most relevant
capital. The Optimal capital structure is concerned with the two important variables at one time ?
The minimization of cost as well as maximization of worth.
28. Cost of capital: Cost of capital refers to the opportunity cost of making a specific investment.
It is the rate of return that could have been earned by putting the same money into a different
investor to make a given investment.
29. Definition of 'Weighted Average Cost Of Capital ? WACC'
A calculation of a firm's cost of capital in which each category of capital is proportionately
weighted. All capital sources ? common stock, preferred stock, bonds and any other long?term
beta and rate of return on equity increases, as an increase in WACC notes a decrease in valuation
and a higher risk.
30. EBIT ? Earnings Before Interest and Taxes. Accountants like to use the term Net Operating
Income for this income statement item, but finance people usually refer to it as EBIT
income that a company has after subtracting operating expenses from sales (hence the term net
operating income). Another way of looking at it is that this is the income that the company has
before subtracting interest and taxes (hence, EBIT) .
31. EAT ? Earnings After Taxes. Accountants call this Net Income or Net Profit After Taxes, but
32. EPS ? Earnings Per Share. This is the amount of income that the common stockholders are
entitled to receive (per share of stock owned). This income may be paid out in the form of
dividends, retained and reinvested by the company, or a combination of both. (It is pronounced
E. P. S).
A firm. The book value of ordinary shares is equal to the paid?up capital plus retained earnings
i.e. net worth.
34. Par value: The stated or face nominal) value of a security.
35. Market value: It is determined on the basis of the stock market quotations of the company?s
36. Flotation costs: Costs incurred in issuing securities, e.g., underwriting and brokerage costs,
printing, legal, publicity and so on.
37. Equity share capital: Long term funds provided by the owners of a firm and consist of
ordinary share capital and retained earnings.
shareholders as dividends.
39. Preference shares: Preference shares have a fixed percentage dividend before any dividend is
paid to the ordinary shareholders. As with ordinary shares a preference dividend can only be paid
if sufficient distributable profits are available, although with 'cumulative' preference shares the
cumulative preference shares must be paid before any dividend is paid to the ordinary
shareholders.
40. Definition of 'Dividend Policy': The policy a company uses to decide how much it will pay
out to shareholders in dividends.
dividend policies almost always affect the value of the firm. His model, one of the earlier
theoretical works shows the importance of the relationship between the firm?s rate of return, r
and its cost of capital, k in determining the dividend policy that will maximize the wealth of
shareholders.
Miller (MM), under a perfect market situation, the dividend policy of a firm is irrelevant, as it
does not affect the value of the firm. They argue that the value of the firm depends on the firm?s
earnings that result from its investment policy.
43. Gordon Model: A valuation model in which the value of a firm is equal to the present value
44. Inventory management: Definition: Activities employed in maintaining the optimum number
or amount of each inventory item. The objective of inventory management is to provide
uninterrupted production, sales, and/or customer?service levels at the minimum cost. Since for
many companies inventory is the largest item in the current assets category, inventory problems
45. Economic Order Quantity: The optimum quantity of inventory to order or to produce based
on trade?off between carrying and ordering costs.
46. Accounts Receivable Management: The term receivables is defined as debt owed to the firm
by customers arising from sale of goods or services in the ordinary course of business.
and controlling of receivables.
48. Collection period:
The average period taken to collect receivables. It is equal to the average credit sales divided by
the number of days in a year.
term) investing cash. A key component of ensuring a company's financial stability and
solvency. Frequently corporate treasurers or a business manager is responsible for overall cash
management.
50. Cash management: Successful cash management involves not only avoiding insolvency (and
rates, selecting appropriate short?term investment vehicles, and increasing days cash on hand all
in order to improve a company's overall financial profitability.
51. Cash cycle: The length of time from the point a firm purchases raw materials to the point
when cash is collected from the sale of the resulting finished goods. In other words, it represents
52. Liquidity/Solvency: Abilityof a firm to meet its obligations when they become due.
53. Current assets: Assets which can be converted into cash within a year.
54. Current liabilities: Liabilities hat are payable within a year.
55. Cash Budget: A Cash budget is an estimate of cash receipts and disbursements of cash during
cash in a business over a future, short or long period of time. It is a forecast of expected cash
intake and outlay.
56. Value Based Management: Definition of value based management: Value Based
Management is the management approach that ensures corporations are run consistently on value
It
is useful to understand that Value Based Management includes all three of the following:
? Creating Value: ways to actually increase or generate maximum future value ?
strategy.Value Based Management VBM
communication, leadership
? Measuring Value: valuation.
57. Corporate governance: Corporate governance refers to the set of systems, principles and
processes by which a company is governed. They provide the guidelines as to how the company
to the value of the company and is also beneficial for all stakeholders in the long term.
Stakeholders in this case would include everyone ranging from the board of directors,
management, shareholders to customers, employees and society. The management of the
company hence assumes the role of a trustee for all the others.
pooling of interests
59. Acquisition: The act of contracting or assuming or acquiring possession of something? "the
acquisition of wealth"? the acquisition of one company by another"
60. Takeover: Takeover is a term referring to transfer of control of a firm from one group of
corporation, either through a friendly acquisition or an unfriendly, hostile, bid. A hostile
takeover (with the aim of replacing current existing management) is usually attempted
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Department of Business Managment
1. Finance.
a.Finance is a simple task of providing the necessary funds (money) required by the business of
entities like companies, firms, individuals and others on the terms that are most favourable to
achieve their economic objectives."
of funds. It also deals with profits that adequately compensate for the cost and risks borne by the
business."
2. Financial decisions:
Financial decisions refers to decisions concerning financial matters of a business firm. There are
shareholder?s wealth, viz., kind of assets to be acquired , pattern of capitalization, distribution of
firm?s income etc. we can classify these decisions into three major groups:
? Investment decisions
? Financing decisions
3. Investment Decisions:
Investment decision relates to the determination of total amount of assets to be held in the firm,
the composition of these assets and the business risk complexions of the firm as perceived by its
investors.
Long?term investment decision and
Short? term investment
4. Wealth maximization ?Definition
A process that increases the current net value of business or shareholder capital gains, with the
involves making sound financial investment decisions which take into consideration any risk
factors that would compromise or outweigh the anticipated benefits.
5. Profit maximization ? Definition
A process that companies undergo to determine the best output and price levels in order to
sale prices, and output levels as a way of reaching its profit goal. There are two main profit
maximization methods used, and they are Marginal Cost?Marginal Revenue Method and Total
Cost?Total Revenue Method. Profit maximization is a good thing for a company, but can be a
bad thing for consumers if the company starts to use cheaper products or decides to raise prices.
The recognition of the time value of money is extremely vital in financial decision making. If the
timing of cash flows is not considered the firm may make decisions which may faulter its
objectives of maximizing the owner?s welfare. The welfare of the owners would be maximised,
when net wealth or net present worth is created from making a financial decision.
earned on the initial principal in previous period/s. The interest earned in one period becomes a
part of the principal in the succeeding period.
8. Present value:
The present value of current cash inflow or outflow is the amount of current cash that is of
paid at a future date.
9. Reasons for Time value of money:
Three reasons may be attributed to the individual?s time preference for money:
? Risk
? Investment opportunities
S
10. Annuity: A series of receipts or payments of a fixed amount for a specified number of years.
Alternatively, a pattern of cash flows that is equal in each year, i.e. equal annual cash flows.
undertaking, by comparing their expected discounted cash flows with their internal rates of
return.
12. Capital Budgeting techniques: The following are the capital?budgetingtechniques:
Non ?Discounted cash flow (DCF) criteria?
? Accounting Rate of return
Discounted Cash flow techniques:
? Net present value (NPV)
? Profitability Index (PI)
13. Payback Period: The length of time required to recover the cost of an investment. The
payback period of a given investment or project is an important determinant of whether to
undertake the position or project, as longer payback periods are typically not desirable for
investment positions.
Annual Cash Inflows
14. Accounting rate of return method: The accounting rate of return also known as the return on
Investment (ROI) Uses accounting information, as revealed by financial statements, to measure
the profitability of an investment. The accounting rate of return is the ratio of the average after
the original investment if it were depreciated constantly. Alternatively, it can be found out by
dividing the total of the investment?s book value after depreciation by the life of the project. The
accounting rate of return, thus, is an average rate and can be determined by the following
equation.
Average Investment
15. Net Present Value ? NPV?The difference between the present value of cash inflows and the
present value of cash outflows. NPV is used in capital budgeting to analyze the profitability of an
investment or project. NPV analysis is sensitive to the reliability of future cash inflows that an
16. Internal Rate Of Return ? IRR? The IRR of an investment is the discount rate at which the net
present value of costs (negative cash flows) of the investment equals the net present value of the
benefits (positive cash flows) of the investment. The discount rate often used in capital budgeting
that makes the net present value of all cash flows from a particular project equal to zero.
benefits, at the required rate of return to the initial cash flow of the investment?.
Formula: PI. = Present value of cash inflows
Present value of initial cash outlay
18. Accept?Reject criterion: Evaluation of capital budgeting proposals to determine whether the
19. Capital Rationing: Risk?Return Trade off A situation in which due to financial constraints,
the limited funds are allocated a number of mutually exclusive capital budgeting projects.
20. Definition of Risk: The chance that an investment's actual return will be different than
expected. Risk includes the possibility of losing some or all of the original investment. Different
returns or average returns of a specific investment. A high standard deviation indicates a high
degree of risk.
21. Risk premium: The difference between expected rate of return on a risky project and the rate
of return on a risk less project.
23. Definition of Risk?Adjusted Return: A concept that defines an investment's return by
measuring how much risk is involved in producing that return, which is generally expressed as a
number or rating. Risk?adjusted returns are applied to individual securities and investment funds
and portfolios.
between this certain return and a particular uncertain (risky) return.
25. Coefficient of variation: A relative measure of the variability of the outcomes associated
with an event. It is calculated by dividing the standard deviation of a distribution by the mean.
26. Sensitivity Analysis: The analysis of the effect of change in certain variable on an outcome,
27. Decision Tree: A decision tree is a graphic display of the relationship between a present
decision and future events, future decisions and their consequences. The sequence of events is
mapped out over time in a format similar to the branches of a tree.
28. Leverage: A General Dictionary meaning of the term ?Leverage? refers to an increased means
otherwise not possible, viz? Lifting of heavy objects with the help of leverage. The concept of
leverage is valid in business also.
In Financial Management, the term ?leverage? is used to describe the firm?s ability to use fixed
cost assets or funds to increase the return to its owners? i.e. equity shareholders. James Home has
pay a fixed cost or fixed return?. The fixed cost and fixed return remain constant irrespective of
the changes in volume of output or sales. Thus, the employment of an asset or source of funds for
which the firm has to pay a fixed cost or return has a considerable influence on the earnings
available for equity shareholders.
The ability of fixed financial charges magnify the effect of changes in EBIT on the earnings per
share(EPS) . Also known as Trading on Equity.
? To use debt to finance an activity. For example, one usually borrows money in the form
of a mortgage to buy a house. One commonly refers to this as leveraging the house.
? The amount of debt that has been used to finance activities. A company with much more
debt than equity is generally called "highly leveraged." Too much leverage is often
thought to be unhealthy, but many firms use leverage in order to expand operations.
OR
The extent to which interest on debt magnifies changes in operating income into even greater
proportionate changes in earnings after taxes. Financial leverage magnifies increases in earnings
per share during periods of rising operating income but adds significant risks for stockholders
and creditors because of added interest obligations.
A measurement of the degree to which a firm or project incurs a combination of fixed and
variable costs.
? A business that makes few sales, with each sale providing a very high gross margin,
is said to be highly leveraged. A business that makes many sales, with each sale
in a business increases, each new sale contributes less to fixed costs and more to
profitability.
? A business that has a higher proportion of fixed costs and a lower proportion of
variable costs is said to have used more operating leverage. Those businesses with
26. Capital structure: Capital structure of a company means the composition of long ?term
sources of funds. Such as ordinary shares, preference shares, debentures, bonds, long?term debts
etc. It refers to the kind and proportion of securities for raising long?term funds. It implies the
determination of form or makeup of a company?s capitalization.
that combination of debt and equity that attains the stated managerial goal in the most relevant
manner? the maximization of the firm?s market value and the minimization of the firm?s cost of
capital. The Optimal capital structure is concerned with the two important variables at one time ?
The minimization of cost as well as maximization of worth.
It is the rate of return that could have been earned by putting the same money into a different
investment with equal risk. Thus, the cost of capital is the rate of return required to persuade the
investor to make a given investment.
29. Definition of 'Weighted Average Cost Of Capital ? WACC'
weighted. All capital sources ? common stock, preferred stock, bonds and any other long?term
debt ? are included in a WACC calculation. All else equal, the WACC of a firm increases as the
beta and rate of return on equity increases, as an increase in WACC notes a decrease in valuation
and a higher risk.
Income for this income statement item, but finance people usually refer to it as EBIT
(pronounced as it is spelled ? E.B.I. T). Either way, on an income statement, it is the amount of
income that a company has after subtracting operating expenses from sales (hence the term net
operating income). Another way of looking at it is that this is the income that the company has
31. EAT ? Earnings After Taxes. Accountants call this Net Income or Net Profit After Taxes, but
finance people usually refer to it as EAT (pronounced E. A. T) .
32. EPS ? Earnings Per Share. This is the amount of income that the common stockholders are
entitled to receive (per share of stock owned). This income may be paid out in the form of
E. P. S).
33. Book value: The value of an asset, a liability or equity, as recorded in the accounts of
A firm. The book value of ordinary shares is equal to the paid?up capital plus retained earnings
i.e. net worth.
35. Market value: It is determined on the basis of the stock market quotations of the company?s
securities.
36. Flotation costs: Costs incurred in issuing securities, e.g., underwriting and brokerage costs,
printing, legal, publicity and so on.
ordinary share capital and retained earnings.
38. Retained Earnings: The portion of the after?tax profits that are not paid out to the
shareholders as dividends.
39. Preference shares: Preference shares have a fixed percentage dividend before any dividend is
if sufficient distributable profits are available, although with 'cumulative' preference shares the
right to an unpaid dividend is carried forward to later years. The arrears of dividend on
cumulative preference shares must be paid before any dividend is paid to the ordinary
shareholders.
out to shareholders in dividends.
41. Dividend Relevance: Walter?s Models: Professor James E. Walter argues that the choice of
dividend policies almost always affect the value of the firm. His model, one of the earlier
theoretical works shows the importance of the relationship between the firm?s rate of return, r
shareholders.
42. Dividend Irrelevance: The Miller Modgiliani (MM) approach: According to Modgiliani and
Miller (MM), under a perfect market situation, the dividend policy of a firm is irrelevant, as it
does not affect the value of the firm. They argue that the value of the firm depends on the firm?s
43. Gordon Model: A valuation model in which the value of a firm is equal to the present value
of all future dividends expected over the life of the firm.
44. Inventory management: Definition: Activities employed in maintaining the optimum number
or amount of each inventory item. The objective of inventory management is to provide
many companies inventory is the largest item in the current assets category, inventory problems
can and do contribute to losses or even business failures.
45. Economic Order Quantity: The optimum quantity of inventory to order or to produce based
on trade?off between carrying and ordering costs.
by customers arising from sale of goods or services in the ordinary course of business.
47. Receivables management: Receivables Management means planning, organising, directing
and controlling of receivables.
48. Collection period:
the number of days in a year.
49. Definition of Cash Management: The corporate process of collecting, managing and (short?
term) investing cash. A key component of ensuring a company's financial stability and
solvency. Frequently corporate treasurers or a business manager is responsible for overall cash
50. Cash management: Successful cash management involves not only avoiding insolvency (and
therefore bankruptcy), but also reducing days in account receivables (AR), increasing collection
rates, selecting appropriate short?term investment vehicles, and increasing days cash on hand all
in order to improve a company's overall financial profitability.
when cash is collected from the sale of the resulting finished goods. In other words, it represents
the time during which cash is tied up in operations.
52. Liquidity/Solvency: Abilityof a firm to meet its obligations when they become due.
53. Current assets: Assets which can be converted into cash within a year.
55. Cash Budget: A Cash budget is an estimate of cash receipts and disbursements of cash during
a future period of time. In the words of Solomon Ezra, a cash budget is ?an analysis of flow of
cash in a business over a future, short or long period of time. It is a forecast of expected cash
intake and outlay.
Management is the management approach that ensures corporations are run consistently on value
(normally: maximizing shareholder value).
It
is useful to understand that Value Based Management includes all three of the following:
strategy.Value Based Management VBM
? Managing for Value: (governance, change management, organizational culture,
communication, leadership
? Measuring Value: valuation.
processes by which a company is governed. They provide the guidelines as to how the company
can be directed or controlled such that it can fulfil its goals and objectives in a manner that adds
to the value of the company and is also beneficial for all stakeholders in the long term.
Stakeholders in this case would include everyone ranging from the board of directors,
company hence assumes the role of a trustee for all the others.
58. Merger: The combining of two or more entities into one, through a purchase acquisition or a
pooling of interests
59. Acquisition: The act of contracting or assuming or acquiring possession of something? "the
60. Takeover: Takeover is a term referring to transfer of control of a firm from one group of
shareholders to another group of shareholders. Change in the controlling interest of a
corporation, either through a friendly acquisition or an unfriendly, hostile, bid. A hostile
takeover (with the aim of replacing current existing management) is usually attempted
61. Concentric merger: Concentric mergers take place when two firms from different but
" adjacent" industries merge. For example, if an auto manufacturer and a motorcycle
manufacturer merge, the merger is a concentric one. Although both industries serve the
transportation needs of their customers, the two are quite unique in their competitive structures.
different businesses merge to diversify the products marketed. The companies may not be related
to each other horizontally
A conglomerate merger is a type of merger whereby the two companies that merge with each
other are involved in different sorts of businesses. The importance of the conglomerate mergers
63. Vertical Merger: Merger between a company that supplies goods and services and a
company that buys those goods and services. For example, if a publishing company buys a paper
producer, it is considered a vertical merger because the publisher buys large amounts of paper. In
some cases, vertical mergers may be challenged by the government if they are found to violate
64. Operating cycle concept : Maximization of share holder?s wealth of a firm is possible only
when there are sufficient return from the operations. Successful sales activity is necessary for
earning profit. Sales do not convert into cash immediately? There is invisible time gap between
the sale of goods and receipt of cash. The time taken to convert raw material into cash is known
Conversion of cash into raw material -* Conversion of raw material into work in progress -*
Conversion of Work in progress into finished goods -* Conversion of finished goods into Sales -*
Sales into Debtors -* Debtors into cash.
65. Certainty: Certainty is a situation in which investor is certain about the future price. Certainty has
a . Availability of full information
b. Uniqueness of Outcomes
Ex: Suppose nvestor knows that the ecurity will definitely be old at Rs. 20.
66. Uncertainty: There is an inability to forecast the future accurately and reliably. It has two
? In adequate information
? Multiple outcomes.
Ex: Suppose he expects that the price of the ecurity could be Rs. 80, Rs. 10 or Rs. 20.
67. Risk: Definitions:
Department of Business Managment
CONCEPTS IN FINANCIAL MANAGEMENT
1. Finance.
a.Finance is a simple task of providing the necessary funds (money) required by the business of
achieve their economic objectives."
b.Finance is the procurement (to get, obtain) of funds and effective (properly planned) utilisation
of funds. It also deals with profits that adequately compensate for the cost and risks borne by the
business."
Financial decisions refers to decisions concerning financial matters of a business firm. There are
many kinds of financial management decisions that the firm makes min pursuit of maximizing
shareholder?s wealth, viz., kind of assets to be acquired , pattern of capitalization, distribution of
firm?s income etc. we can classify these decisions into three major groups:
? Financing decisions
? Dividend decisions
3. Investment Decisions:
Investment decision relates to the determination of total amount of assets to be held in the firm,
investors.
Investment decisions can be classified under two broad groups:
Long?term investment decision and
Short? term investment
A process that increases the current net value of business or shareholder capital gains, with the
objective of bringing in the highest possible return. The wealth maximization strategy generally
involves making sound financial investment decisions which take into consideration any risk
factors that would compromise or outweigh the anticipated benefits.
A process that companies undergo to determine the best output and price levels in order to
maximize its return. The company will usually adjust influential factors such as production costs,
sale prices, and output levels as a way of reaching its profit goal. There are two main profit
maximization methods used, and they are Marginal Cost?Marginal Revenue Method and Total
bad thing for consumers if the company starts to use cheaper products or decides to raise prices.
6. Time value of money:
The recognition of the time value of money is extremely vital in financial decision making. If the
timing of cash flows is not considered the firm may make decisions which may faulter its
when net wealth or net present worth is created from making a financial decision.
7. Compound Value: Interest that is paid both on the initial principal as also on the interest
earned on the initial principal in previous period/s. The interest earned in one period becomes a
part of the principal in the succeeding period.
The present value of current cash inflow or outflow is the amount of current cash that is of
equivalent desirability, to the decision maker, to a specified amount of cash to be received or
paid at a future date.
9. Reasons for Time value of money:
? Risk
? Preference for consumption
? Investment opportunities
S
Alternatively, a pattern of cash flows that is equal in each year, i.e. equal annual cash flows.
11. Capital budgeting: The process of determining which potential long?term projects are worth
undertaking, by comparing their expected discounted cash flows with their internal rates of
return.
Non ?Discounted cash flow (DCF) criteria?
? Pay back period (PBP)
? Accounting Rate of return
Discounted Cash flow techniques:
? Profitability Index (PI)
? Internal rate of return (IRR)
13. Payback Period: The length of time required to recover the cost of an investment. The
payback period of a given investment or project is an important determinant of whether to
investment positions.
Calculated as: Cost of Project
Annual Cash Inflows
14. Accounting rate of return method: The accounting rate of return also known as the return on
the profitability of an investment. The accounting rate of return is the ratio of the average after
tax profit divided by the average investment. The average investment would be equal to half of
the original investment if it were depreciated constantly. Alternatively, it can be found out by
dividing the total of the investment?s book value after depreciation by the life of the project. The
equation.
ARR= Average Income
Average Investment
15. Net Present Value ? NPV?The difference between the present value of cash inflows and the
investment or project. NPV analysis is sensitive to the reliability of future cash inflows that an
investment or project will yield.
16. Internal Rate Of Return ? IRR? The IRR of an investment is the discount rate at which the net
present value of costs (negative cash flows) of the investment equals the net present value of the
that makes the net present value of all cash flows from a particular project equal to zero.
17. Profitability Index (P.I.) or Benefit cost ratio: It is the ratio of the present value of future cash
benefits, at the required rate of return to the initial cash flow of the investment?.
Formula: PI. = Present value of cash inflows
18. Accept?Reject criterion: Evaluation of capital budgeting proposals to determine whether the
project under consideration satisfies the minimum acceptance standard and should be accepted.
19. Capital Rationing: Risk?Return Trade off A situation in which due to financial constraints,
the limited funds are allocated a number of mutually exclusive capital budgeting projects.
expected. Risk includes the possibility of losing some or all of the original investment. Different
versions of risk are usually measured by calculating the standard deviation of the historical
returns or average returns of a specific investment. A high standard deviation indicates a high
degree of risk.
of return on a risk less project.
22. Risk?Return Trade?off: The relationship between the risk and the required Rate of return.
23. Definition of Risk?Adjusted Return: A concept that defines an investment's return by
measuring how much risk is involved in producing that return, which is generally expressed as a
and portfolios.
24. Certainty?Equivalents: The return required with certainty to make investors indifferent
between this certain return and a particular uncertain (risky) return.
25. Coefficient of variation: A relative measure of the variability of the outcomes associated
26. Sensitivity Analysis: The analysis of the effect of change in certain variable on an outcome,
to estimate the variability of the outcome, or risk associated with a project or a situation.
27. Decision Tree: A decision tree is a graphic display of the relationship between a present
decision and future events, future decisions and their consequences. The sequence of events is
28. Leverage: A General Dictionary meaning of the term ?Leverage? refers to an increased means
of accomplishing some purpose.? Leverage allows us to accomplish certain things which are
otherwise not possible, viz? Lifting of heavy objects with the help of leverage. The concept of
leverage is valid in business also.
cost assets or funds to increase the return to its owners? i.e. equity shareholders. James Home has
defined leverage as ?the employment of an asset or sources of funds for which the firm has to
pay a fixed cost or fixed return?. The fixed cost and fixed return remain constant irrespective of
the changes in volume of output or sales. Thus, the employment of an asset or source of funds for
available for equity shareholders.
24. Financial Leverage/Trading on Equity:
The ability of fixed financial charges magnify the effect of changes in EBIT on the earnings per
share(EPS) . Also known as Trading on Equity.
of a mortgage to buy a house. One commonly refers to this as leveraging the house.
Likewise, one leverages when one uses a margin in order to purchase securities.
? The amount of debt that has been used to finance activities. A company with much more
debt than equity is generally called "highly leveraged." Too much leverage is often
OR
Financial leverage
The extent to which interest on debt magnifies changes in operating income into even greater
proportionate changes in earnings after taxes. Financial leverage magnifies increases in earnings
and creditors because of added interest obligations.
25. Definition of 'Operating Leverage'
A measurement of the degree to which a firm or project incurs a combination of fixed and
variable costs.
is said to be highly leveraged. A business that makes many sales, with each sale
contributing a very slight margin, is said to be less leveraged. As the volume of sales
in a business increases, each new sale contributes less to fixed costs and more to
profitability.
variable costs is said to have used more operating leverage. Those businesses with
lower fixed costs and higher variable costs are said to employ less operating leverage.
26. Capital structure: Capital structure of a company means the composition of long ?term
sources of funds. Such as ordinary shares, preference shares, debentures, bonds, long?term debts
determination of form or makeup of a company?s capitalization.
27. Optimum capital structure: An optimal or sound capital structure can be properly defined as
that combination of debt and equity that attains the stated managerial goal in the most relevant
manner? the maximization of the firm?s market value and the minimization of the firm?s cost of
The minimization of cost as well as maximization of worth.
28. Cost of capital: Cost of capital refers to the opportunity cost of making a specific investment.
It is the rate of return that could have been earned by putting the same money into a different
investment with equal risk. Thus, the cost of capital is the rate of return required to persuade the
29. Definition of 'Weighted Average Cost Of Capital ? WACC'
A calculation of a firm's cost of capital in which each category of capital is proportionately
weighted. All capital sources ? common stock, preferred stock, bonds and any other long?term
debt ? are included in a WACC calculation. All else equal, the WACC of a firm increases as the
and a higher risk.
30. EBIT ? Earnings Before Interest and Taxes. Accountants like to use the term Net Operating
Income for this income statement item, but finance people usually refer to it as EBIT
(pronounced as it is spelled ? E.B.I. T). Either way, on an income statement, it is the amount of
operating income). Another way of looking at it is that this is the income that the company has
before subtracting interest and taxes (hence, EBIT) .
31. EAT ? Earnings After Taxes. Accountants call this Net Income or Net Profit After Taxes, but
finance people usually refer to it as EAT (pronounced E. A. T) .
entitled to receive (per share of stock owned). This income may be paid out in the form of
dividends, retained and reinvested by the company, or a combination of both. (It is pronounced
E. P. S).
33. Book value: The value of an asset, a liability or equity, as recorded in the accounts of
i.e. net worth.
34. Par value: The stated or face nominal) value of a security.
35. Market value: It is determined on the basis of the stock market quotations of the company?s
securities.
printing, legal, publicity and so on.
37. Equity share capital: Long term funds provided by the owners of a firm and consist of
ordinary share capital and retained earnings.
38. Retained Earnings: The portion of the after?tax profits that are not paid out to the
39. Preference shares: Preference shares have a fixed percentage dividend before any dividend is
paid to the ordinary shareholders. As with ordinary shares a preference dividend can only be paid
if sufficient distributable profits are available, although with 'cumulative' preference shares the
right to an unpaid dividend is carried forward to later years. The arrears of dividend on
shareholders.
40. Definition of 'Dividend Policy': The policy a company uses to decide how much it will pay
out to shareholders in dividends.
41. Dividend Relevance: Walter?s Models: Professor James E. Walter argues that the choice of
theoretical works shows the importance of the relationship between the firm?s rate of return, r
and its cost of capital, k in determining the dividend policy that will maximize the wealth of
shareholders.
42. Dividend Irrelevance: The Miller Modgiliani (MM) approach: According to Modgiliani and
does not affect the value of the firm. They argue that the value of the firm depends on the firm?s
earnings that result from its investment policy.
43. Gordon Model: A valuation model in which the value of a firm is equal to the present value
of all future dividends expected over the life of the firm.
or amount of each inventory item. The objective of inventory management is to provide
uninterrupted production, sales, and/or customer?service levels at the minimum cost. Since for
many companies inventory is the largest item in the current assets category, inventory problems
can and do contribute to losses or even business failures.
on trade?off between carrying and ordering costs.
46. Accounts Receivable Management: The term receivables is defined as debt owed to the firm
by customers arising from sale of goods or services in the ordinary course of business.
47. Receivables management: Receivables Management means planning, organising, directing
48. Collection period:
The average period taken to collect receivables. It is equal to the average credit sales divided by
the number of days in a year.
49. Definition of Cash Management: The corporate process of collecting, managing and (short?
solvency. Frequently corporate treasurers or a business manager is responsible for overall cash
management.
50. Cash management: Successful cash management involves not only avoiding insolvency (and
therefore bankruptcy), but also reducing days in account receivables (AR), increasing collection
in order to improve a company's overall financial profitability.
51. Cash cycle: The length of time from the point a firm purchases raw materials to the point
when cash is collected from the sale of the resulting finished goods. In other words, it represents
the time during which cash is tied up in operations.
53. Current assets: Assets which can be converted into cash within a year.
54. Current liabilities: Liabilities hat are payable within a year.
55. Cash Budget: A Cash budget is an estimate of cash receipts and disbursements of cash during
a future period of time. In the words of Solomon Ezra, a cash budget is ?an analysis of flow of
intake and outlay.
56. Value Based Management: Definition of value based management: Value Based
Management is the management approach that ensures corporations are run consistently on value
(normally: maximizing shareholder value).
is useful to understand that Value Based Management includes all three of the following:
? Creating Value: ways to actually increase or generate maximum future value ?
strategy.Value Based Management VBM
? Managing for Value: (governance, change management, organizational culture,
? Measuring Value: valuation.
57. Corporate governance: Corporate governance refers to the set of systems, principles and
processes by which a company is governed. They provide the guidelines as to how the company
can be directed or controlled such that it can fulfil its goals and objectives in a manner that adds
Stakeholders in this case would include everyone ranging from the board of directors,
management, shareholders to customers, employees and society. The management of the
company hence assumes the role of a trustee for all the others.
58. Merger: The combining of two or more entities into one, through a purchase acquisition or a
59. Acquisition: The act of contracting or assuming or acquiring possession of something? "the
acquisition of wealth"? the acquisition of one company by another"
60. Takeover: Takeover is a term referring to transfer of control of a firm from one group of
shareholders to another group of shareholders. Change in the controlling interest of a
takeover (with the aim of replacing current existing management) is usually attempted
through a public tender offer.
61. Concentric merger: Concentric mergers take place when two firms from different but
" adjacent" industries merge. For example, if an auto manufacturer and a motorcycle
transportation needs of their customers, the two are quite unique in their competitive structures.
62. Conglomerate mergers: A conglomerate merger is one where two or more companies with
different businesses merge to diversify the products marketed. The companies may not be related
to each other horizontally
other are involved in different sorts of businesses. The importance of the conglomerate mergers
lies in the fact that they help the merging companies to be better than before.
63. Vertical Merger: Merger between a company that supplies goods and services and a
company that buys those goods and services. For example, if a publishing company buys a paper
some cases, vertical mergers may be challenged by the government if they are found to violate
antitrust laws.
64. Operating cycle concept : Maximization of share holder?s wealth of a firm is possible only
when there are sufficient return from the operations. Successful sales activity is necessary for
the sale of goods and receipt of cash. The time taken to convert raw material into cash is known
as operating cycle.
Conversion of cash into raw material -* Conversion of raw material into work in progress -*
Conversion of Work in progress into finished goods -* Conversion of finished goods into Sales -*
65. Certainty: Certainty is a situation in which investor is certain about the future price. Certainty has
two characteristics.
a . Availability of full information
b. Uniqueness of Outcomes
66. Uncertainty: There is an inability to forecast the future accurately and reliably. It has two
characteristics:
? In adequate information
? Multiple outcomes.
67. Risk: Definitions:
Uncertainty of future outcome Or Probability of an adverse Outcome Or Risk is defined as the
variability of return around the expected average.
Risk has three characteristics:
? Possession of probability distribution
? Replicability of past experiment.
Ex: Suppose the investor possesses information that permits him to assign probabilities to each oif the
above likely prices of the security. He assigns a probability of 60% to the prioce being Rs. 12?, 30% to the
68. The Hedging approach / Matching approach:
In this approach maturity of source of fund should
match the nature of asset to be financed.
Hedging approach refers to a process of matching maturities of
debt with the maturities of financial need. The hedging approach suggests that the permanent working
capital requirement should be financed with fund from long term sources while the temporary working
capital requirement should be financed with short term funds. This approach is also known as matching
69. Conservative Approach : This approach suggested that the entire estimated investments in current
asset should be finance from long term source and short term should be use only for emergency
requirement . Distinct features of this approach ~
? Liquidity is greater
? The cost of financing is relatively more as interest has to be paid even on seasonal requirement
for the entire period.
70. Aggressive approach: This approach make the finance mix. The aggressive approach suggests that
the entire estimated requirement of current asset should be financed from short?term sources and even a
? More Profitable
? Less costly
?
71. Definitions of Financial Management: According to S.N. Maheswari:
Financial management is concerned with raising financial resources and their effective utilisation towards
achieving the organizational goals
? According to Richard.A. Brealey: Financial management is the process of putting the available
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Department of Business Managment
CONCEPTS IN FINANCIAL MANAGEMENT
1. Finance.
entities like companies, firms, individuals and others on the terms that are most favourable to
achieve their economic objectives."
b.Finance is the procurement (to get, obtain) of funds and effective (properly planned) utilisation
of funds. It also deals with profits that adequately compensate for the cost and risks borne by the
2. Financial decisions:
Financial decisions refers to decisions concerning financial matters of a business firm. There are
many kinds of financial management decisions that the firm makes min pursuit of maximizing
shareholder?s wealth, viz., kind of assets to be acquired , pattern of capitalization, distribution of
? Investment decisions
? Financing decisions
? Dividend decisions
3. Investment Decisions:
the composition of these assets and the business risk complexions of the firm as perceived by its
investors.
Investment decisions can be classified under two broad groups:
Long?term investment decision and
4. Wealth maximization ?Definition
A process that increases the current net value of business or shareholder capital gains, with the
objective of bringing in the highest possible return. The wealth maximization strategy generally
involves making sound financial investment decisions which take into consideration any risk
5. Profit maximization ? Definition
A process that companies undergo to determine the best output and price levels in order to
maximize its return. The company will usually adjust influential factors such as production costs,
sale prices, and output levels as a way of reaching its profit goal. There are two main profit
Cost?Total Revenue Method. Profit maximization is a good thing for a company, but can be a
bad thing for consumers if the company starts to use cheaper products or decides to raise prices.
6. Time value of money:
The recognition of the time value of money is extremely vital in financial decision making. If the
objectives of maximizing the owner?s welfare. The welfare of the owners would be maximised,
when net wealth or net present worth is created from making a financial decision.
7. Compound Value: Interest that is paid both on the initial principal as also on the interest
earned on the initial principal in previous period/s. The interest earned in one period becomes a
8. Present value:
The present value of current cash inflow or outflow is the amount of current cash that is of
equivalent desirability, to the decision maker, to a specified amount of cash to be received or
paid at a future date.
Three reasons may be attributed to the individual?s time preference for money:
? Risk
? Preference for consumption
? Investment opportunities
10. Annuity: A series of receipts or payments of a fixed amount for a specified number of years.
Alternatively, a pattern of cash flows that is equal in each year, i.e. equal annual cash flows.
11. Capital budgeting: The process of determining which potential long?term projects are worth
undertaking, by comparing their expected discounted cash flows with their internal rates of
12. Capital Budgeting techniques: The following are the capital?budgetingtechniques:
Non ?Discounted cash flow (DCF) criteria?
? Pay back period (PBP)
? Accounting Rate of return
? Net present value (NPV)
? Profitability Index (PI)
? Internal rate of return (IRR)
13. Payback Period: The length of time required to recover the cost of an investment. The
undertake the position or project, as longer payback periods are typically not desirable for
investment positions.
Calculated as: Cost of Project
Annual Cash Inflows
Investment (ROI) Uses accounting information, as revealed by financial statements, to measure
the profitability of an investment. The accounting rate of return is the ratio of the average after
tax profit divided by the average investment. The average investment would be equal to half of
the original investment if it were depreciated constantly. Alternatively, it can be found out by
accounting rate of return, thus, is an average rate and can be determined by the following
equation.
ARR= Average Income
Average Investment
present value of cash outflows. NPV is used in capital budgeting to analyze the profitability of an
investment or project. NPV analysis is sensitive to the reliability of future cash inflows that an
investment or project will yield.
16. Internal Rate Of Return ? IRR? The IRR of an investment is the discount rate at which the net
benefits (positive cash flows) of the investment. The discount rate often used in capital budgeting
that makes the net present value of all cash flows from a particular project equal to zero.
17. Profitability Index (P.I.) or Benefit cost ratio: It is the ratio of the present value of future cash
benefits, at the required rate of return to the initial cash flow of the investment?.
Present value of initial cash outlay
18. Accept?Reject criterion: Evaluation of capital budgeting proposals to determine whether the
project under consideration satisfies the minimum acceptance standard and should be accepted.
19. Capital Rationing: Risk?Return Trade off A situation in which due to financial constraints,
20. Definition of Risk: The chance that an investment's actual return will be different than
expected. Risk includes the possibility of losing some or all of the original investment. Different
versions of risk are usually measured by calculating the standard deviation of the historical
returns or average returns of a specific investment. A high standard deviation indicates a high
21. Risk premium: The difference between expected rate of return on a risky project and the rate
of return on a risk less project.
22. Risk?Return Trade?off: The relationship between the risk and the required Rate of return.
23. Definition of Risk?Adjusted Return: A concept that defines an investment's return by
number or rating. Risk?adjusted returns are applied to individual securities and investment funds
and portfolios.
24. Certainty?Equivalents: The return required with certainty to make investors indifferent
between this certain return and a particular uncertain (risky) return.
with an event. It is calculated by dividing the standard deviation of a distribution by the mean.
26. Sensitivity Analysis: The analysis of the effect of change in certain variable on an outcome,
to estimate the variability of the outcome, or risk associated with a project or a situation.
27. Decision Tree: A decision tree is a graphic display of the relationship between a present
mapped out over time in a format similar to the branches of a tree.
28. Leverage: A General Dictionary meaning of the term ?Leverage? refers to an increased means
of accomplishing some purpose.? Leverage allows us to accomplish certain things which are
otherwise not possible, viz? Lifting of heavy objects with the help of leverage. The concept of
In Financial Management, the term ?leverage? is used to describe the firm?s ability to use fixed
cost assets or funds to increase the return to its owners? i.e. equity shareholders. James Home has
defined leverage as ?the employment of an asset or sources of funds for which the firm has to
pay a fixed cost or fixed return?. The fixed cost and fixed return remain constant irrespective of
which the firm has to pay a fixed cost or return has a considerable influence on the earnings
available for equity shareholders.
24. Financial Leverage/Trading on Equity:
The ability of fixed financial charges magnify the effect of changes in EBIT on the earnings per
? To use debt to finance an activity. For example, one usually borrows money in the form
of a mortgage to buy a house. One commonly refers to this as leveraging the house.
Likewise, one leverages when one uses a margin in order to purchase securities.
? The amount of debt that has been used to finance activities. A company with much more
thought to be unhealthy, but many firms use leverage in order to expand operations.
OR
Financial leverage
The extent to which interest on debt magnifies changes in operating income into even greater
per share during periods of rising operating income but adds significant risks for stockholders
and creditors because of added interest obligations.
25. Definition of 'Operating Leverage'
A measurement of the degree to which a firm or project incurs a combination of fixed and
? A business that makes few sales, with each sale providing a very high gross margin,
is said to be highly leveraged. A business that makes many sales, with each sale
contributing a very slight margin, is said to be less leveraged. As the volume of sales
in a business increases, each new sale contributes less to fixed costs and more to
? A business that has a higher proportion of fixed costs and a lower proportion of
variable costs is said to have used more operating leverage. Those businesses with
lower fixed costs and higher variable costs are said to employ less operating leverage.
26. Capital structure: Capital structure of a company means the composition of long ?term
etc. It refers to the kind and proportion of securities for raising long?term funds. It implies the
determination of form or makeup of a company?s capitalization.
27. Optimum capital structure: An optimal or sound capital structure can be properly defined as
that combination of debt and equity that attains the stated managerial goal in the most relevant
capital. The Optimal capital structure is concerned with the two important variables at one time ?
The minimization of cost as well as maximization of worth.
28. Cost of capital: Cost of capital refers to the opportunity cost of making a specific investment.
It is the rate of return that could have been earned by putting the same money into a different
investor to make a given investment.
29. Definition of 'Weighted Average Cost Of Capital ? WACC'
A calculation of a firm's cost of capital in which each category of capital is proportionately
weighted. All capital sources ? common stock, preferred stock, bonds and any other long?term
beta and rate of return on equity increases, as an increase in WACC notes a decrease in valuation
and a higher risk.
30. EBIT ? Earnings Before Interest and Taxes. Accountants like to use the term Net Operating
Income for this income statement item, but finance people usually refer to it as EBIT
income that a company has after subtracting operating expenses from sales (hence the term net
operating income). Another way of looking at it is that this is the income that the company has
before subtracting interest and taxes (hence, EBIT) .
31. EAT ? Earnings After Taxes. Accountants call this Net Income or Net Profit After Taxes, but
32. EPS ? Earnings Per Share. This is the amount of income that the common stockholders are
entitled to receive (per share of stock owned). This income may be paid out in the form of
dividends, retained and reinvested by the company, or a combination of both. (It is pronounced
E. P. S).
A firm. The book value of ordinary shares is equal to the paid?up capital plus retained earnings
i.e. net worth.
34. Par value: The stated or face nominal) value of a security.
35. Market value: It is determined on the basis of the stock market quotations of the company?s
36. Flotation costs: Costs incurred in issuing securities, e.g., underwriting and brokerage costs,
printing, legal, publicity and so on.
37. Equity share capital: Long term funds provided by the owners of a firm and consist of
ordinary share capital and retained earnings.
shareholders as dividends.
39. Preference shares: Preference shares have a fixed percentage dividend before any dividend is
paid to the ordinary shareholders. As with ordinary shares a preference dividend can only be paid
if sufficient distributable profits are available, although with 'cumulative' preference shares the
cumulative preference shares must be paid before any dividend is paid to the ordinary
shareholders.
40. Definition of 'Dividend Policy': The policy a company uses to decide how much it will pay
out to shareholders in dividends.
dividend policies almost always affect the value of the firm. His model, one of the earlier
theoretical works shows the importance of the relationship between the firm?s rate of return, r
and its cost of capital, k in determining the dividend policy that will maximize the wealth of
shareholders.
Miller (MM), under a perfect market situation, the dividend policy of a firm is irrelevant, as it
does not affect the value of the firm. They argue that the value of the firm depends on the firm?s
earnings that result from its investment policy.
43. Gordon Model: A valuation model in which the value of a firm is equal to the present value
44. Inventory management: Definition: Activities employed in maintaining the optimum number
or amount of each inventory item. The objective of inventory management is to provide
uninterrupted production, sales, and/or customer?service levels at the minimum cost. Since for
many companies inventory is the largest item in the current assets category, inventory problems
45. Economic Order Quantity: The optimum quantity of inventory to order or to produce based
on trade?off between carrying and ordering costs.
46. Accounts Receivable Management: The term receivables is defined as debt owed to the firm
by customers arising from sale of goods or services in the ordinary course of business.
and controlling of receivables.
48. Collection period:
The average period taken to collect receivables. It is equal to the average credit sales divided by
the number of days in a year.
term) investing cash. A key component of ensuring a company's financial stability and
solvency. Frequently corporate treasurers or a business manager is responsible for overall cash
management.
50. Cash management: Successful cash management involves not only avoiding insolvency (and
rates, selecting appropriate short?term investment vehicles, and increasing days cash on hand all
in order to improve a company's overall financial profitability.
51. Cash cycle: The length of time from the point a firm purchases raw materials to the point
when cash is collected from the sale of the resulting finished goods. In other words, it represents
52. Liquidity/Solvency: Abilityof a firm to meet its obligations when they become due.
53. Current assets: Assets which can be converted into cash within a year.
54. Current liabilities: Liabilities hat are payable within a year.
55. Cash Budget: A Cash budget is an estimate of cash receipts and disbursements of cash during
cash in a business over a future, short or long period of time. It is a forecast of expected cash
intake and outlay.
56. Value Based Management: Definition of value based management: Value Based
Management is the management approach that ensures corporations are run consistently on value
It
is useful to understand that Value Based Management includes all three of the following:
? Creating Value: ways to actually increase or generate maximum future value ?
strategy.Value Based Management VBM
communication, leadership
? Measuring Value: valuation.
57. Corporate governance: Corporate governance refers to the set of systems, principles and
processes by which a company is governed. They provide the guidelines as to how the company
to the value of the company and is also beneficial for all stakeholders in the long term.
Stakeholders in this case would include everyone ranging from the board of directors,
management, shareholders to customers, employees and society. The management of the
company hence assumes the role of a trustee for all the others.
pooling of interests
59. Acquisition: The act of contracting or assuming or acquiring possession of something? "the
acquisition of wealth"? the acquisition of one company by another"
60. Takeover: Takeover is a term referring to transfer of control of a firm from one group of
corporation, either through a friendly acquisition or an unfriendly, hostile, bid. A hostile
takeover (with the aim of replacing current existing management) is usually attempted
through a public tender offer.
61. Concentric merger: Concentric mergers take place when two firms from different but
manufacturer merge, the merger is a concentric one. Although both industries serve the
transportation needs of their customers, the two are quite unique in their competitive structures.
62. Conglomerate mergers: A conglomerate merger is one where two or more companies with
different businesses merge to diversify the products marketed. The companies may not be related
A conglomerate merger is a type of merger whereby the two companies that merge with each
other are involved in different sorts of businesses. The importance of the conglomerate mergers
lies in the fact that they help the merging companies to be better than before.
63. Vertical Merger: Merger between a company that supplies goods and services and a
producer, it is considered a vertical merger because the publisher buys large amounts of paper. In
some cases, vertical mergers may be challenged by the government if they are found to violate
antitrust laws.
64. Operating cycle concept : Maximization of share holder?s wealth of a firm is possible only
earning profit. Sales do not convert into cash immediately? There is invisible time gap between
the sale of goods and receipt of cash. The time taken to convert raw material into cash is known
as operating cycle.
Conversion of cash into raw material -* Conversion of raw material into work in progress -*
Sales into Debtors -* Debtors into cash.
65. Certainty: Certainty is a situation in which investor is certain about the future price. Certainty has
two characteristics.
a . Availability of full information
Ex: Suppose nvestor knows that the ecurity will definitely be old at Rs. 20.
66. Uncertainty: There is an inability to forecast the future accurately and reliably. It has two
characteristics:
? In adequate information
Ex: Suppose he expects that the price of the ecurity could be Rs. 80, Rs. 10 or Rs. 20.
67. Risk: Definitions:
Uncertainty of future outcome Or Probability of an adverse Outcome Or Risk is defined as the
variability of return around the expected average.
? Knowledge of Probability of each outcome
? Possession of probability distribution
? Replicability of past experiment.
Ex: Suppose the investor possesses information that permits him to assign probabilities to each oif the
price being Rs . 1 1 0 and 1 0% to the price being Rs . 80. The investor faced with a risky situation.
68. The Hedging approach / Matching approach:
In this approach maturity of source of fund should
Hedging approach refers to a process of matching maturities of
debt with the maturities of financial need. The hedging approach suggests that the permanent working
capital requirement should be financed with fund from long term sources while the temporary working
approach.
69. Conservative Approach : This approach suggested that the entire estimated investments in current
asset should be finance from long term source and short term should be use only for emergency
requirement . Distinct features of this approach ~
? Risk is minimized?
? The cost of financing is relatively more as interest has to be paid even on seasonal requirement
for the entire period.
70. Aggressive approach: This approach make the finance mix. The aggressive approach suggests that
part of fixed asset investment be financed from short ? term sources. Distinct features of this approach:
? More Profitable
? Less costly
?
More Risky
71. Definitions of Financial Management: According to S.N. Maheswari:
Financial management is concerned with raising financial resources and their effective utilisation towards
achieving the organizational goals
funds to the best advantage from the long term point of view of business objectives."
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CONCEPTS IN FINANCIAL MANAGEMENT
1. Finance.
a.Finance is a simple task of providing the necessary funds (money) required by the business of
entities like companies, firms, individuals and others on the terms that are most favourable to
--- Content provided by FirstRanker.com ---
achieve their economic objectives."b.Finance is the procurement (to get, obtain) of funds and effective (properly planned) utilisation
of funds. It also deals with profits that adequately compensate for the cost and risks borne by the
business."
2. Financial decisions:
--- Content provided by FirstRanker.com ---
Financial decisions refers to decisions concerning financial matters of a business firm. There aremany kinds of financial management decisions that the firm makes min pursuit of maximizing
shareholder?s wealth, viz., kind of assets to be acquired , pattern of capitalization, distribution of
firm?s income etc. we can classify these decisions into three major groups:
? Investment decisions
--- Content provided by FirstRanker.com ---
? Financing decisions? Dividend decisions
3. Investment Decisions:
Investment decision relates to the determination of total amount of assets to be held in the firm,
the composition of these assets and the business risk complexions of the firm as perceived by its
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investors.Investment decisions can be classified under two broad groups:
Long?term investment decision and
Short? term investment
4. Wealth maximization ?Definition
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A process that increases the current net value of business or shareholder capital gains, with theobjective of bringing in the highest possible return. The wealth maximization strategy generally
involves making sound financial investment decisions which take into consideration any risk
factors that would compromise or outweigh the anticipated benefits.
5. Profit maximization ? Definition
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A process that companies undergo to determine the best output and price levels in order tomaximize its return. The company will usually adjust influential factors such as production costs,
sale prices, and output levels as a way of reaching its profit goal. There are two main profit
maximization methods used, and they are Marginal Cost?Marginal Revenue Method and Total
Cost?Total Revenue Method. Profit maximization is a good thing for a company, but can be a
--- Content provided by FirstRanker.com ---
bad thing for consumers if the company starts to use cheaper products or decides to raise prices.FirstRanker.com - FirstRanker's Choice
Department of Business Managment
CONCEPTS IN FINANCIAL MANAGEMENT
1. Finance.
--- Content provided by FirstRanker.com ---
a.Finance is a simple task of providing the necessary funds (money) required by the business ofentities like companies, firms, individuals and others on the terms that are most favourable to
achieve their economic objectives."
b.Finance is the procurement (to get, obtain) of funds and effective (properly planned) utilisation
of funds. It also deals with profits that adequately compensate for the cost and risks borne by the
--- Content provided by FirstRanker.com ---
business."2. Financial decisions:
Financial decisions refers to decisions concerning financial matters of a business firm. There are
many kinds of financial management decisions that the firm makes min pursuit of maximizing
shareholder?s wealth, viz., kind of assets to be acquired , pattern of capitalization, distribution of
--- Content provided by FirstRanker.com ---
firm?s income etc. we can classify these decisions into three major groups:? Investment decisions
? Financing decisions
? Dividend decisions
3. Investment Decisions:
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Investment decision relates to the determination of total amount of assets to be held in the firm,the composition of these assets and the business risk complexions of the firm as perceived by its
investors.
Investment decisions can be classified under two broad groups:
Long?term investment decision and
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Short? term investment4. Wealth maximization ?Definition
A process that increases the current net value of business or shareholder capital gains, with the
objective of bringing in the highest possible return. The wealth maximization strategy generally
involves making sound financial investment decisions which take into consideration any risk
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factors that would compromise or outweigh the anticipated benefits.5. Profit maximization ? Definition
A process that companies undergo to determine the best output and price levels in order to
maximize its return. The company will usually adjust influential factors such as production costs,
sale prices, and output levels as a way of reaching its profit goal. There are two main profit
--- Content provided by FirstRanker.com ---
maximization methods used, and they are Marginal Cost?Marginal Revenue Method and TotalCost?Total Revenue Method. Profit maximization is a good thing for a company, but can be a
bad thing for consumers if the company starts to use cheaper products or decides to raise prices.
6. Time value of money:
The recognition of the time value of money is extremely vital in financial decision making. If the
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timing of cash flows is not considered the firm may make decisions which may faulter itsobjectives of maximizing the owner?s welfare. The welfare of the owners would be maximised,
when net wealth or net present worth is created from making a financial decision.
7. Compound Value: Interest that is paid both on the initial principal as also on the interest
earned on the initial principal in previous period/s. The interest earned in one period becomes a
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part of the principal in the succeeding period.8. Present value:
The present value of current cash inflow or outflow is the amount of current cash that is of
equivalent desirability, to the decision maker, to a specified amount of cash to be received or
paid at a future date.
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9. Reasons for Time value of money:Three reasons may be attributed to the individual?s time preference for money:
? Risk
? Preference for consumption
? Investment opportunities
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S10. Annuity: A series of receipts or payments of a fixed amount for a specified number of years.
Alternatively, a pattern of cash flows that is equal in each year, i.e. equal annual cash flows.
11. Capital budgeting: The process of determining which potential long?term projects are worth
undertaking, by comparing their expected discounted cash flows with their internal rates of
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return.12. Capital Budgeting techniques: The following are the capital?budgetingtechniques:
Non ?Discounted cash flow (DCF) criteria?
? Pay back period (PBP)
? Accounting Rate of return
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Discounted Cash flow techniques:? Net present value (NPV)
? Profitability Index (PI)
? Internal rate of return (IRR)
13. Payback Period: The length of time required to recover the cost of an investment. The
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payback period of a given investment or project is an important determinant of whether toundertake the position or project, as longer payback periods are typically not desirable for
investment positions.
Calculated as: Cost of Project
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Department of Business ManagmentCONCEPTS IN FINANCIAL MANAGEMENT
1. Finance.
a.Finance is a simple task of providing the necessary funds (money) required by the business of
entities like companies, firms, individuals and others on the terms that are most favourable to
--- Content provided by FirstRanker.com ---
achieve their economic objectives."b.Finance is the procurement (to get, obtain) of funds and effective (properly planned) utilisation
of funds. It also deals with profits that adequately compensate for the cost and risks borne by the
business."
2. Financial decisions:
--- Content provided by FirstRanker.com ---
Financial decisions refers to decisions concerning financial matters of a business firm. There aremany kinds of financial management decisions that the firm makes min pursuit of maximizing
shareholder?s wealth, viz., kind of assets to be acquired , pattern of capitalization, distribution of
firm?s income etc. we can classify these decisions into three major groups:
? Investment decisions
--- Content provided by FirstRanker.com ---
? Financing decisions? Dividend decisions
3. Investment Decisions:
Investment decision relates to the determination of total amount of assets to be held in the firm,
the composition of these assets and the business risk complexions of the firm as perceived by its
--- Content provided by FirstRanker.com ---
investors.Investment decisions can be classified under two broad groups:
Long?term investment decision and
Short? term investment
4. Wealth maximization ?Definition
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A process that increases the current net value of business or shareholder capital gains, with theobjective of bringing in the highest possible return. The wealth maximization strategy generally
involves making sound financial investment decisions which take into consideration any risk
factors that would compromise or outweigh the anticipated benefits.
5. Profit maximization ? Definition
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A process that companies undergo to determine the best output and price levels in order tomaximize its return. The company will usually adjust influential factors such as production costs,
sale prices, and output levels as a way of reaching its profit goal. There are two main profit
maximization methods used, and they are Marginal Cost?Marginal Revenue Method and Total
Cost?Total Revenue Method. Profit maximization is a good thing for a company, but can be a
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bad thing for consumers if the company starts to use cheaper products or decides to raise prices.6. Time value of money:
The recognition of the time value of money is extremely vital in financial decision making. If the
timing of cash flows is not considered the firm may make decisions which may faulter its
objectives of maximizing the owner?s welfare. The welfare of the owners would be maximised,
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when net wealth or net present worth is created from making a financial decision.7. Compound Value: Interest that is paid both on the initial principal as also on the interest
earned on the initial principal in previous period/s. The interest earned in one period becomes a
part of the principal in the succeeding period.
8. Present value:
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The present value of current cash inflow or outflow is the amount of current cash that is ofequivalent desirability, to the decision maker, to a specified amount of cash to be received or
paid at a future date.
9. Reasons for Time value of money:
Three reasons may be attributed to the individual?s time preference for money:
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? Risk? Preference for consumption
? Investment opportunities
S
10. Annuity: A series of receipts or payments of a fixed amount for a specified number of years.
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Alternatively, a pattern of cash flows that is equal in each year, i.e. equal annual cash flows.11. Capital budgeting: The process of determining which potential long?term projects are worth
undertaking, by comparing their expected discounted cash flows with their internal rates of
return.
12. Capital Budgeting techniques: The following are the capital?budgetingtechniques:
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Non ?Discounted cash flow (DCF) criteria?? Pay back period (PBP)
? Accounting Rate of return
Discounted Cash flow techniques:
? Net present value (NPV)
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? Profitability Index (PI)? Internal rate of return (IRR)
13. Payback Period: The length of time required to recover the cost of an investment. The
payback period of a given investment or project is an important determinant of whether to
undertake the position or project, as longer payback periods are typically not desirable for
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investment positions.Calculated as: Cost of Project
Annual Cash Inflows
14. Accounting rate of return method: The accounting rate of return also known as the return on
Investment (ROI) Uses accounting information, as revealed by financial statements, to measure
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the profitability of an investment. The accounting rate of return is the ratio of the average aftertax profit divided by the average investment. The average investment would be equal to half of
the original investment if it were depreciated constantly. Alternatively, it can be found out by
dividing the total of the investment?s book value after depreciation by the life of the project. The
accounting rate of return, thus, is an average rate and can be determined by the following
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equation.ARR= Average Income
Average Investment
15. Net Present Value ? NPV?The difference between the present value of cash inflows and the
present value of cash outflows. NPV is used in capital budgeting to analyze the profitability of an
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investment or project. NPV analysis is sensitive to the reliability of future cash inflows that aninvestment or project will yield.
16. Internal Rate Of Return ? IRR? The IRR of an investment is the discount rate at which the net
present value of costs (negative cash flows) of the investment equals the net present value of the
benefits (positive cash flows) of the investment. The discount rate often used in capital budgeting
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that makes the net present value of all cash flows from a particular project equal to zero.17. Profitability Index (P.I.) or Benefit cost ratio: It is the ratio of the present value of future cash
benefits, at the required rate of return to the initial cash flow of the investment?.
Formula: PI. = Present value of cash inflows
Present value of initial cash outlay
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18. Accept?Reject criterion: Evaluation of capital budgeting proposals to determine whether theproject under consideration satisfies the minimum acceptance standard and should be accepted.
19. Capital Rationing: Risk?Return Trade off A situation in which due to financial constraints,
the limited funds are allocated a number of mutually exclusive capital budgeting projects.
20. Definition of Risk: The chance that an investment's actual return will be different than
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expected. Risk includes the possibility of losing some or all of the original investment. Differentversions of risk are usually measured by calculating the standard deviation of the historical
returns or average returns of a specific investment. A high standard deviation indicates a high
degree of risk.
21. Risk premium: The difference between expected rate of return on a risky project and the rate
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of return on a risk less project.22. Risk?Return Trade?off: The relationship between the risk and the required Rate of return.
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Department of Business Managment
CONCEPTS IN FINANCIAL MANAGEMENT
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1. Finance.a.Finance is a simple task of providing the necessary funds (money) required by the business of
entities like companies, firms, individuals and others on the terms that are most favourable to
achieve their economic objectives."
b.Finance is the procurement (to get, obtain) of funds and effective (properly planned) utilisation
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of funds. It also deals with profits that adequately compensate for the cost and risks borne by thebusiness."
2. Financial decisions:
Financial decisions refers to decisions concerning financial matters of a business firm. There are
many kinds of financial management decisions that the firm makes min pursuit of maximizing
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shareholder?s wealth, viz., kind of assets to be acquired , pattern of capitalization, distribution offirm?s income etc. we can classify these decisions into three major groups:
? Investment decisions
? Financing decisions
? Dividend decisions
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3. Investment Decisions:Investment decision relates to the determination of total amount of assets to be held in the firm,
the composition of these assets and the business risk complexions of the firm as perceived by its
investors.
Investment decisions can be classified under two broad groups:
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Long?term investment decision andShort? term investment
4. Wealth maximization ?Definition
A process that increases the current net value of business or shareholder capital gains, with the
objective of bringing in the highest possible return. The wealth maximization strategy generally
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involves making sound financial investment decisions which take into consideration any riskfactors that would compromise or outweigh the anticipated benefits.
5. Profit maximization ? Definition
A process that companies undergo to determine the best output and price levels in order to
maximize its return. The company will usually adjust influential factors such as production costs,
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sale prices, and output levels as a way of reaching its profit goal. There are two main profitmaximization methods used, and they are Marginal Cost?Marginal Revenue Method and Total
Cost?Total Revenue Method. Profit maximization is a good thing for a company, but can be a
bad thing for consumers if the company starts to use cheaper products or decides to raise prices.
6. Time value of money:
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The recognition of the time value of money is extremely vital in financial decision making. If thetiming of cash flows is not considered the firm may make decisions which may faulter its
objectives of maximizing the owner?s welfare. The welfare of the owners would be maximised,
when net wealth or net present worth is created from making a financial decision.
7. Compound Value: Interest that is paid both on the initial principal as also on the interest
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earned on the initial principal in previous period/s. The interest earned in one period becomes apart of the principal in the succeeding period.
8. Present value:
The present value of current cash inflow or outflow is the amount of current cash that is of
equivalent desirability, to the decision maker, to a specified amount of cash to be received or
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paid at a future date.9. Reasons for Time value of money:
Three reasons may be attributed to the individual?s time preference for money:
? Risk
? Preference for consumption
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? Investment opportunitiesS
10. Annuity: A series of receipts or payments of a fixed amount for a specified number of years.
Alternatively, a pattern of cash flows that is equal in each year, i.e. equal annual cash flows.
11. Capital budgeting: The process of determining which potential long?term projects are worth
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undertaking, by comparing their expected discounted cash flows with their internal rates ofreturn.
12. Capital Budgeting techniques: The following are the capital?budgetingtechniques:
Non ?Discounted cash flow (DCF) criteria?
? Pay back period (PBP)
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? Accounting Rate of returnDiscounted Cash flow techniques:
? Net present value (NPV)
? Profitability Index (PI)
? Internal rate of return (IRR)
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13. Payback Period: The length of time required to recover the cost of an investment. Thepayback period of a given investment or project is an important determinant of whether to
undertake the position or project, as longer payback periods are typically not desirable for
investment positions.
Calculated as: Cost of Project
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Annual Cash Inflows14. Accounting rate of return method: The accounting rate of return also known as the return on
Investment (ROI) Uses accounting information, as revealed by financial statements, to measure
the profitability of an investment. The accounting rate of return is the ratio of the average after
tax profit divided by the average investment. The average investment would be equal to half of
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the original investment if it were depreciated constantly. Alternatively, it can be found out bydividing the total of the investment?s book value after depreciation by the life of the project. The
accounting rate of return, thus, is an average rate and can be determined by the following
equation.
ARR= Average Income
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Average Investment15. Net Present Value ? NPV?The difference between the present value of cash inflows and the
present value of cash outflows. NPV is used in capital budgeting to analyze the profitability of an
investment or project. NPV analysis is sensitive to the reliability of future cash inflows that an
investment or project will yield.
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16. Internal Rate Of Return ? IRR? The IRR of an investment is the discount rate at which the netpresent value of costs (negative cash flows) of the investment equals the net present value of the
benefits (positive cash flows) of the investment. The discount rate often used in capital budgeting
that makes the net present value of all cash flows from a particular project equal to zero.
17. Profitability Index (P.I.) or Benefit cost ratio: It is the ratio of the present value of future cash
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benefits, at the required rate of return to the initial cash flow of the investment?.Formula: PI. = Present value of cash inflows
Present value of initial cash outlay
18. Accept?Reject criterion: Evaluation of capital budgeting proposals to determine whether the
project under consideration satisfies the minimum acceptance standard and should be accepted.
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19. Capital Rationing: Risk?Return Trade off A situation in which due to financial constraints,the limited funds are allocated a number of mutually exclusive capital budgeting projects.
20. Definition of Risk: The chance that an investment's actual return will be different than
expected. Risk includes the possibility of losing some or all of the original investment. Different
versions of risk are usually measured by calculating the standard deviation of the historical
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returns or average returns of a specific investment. A high standard deviation indicates a highdegree of risk.
21. Risk premium: The difference between expected rate of return on a risky project and the rate
of return on a risk less project.
22. Risk?Return Trade?off: The relationship between the risk and the required Rate of return.
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23. Definition of Risk?Adjusted Return: A concept that defines an investment's return bymeasuring how much risk is involved in producing that return, which is generally expressed as a
number or rating. Risk?adjusted returns are applied to individual securities and investment funds
and portfolios.
24. Certainty?Equivalents: The return required with certainty to make investors indifferent
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between this certain return and a particular uncertain (risky) return.25. Coefficient of variation: A relative measure of the variability of the outcomes associated
with an event. It is calculated by dividing the standard deviation of a distribution by the mean.
26. Sensitivity Analysis: The analysis of the effect of change in certain variable on an outcome,
to estimate the variability of the outcome, or risk associated with a project or a situation.
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27. Decision Tree: A decision tree is a graphic display of the relationship between a presentdecision and future events, future decisions and their consequences. The sequence of events is
mapped out over time in a format similar to the branches of a tree.
28. Leverage: A General Dictionary meaning of the term ?Leverage? refers to an increased means
of accomplishing some purpose.? Leverage allows us to accomplish certain things which are
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otherwise not possible, viz? Lifting of heavy objects with the help of leverage. The concept ofleverage is valid in business also.
In Financial Management, the term ?leverage? is used to describe the firm?s ability to use fixed
cost assets or funds to increase the return to its owners? i.e. equity shareholders. James Home has
defined leverage as ?the employment of an asset or sources of funds for which the firm has to
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pay a fixed cost or fixed return?. The fixed cost and fixed return remain constant irrespective ofthe changes in volume of output or sales. Thus, the employment of an asset or source of funds for
which the firm has to pay a fixed cost or return has a considerable influence on the earnings
available for equity shareholders.
24. Financial Leverage/Trading on Equity:
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The ability of fixed financial charges magnify the effect of changes in EBIT on the earnings pershare(EPS) . Also known as Trading on Equity.
? To use debt to finance an activity. For example, one usually borrows money in the form
of a mortgage to buy a house. One commonly refers to this as leveraging the house.
Likewise, one leverages when one uses a margin in order to purchase securities.
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? The amount of debt that has been used to finance activities. A company with much moredebt than equity is generally called "highly leveraged." Too much leverage is often
thought to be unhealthy, but many firms use leverage in order to expand operations.
OR
Financial leverage
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The extent to which interest on debt magnifies changes in operating income into even greaterproportionate changes in earnings after taxes. Financial leverage magnifies increases in earnings
per share during periods of rising operating income but adds significant risks for stockholders
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Department of Business Managment
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CONCEPTS IN FINANCIAL MANAGEMENT1. Finance.
a.Finance is a simple task of providing the necessary funds (money) required by the business of
entities like companies, firms, individuals and others on the terms that are most favourable to
achieve their economic objectives."
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b.Finance is the procurement (to get, obtain) of funds and effective (properly planned) utilisationof funds. It also deals with profits that adequately compensate for the cost and risks borne by the
business."
2. Financial decisions:
Financial decisions refers to decisions concerning financial matters of a business firm. There are
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many kinds of financial management decisions that the firm makes min pursuit of maximizingshareholder?s wealth, viz., kind of assets to be acquired , pattern of capitalization, distribution of
firm?s income etc. we can classify these decisions into three major groups:
? Investment decisions
? Financing decisions
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? Dividend decisions3. Investment Decisions:
Investment decision relates to the determination of total amount of assets to be held in the firm,
the composition of these assets and the business risk complexions of the firm as perceived by its
investors.
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Investment decisions can be classified under two broad groups:Long?term investment decision and
Short? term investment
4. Wealth maximization ?Definition
A process that increases the current net value of business or shareholder capital gains, with the
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objective of bringing in the highest possible return. The wealth maximization strategy generallyinvolves making sound financial investment decisions which take into consideration any risk
factors that would compromise or outweigh the anticipated benefits.
5. Profit maximization ? Definition
A process that companies undergo to determine the best output and price levels in order to
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maximize its return. The company will usually adjust influential factors such as production costs,sale prices, and output levels as a way of reaching its profit goal. There are two main profit
maximization methods used, and they are Marginal Cost?Marginal Revenue Method and Total
Cost?Total Revenue Method. Profit maximization is a good thing for a company, but can be a
bad thing for consumers if the company starts to use cheaper products or decides to raise prices.
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6. Time value of money:The recognition of the time value of money is extremely vital in financial decision making. If the
timing of cash flows is not considered the firm may make decisions which may faulter its
objectives of maximizing the owner?s welfare. The welfare of the owners would be maximised,
when net wealth or net present worth is created from making a financial decision.
--- Content provided by FirstRanker.com ---
7. Compound Value: Interest that is paid both on the initial principal as also on the interestearned on the initial principal in previous period/s. The interest earned in one period becomes a
part of the principal in the succeeding period.
8. Present value:
The present value of current cash inflow or outflow is the amount of current cash that is of
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equivalent desirability, to the decision maker, to a specified amount of cash to be received orpaid at a future date.
9. Reasons for Time value of money:
Three reasons may be attributed to the individual?s time preference for money:
? Risk
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? Preference for consumption? Investment opportunities
S
10. Annuity: A series of receipts or payments of a fixed amount for a specified number of years.
Alternatively, a pattern of cash flows that is equal in each year, i.e. equal annual cash flows.
--- Content provided by FirstRanker.com ---
11. Capital budgeting: The process of determining which potential long?term projects are worthundertaking, by comparing their expected discounted cash flows with their internal rates of
return.
12. Capital Budgeting techniques: The following are the capital?budgetingtechniques:
Non ?Discounted cash flow (DCF) criteria?
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? Pay back period (PBP)? Accounting Rate of return
Discounted Cash flow techniques:
? Net present value (NPV)
? Profitability Index (PI)
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? Internal rate of return (IRR)13. Payback Period: The length of time required to recover the cost of an investment. The
payback period of a given investment or project is an important determinant of whether to
undertake the position or project, as longer payback periods are typically not desirable for
investment positions.
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Calculated as: Cost of ProjectAnnual Cash Inflows
14. Accounting rate of return method: The accounting rate of return also known as the return on
Investment (ROI) Uses accounting information, as revealed by financial statements, to measure
the profitability of an investment. The accounting rate of return is the ratio of the average after
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tax profit divided by the average investment. The average investment would be equal to half ofthe original investment if it were depreciated constantly. Alternatively, it can be found out by
dividing the total of the investment?s book value after depreciation by the life of the project. The
accounting rate of return, thus, is an average rate and can be determined by the following
equation.
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ARR= Average IncomeAverage Investment
15. Net Present Value ? NPV?The difference between the present value of cash inflows and the
present value of cash outflows. NPV is used in capital budgeting to analyze the profitability of an
investment or project. NPV analysis is sensitive to the reliability of future cash inflows that an
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investment or project will yield.16. Internal Rate Of Return ? IRR? The IRR of an investment is the discount rate at which the net
present value of costs (negative cash flows) of the investment equals the net present value of the
benefits (positive cash flows) of the investment. The discount rate often used in capital budgeting
that makes the net present value of all cash flows from a particular project equal to zero.
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17. Profitability Index (P.I.) or Benefit cost ratio: It is the ratio of the present value of future cashbenefits, at the required rate of return to the initial cash flow of the investment?.
Formula: PI. = Present value of cash inflows
Present value of initial cash outlay
18. Accept?Reject criterion: Evaluation of capital budgeting proposals to determine whether the
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project under consideration satisfies the minimum acceptance standard and should be accepted.19. Capital Rationing: Risk?Return Trade off A situation in which due to financial constraints,
the limited funds are allocated a number of mutually exclusive capital budgeting projects.
20. Definition of Risk: The chance that an investment's actual return will be different than
expected. Risk includes the possibility of losing some or all of the original investment. Different
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versions of risk are usually measured by calculating the standard deviation of the historicalreturns or average returns of a specific investment. A high standard deviation indicates a high
degree of risk.
21. Risk premium: The difference between expected rate of return on a risky project and the rate
of return on a risk less project.
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22. Risk?Return Trade?off: The relationship between the risk and the required Rate of return.23. Definition of Risk?Adjusted Return: A concept that defines an investment's return by
measuring how much risk is involved in producing that return, which is generally expressed as a
number or rating. Risk?adjusted returns are applied to individual securities and investment funds
and portfolios.
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24. Certainty?Equivalents: The return required with certainty to make investors indifferentbetween this certain return and a particular uncertain (risky) return.
25. Coefficient of variation: A relative measure of the variability of the outcomes associated
with an event. It is calculated by dividing the standard deviation of a distribution by the mean.
26. Sensitivity Analysis: The analysis of the effect of change in certain variable on an outcome,
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to estimate the variability of the outcome, or risk associated with a project or a situation.27. Decision Tree: A decision tree is a graphic display of the relationship between a present
decision and future events, future decisions and their consequences. The sequence of events is
mapped out over time in a format similar to the branches of a tree.
28. Leverage: A General Dictionary meaning of the term ?Leverage? refers to an increased means
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of accomplishing some purpose.? Leverage allows us to accomplish certain things which areotherwise not possible, viz? Lifting of heavy objects with the help of leverage. The concept of
leverage is valid in business also.
In Financial Management, the term ?leverage? is used to describe the firm?s ability to use fixed
cost assets or funds to increase the return to its owners? i.e. equity shareholders. James Home has
--- Content provided by FirstRanker.com ---
defined leverage as ?the employment of an asset or sources of funds for which the firm has topay a fixed cost or fixed return?. The fixed cost and fixed return remain constant irrespective of
the changes in volume of output or sales. Thus, the employment of an asset or source of funds for
which the firm has to pay a fixed cost or return has a considerable influence on the earnings
available for equity shareholders.
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24. Financial Leverage/Trading on Equity:The ability of fixed financial charges magnify the effect of changes in EBIT on the earnings per
share(EPS) . Also known as Trading on Equity.
? To use debt to finance an activity. For example, one usually borrows money in the form
of a mortgage to buy a house. One commonly refers to this as leveraging the house.
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Likewise, one leverages when one uses a margin in order to purchase securities.? The amount of debt that has been used to finance activities. A company with much more
debt than equity is generally called "highly leveraged." Too much leverage is often
thought to be unhealthy, but many firms use leverage in order to expand operations.
OR
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Financial leverageThe extent to which interest on debt magnifies changes in operating income into even greater
proportionate changes in earnings after taxes. Financial leverage magnifies increases in earnings
per share during periods of rising operating income but adds significant risks for stockholders
and creditors because of added interest obligations.
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25. Definition of 'Operating Leverage'A measurement of the degree to which a firm or project incurs a combination of fixed and
variable costs.
? A business that makes few sales, with each sale providing a very high gross margin,
is said to be highly leveraged. A business that makes many sales, with each sale
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contributing a very slight margin, is said to be less leveraged. As the volume of salesin a business increases, each new sale contributes less to fixed costs and more to
profitability.
? A business that has a higher proportion of fixed costs and a lower proportion of
variable costs is said to have used more operating leverage. Those businesses with
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lower fixed costs and higher variable costs are said to employ less operating leverage.26. Capital structure: Capital structure of a company means the composition of long ?term
sources of funds. Such as ordinary shares, preference shares, debentures, bonds, long?term debts
etc. It refers to the kind and proportion of securities for raising long?term funds. It implies the
determination of form or makeup of a company?s capitalization.
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27. Optimum capital structure: An optimal or sound capital structure can be properly defined asthat combination of debt and equity that attains the stated managerial goal in the most relevant
manner? the maximization of the firm?s market value and the minimization of the firm?s cost of
capital. The Optimal capital structure is concerned with the two important variables at one time ?
The minimization of cost as well as maximization of worth.
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28. Cost of capital: Cost of capital refers to the opportunity cost of making a specific investment.It is the rate of return that could have been earned by putting the same money into a different
investment with equal risk. Thus, the cost of capital is the rate of return required to persuade the
investor to make a given investment.
29. Definition of 'Weighted Average Cost Of Capital ? WACC'
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A calculation of a firm's cost of capital in which each category of capital is proportionatelyweighted. All capital sources ? common stock, preferred stock, bonds and any other long?term
debt ? are included in a WACC calculation. All else equal, the WACC of a firm increases as the
beta and rate of return on equity increases, as an increase in WACC notes a decrease in valuation
and a higher risk.
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30. EBIT ? Earnings Before Interest and Taxes. Accountants like to use the term Net OperatingIncome for this income statement item, but finance people usually refer to it as EBIT
(pronounced as it is spelled ? E.B.I. T). Either way, on an income statement, it is the amount of
income that a company has after subtracting operating expenses from sales (hence the term net
operating income). Another way of looking at it is that this is the income that the company has
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before subtracting interest and taxes (hence, EBIT) .FirstRanker.com - FirstRanker's Choice
Department of Business Managment
CONCEPTS IN FINANCIAL MANAGEMENT
1. Finance.
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a.Finance is a simple task of providing the necessary funds (money) required by the business ofentities like companies, firms, individuals and others on the terms that are most favourable to
achieve their economic objectives."
b.Finance is the procurement (to get, obtain) of funds and effective (properly planned) utilisation
of funds. It also deals with profits that adequately compensate for the cost and risks borne by the
--- Content provided by FirstRanker.com ---
business."2. Financial decisions:
Financial decisions refers to decisions concerning financial matters of a business firm. There are
many kinds of financial management decisions that the firm makes min pursuit of maximizing
shareholder?s wealth, viz., kind of assets to be acquired , pattern of capitalization, distribution of
--- Content provided by FirstRanker.com ---
firm?s income etc. we can classify these decisions into three major groups:? Investment decisions
? Financing decisions
? Dividend decisions
3. Investment Decisions:
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Investment decision relates to the determination of total amount of assets to be held in the firm,the composition of these assets and the business risk complexions of the firm as perceived by its
investors.
Investment decisions can be classified under two broad groups:
Long?term investment decision and
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Short? term investment4. Wealth maximization ?Definition
A process that increases the current net value of business or shareholder capital gains, with the
objective of bringing in the highest possible return. The wealth maximization strategy generally
involves making sound financial investment decisions which take into consideration any risk
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factors that would compromise or outweigh the anticipated benefits.5. Profit maximization ? Definition
A process that companies undergo to determine the best output and price levels in order to
maximize its return. The company will usually adjust influential factors such as production costs,
sale prices, and output levels as a way of reaching its profit goal. There are two main profit
--- Content provided by FirstRanker.com ---
maximization methods used, and they are Marginal Cost?Marginal Revenue Method and TotalCost?Total Revenue Method. Profit maximization is a good thing for a company, but can be a
bad thing for consumers if the company starts to use cheaper products or decides to raise prices.
6. Time value of money:
The recognition of the time value of money is extremely vital in financial decision making. If the
--- Content provided by FirstRanker.com ---
timing of cash flows is not considered the firm may make decisions which may faulter itsobjectives of maximizing the owner?s welfare. The welfare of the owners would be maximised,
when net wealth or net present worth is created from making a financial decision.
7. Compound Value: Interest that is paid both on the initial principal as also on the interest
earned on the initial principal in previous period/s. The interest earned in one period becomes a
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part of the principal in the succeeding period.8. Present value:
The present value of current cash inflow or outflow is the amount of current cash that is of
equivalent desirability, to the decision maker, to a specified amount of cash to be received or
paid at a future date.
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9. Reasons for Time value of money:Three reasons may be attributed to the individual?s time preference for money:
? Risk
? Preference for consumption
? Investment opportunities
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S10. Annuity: A series of receipts or payments of a fixed amount for a specified number of years.
Alternatively, a pattern of cash flows that is equal in each year, i.e. equal annual cash flows.
11. Capital budgeting: The process of determining which potential long?term projects are worth
undertaking, by comparing their expected discounted cash flows with their internal rates of
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return.12. Capital Budgeting techniques: The following are the capital?budgetingtechniques:
Non ?Discounted cash flow (DCF) criteria?
? Pay back period (PBP)
? Accounting Rate of return
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Discounted Cash flow techniques:? Net present value (NPV)
? Profitability Index (PI)
? Internal rate of return (IRR)
13. Payback Period: The length of time required to recover the cost of an investment. The
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payback period of a given investment or project is an important determinant of whether toundertake the position or project, as longer payback periods are typically not desirable for
investment positions.
Calculated as: Cost of Project
Annual Cash Inflows
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14. Accounting rate of return method: The accounting rate of return also known as the return onInvestment (ROI) Uses accounting information, as revealed by financial statements, to measure
the profitability of an investment. The accounting rate of return is the ratio of the average after
tax profit divided by the average investment. The average investment would be equal to half of
the original investment if it were depreciated constantly. Alternatively, it can be found out by
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dividing the total of the investment?s book value after depreciation by the life of the project. Theaccounting rate of return, thus, is an average rate and can be determined by the following
equation.
ARR= Average Income
Average Investment
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15. Net Present Value ? NPV?The difference between the present value of cash inflows and thepresent value of cash outflows. NPV is used in capital budgeting to analyze the profitability of an
investment or project. NPV analysis is sensitive to the reliability of future cash inflows that an
investment or project will yield.
16. Internal Rate Of Return ? IRR? The IRR of an investment is the discount rate at which the net
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present value of costs (negative cash flows) of the investment equals the net present value of thebenefits (positive cash flows) of the investment. The discount rate often used in capital budgeting
that makes the net present value of all cash flows from a particular project equal to zero.
17. Profitability Index (P.I.) or Benefit cost ratio: It is the ratio of the present value of future cash
benefits, at the required rate of return to the initial cash flow of the investment?.
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Formula: PI. = Present value of cash inflowsPresent value of initial cash outlay
18. Accept?Reject criterion: Evaluation of capital budgeting proposals to determine whether the
project under consideration satisfies the minimum acceptance standard and should be accepted.
19. Capital Rationing: Risk?Return Trade off A situation in which due to financial constraints,
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the limited funds are allocated a number of mutually exclusive capital budgeting projects.20. Definition of Risk: The chance that an investment's actual return will be different than
expected. Risk includes the possibility of losing some or all of the original investment. Different
versions of risk are usually measured by calculating the standard deviation of the historical
returns or average returns of a specific investment. A high standard deviation indicates a high
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degree of risk.21. Risk premium: The difference between expected rate of return on a risky project and the rate
of return on a risk less project.
22. Risk?Return Trade?off: The relationship between the risk and the required Rate of return.
23. Definition of Risk?Adjusted Return: A concept that defines an investment's return by
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measuring how much risk is involved in producing that return, which is generally expressed as anumber or rating. Risk?adjusted returns are applied to individual securities and investment funds
and portfolios.
24. Certainty?Equivalents: The return required with certainty to make investors indifferent
between this certain return and a particular uncertain (risky) return.
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25. Coefficient of variation: A relative measure of the variability of the outcomes associatedwith an event. It is calculated by dividing the standard deviation of a distribution by the mean.
26. Sensitivity Analysis: The analysis of the effect of change in certain variable on an outcome,
to estimate the variability of the outcome, or risk associated with a project or a situation.
27. Decision Tree: A decision tree is a graphic display of the relationship between a present
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decision and future events, future decisions and their consequences. The sequence of events ismapped out over time in a format similar to the branches of a tree.
28. Leverage: A General Dictionary meaning of the term ?Leverage? refers to an increased means
of accomplishing some purpose.? Leverage allows us to accomplish certain things which are
otherwise not possible, viz? Lifting of heavy objects with the help of leverage. The concept of
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leverage is valid in business also.In Financial Management, the term ?leverage? is used to describe the firm?s ability to use fixed
cost assets or funds to increase the return to its owners? i.e. equity shareholders. James Home has
defined leverage as ?the employment of an asset or sources of funds for which the firm has to
pay a fixed cost or fixed return?. The fixed cost and fixed return remain constant irrespective of
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the changes in volume of output or sales. Thus, the employment of an asset or source of funds forwhich the firm has to pay a fixed cost or return has a considerable influence on the earnings
available for equity shareholders.
24. Financial Leverage/Trading on Equity:
The ability of fixed financial charges magnify the effect of changes in EBIT on the earnings per
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share(EPS) . Also known as Trading on Equity.? To use debt to finance an activity. For example, one usually borrows money in the form
of a mortgage to buy a house. One commonly refers to this as leveraging the house.
Likewise, one leverages when one uses a margin in order to purchase securities.
? The amount of debt that has been used to finance activities. A company with much more
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debt than equity is generally called "highly leveraged." Too much leverage is oftenthought to be unhealthy, but many firms use leverage in order to expand operations.
OR
Financial leverage
The extent to which interest on debt magnifies changes in operating income into even greater
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proportionate changes in earnings after taxes. Financial leverage magnifies increases in earningsper share during periods of rising operating income but adds significant risks for stockholders
and creditors because of added interest obligations.
25. Definition of 'Operating Leverage'
A measurement of the degree to which a firm or project incurs a combination of fixed and
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variable costs.? A business that makes few sales, with each sale providing a very high gross margin,
is said to be highly leveraged. A business that makes many sales, with each sale
contributing a very slight margin, is said to be less leveraged. As the volume of sales
in a business increases, each new sale contributes less to fixed costs and more to
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profitability.? A business that has a higher proportion of fixed costs and a lower proportion of
variable costs is said to have used more operating leverage. Those businesses with
lower fixed costs and higher variable costs are said to employ less operating leverage.
26. Capital structure: Capital structure of a company means the composition of long ?term
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sources of funds. Such as ordinary shares, preference shares, debentures, bonds, long?term debtsetc. It refers to the kind and proportion of securities for raising long?term funds. It implies the
determination of form or makeup of a company?s capitalization.
27. Optimum capital structure: An optimal or sound capital structure can be properly defined as
that combination of debt and equity that attains the stated managerial goal in the most relevant
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manner? the maximization of the firm?s market value and the minimization of the firm?s cost ofcapital. The Optimal capital structure is concerned with the two important variables at one time ?
The minimization of cost as well as maximization of worth.
28. Cost of capital: Cost of capital refers to the opportunity cost of making a specific investment.
It is the rate of return that could have been earned by putting the same money into a different
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investment with equal risk. Thus, the cost of capital is the rate of return required to persuade theinvestor to make a given investment.
29. Definition of 'Weighted Average Cost Of Capital ? WACC'
A calculation of a firm's cost of capital in which each category of capital is proportionately
weighted. All capital sources ? common stock, preferred stock, bonds and any other long?term
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debt ? are included in a WACC calculation. All else equal, the WACC of a firm increases as thebeta and rate of return on equity increases, as an increase in WACC notes a decrease in valuation
and a higher risk.
30. EBIT ? Earnings Before Interest and Taxes. Accountants like to use the term Net Operating
Income for this income statement item, but finance people usually refer to it as EBIT
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(pronounced as it is spelled ? E.B.I. T). Either way, on an income statement, it is the amount ofincome that a company has after subtracting operating expenses from sales (hence the term net
operating income). Another way of looking at it is that this is the income that the company has
before subtracting interest and taxes (hence, EBIT) .
31. EAT ? Earnings After Taxes. Accountants call this Net Income or Net Profit After Taxes, but
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finance people usually refer to it as EAT (pronounced E. A. T) .32. EPS ? Earnings Per Share. This is the amount of income that the common stockholders are
entitled to receive (per share of stock owned). This income may be paid out in the form of
dividends, retained and reinvested by the company, or a combination of both. (It is pronounced
E. P. S).
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33. Book value: The value of an asset, a liability or equity, as recorded in the accounts ofA firm. The book value of ordinary shares is equal to the paid?up capital plus retained earnings
i.e. net worth.
34. Par value: The stated or face nominal) value of a security.
35. Market value: It is determined on the basis of the stock market quotations of the company?s
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securities.36. Flotation costs: Costs incurred in issuing securities, e.g., underwriting and brokerage costs,
printing, legal, publicity and so on.
37. Equity share capital: Long term funds provided by the owners of a firm and consist of
ordinary share capital and retained earnings.
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38. Retained Earnings: The portion of the after?tax profits that are not paid out to theshareholders as dividends.
39. Preference shares: Preference shares have a fixed percentage dividend before any dividend is
paid to the ordinary shareholders. As with ordinary shares a preference dividend can only be paid
if sufficient distributable profits are available, although with 'cumulative' preference shares the
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right to an unpaid dividend is carried forward to later years. The arrears of dividend oncumulative preference shares must be paid before any dividend is paid to the ordinary
shareholders.
40. Definition of 'Dividend Policy': The policy a company uses to decide how much it will pay
out to shareholders in dividends.
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41. Dividend Relevance: Walter?s Models: Professor James E. Walter argues that the choice ofdividend policies almost always affect the value of the firm. His model, one of the earlier
theoretical works shows the importance of the relationship between the firm?s rate of return, r
and its cost of capital, k in determining the dividend policy that will maximize the wealth of
shareholders.
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42. Dividend Irrelevance: The Miller Modgiliani (MM) approach: According to Modgiliani andMiller (MM), under a perfect market situation, the dividend policy of a firm is irrelevant, as it
does not affect the value of the firm. They argue that the value of the firm depends on the firm?s
earnings that result from its investment policy.
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Department of Business ManagmentCONCEPTS IN FINANCIAL MANAGEMENT
1. Finance.
a.Finance is a simple task of providing the necessary funds (money) required by the business of
entities like companies, firms, individuals and others on the terms that are most favourable to
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achieve their economic objectives."b.Finance is the procurement (to get, obtain) of funds and effective (properly planned) utilisation
of funds. It also deals with profits that adequately compensate for the cost and risks borne by the
business."
2. Financial decisions:
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Financial decisions refers to decisions concerning financial matters of a business firm. There aremany kinds of financial management decisions that the firm makes min pursuit of maximizing
shareholder?s wealth, viz., kind of assets to be acquired , pattern of capitalization, distribution of
firm?s income etc. we can classify these decisions into three major groups:
? Investment decisions
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? Financing decisions? Dividend decisions
3. Investment Decisions:
Investment decision relates to the determination of total amount of assets to be held in the firm,
the composition of these assets and the business risk complexions of the firm as perceived by its
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investors.Investment decisions can be classified under two broad groups:
Long?term investment decision and
Short? term investment
4. Wealth maximization ?Definition
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A process that increases the current net value of business or shareholder capital gains, with theobjective of bringing in the highest possible return. The wealth maximization strategy generally
involves making sound financial investment decisions which take into consideration any risk
factors that would compromise or outweigh the anticipated benefits.
5. Profit maximization ? Definition
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A process that companies undergo to determine the best output and price levels in order tomaximize its return. The company will usually adjust influential factors such as production costs,
sale prices, and output levels as a way of reaching its profit goal. There are two main profit
maximization methods used, and they are Marginal Cost?Marginal Revenue Method and Total
Cost?Total Revenue Method. Profit maximization is a good thing for a company, but can be a
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bad thing for consumers if the company starts to use cheaper products or decides to raise prices.6. Time value of money:
The recognition of the time value of money is extremely vital in financial decision making. If the
timing of cash flows is not considered the firm may make decisions which may faulter its
objectives of maximizing the owner?s welfare. The welfare of the owners would be maximised,
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when net wealth or net present worth is created from making a financial decision.7. Compound Value: Interest that is paid both on the initial principal as also on the interest
earned on the initial principal in previous period/s. The interest earned in one period becomes a
part of the principal in the succeeding period.
8. Present value:
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The present value of current cash inflow or outflow is the amount of current cash that is ofequivalent desirability, to the decision maker, to a specified amount of cash to be received or
paid at a future date.
9. Reasons for Time value of money:
Three reasons may be attributed to the individual?s time preference for money:
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? Risk? Preference for consumption
? Investment opportunities
S
10. Annuity: A series of receipts or payments of a fixed amount for a specified number of years.
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Alternatively, a pattern of cash flows that is equal in each year, i.e. equal annual cash flows.11. Capital budgeting: The process of determining which potential long?term projects are worth
undertaking, by comparing their expected discounted cash flows with their internal rates of
return.
12. Capital Budgeting techniques: The following are the capital?budgetingtechniques:
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Non ?Discounted cash flow (DCF) criteria?? Pay back period (PBP)
? Accounting Rate of return
Discounted Cash flow techniques:
? Net present value (NPV)
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? Profitability Index (PI)? Internal rate of return (IRR)
13. Payback Period: The length of time required to recover the cost of an investment. The
payback period of a given investment or project is an important determinant of whether to
undertake the position or project, as longer payback periods are typically not desirable for
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investment positions.Calculated as: Cost of Project
Annual Cash Inflows
14. Accounting rate of return method: The accounting rate of return also known as the return on
Investment (ROI) Uses accounting information, as revealed by financial statements, to measure
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the profitability of an investment. The accounting rate of return is the ratio of the average aftertax profit divided by the average investment. The average investment would be equal to half of
the original investment if it were depreciated constantly. Alternatively, it can be found out by
dividing the total of the investment?s book value after depreciation by the life of the project. The
accounting rate of return, thus, is an average rate and can be determined by the following
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equation.ARR= Average Income
Average Investment
15. Net Present Value ? NPV?The difference between the present value of cash inflows and the
present value of cash outflows. NPV is used in capital budgeting to analyze the profitability of an
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investment or project. NPV analysis is sensitive to the reliability of future cash inflows that aninvestment or project will yield.
16. Internal Rate Of Return ? IRR? The IRR of an investment is the discount rate at which the net
present value of costs (negative cash flows) of the investment equals the net present value of the
benefits (positive cash flows) of the investment. The discount rate often used in capital budgeting
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that makes the net present value of all cash flows from a particular project equal to zero.17. Profitability Index (P.I.) or Benefit cost ratio: It is the ratio of the present value of future cash
benefits, at the required rate of return to the initial cash flow of the investment?.
Formula: PI. = Present value of cash inflows
Present value of initial cash outlay
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18. Accept?Reject criterion: Evaluation of capital budgeting proposals to determine whether theproject under consideration satisfies the minimum acceptance standard and should be accepted.
19. Capital Rationing: Risk?Return Trade off A situation in which due to financial constraints,
the limited funds are allocated a number of mutually exclusive capital budgeting projects.
20. Definition of Risk: The chance that an investment's actual return will be different than
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expected. Risk includes the possibility of losing some or all of the original investment. Differentversions of risk are usually measured by calculating the standard deviation of the historical
returns or average returns of a specific investment. A high standard deviation indicates a high
degree of risk.
21. Risk premium: The difference between expected rate of return on a risky project and the rate
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of return on a risk less project.22. Risk?Return Trade?off: The relationship between the risk and the required Rate of return.
23. Definition of Risk?Adjusted Return: A concept that defines an investment's return by
measuring how much risk is involved in producing that return, which is generally expressed as a
number or rating. Risk?adjusted returns are applied to individual securities and investment funds
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and portfolios.24. Certainty?Equivalents: The return required with certainty to make investors indifferent
between this certain return and a particular uncertain (risky) return.
25. Coefficient of variation: A relative measure of the variability of the outcomes associated
with an event. It is calculated by dividing the standard deviation of a distribution by the mean.
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26. Sensitivity Analysis: The analysis of the effect of change in certain variable on an outcome,to estimate the variability of the outcome, or risk associated with a project or a situation.
27. Decision Tree: A decision tree is a graphic display of the relationship between a present
decision and future events, future decisions and their consequences. The sequence of events is
mapped out over time in a format similar to the branches of a tree.
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28. Leverage: A General Dictionary meaning of the term ?Leverage? refers to an increased meansof accomplishing some purpose.? Leverage allows us to accomplish certain things which are
otherwise not possible, viz? Lifting of heavy objects with the help of leverage. The concept of
leverage is valid in business also.
In Financial Management, the term ?leverage? is used to describe the firm?s ability to use fixed
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cost assets or funds to increase the return to its owners? i.e. equity shareholders. James Home hasdefined leverage as ?the employment of an asset or sources of funds for which the firm has to
pay a fixed cost or fixed return?. The fixed cost and fixed return remain constant irrespective of
the changes in volume of output or sales. Thus, the employment of an asset or source of funds for
which the firm has to pay a fixed cost or return has a considerable influence on the earnings
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available for equity shareholders.24. Financial Leverage/Trading on Equity:
The ability of fixed financial charges magnify the effect of changes in EBIT on the earnings per
share(EPS) . Also known as Trading on Equity.
? To use debt to finance an activity. For example, one usually borrows money in the form
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of a mortgage to buy a house. One commonly refers to this as leveraging the house.Likewise, one leverages when one uses a margin in order to purchase securities.
? The amount of debt that has been used to finance activities. A company with much more
debt than equity is generally called "highly leveraged." Too much leverage is often
thought to be unhealthy, but many firms use leverage in order to expand operations.
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ORFinancial leverage
The extent to which interest on debt magnifies changes in operating income into even greater
proportionate changes in earnings after taxes. Financial leverage magnifies increases in earnings
per share during periods of rising operating income but adds significant risks for stockholders
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and creditors because of added interest obligations.25. Definition of 'Operating Leverage'
A measurement of the degree to which a firm or project incurs a combination of fixed and
variable costs.
? A business that makes few sales, with each sale providing a very high gross margin,
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is said to be highly leveraged. A business that makes many sales, with each salecontributing a very slight margin, is said to be less leveraged. As the volume of sales
in a business increases, each new sale contributes less to fixed costs and more to
profitability.
? A business that has a higher proportion of fixed costs and a lower proportion of
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variable costs is said to have used more operating leverage. Those businesses withlower fixed costs and higher variable costs are said to employ less operating leverage.
26. Capital structure: Capital structure of a company means the composition of long ?term
sources of funds. Such as ordinary shares, preference shares, debentures, bonds, long?term debts
etc. It refers to the kind and proportion of securities for raising long?term funds. It implies the
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determination of form or makeup of a company?s capitalization.27. Optimum capital structure: An optimal or sound capital structure can be properly defined as
that combination of debt and equity that attains the stated managerial goal in the most relevant
manner? the maximization of the firm?s market value and the minimization of the firm?s cost of
capital. The Optimal capital structure is concerned with the two important variables at one time ?
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The minimization of cost as well as maximization of worth.28. Cost of capital: Cost of capital refers to the opportunity cost of making a specific investment.
It is the rate of return that could have been earned by putting the same money into a different
investment with equal risk. Thus, the cost of capital is the rate of return required to persuade the
investor to make a given investment.
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29. Definition of 'Weighted Average Cost Of Capital ? WACC'A calculation of a firm's cost of capital in which each category of capital is proportionately
weighted. All capital sources ? common stock, preferred stock, bonds and any other long?term
debt ? are included in a WACC calculation. All else equal, the WACC of a firm increases as the
beta and rate of return on equity increases, as an increase in WACC notes a decrease in valuation
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and a higher risk.30. EBIT ? Earnings Before Interest and Taxes. Accountants like to use the term Net Operating
Income for this income statement item, but finance people usually refer to it as EBIT
(pronounced as it is spelled ? E.B.I. T). Either way, on an income statement, it is the amount of
income that a company has after subtracting operating expenses from sales (hence the term net
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operating income). Another way of looking at it is that this is the income that the company hasbefore subtracting interest and taxes (hence, EBIT) .
31. EAT ? Earnings After Taxes. Accountants call this Net Income or Net Profit After Taxes, but
finance people usually refer to it as EAT (pronounced E. A. T) .
32. EPS ? Earnings Per Share. This is the amount of income that the common stockholders are
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entitled to receive (per share of stock owned). This income may be paid out in the form ofdividends, retained and reinvested by the company, or a combination of both. (It is pronounced
E. P. S).
33. Book value: The value of an asset, a liability or equity, as recorded in the accounts of
A firm. The book value of ordinary shares is equal to the paid?up capital plus retained earnings
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i.e. net worth.34. Par value: The stated or face nominal) value of a security.
35. Market value: It is determined on the basis of the stock market quotations of the company?s
securities.
36. Flotation costs: Costs incurred in issuing securities, e.g., underwriting and brokerage costs,
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printing, legal, publicity and so on.37. Equity share capital: Long term funds provided by the owners of a firm and consist of
ordinary share capital and retained earnings.
38. Retained Earnings: The portion of the after?tax profits that are not paid out to the
shareholders as dividends.
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39. Preference shares: Preference shares have a fixed percentage dividend before any dividend ispaid to the ordinary shareholders. As with ordinary shares a preference dividend can only be paid
if sufficient distributable profits are available, although with 'cumulative' preference shares the
right to an unpaid dividend is carried forward to later years. The arrears of dividend on
cumulative preference shares must be paid before any dividend is paid to the ordinary
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shareholders.40. Definition of 'Dividend Policy': The policy a company uses to decide how much it will pay
out to shareholders in dividends.
41. Dividend Relevance: Walter?s Models: Professor James E. Walter argues that the choice of
dividend policies almost always affect the value of the firm. His model, one of the earlier
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theoretical works shows the importance of the relationship between the firm?s rate of return, rand its cost of capital, k in determining the dividend policy that will maximize the wealth of
shareholders.
42. Dividend Irrelevance: The Miller Modgiliani (MM) approach: According to Modgiliani and
Miller (MM), under a perfect market situation, the dividend policy of a firm is irrelevant, as it
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does not affect the value of the firm. They argue that the value of the firm depends on the firm?searnings that result from its investment policy.
43. Gordon Model: A valuation model in which the value of a firm is equal to the present value
of all future dividends expected over the life of the firm.
44. Inventory management: Definition: Activities employed in maintaining the optimum number
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or amount of each inventory item. The objective of inventory management is to provideuninterrupted production, sales, and/or customer?service levels at the minimum cost. Since for
many companies inventory is the largest item in the current assets category, inventory problems
can and do contribute to losses or even business failures.
45. Economic Order Quantity: The optimum quantity of inventory to order or to produce based
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on trade?off between carrying and ordering costs.46. Accounts Receivable Management: The term receivables is defined as debt owed to the firm
by customers arising from sale of goods or services in the ordinary course of business.
47. Receivables management: Receivables Management means planning, organising, directing
and controlling of receivables.
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48. Collection period:The average period taken to collect receivables. It is equal to the average credit sales divided by
the number of days in a year.
49. Definition of Cash Management: The corporate process of collecting, managing and (short?
term) investing cash. A key component of ensuring a company's financial stability and
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solvency. Frequently corporate treasurers or a business manager is responsible for overall cashmanagement.
50. Cash management: Successful cash management involves not only avoiding insolvency (and
therefore bankruptcy), but also reducing days in account receivables (AR), increasing collection
rates, selecting appropriate short?term investment vehicles, and increasing days cash on hand all
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in order to improve a company's overall financial profitability.51. Cash cycle: The length of time from the point a firm purchases raw materials to the point
when cash is collected from the sale of the resulting finished goods. In other words, it represents
the time during which cash is tied up in operations.
52. Liquidity/Solvency: Abilityof a firm to meet its obligations when they become due.
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53. Current assets: Assets which can be converted into cash within a year.54. Current liabilities: Liabilities hat are payable within a year.
55. Cash Budget: A Cash budget is an estimate of cash receipts and disbursements of cash during
a future period of time. In the words of Solomon Ezra, a cash budget is ?an analysis of flow of
cash in a business over a future, short or long period of time. It is a forecast of expected cash
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Department of Business Managment
CONCEPTS IN FINANCIAL MANAGEMENT
1. Finance.
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a.Finance is a simple task of providing the necessary funds (money) required by the business ofentities like companies, firms, individuals and others on the terms that are most favourable to
achieve their economic objectives."
b.Finance is the procurement (to get, obtain) of funds and effective (properly planned) utilisation
of funds. It also deals with profits that adequately compensate for the cost and risks borne by the
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business."2. Financial decisions:
Financial decisions refers to decisions concerning financial matters of a business firm. There are
many kinds of financial management decisions that the firm makes min pursuit of maximizing
shareholder?s wealth, viz., kind of assets to be acquired , pattern of capitalization, distribution of
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firm?s income etc. we can classify these decisions into three major groups:? Investment decisions
? Financing decisions
? Dividend decisions
3. Investment Decisions:
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Investment decision relates to the determination of total amount of assets to be held in the firm,the composition of these assets and the business risk complexions of the firm as perceived by its
investors.
Investment decisions can be classified under two broad groups:
Long?term investment decision and
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Short? term investment4. Wealth maximization ?Definition
A process that increases the current net value of business or shareholder capital gains, with the
objective of bringing in the highest possible return. The wealth maximization strategy generally
involves making sound financial investment decisions which take into consideration any risk
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factors that would compromise or outweigh the anticipated benefits.5. Profit maximization ? Definition
A process that companies undergo to determine the best output and price levels in order to
maximize its return. The company will usually adjust influential factors such as production costs,
sale prices, and output levels as a way of reaching its profit goal. There are two main profit
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maximization methods used, and they are Marginal Cost?Marginal Revenue Method and TotalCost?Total Revenue Method. Profit maximization is a good thing for a company, but can be a
bad thing for consumers if the company starts to use cheaper products or decides to raise prices.
6. Time value of money:
The recognition of the time value of money is extremely vital in financial decision making. If the
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timing of cash flows is not considered the firm may make decisions which may faulter itsobjectives of maximizing the owner?s welfare. The welfare of the owners would be maximised,
when net wealth or net present worth is created from making a financial decision.
7. Compound Value: Interest that is paid both on the initial principal as also on the interest
earned on the initial principal in previous period/s. The interest earned in one period becomes a
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part of the principal in the succeeding period.8. Present value:
The present value of current cash inflow or outflow is the amount of current cash that is of
equivalent desirability, to the decision maker, to a specified amount of cash to be received or
paid at a future date.
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9. Reasons for Time value of money:Three reasons may be attributed to the individual?s time preference for money:
? Risk
? Preference for consumption
? Investment opportunities
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S10. Annuity: A series of receipts or payments of a fixed amount for a specified number of years.
Alternatively, a pattern of cash flows that is equal in each year, i.e. equal annual cash flows.
11. Capital budgeting: The process of determining which potential long?term projects are worth
undertaking, by comparing their expected discounted cash flows with their internal rates of
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return.12. Capital Budgeting techniques: The following are the capital?budgetingtechniques:
Non ?Discounted cash flow (DCF) criteria?
? Pay back period (PBP)
? Accounting Rate of return
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Discounted Cash flow techniques:? Net present value (NPV)
? Profitability Index (PI)
? Internal rate of return (IRR)
13. Payback Period: The length of time required to recover the cost of an investment. The
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payback period of a given investment or project is an important determinant of whether toundertake the position or project, as longer payback periods are typically not desirable for
investment positions.
Calculated as: Cost of Project
Annual Cash Inflows
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14. Accounting rate of return method: The accounting rate of return also known as the return onInvestment (ROI) Uses accounting information, as revealed by financial statements, to measure
the profitability of an investment. The accounting rate of return is the ratio of the average after
tax profit divided by the average investment. The average investment would be equal to half of
the original investment if it were depreciated constantly. Alternatively, it can be found out by
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dividing the total of the investment?s book value after depreciation by the life of the project. Theaccounting rate of return, thus, is an average rate and can be determined by the following
equation.
ARR= Average Income
Average Investment
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15. Net Present Value ? NPV?The difference between the present value of cash inflows and thepresent value of cash outflows. NPV is used in capital budgeting to analyze the profitability of an
investment or project. NPV analysis is sensitive to the reliability of future cash inflows that an
investment or project will yield.
16. Internal Rate Of Return ? IRR? The IRR of an investment is the discount rate at which the net
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present value of costs (negative cash flows) of the investment equals the net present value of thebenefits (positive cash flows) of the investment. The discount rate often used in capital budgeting
that makes the net present value of all cash flows from a particular project equal to zero.
17. Profitability Index (P.I.) or Benefit cost ratio: It is the ratio of the present value of future cash
benefits, at the required rate of return to the initial cash flow of the investment?.
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Formula: PI. = Present value of cash inflowsPresent value of initial cash outlay
18. Accept?Reject criterion: Evaluation of capital budgeting proposals to determine whether the
project under consideration satisfies the minimum acceptance standard and should be accepted.
19. Capital Rationing: Risk?Return Trade off A situation in which due to financial constraints,
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the limited funds are allocated a number of mutually exclusive capital budgeting projects.20. Definition of Risk: The chance that an investment's actual return will be different than
expected. Risk includes the possibility of losing some or all of the original investment. Different
versions of risk are usually measured by calculating the standard deviation of the historical
returns or average returns of a specific investment. A high standard deviation indicates a high
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degree of risk.21. Risk premium: The difference between expected rate of return on a risky project and the rate
of return on a risk less project.
22. Risk?Return Trade?off: The relationship between the risk and the required Rate of return.
23. Definition of Risk?Adjusted Return: A concept that defines an investment's return by
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measuring how much risk is involved in producing that return, which is generally expressed as anumber or rating. Risk?adjusted returns are applied to individual securities and investment funds
and portfolios.
24. Certainty?Equivalents: The return required with certainty to make investors indifferent
between this certain return and a particular uncertain (risky) return.
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25. Coefficient of variation: A relative measure of the variability of the outcomes associatedwith an event. It is calculated by dividing the standard deviation of a distribution by the mean.
26. Sensitivity Analysis: The analysis of the effect of change in certain variable on an outcome,
to estimate the variability of the outcome, or risk associated with a project or a situation.
27. Decision Tree: A decision tree is a graphic display of the relationship between a present
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decision and future events, future decisions and their consequences. The sequence of events ismapped out over time in a format similar to the branches of a tree.
28. Leverage: A General Dictionary meaning of the term ?Leverage? refers to an increased means
of accomplishing some purpose.? Leverage allows us to accomplish certain things which are
otherwise not possible, viz? Lifting of heavy objects with the help of leverage. The concept of
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leverage is valid in business also.In Financial Management, the term ?leverage? is used to describe the firm?s ability to use fixed
cost assets or funds to increase the return to its owners? i.e. equity shareholders. James Home has
defined leverage as ?the employment of an asset or sources of funds for which the firm has to
pay a fixed cost or fixed return?. The fixed cost and fixed return remain constant irrespective of
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the changes in volume of output or sales. Thus, the employment of an asset or source of funds forwhich the firm has to pay a fixed cost or return has a considerable influence on the earnings
available for equity shareholders.
24. Financial Leverage/Trading on Equity:
The ability of fixed financial charges magnify the effect of changes in EBIT on the earnings per
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share(EPS) . Also known as Trading on Equity.? To use debt to finance an activity. For example, one usually borrows money in the form
of a mortgage to buy a house. One commonly refers to this as leveraging the house.
Likewise, one leverages when one uses a margin in order to purchase securities.
? The amount of debt that has been used to finance activities. A company with much more
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debt than equity is generally called "highly leveraged." Too much leverage is oftenthought to be unhealthy, but many firms use leverage in order to expand operations.
OR
Financial leverage
The extent to which interest on debt magnifies changes in operating income into even greater
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proportionate changes in earnings after taxes. Financial leverage magnifies increases in earningsper share during periods of rising operating income but adds significant risks for stockholders
and creditors because of added interest obligations.
25. Definition of 'Operating Leverage'
A measurement of the degree to which a firm or project incurs a combination of fixed and
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variable costs.? A business that makes few sales, with each sale providing a very high gross margin,
is said to be highly leveraged. A business that makes many sales, with each sale
contributing a very slight margin, is said to be less leveraged. As the volume of sales
in a business increases, each new sale contributes less to fixed costs and more to
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profitability.? A business that has a higher proportion of fixed costs and a lower proportion of
variable costs is said to have used more operating leverage. Those businesses with
lower fixed costs and higher variable costs are said to employ less operating leverage.
26. Capital structure: Capital structure of a company means the composition of long ?term
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sources of funds. Such as ordinary shares, preference shares, debentures, bonds, long?term debtsetc. It refers to the kind and proportion of securities for raising long?term funds. It implies the
determination of form or makeup of a company?s capitalization.
27. Optimum capital structure: An optimal or sound capital structure can be properly defined as
that combination of debt and equity that attains the stated managerial goal in the most relevant
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manner? the maximization of the firm?s market value and the minimization of the firm?s cost ofcapital. The Optimal capital structure is concerned with the two important variables at one time ?
The minimization of cost as well as maximization of worth.
28. Cost of capital: Cost of capital refers to the opportunity cost of making a specific investment.
It is the rate of return that could have been earned by putting the same money into a different
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investment with equal risk. Thus, the cost of capital is the rate of return required to persuade theinvestor to make a given investment.
29. Definition of 'Weighted Average Cost Of Capital ? WACC'
A calculation of a firm's cost of capital in which each category of capital is proportionately
weighted. All capital sources ? common stock, preferred stock, bonds and any other long?term
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debt ? are included in a WACC calculation. All else equal, the WACC of a firm increases as thebeta and rate of return on equity increases, as an increase in WACC notes a decrease in valuation
and a higher risk.
30. EBIT ? Earnings Before Interest and Taxes. Accountants like to use the term Net Operating
Income for this income statement item, but finance people usually refer to it as EBIT
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(pronounced as it is spelled ? E.B.I. T). Either way, on an income statement, it is the amount ofincome that a company has after subtracting operating expenses from sales (hence the term net
operating income). Another way of looking at it is that this is the income that the company has
before subtracting interest and taxes (hence, EBIT) .
31. EAT ? Earnings After Taxes. Accountants call this Net Income or Net Profit After Taxes, but
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finance people usually refer to it as EAT (pronounced E. A. T) .32. EPS ? Earnings Per Share. This is the amount of income that the common stockholders are
entitled to receive (per share of stock owned). This income may be paid out in the form of
dividends, retained and reinvested by the company, or a combination of both. (It is pronounced
E. P. S).
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33. Book value: The value of an asset, a liability or equity, as recorded in the accounts ofA firm. The book value of ordinary shares is equal to the paid?up capital plus retained earnings
i.e. net worth.
34. Par value: The stated or face nominal) value of a security.
35. Market value: It is determined on the basis of the stock market quotations of the company?s
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securities.36. Flotation costs: Costs incurred in issuing securities, e.g., underwriting and brokerage costs,
printing, legal, publicity and so on.
37. Equity share capital: Long term funds provided by the owners of a firm and consist of
ordinary share capital and retained earnings.
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38. Retained Earnings: The portion of the after?tax profits that are not paid out to theshareholders as dividends.
39. Preference shares: Preference shares have a fixed percentage dividend before any dividend is
paid to the ordinary shareholders. As with ordinary shares a preference dividend can only be paid
if sufficient distributable profits are available, although with 'cumulative' preference shares the
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right to an unpaid dividend is carried forward to later years. The arrears of dividend oncumulative preference shares must be paid before any dividend is paid to the ordinary
shareholders.
40. Definition of 'Dividend Policy': The policy a company uses to decide how much it will pay
out to shareholders in dividends.
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41. Dividend Relevance: Walter?s Models: Professor James E. Walter argues that the choice ofdividend policies almost always affect the value of the firm. His model, one of the earlier
theoretical works shows the importance of the relationship between the firm?s rate of return, r
and its cost of capital, k in determining the dividend policy that will maximize the wealth of
shareholders.
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42. Dividend Irrelevance: The Miller Modgiliani (MM) approach: According to Modgiliani andMiller (MM), under a perfect market situation, the dividend policy of a firm is irrelevant, as it
does not affect the value of the firm. They argue that the value of the firm depends on the firm?s
earnings that result from its investment policy.
43. Gordon Model: A valuation model in which the value of a firm is equal to the present value
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of all future dividends expected over the life of the firm.44. Inventory management: Definition: Activities employed in maintaining the optimum number
or amount of each inventory item. The objective of inventory management is to provide
uninterrupted production, sales, and/or customer?service levels at the minimum cost. Since for
many companies inventory is the largest item in the current assets category, inventory problems
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can and do contribute to losses or even business failures.45. Economic Order Quantity: The optimum quantity of inventory to order or to produce based
on trade?off between carrying and ordering costs.
46. Accounts Receivable Management: The term receivables is defined as debt owed to the firm
by customers arising from sale of goods or services in the ordinary course of business.
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47. Receivables management: Receivables Management means planning, organising, directingand controlling of receivables.
48. Collection period:
The average period taken to collect receivables. It is equal to the average credit sales divided by
the number of days in a year.
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49. Definition of Cash Management: The corporate process of collecting, managing and (short?term) investing cash. A key component of ensuring a company's financial stability and
solvency. Frequently corporate treasurers or a business manager is responsible for overall cash
management.
50. Cash management: Successful cash management involves not only avoiding insolvency (and
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therefore bankruptcy), but also reducing days in account receivables (AR), increasing collectionrates, selecting appropriate short?term investment vehicles, and increasing days cash on hand all
in order to improve a company's overall financial profitability.
51. Cash cycle: The length of time from the point a firm purchases raw materials to the point
when cash is collected from the sale of the resulting finished goods. In other words, it represents
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the time during which cash is tied up in operations.52. Liquidity/Solvency: Abilityof a firm to meet its obligations when they become due.
53. Current assets: Assets which can be converted into cash within a year.
54. Current liabilities: Liabilities hat are payable within a year.
55. Cash Budget: A Cash budget is an estimate of cash receipts and disbursements of cash during
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a future period of time. In the words of Solomon Ezra, a cash budget is ?an analysis of flow ofcash in a business over a future, short or long period of time. It is a forecast of expected cash
intake and outlay.
56. Value Based Management: Definition of value based management: Value Based
Management is the management approach that ensures corporations are run consistently on value
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(normally: maximizing shareholder value).It
is useful to understand that Value Based Management includes all three of the following:
? Creating Value: ways to actually increase or generate maximum future value ?
strategy.Value Based Management VBM
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? Managing for Value: (governance, change management, organizational culture,communication, leadership
? Measuring Value: valuation.
57. Corporate governance: Corporate governance refers to the set of systems, principles and
processes by which a company is governed. They provide the guidelines as to how the company
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can be directed or controlled such that it can fulfil its goals and objectives in a manner that addsto the value of the company and is also beneficial for all stakeholders in the long term.
Stakeholders in this case would include everyone ranging from the board of directors,
management, shareholders to customers, employees and society. The management of the
company hence assumes the role of a trustee for all the others.
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58. Merger: The combining of two or more entities into one, through a purchase acquisition or apooling of interests
59. Acquisition: The act of contracting or assuming or acquiring possession of something? "the
acquisition of wealth"? the acquisition of one company by another"
60. Takeover: Takeover is a term referring to transfer of control of a firm from one group of
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shareholders to another group of shareholders. Change in the controlling interest of acorporation, either through a friendly acquisition or an unfriendly, hostile, bid. A hostile
takeover (with the aim of replacing current existing management) is usually attempted
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Department of Business Managment
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CONCEPTS IN FINANCIAL MANAGEMENT1. Finance.
a.Finance is a simple task of providing the necessary funds (money) required by the business of
entities like companies, firms, individuals and others on the terms that are most favourable to
achieve their economic objectives."
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b.Finance is the procurement (to get, obtain) of funds and effective (properly planned) utilisationof funds. It also deals with profits that adequately compensate for the cost and risks borne by the
business."
2. Financial decisions:
Financial decisions refers to decisions concerning financial matters of a business firm. There are
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many kinds of financial management decisions that the firm makes min pursuit of maximizingshareholder?s wealth, viz., kind of assets to be acquired , pattern of capitalization, distribution of
firm?s income etc. we can classify these decisions into three major groups:
? Investment decisions
? Financing decisions
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? Dividend decisions3. Investment Decisions:
Investment decision relates to the determination of total amount of assets to be held in the firm,
the composition of these assets and the business risk complexions of the firm as perceived by its
investors.
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Investment decisions can be classified under two broad groups:Long?term investment decision and
Short? term investment
4. Wealth maximization ?Definition
A process that increases the current net value of business or shareholder capital gains, with the
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objective of bringing in the highest possible return. The wealth maximization strategy generallyinvolves making sound financial investment decisions which take into consideration any risk
factors that would compromise or outweigh the anticipated benefits.
5. Profit maximization ? Definition
A process that companies undergo to determine the best output and price levels in order to
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maximize its return. The company will usually adjust influential factors such as production costs,sale prices, and output levels as a way of reaching its profit goal. There are two main profit
maximization methods used, and they are Marginal Cost?Marginal Revenue Method and Total
Cost?Total Revenue Method. Profit maximization is a good thing for a company, but can be a
bad thing for consumers if the company starts to use cheaper products or decides to raise prices.
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6. Time value of money:The recognition of the time value of money is extremely vital in financial decision making. If the
timing of cash flows is not considered the firm may make decisions which may faulter its
objectives of maximizing the owner?s welfare. The welfare of the owners would be maximised,
when net wealth or net present worth is created from making a financial decision.
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7. Compound Value: Interest that is paid both on the initial principal as also on the interestearned on the initial principal in previous period/s. The interest earned in one period becomes a
part of the principal in the succeeding period.
8. Present value:
The present value of current cash inflow or outflow is the amount of current cash that is of
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equivalent desirability, to the decision maker, to a specified amount of cash to be received orpaid at a future date.
9. Reasons for Time value of money:
Three reasons may be attributed to the individual?s time preference for money:
? Risk
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? Preference for consumption? Investment opportunities
S
10. Annuity: A series of receipts or payments of a fixed amount for a specified number of years.
Alternatively, a pattern of cash flows that is equal in each year, i.e. equal annual cash flows.
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11. Capital budgeting: The process of determining which potential long?term projects are worthundertaking, by comparing their expected discounted cash flows with their internal rates of
return.
12. Capital Budgeting techniques: The following are the capital?budgetingtechniques:
Non ?Discounted cash flow (DCF) criteria?
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? Pay back period (PBP)? Accounting Rate of return
Discounted Cash flow techniques:
? Net present value (NPV)
? Profitability Index (PI)
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? Internal rate of return (IRR)13. Payback Period: The length of time required to recover the cost of an investment. The
payback period of a given investment or project is an important determinant of whether to
undertake the position or project, as longer payback periods are typically not desirable for
investment positions.
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Calculated as: Cost of ProjectAnnual Cash Inflows
14. Accounting rate of return method: The accounting rate of return also known as the return on
Investment (ROI) Uses accounting information, as revealed by financial statements, to measure
the profitability of an investment. The accounting rate of return is the ratio of the average after
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tax profit divided by the average investment. The average investment would be equal to half ofthe original investment if it were depreciated constantly. Alternatively, it can be found out by
dividing the total of the investment?s book value after depreciation by the life of the project. The
accounting rate of return, thus, is an average rate and can be determined by the following
equation.
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ARR= Average IncomeAverage Investment
15. Net Present Value ? NPV?The difference between the present value of cash inflows and the
present value of cash outflows. NPV is used in capital budgeting to analyze the profitability of an
investment or project. NPV analysis is sensitive to the reliability of future cash inflows that an
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investment or project will yield.16. Internal Rate Of Return ? IRR? The IRR of an investment is the discount rate at which the net
present value of costs (negative cash flows) of the investment equals the net present value of the
benefits (positive cash flows) of the investment. The discount rate often used in capital budgeting
that makes the net present value of all cash flows from a particular project equal to zero.
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17. Profitability Index (P.I.) or Benefit cost ratio: It is the ratio of the present value of future cashbenefits, at the required rate of return to the initial cash flow of the investment?.
Formula: PI. = Present value of cash inflows
Present value of initial cash outlay
18. Accept?Reject criterion: Evaluation of capital budgeting proposals to determine whether the
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project under consideration satisfies the minimum acceptance standard and should be accepted.19. Capital Rationing: Risk?Return Trade off A situation in which due to financial constraints,
the limited funds are allocated a number of mutually exclusive capital budgeting projects.
20. Definition of Risk: The chance that an investment's actual return will be different than
expected. Risk includes the possibility of losing some or all of the original investment. Different
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versions of risk are usually measured by calculating the standard deviation of the historicalreturns or average returns of a specific investment. A high standard deviation indicates a high
degree of risk.
21. Risk premium: The difference between expected rate of return on a risky project and the rate
of return on a risk less project.
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22. Risk?Return Trade?off: The relationship between the risk and the required Rate of return.23. Definition of Risk?Adjusted Return: A concept that defines an investment's return by
measuring how much risk is involved in producing that return, which is generally expressed as a
number or rating. Risk?adjusted returns are applied to individual securities and investment funds
and portfolios.
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24. Certainty?Equivalents: The return required with certainty to make investors indifferentbetween this certain return and a particular uncertain (risky) return.
25. Coefficient of variation: A relative measure of the variability of the outcomes associated
with an event. It is calculated by dividing the standard deviation of a distribution by the mean.
26. Sensitivity Analysis: The analysis of the effect of change in certain variable on an outcome,
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to estimate the variability of the outcome, or risk associated with a project or a situation.27. Decision Tree: A decision tree is a graphic display of the relationship between a present
decision and future events, future decisions and their consequences. The sequence of events is
mapped out over time in a format similar to the branches of a tree.
28. Leverage: A General Dictionary meaning of the term ?Leverage? refers to an increased means
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of accomplishing some purpose.? Leverage allows us to accomplish certain things which areotherwise not possible, viz? Lifting of heavy objects with the help of leverage. The concept of
leverage is valid in business also.
In Financial Management, the term ?leverage? is used to describe the firm?s ability to use fixed
cost assets or funds to increase the return to its owners? i.e. equity shareholders. James Home has
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defined leverage as ?the employment of an asset or sources of funds for which the firm has topay a fixed cost or fixed return?. The fixed cost and fixed return remain constant irrespective of
the changes in volume of output or sales. Thus, the employment of an asset or source of funds for
which the firm has to pay a fixed cost or return has a considerable influence on the earnings
available for equity shareholders.
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24. Financial Leverage/Trading on Equity:The ability of fixed financial charges magnify the effect of changes in EBIT on the earnings per
share(EPS) . Also known as Trading on Equity.
? To use debt to finance an activity. For example, one usually borrows money in the form
of a mortgage to buy a house. One commonly refers to this as leveraging the house.
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Likewise, one leverages when one uses a margin in order to purchase securities.? The amount of debt that has been used to finance activities. A company with much more
debt than equity is generally called "highly leveraged." Too much leverage is often
thought to be unhealthy, but many firms use leverage in order to expand operations.
OR
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Financial leverageThe extent to which interest on debt magnifies changes in operating income into even greater
proportionate changes in earnings after taxes. Financial leverage magnifies increases in earnings
per share during periods of rising operating income but adds significant risks for stockholders
and creditors because of added interest obligations.
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25. Definition of 'Operating Leverage'A measurement of the degree to which a firm or project incurs a combination of fixed and
variable costs.
? A business that makes few sales, with each sale providing a very high gross margin,
is said to be highly leveraged. A business that makes many sales, with each sale
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contributing a very slight margin, is said to be less leveraged. As the volume of salesin a business increases, each new sale contributes less to fixed costs and more to
profitability.
? A business that has a higher proportion of fixed costs and a lower proportion of
variable costs is said to have used more operating leverage. Those businesses with
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lower fixed costs and higher variable costs are said to employ less operating leverage.26. Capital structure: Capital structure of a company means the composition of long ?term
sources of funds. Such as ordinary shares, preference shares, debentures, bonds, long?term debts
etc. It refers to the kind and proportion of securities for raising long?term funds. It implies the
determination of form or makeup of a company?s capitalization.
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27. Optimum capital structure: An optimal or sound capital structure can be properly defined asthat combination of debt and equity that attains the stated managerial goal in the most relevant
manner? the maximization of the firm?s market value and the minimization of the firm?s cost of
capital. The Optimal capital structure is concerned with the two important variables at one time ?
The minimization of cost as well as maximization of worth.
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28. Cost of capital: Cost of capital refers to the opportunity cost of making a specific investment.It is the rate of return that could have been earned by putting the same money into a different
investment with equal risk. Thus, the cost of capital is the rate of return required to persuade the
investor to make a given investment.
29. Definition of 'Weighted Average Cost Of Capital ? WACC'
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A calculation of a firm's cost of capital in which each category of capital is proportionatelyweighted. All capital sources ? common stock, preferred stock, bonds and any other long?term
debt ? are included in a WACC calculation. All else equal, the WACC of a firm increases as the
beta and rate of return on equity increases, as an increase in WACC notes a decrease in valuation
and a higher risk.
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30. EBIT ? Earnings Before Interest and Taxes. Accountants like to use the term Net OperatingIncome for this income statement item, but finance people usually refer to it as EBIT
(pronounced as it is spelled ? E.B.I. T). Either way, on an income statement, it is the amount of
income that a company has after subtracting operating expenses from sales (hence the term net
operating income). Another way of looking at it is that this is the income that the company has
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before subtracting interest and taxes (hence, EBIT) .31. EAT ? Earnings After Taxes. Accountants call this Net Income or Net Profit After Taxes, but
finance people usually refer to it as EAT (pronounced E. A. T) .
32. EPS ? Earnings Per Share. This is the amount of income that the common stockholders are
entitled to receive (per share of stock owned). This income may be paid out in the form of
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dividends, retained and reinvested by the company, or a combination of both. (It is pronouncedE. P. S).
33. Book value: The value of an asset, a liability or equity, as recorded in the accounts of
A firm. The book value of ordinary shares is equal to the paid?up capital plus retained earnings
i.e. net worth.
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34. Par value: The stated or face nominal) value of a security.35. Market value: It is determined on the basis of the stock market quotations of the company?s
securities.
36. Flotation costs: Costs incurred in issuing securities, e.g., underwriting and brokerage costs,
printing, legal, publicity and so on.
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37. Equity share capital: Long term funds provided by the owners of a firm and consist ofordinary share capital and retained earnings.
38. Retained Earnings: The portion of the after?tax profits that are not paid out to the
shareholders as dividends.
39. Preference shares: Preference shares have a fixed percentage dividend before any dividend is
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paid to the ordinary shareholders. As with ordinary shares a preference dividend can only be paidif sufficient distributable profits are available, although with 'cumulative' preference shares the
right to an unpaid dividend is carried forward to later years. The arrears of dividend on
cumulative preference shares must be paid before any dividend is paid to the ordinary
shareholders.
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40. Definition of 'Dividend Policy': The policy a company uses to decide how much it will payout to shareholders in dividends.
41. Dividend Relevance: Walter?s Models: Professor James E. Walter argues that the choice of
dividend policies almost always affect the value of the firm. His model, one of the earlier
theoretical works shows the importance of the relationship between the firm?s rate of return, r
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and its cost of capital, k in determining the dividend policy that will maximize the wealth ofshareholders.
42. Dividend Irrelevance: The Miller Modgiliani (MM) approach: According to Modgiliani and
Miller (MM), under a perfect market situation, the dividend policy of a firm is irrelevant, as it
does not affect the value of the firm. They argue that the value of the firm depends on the firm?s
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earnings that result from its investment policy.43. Gordon Model: A valuation model in which the value of a firm is equal to the present value
of all future dividends expected over the life of the firm.
44. Inventory management: Definition: Activities employed in maintaining the optimum number
or amount of each inventory item. The objective of inventory management is to provide
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uninterrupted production, sales, and/or customer?service levels at the minimum cost. Since formany companies inventory is the largest item in the current assets category, inventory problems
can and do contribute to losses or even business failures.
45. Economic Order Quantity: The optimum quantity of inventory to order or to produce based
on trade?off between carrying and ordering costs.
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46. Accounts Receivable Management: The term receivables is defined as debt owed to the firmby customers arising from sale of goods or services in the ordinary course of business.
47. Receivables management: Receivables Management means planning, organising, directing
and controlling of receivables.
48. Collection period:
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The average period taken to collect receivables. It is equal to the average credit sales divided bythe number of days in a year.
49. Definition of Cash Management: The corporate process of collecting, managing and (short?
term) investing cash. A key component of ensuring a company's financial stability and
solvency. Frequently corporate treasurers or a business manager is responsible for overall cash
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management.50. Cash management: Successful cash management involves not only avoiding insolvency (and
therefore bankruptcy), but also reducing days in account receivables (AR), increasing collection
rates, selecting appropriate short?term investment vehicles, and increasing days cash on hand all
in order to improve a company's overall financial profitability.
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51. Cash cycle: The length of time from the point a firm purchases raw materials to the pointwhen cash is collected from the sale of the resulting finished goods. In other words, it represents
the time during which cash is tied up in operations.
52. Liquidity/Solvency: Abilityof a firm to meet its obligations when they become due.
53. Current assets: Assets which can be converted into cash within a year.
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54. Current liabilities: Liabilities hat are payable within a year.55. Cash Budget: A Cash budget is an estimate of cash receipts and disbursements of cash during
a future period of time. In the words of Solomon Ezra, a cash budget is ?an analysis of flow of
cash in a business over a future, short or long period of time. It is a forecast of expected cash
intake and outlay.
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56. Value Based Management: Definition of value based management: Value BasedManagement is the management approach that ensures corporations are run consistently on value
(normally: maximizing shareholder value).
It
is useful to understand that Value Based Management includes all three of the following:
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? Creating Value: ways to actually increase or generate maximum future value ?strategy.Value Based Management VBM
? Managing for Value: (governance, change management, organizational culture,
communication, leadership
? Measuring Value: valuation.
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57. Corporate governance: Corporate governance refers to the set of systems, principles andprocesses by which a company is governed. They provide the guidelines as to how the company
can be directed or controlled such that it can fulfil its goals and objectives in a manner that adds
to the value of the company and is also beneficial for all stakeholders in the long term.
Stakeholders in this case would include everyone ranging from the board of directors,
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management, shareholders to customers, employees and society. The management of thecompany hence assumes the role of a trustee for all the others.
58. Merger: The combining of two or more entities into one, through a purchase acquisition or a
pooling of interests
59. Acquisition: The act of contracting or assuming or acquiring possession of something? "the
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acquisition of wealth"? the acquisition of one company by another"60. Takeover: Takeover is a term referring to transfer of control of a firm from one group of
shareholders to another group of shareholders. Change in the controlling interest of a
corporation, either through a friendly acquisition or an unfriendly, hostile, bid. A hostile
takeover (with the aim of replacing current existing management) is usually attempted
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through a public tender offer.61. Concentric merger: Concentric mergers take place when two firms from different but
" adjacent" industries merge. For example, if an auto manufacturer and a motorcycle
manufacturer merge, the merger is a concentric one. Although both industries serve the
transportation needs of their customers, the two are quite unique in their competitive structures.
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62. Conglomerate mergers: A conglomerate merger is one where two or more companies withdifferent businesses merge to diversify the products marketed. The companies may not be related
to each other horizontally
A conglomerate merger is a type of merger whereby the two companies that merge with each
other are involved in different sorts of businesses. The importance of the conglomerate mergers
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lies in the fact that they help the merging companies to be better than before.63. Vertical Merger: Merger between a company that supplies goods and services and a
company that buys those goods and services. For example, if a publishing company buys a paper
producer, it is considered a vertical merger because the publisher buys large amounts of paper. In
some cases, vertical mergers may be challenged by the government if they are found to violate
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antitrust laws.64. Operating cycle concept : Maximization of share holder?s wealth of a firm is possible only
when there are sufficient return from the operations. Successful sales activity is necessary for
earning profit. Sales do not convert into cash immediately? There is invisible time gap between
the sale of goods and receipt of cash. The time taken to convert raw material into cash is known
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as operating cycle.Conversion of cash into raw material -* Conversion of raw material into work in progress -*
Conversion of Work in progress into finished goods -* Conversion of finished goods into Sales -*
Sales into Debtors -* Debtors into cash.
65. Certainty: Certainty is a situation in which investor is certain about the future price. Certainty has
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two characteristics.a . Availability of full information
b. Uniqueness of Outcomes
Ex: Suppose nvestor knows that the ecurity will definitely be old at Rs. 20.
66. Uncertainty: There is an inability to forecast the future accurately and reliably. It has two
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characteristics:? In adequate information
? Multiple outcomes.
Ex: Suppose he expects that the price of the ecurity could be Rs. 80, Rs. 10 or Rs. 20.
67. Risk: Definitions:
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FirstRanker.com - FirstRanker's ChoiceDepartment of Business Managment
CONCEPTS IN FINANCIAL MANAGEMENT
1. Finance.
a.Finance is a simple task of providing the necessary funds (money) required by the business of
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entities like companies, firms, individuals and others on the terms that are most favourable toachieve their economic objectives."
b.Finance is the procurement (to get, obtain) of funds and effective (properly planned) utilisation
of funds. It also deals with profits that adequately compensate for the cost and risks borne by the
business."
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2. Financial decisions:Financial decisions refers to decisions concerning financial matters of a business firm. There are
many kinds of financial management decisions that the firm makes min pursuit of maximizing
shareholder?s wealth, viz., kind of assets to be acquired , pattern of capitalization, distribution of
firm?s income etc. we can classify these decisions into three major groups:
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? Investment decisions? Financing decisions
? Dividend decisions
3. Investment Decisions:
Investment decision relates to the determination of total amount of assets to be held in the firm,
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the composition of these assets and the business risk complexions of the firm as perceived by itsinvestors.
Investment decisions can be classified under two broad groups:
Long?term investment decision and
Short? term investment
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4. Wealth maximization ?DefinitionA process that increases the current net value of business or shareholder capital gains, with the
objective of bringing in the highest possible return. The wealth maximization strategy generally
involves making sound financial investment decisions which take into consideration any risk
factors that would compromise or outweigh the anticipated benefits.
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5. Profit maximization ? DefinitionA process that companies undergo to determine the best output and price levels in order to
maximize its return. The company will usually adjust influential factors such as production costs,
sale prices, and output levels as a way of reaching its profit goal. There are two main profit
maximization methods used, and they are Marginal Cost?Marginal Revenue Method and Total
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Cost?Total Revenue Method. Profit maximization is a good thing for a company, but can be abad thing for consumers if the company starts to use cheaper products or decides to raise prices.
6. Time value of money:
The recognition of the time value of money is extremely vital in financial decision making. If the
timing of cash flows is not considered the firm may make decisions which may faulter its
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objectives of maximizing the owner?s welfare. The welfare of the owners would be maximised,when net wealth or net present worth is created from making a financial decision.
7. Compound Value: Interest that is paid both on the initial principal as also on the interest
earned on the initial principal in previous period/s. The interest earned in one period becomes a
part of the principal in the succeeding period.
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8. Present value:The present value of current cash inflow or outflow is the amount of current cash that is of
equivalent desirability, to the decision maker, to a specified amount of cash to be received or
paid at a future date.
9. Reasons for Time value of money:
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Three reasons may be attributed to the individual?s time preference for money:? Risk
? Preference for consumption
? Investment opportunities
S
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10. Annuity: A series of receipts or payments of a fixed amount for a specified number of years.Alternatively, a pattern of cash flows that is equal in each year, i.e. equal annual cash flows.
11. Capital budgeting: The process of determining which potential long?term projects are worth
undertaking, by comparing their expected discounted cash flows with their internal rates of
return.
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12. Capital Budgeting techniques: The following are the capital?budgetingtechniques:Non ?Discounted cash flow (DCF) criteria?
? Pay back period (PBP)
? Accounting Rate of return
Discounted Cash flow techniques:
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? Net present value (NPV)? Profitability Index (PI)
? Internal rate of return (IRR)
13. Payback Period: The length of time required to recover the cost of an investment. The
payback period of a given investment or project is an important determinant of whether to
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undertake the position or project, as longer payback periods are typically not desirable forinvestment positions.
Calculated as: Cost of Project
Annual Cash Inflows
14. Accounting rate of return method: The accounting rate of return also known as the return on
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Investment (ROI) Uses accounting information, as revealed by financial statements, to measurethe profitability of an investment. The accounting rate of return is the ratio of the average after
tax profit divided by the average investment. The average investment would be equal to half of
the original investment if it were depreciated constantly. Alternatively, it can be found out by
dividing the total of the investment?s book value after depreciation by the life of the project. The
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accounting rate of return, thus, is an average rate and can be determined by the followingequation.
ARR= Average Income
Average Investment
15. Net Present Value ? NPV?The difference between the present value of cash inflows and the
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present value of cash outflows. NPV is used in capital budgeting to analyze the profitability of aninvestment or project. NPV analysis is sensitive to the reliability of future cash inflows that an
investment or project will yield.
16. Internal Rate Of Return ? IRR? The IRR of an investment is the discount rate at which the net
present value of costs (negative cash flows) of the investment equals the net present value of the
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benefits (positive cash flows) of the investment. The discount rate often used in capital budgetingthat makes the net present value of all cash flows from a particular project equal to zero.
17. Profitability Index (P.I.) or Benefit cost ratio: It is the ratio of the present value of future cash
benefits, at the required rate of return to the initial cash flow of the investment?.
Formula: PI. = Present value of cash inflows
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Present value of initial cash outlay18. Accept?Reject criterion: Evaluation of capital budgeting proposals to determine whether the
project under consideration satisfies the minimum acceptance standard and should be accepted.
19. Capital Rationing: Risk?Return Trade off A situation in which due to financial constraints,
the limited funds are allocated a number of mutually exclusive capital budgeting projects.
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20. Definition of Risk: The chance that an investment's actual return will be different thanexpected. Risk includes the possibility of losing some or all of the original investment. Different
versions of risk are usually measured by calculating the standard deviation of the historical
returns or average returns of a specific investment. A high standard deviation indicates a high
degree of risk.
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21. Risk premium: The difference between expected rate of return on a risky project and the rateof return on a risk less project.
22. Risk?Return Trade?off: The relationship between the risk and the required Rate of return.
23. Definition of Risk?Adjusted Return: A concept that defines an investment's return by
measuring how much risk is involved in producing that return, which is generally expressed as a
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number or rating. Risk?adjusted returns are applied to individual securities and investment fundsand portfolios.
24. Certainty?Equivalents: The return required with certainty to make investors indifferent
between this certain return and a particular uncertain (risky) return.
25. Coefficient of variation: A relative measure of the variability of the outcomes associated
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with an event. It is calculated by dividing the standard deviation of a distribution by the mean.26. Sensitivity Analysis: The analysis of the effect of change in certain variable on an outcome,
to estimate the variability of the outcome, or risk associated with a project or a situation.
27. Decision Tree: A decision tree is a graphic display of the relationship between a present
decision and future events, future decisions and their consequences. The sequence of events is
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mapped out over time in a format similar to the branches of a tree.28. Leverage: A General Dictionary meaning of the term ?Leverage? refers to an increased means
of accomplishing some purpose.? Leverage allows us to accomplish certain things which are
otherwise not possible, viz? Lifting of heavy objects with the help of leverage. The concept of
leverage is valid in business also.
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In Financial Management, the term ?leverage? is used to describe the firm?s ability to use fixedcost assets or funds to increase the return to its owners? i.e. equity shareholders. James Home has
defined leverage as ?the employment of an asset or sources of funds for which the firm has to
pay a fixed cost or fixed return?. The fixed cost and fixed return remain constant irrespective of
the changes in volume of output or sales. Thus, the employment of an asset or source of funds for
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which the firm has to pay a fixed cost or return has a considerable influence on the earningsavailable for equity shareholders.
24. Financial Leverage/Trading on Equity:
The ability of fixed financial charges magnify the effect of changes in EBIT on the earnings per
share(EPS) . Also known as Trading on Equity.
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? To use debt to finance an activity. For example, one usually borrows money in the formof a mortgage to buy a house. One commonly refers to this as leveraging the house.
Likewise, one leverages when one uses a margin in order to purchase securities.
? The amount of debt that has been used to finance activities. A company with much more
debt than equity is generally called "highly leveraged." Too much leverage is often
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thought to be unhealthy, but many firms use leverage in order to expand operations.OR
Financial leverage
The extent to which interest on debt magnifies changes in operating income into even greater
proportionate changes in earnings after taxes. Financial leverage magnifies increases in earnings
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per share during periods of rising operating income but adds significant risks for stockholdersand creditors because of added interest obligations.
25. Definition of 'Operating Leverage'
A measurement of the degree to which a firm or project incurs a combination of fixed and
variable costs.
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? A business that makes few sales, with each sale providing a very high gross margin,is said to be highly leveraged. A business that makes many sales, with each sale
contributing a very slight margin, is said to be less leveraged. As the volume of sales
in a business increases, each new sale contributes less to fixed costs and more to
profitability.
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? A business that has a higher proportion of fixed costs and a lower proportion ofvariable costs is said to have used more operating leverage. Those businesses with
lower fixed costs and higher variable costs are said to employ less operating leverage.
26. Capital structure: Capital structure of a company means the composition of long ?term
sources of funds. Such as ordinary shares, preference shares, debentures, bonds, long?term debts
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etc. It refers to the kind and proportion of securities for raising long?term funds. It implies thedetermination of form or makeup of a company?s capitalization.
27. Optimum capital structure: An optimal or sound capital structure can be properly defined as
that combination of debt and equity that attains the stated managerial goal in the most relevant
manner? the maximization of the firm?s market value and the minimization of the firm?s cost of
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capital. The Optimal capital structure is concerned with the two important variables at one time ?The minimization of cost as well as maximization of worth.
28. Cost of capital: Cost of capital refers to the opportunity cost of making a specific investment.
It is the rate of return that could have been earned by putting the same money into a different
investment with equal risk. Thus, the cost of capital is the rate of return required to persuade the
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investor to make a given investment.29. Definition of 'Weighted Average Cost Of Capital ? WACC'
A calculation of a firm's cost of capital in which each category of capital is proportionately
weighted. All capital sources ? common stock, preferred stock, bonds and any other long?term
debt ? are included in a WACC calculation. All else equal, the WACC of a firm increases as the
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beta and rate of return on equity increases, as an increase in WACC notes a decrease in valuationand a higher risk.
30. EBIT ? Earnings Before Interest and Taxes. Accountants like to use the term Net Operating
Income for this income statement item, but finance people usually refer to it as EBIT
(pronounced as it is spelled ? E.B.I. T). Either way, on an income statement, it is the amount of
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income that a company has after subtracting operating expenses from sales (hence the term netoperating income). Another way of looking at it is that this is the income that the company has
before subtracting interest and taxes (hence, EBIT) .
31. EAT ? Earnings After Taxes. Accountants call this Net Income or Net Profit After Taxes, but
finance people usually refer to it as EAT (pronounced E. A. T) .
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32. EPS ? Earnings Per Share. This is the amount of income that the common stockholders areentitled to receive (per share of stock owned). This income may be paid out in the form of
dividends, retained and reinvested by the company, or a combination of both. (It is pronounced
E. P. S).
33. Book value: The value of an asset, a liability or equity, as recorded in the accounts of
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A firm. The book value of ordinary shares is equal to the paid?up capital plus retained earningsi.e. net worth.
34. Par value: The stated or face nominal) value of a security.
35. Market value: It is determined on the basis of the stock market quotations of the company?s
securities.
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36. Flotation costs: Costs incurred in issuing securities, e.g., underwriting and brokerage costs,printing, legal, publicity and so on.
37. Equity share capital: Long term funds provided by the owners of a firm and consist of
ordinary share capital and retained earnings.
38. Retained Earnings: The portion of the after?tax profits that are not paid out to the
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shareholders as dividends.39. Preference shares: Preference shares have a fixed percentage dividend before any dividend is
paid to the ordinary shareholders. As with ordinary shares a preference dividend can only be paid
if sufficient distributable profits are available, although with 'cumulative' preference shares the
right to an unpaid dividend is carried forward to later years. The arrears of dividend on
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cumulative preference shares must be paid before any dividend is paid to the ordinaryshareholders.
40. Definition of 'Dividend Policy': The policy a company uses to decide how much it will pay
out to shareholders in dividends.
41. Dividend Relevance: Walter?s Models: Professor James E. Walter argues that the choice of
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dividend policies almost always affect the value of the firm. His model, one of the earliertheoretical works shows the importance of the relationship between the firm?s rate of return, r
and its cost of capital, k in determining the dividend policy that will maximize the wealth of
shareholders.
42. Dividend Irrelevance: The Miller Modgiliani (MM) approach: According to Modgiliani and
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Miller (MM), under a perfect market situation, the dividend policy of a firm is irrelevant, as itdoes not affect the value of the firm. They argue that the value of the firm depends on the firm?s
earnings that result from its investment policy.
43. Gordon Model: A valuation model in which the value of a firm is equal to the present value
of all future dividends expected over the life of the firm.
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44. Inventory management: Definition: Activities employed in maintaining the optimum numberor amount of each inventory item. The objective of inventory management is to provide
uninterrupted production, sales, and/or customer?service levels at the minimum cost. Since for
many companies inventory is the largest item in the current assets category, inventory problems
can and do contribute to losses or even business failures.
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45. Economic Order Quantity: The optimum quantity of inventory to order or to produce basedon trade?off between carrying and ordering costs.
46. Accounts Receivable Management: The term receivables is defined as debt owed to the firm
by customers arising from sale of goods or services in the ordinary course of business.
47. Receivables management: Receivables Management means planning, organising, directing
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and controlling of receivables.48. Collection period:
The average period taken to collect receivables. It is equal to the average credit sales divided by
the number of days in a year.
49. Definition of Cash Management: The corporate process of collecting, managing and (short?
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term) investing cash. A key component of ensuring a company's financial stability andsolvency. Frequently corporate treasurers or a business manager is responsible for overall cash
management.
50. Cash management: Successful cash management involves not only avoiding insolvency (and
therefore bankruptcy), but also reducing days in account receivables (AR), increasing collection
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rates, selecting appropriate short?term investment vehicles, and increasing days cash on hand allin order to improve a company's overall financial profitability.
51. Cash cycle: The length of time from the point a firm purchases raw materials to the point
when cash is collected from the sale of the resulting finished goods. In other words, it represents
the time during which cash is tied up in operations.
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52. Liquidity/Solvency: Abilityof a firm to meet its obligations when they become due.53. Current assets: Assets which can be converted into cash within a year.
54. Current liabilities: Liabilities hat are payable within a year.
55. Cash Budget: A Cash budget is an estimate of cash receipts and disbursements of cash during
a future period of time. In the words of Solomon Ezra, a cash budget is ?an analysis of flow of
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cash in a business over a future, short or long period of time. It is a forecast of expected cashintake and outlay.
56. Value Based Management: Definition of value based management: Value Based
Management is the management approach that ensures corporations are run consistently on value
(normally: maximizing shareholder value).
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Itis useful to understand that Value Based Management includes all three of the following:
? Creating Value: ways to actually increase or generate maximum future value ?
strategy.Value Based Management VBM
? Managing for Value: (governance, change management, organizational culture,
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communication, leadership? Measuring Value: valuation.
57. Corporate governance: Corporate governance refers to the set of systems, principles and
processes by which a company is governed. They provide the guidelines as to how the company
can be directed or controlled such that it can fulfil its goals and objectives in a manner that adds
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to the value of the company and is also beneficial for all stakeholders in the long term.Stakeholders in this case would include everyone ranging from the board of directors,
management, shareholders to customers, employees and society. The management of the
company hence assumes the role of a trustee for all the others.
58. Merger: The combining of two or more entities into one, through a purchase acquisition or a
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pooling of interests59. Acquisition: The act of contracting or assuming or acquiring possession of something? "the
acquisition of wealth"? the acquisition of one company by another"
60. Takeover: Takeover is a term referring to transfer of control of a firm from one group of
shareholders to another group of shareholders. Change in the controlling interest of a
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corporation, either through a friendly acquisition or an unfriendly, hostile, bid. A hostiletakeover (with the aim of replacing current existing management) is usually attempted
through a public tender offer.
61. Concentric merger: Concentric mergers take place when two firms from different but
" adjacent" industries merge. For example, if an auto manufacturer and a motorcycle
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manufacturer merge, the merger is a concentric one. Although both industries serve thetransportation needs of their customers, the two are quite unique in their competitive structures.
62. Conglomerate mergers: A conglomerate merger is one where two or more companies with
different businesses merge to diversify the products marketed. The companies may not be related
to each other horizontally
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A conglomerate merger is a type of merger whereby the two companies that merge with eachother are involved in different sorts of businesses. The importance of the conglomerate mergers
lies in the fact that they help the merging companies to be better than before.
63. Vertical Merger: Merger between a company that supplies goods and services and a
company that buys those goods and services. For example, if a publishing company buys a paper
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producer, it is considered a vertical merger because the publisher buys large amounts of paper. Insome cases, vertical mergers may be challenged by the government if they are found to violate
antitrust laws.
64. Operating cycle concept : Maximization of share holder?s wealth of a firm is possible only
when there are sufficient return from the operations. Successful sales activity is necessary for
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earning profit. Sales do not convert into cash immediately? There is invisible time gap betweenthe sale of goods and receipt of cash. The time taken to convert raw material into cash is known
as operating cycle.
Conversion of cash into raw material -* Conversion of raw material into work in progress -*
Conversion of Work in progress into finished goods -* Conversion of finished goods into Sales -*
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Sales into Debtors -* Debtors into cash.65. Certainty: Certainty is a situation in which investor is certain about the future price. Certainty has
two characteristics.
a . Availability of full information
b. Uniqueness of Outcomes
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Ex: Suppose nvestor knows that the ecurity will definitely be old at Rs. 20.66. Uncertainty: There is an inability to forecast the future accurately and reliably. It has two
characteristics:
? In adequate information
? Multiple outcomes.
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Ex: Suppose he expects that the price of the ecurity could be Rs. 80, Rs. 10 or Rs. 20.67. Risk: Definitions:
Uncertainty of future outcome Or Probability of an adverse Outcome Or Risk is defined as the
variability of return around the expected average.
Risk has three characteristics:
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? Knowledge of Probability of each outcome? Possession of probability distribution
? Replicability of past experiment.
Ex: Suppose the investor possesses information that permits him to assign probabilities to each oif the
above likely prices of the security. He assigns a probability of 60% to the prioce being Rs. 12?, 30% to the
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price being Rs . 1 1 0 and 1 0% to the price being Rs . 80. The investor faced with a risky situation.68. The Hedging approach / Matching approach:
In this approach maturity of source of fund should
match the nature of asset to be financed.
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Hedging approach refers to a process of matching maturities of
debt with the maturities of financial need. The hedging approach suggests that the permanent working
capital requirement should be financed with fund from long term sources while the temporary working
capital requirement should be financed with short term funds. This approach is also known as matching
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approach.69. Conservative Approach : This approach suggested that the entire estimated investments in current
asset should be finance from long term source and short term should be use only for emergency
requirement . Distinct features of this approach ~
? Liquidity is greater
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? Risk is minimized?? The cost of financing is relatively more as interest has to be paid even on seasonal requirement
for the entire period.
70. Aggressive approach: This approach make the finance mix. The aggressive approach suggests that
the entire estimated requirement of current asset should be financed from short?term sources and even a
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part of fixed asset investment be financed from short ? term sources. Distinct features of this approach:? More Profitable
? Less costly
?
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More Risky71. Definitions of Financial Management: According to S.N. Maheswari:
Financial management is concerned with raising financial resources and their effective utilisation towards
achieving the organizational goals
? According to Richard.A. Brealey: Financial management is the process of putting the available
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funds to the best advantage from the long term point of view of business objectives."FirstRanker.com - FirstRanker's Choice
Department of Business Managment
CONCEPTS IN FINANCIAL MANAGEMENT
1. Finance.
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a.Finance is a simple task of providing the necessary funds (money) required by the business ofentities like companies, firms, individuals and others on the terms that are most favourable to
achieve their economic objectives."
b.Finance is the procurement (to get, obtain) of funds and effective (properly planned) utilisation
of funds. It also deals with profits that adequately compensate for the cost and risks borne by the
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business."2. Financial decisions:
Financial decisions refers to decisions concerning financial matters of a business firm. There are
many kinds of financial management decisions that the firm makes min pursuit of maximizing
shareholder?s wealth, viz., kind of assets to be acquired , pattern of capitalization, distribution of
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firm?s income etc. we can classify these decisions into three major groups:? Investment decisions
? Financing decisions
? Dividend decisions
3. Investment Decisions:
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Investment decision relates to the determination of total amount of assets to be held in the firm,the composition of these assets and the business risk complexions of the firm as perceived by its
investors.
Investment decisions can be classified under two broad groups:
Long?term investment decision and
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Short? term investment4. Wealth maximization ?Definition
A process that increases the current net value of business or shareholder capital gains, with the
objective of bringing in the highest possible return. The wealth maximization strategy generally
involves making sound financial investment decisions which take into consideration any risk
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factors that would compromise or outweigh the anticipated benefits.5. Profit maximization ? Definition
A process that companies undergo to determine the best output and price levels in order to
maximize its return. The company will usually adjust influential factors such as production costs,
sale prices, and output levels as a way of reaching its profit goal. There are two main profit
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maximization methods used, and they are Marginal Cost?Marginal Revenue Method and TotalCost?Total Revenue Method. Profit maximization is a good thing for a company, but can be a
bad thing for consumers if the company starts to use cheaper products or decides to raise prices.
6. Time value of money:
The recognition of the time value of money is extremely vital in financial decision making. If the
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timing of cash flows is not considered the firm may make decisions which may faulter itsobjectives of maximizing the owner?s welfare. The welfare of the owners would be maximised,
when net wealth or net present worth is created from making a financial decision.
7. Compound Value: Interest that is paid both on the initial principal as also on the interest
earned on the initial principal in previous period/s. The interest earned in one period becomes a
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part of the principal in the succeeding period.8. Present value:
The present value of current cash inflow or outflow is the amount of current cash that is of
equivalent desirability, to the decision maker, to a specified amount of cash to be received or
paid at a future date.
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9. Reasons for Time value of money:Three reasons may be attributed to the individual?s time preference for money:
? Risk
? Preference for consumption
? Investment opportunities
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S10. Annuity: A series of receipts or payments of a fixed amount for a specified number of years.
Alternatively, a pattern of cash flows that is equal in each year, i.e. equal annual cash flows.
11. Capital budgeting: The process of determining which potential long?term projects are worth
undertaking, by comparing their expected discounted cash flows with their internal rates of
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return.12. Capital Budgeting techniques: The following are the capital?budgetingtechniques:
Non ?Discounted cash flow (DCF) criteria?
? Pay back period (PBP)
? Accounting Rate of return
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Discounted Cash flow techniques:? Net present value (NPV)
? Profitability Index (PI)
? Internal rate of return (IRR)
13. Payback Period: The length of time required to recover the cost of an investment. The
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payback period of a given investment or project is an important determinant of whether toundertake the position or project, as longer payback periods are typically not desirable for
investment positions.
Calculated as: Cost of Project
Annual Cash Inflows
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14. Accounting rate of return method: The accounting rate of return also known as the return onInvestment (ROI) Uses accounting information, as revealed by financial statements, to measure
the profitability of an investment. The accounting rate of return is the ratio of the average after
tax profit divided by the average investment. The average investment would be equal to half of
the original investment if it were depreciated constantly. Alternatively, it can be found out by
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dividing the total of the investment?s book value after depreciation by the life of the project. Theaccounting rate of return, thus, is an average rate and can be determined by the following
equation.
ARR= Average Income
Average Investment
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15. Net Present Value ? NPV?The difference between the present value of cash inflows and thepresent value of cash outflows. NPV is used in capital budgeting to analyze the profitability of an
investment or project. NPV analysis is sensitive to the reliability of future cash inflows that an
investment or project will yield.
16. Internal Rate Of Return ? IRR? The IRR of an investment is the discount rate at which the net
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present value of costs (negative cash flows) of the investment equals the net present value of thebenefits (positive cash flows) of the investment. The discount rate often used in capital budgeting
that makes the net present value of all cash flows from a particular project equal to zero.
17. Profitability Index (P.I.) or Benefit cost ratio: It is the ratio of the present value of future cash
benefits, at the required rate of return to the initial cash flow of the investment?.
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Formula: PI. = Present value of cash inflowsPresent value of initial cash outlay
18. Accept?Reject criterion: Evaluation of capital budgeting proposals to determine whether the
project under consideration satisfies the minimum acceptance standard and should be accepted.
19. Capital Rationing: Risk?Return Trade off A situation in which due to financial constraints,
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the limited funds are allocated a number of mutually exclusive capital budgeting projects.20. Definition of Risk: The chance that an investment's actual return will be different than
expected. Risk includes the possibility of losing some or all of the original investment. Different
versions of risk are usually measured by calculating the standard deviation of the historical
returns or average returns of a specific investment. A high standard deviation indicates a high
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degree of risk.21. Risk premium: The difference between expected rate of return on a risky project and the rate
of return on a risk less project.
22. Risk?Return Trade?off: The relationship between the risk and the required Rate of return.
23. Definition of Risk?Adjusted Return: A concept that defines an investment's return by
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measuring how much risk is involved in producing that return, which is generally expressed as anumber or rating. Risk?adjusted returns are applied to individual securities and investment funds
and portfolios.
24. Certainty?Equivalents: The return required with certainty to make investors indifferent
between this certain return and a particular uncertain (risky) return.
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25. Coefficient of variation: A relative measure of the variability of the outcomes associatedwith an event. It is calculated by dividing the standard deviation of a distribution by the mean.
26. Sensitivity Analysis: The analysis of the effect of change in certain variable on an outcome,
to estimate the variability of the outcome, or risk associated with a project or a situation.
27. Decision Tree: A decision tree is a graphic display of the relationship between a present
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decision and future events, future decisions and their consequences. The sequence of events ismapped out over time in a format similar to the branches of a tree.
28. Leverage: A General Dictionary meaning of the term ?Leverage? refers to an increased means
of accomplishing some purpose.? Leverage allows us to accomplish certain things which are
otherwise not possible, viz? Lifting of heavy objects with the help of leverage. The concept of
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leverage is valid in business also.In Financial Management, the term ?leverage? is used to describe the firm?s ability to use fixed
cost assets or funds to increase the return to its owners? i.e. equity shareholders. James Home has
defined leverage as ?the employment of an asset or sources of funds for which the firm has to
pay a fixed cost or fixed return?. The fixed cost and fixed return remain constant irrespective of
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the changes in volume of output or sales. Thus, the employment of an asset or source of funds forwhich the firm has to pay a fixed cost or return has a considerable influence on the earnings
available for equity shareholders.
24. Financial Leverage/Trading on Equity:
The ability of fixed financial charges magnify the effect of changes in EBIT on the earnings per
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share(EPS) . Also known as Trading on Equity.? To use debt to finance an activity. For example, one usually borrows money in the form
of a mortgage to buy a house. One commonly refers to this as leveraging the house.
Likewise, one leverages when one uses a margin in order to purchase securities.
? The amount of debt that has been used to finance activities. A company with much more
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debt than equity is generally called "highly leveraged." Too much leverage is oftenthought to be unhealthy, but many firms use leverage in order to expand operations.
OR
Financial leverage
The extent to which interest on debt magnifies changes in operating income into even greater
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proportionate changes in earnings after taxes. Financial leverage magnifies increases in earningsper share during periods of rising operating income but adds significant risks for stockholders
and creditors because of added interest obligations.
25. Definition of 'Operating Leverage'
A measurement of the degree to which a firm or project incurs a combination of fixed and
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variable costs.? A business that makes few sales, with each sale providing a very high gross margin,
is said to be highly leveraged. A business that makes many sales, with each sale
contributing a very slight margin, is said to be less leveraged. As the volume of sales
in a business increases, each new sale contributes less to fixed costs and more to
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profitability.? A business that has a higher proportion of fixed costs and a lower proportion of
variable costs is said to have used more operating leverage. Those businesses with
lower fixed costs and higher variable costs are said to employ less operating leverage.
26. Capital structure: Capital structure of a company means the composition of long ?term
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sources of funds. Such as ordinary shares, preference shares, debentures, bonds, long?term debtsetc. It refers to the kind and proportion of securities for raising long?term funds. It implies the
determination of form or makeup of a company?s capitalization.
27. Optimum capital structure: An optimal or sound capital structure can be properly defined as
that combination of debt and equity that attains the stated managerial goal in the most relevant
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manner? the maximization of the firm?s market value and the minimization of the firm?s cost ofcapital. The Optimal capital structure is concerned with the two important variables at one time ?
The minimization of cost as well as maximization of worth.
28. Cost of capital: Cost of capital refers to the opportunity cost of making a specific investment.
It is the rate of return that could have been earned by putting the same money into a different
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investment with equal risk. Thus, the cost of capital is the rate of return required to persuade theinvestor to make a given investment.
29. Definition of 'Weighted Average Cost Of Capital ? WACC'
A calculation of a firm's cost of capital in which each category of capital is proportionately
weighted. All capital sources ? common stock, preferred stock, bonds and any other long?term
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debt ? are included in a WACC calculation. All else equal, the WACC of a firm increases as thebeta and rate of return on equity increases, as an increase in WACC notes a decrease in valuation
and a higher risk.
30. EBIT ? Earnings Before Interest and Taxes. Accountants like to use the term Net Operating
Income for this income statement item, but finance people usually refer to it as EBIT
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(pronounced as it is spelled ? E.B.I. T). Either way, on an income statement, it is the amount ofincome that a company has after subtracting operating expenses from sales (hence the term net
operating income). Another way of looking at it is that this is the income that the company has
before subtracting interest and taxes (hence, EBIT) .
31. EAT ? Earnings After Taxes. Accountants call this Net Income or Net Profit After Taxes, but
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finance people usually refer to it as EAT (pronounced E. A. T) .32. EPS ? Earnings Per Share. This is the amount of income that the common stockholders are
entitled to receive (per share of stock owned). This income may be paid out in the form of
dividends, retained and reinvested by the company, or a combination of both. (It is pronounced
E. P. S).
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33. Book value: The value of an asset, a liability or equity, as recorded in the accounts ofA firm. The book value of ordinary shares is equal to the paid?up capital plus retained earnings
i.e. net worth.
34. Par value: The stated or face nominal) value of a security.
35. Market value: It is determined on the basis of the stock market quotations of the company?s
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securities.36. Flotation costs: Costs incurred in issuing securities, e.g., underwriting and brokerage costs,
printing, legal, publicity and so on.
37. Equity share capital: Long term funds provided by the owners of a firm and consist of
ordinary share capital and retained earnings.
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38. Retained Earnings: The portion of the after?tax profits that are not paid out to theshareholders as dividends.
39. Preference shares: Preference shares have a fixed percentage dividend before any dividend is
paid to the ordinary shareholders. As with ordinary shares a preference dividend can only be paid
if sufficient distributable profits are available, although with 'cumulative' preference shares the
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right to an unpaid dividend is carried forward to later years. The arrears of dividend oncumulative preference shares must be paid before any dividend is paid to the ordinary
shareholders.
40. Definition of 'Dividend Policy': The policy a company uses to decide how much it will pay
out to shareholders in dividends.
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41. Dividend Relevance: Walter?s Models: Professor James E. Walter argues that the choice ofdividend policies almost always affect the value of the firm. His model, one of the earlier
theoretical works shows the importance of the relationship between the firm?s rate of return, r
and its cost of capital, k in determining the dividend policy that will maximize the wealth of
shareholders.
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42. Dividend Irrelevance: The Miller Modgiliani (MM) approach: According to Modgiliani andMiller (MM), under a perfect market situation, the dividend policy of a firm is irrelevant, as it
does not affect the value of the firm. They argue that the value of the firm depends on the firm?s
earnings that result from its investment policy.
43. Gordon Model: A valuation model in which the value of a firm is equal to the present value
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of all future dividends expected over the life of the firm.44. Inventory management: Definition: Activities employed in maintaining the optimum number
or amount of each inventory item. The objective of inventory management is to provide
uninterrupted production, sales, and/or customer?service levels at the minimum cost. Since for
many companies inventory is the largest item in the current assets category, inventory problems
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can and do contribute to losses or even business failures.45. Economic Order Quantity: The optimum quantity of inventory to order or to produce based
on trade?off between carrying and ordering costs.
46. Accounts Receivable Management: The term receivables is defined as debt owed to the firm
by customers arising from sale of goods or services in the ordinary course of business.
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47. Receivables management: Receivables Management means planning, organising, directingand controlling of receivables.
48. Collection period:
The average period taken to collect receivables. It is equal to the average credit sales divided by
the number of days in a year.
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49. Definition of Cash Management: The corporate process of collecting, managing and (short?term) investing cash. A key component of ensuring a company's financial stability and
solvency. Frequently corporate treasurers or a business manager is responsible for overall cash
management.
50. Cash management: Successful cash management involves not only avoiding insolvency (and
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therefore bankruptcy), but also reducing days in account receivables (AR), increasing collectionrates, selecting appropriate short?term investment vehicles, and increasing days cash on hand all
in order to improve a company's overall financial profitability.
51. Cash cycle: The length of time from the point a firm purchases raw materials to the point
when cash is collected from the sale of the resulting finished goods. In other words, it represents
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the time during which cash is tied up in operations.52. Liquidity/Solvency: Abilityof a firm to meet its obligations when they become due.
53. Current assets: Assets which can be converted into cash within a year.
54. Current liabilities: Liabilities hat are payable within a year.
55. Cash Budget: A Cash budget is an estimate of cash receipts and disbursements of cash during
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a future period of time. In the words of Solomon Ezra, a cash budget is ?an analysis of flow ofcash in a business over a future, short or long period of time. It is a forecast of expected cash
intake and outlay.
56. Value Based Management: Definition of value based management: Value Based
Management is the management approach that ensures corporations are run consistently on value
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(normally: maximizing shareholder value).It
is useful to understand that Value Based Management includes all three of the following:
? Creating Value: ways to actually increase or generate maximum future value ?
strategy.Value Based Management VBM
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? Managing for Value: (governance, change management, organizational culture,communication, leadership
? Measuring Value: valuation.
57. Corporate governance: Corporate governance refers to the set of systems, principles and
processes by which a company is governed. They provide the guidelines as to how the company
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can be directed or controlled such that it can fulfil its goals and objectives in a manner that addsto the value of the company and is also beneficial for all stakeholders in the long term.
Stakeholders in this case would include everyone ranging from the board of directors,
management, shareholders to customers, employees and society. The management of the
company hence assumes the role of a trustee for all the others.
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58. Merger: The combining of two or more entities into one, through a purchase acquisition or apooling of interests
59. Acquisition: The act of contracting or assuming or acquiring possession of something? "the
acquisition of wealth"? the acquisition of one company by another"
60. Takeover: Takeover is a term referring to transfer of control of a firm from one group of
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shareholders to another group of shareholders. Change in the controlling interest of acorporation, either through a friendly acquisition or an unfriendly, hostile, bid. A hostile
takeover (with the aim of replacing current existing management) is usually attempted
through a public tender offer.
61. Concentric merger: Concentric mergers take place when two firms from different but
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" adjacent" industries merge. For example, if an auto manufacturer and a motorcyclemanufacturer merge, the merger is a concentric one. Although both industries serve the
transportation needs of their customers, the two are quite unique in their competitive structures.
62. Conglomerate mergers: A conglomerate merger is one where two or more companies with
different businesses merge to diversify the products marketed. The companies may not be related
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to each other horizontallyA conglomerate merger is a type of merger whereby the two companies that merge with each
other are involved in different sorts of businesses. The importance of the conglomerate mergers
lies in the fact that they help the merging companies to be better than before.
63. Vertical Merger: Merger between a company that supplies goods and services and a
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company that buys those goods and services. For example, if a publishing company buys a paperproducer, it is considered a vertical merger because the publisher buys large amounts of paper. In
some cases, vertical mergers may be challenged by the government if they are found to violate
antitrust laws.
64. Operating cycle concept : Maximization of share holder?s wealth of a firm is possible only
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when there are sufficient return from the operations. Successful sales activity is necessary forearning profit. Sales do not convert into cash immediately? There is invisible time gap between
the sale of goods and receipt of cash. The time taken to convert raw material into cash is known
as operating cycle.
Conversion of cash into raw material -* Conversion of raw material into work in progress -*
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Conversion of Work in progress into finished goods -* Conversion of finished goods into Sales -*Sales into Debtors -* Debtors into cash.
65. Certainty: Certainty is a situation in which investor is certain about the future price. Certainty has
two characteristics.
a . Availability of full information
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b. Uniqueness of OutcomesEx: Suppose nvestor knows that the ecurity will definitely be old at Rs. 20.
66. Uncertainty: There is an inability to forecast the future accurately and reliably. It has two
characteristics:
? In adequate information
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? Multiple outcomes.Ex: Suppose he expects that the price of the ecurity could be Rs. 80, Rs. 10 or Rs. 20.
67. Risk: Definitions:
Uncertainty of future outcome Or Probability of an adverse Outcome Or Risk is defined as the
variability of return around the expected average.
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Risk has three characteristics:? Knowledge of Probability of each outcome
? Possession of probability distribution
? Replicability of past experiment.
Ex: Suppose the investor possesses information that permits him to assign probabilities to each oif the
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above likely prices of the security. He assigns a probability of 60% to the prioce being Rs. 12?, 30% to theprice being Rs . 1 1 0 and 1 0% to the price being Rs . 80. The investor faced with a risky situation.
68. The Hedging approach / Matching approach:
In this approach maturity of source of fund should
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match the nature of asset to be financed.Hedging approach refers to a process of matching maturities of
debt with the maturities of financial need. The hedging approach suggests that the permanent working
capital requirement should be financed with fund from long term sources while the temporary working
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capital requirement should be financed with short term funds. This approach is also known as matchingapproach.
69. Conservative Approach : This approach suggested that the entire estimated investments in current
asset should be finance from long term source and short term should be use only for emergency
requirement . Distinct features of this approach ~
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? Liquidity is greater? Risk is minimized?
? The cost of financing is relatively more as interest has to be paid even on seasonal requirement
for the entire period.
70. Aggressive approach: This approach make the finance mix. The aggressive approach suggests that
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the entire estimated requirement of current asset should be financed from short?term sources and even apart of fixed asset investment be financed from short ? term sources. Distinct features of this approach:
? More Profitable
? Less costly
?
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More Risky
71. Definitions of Financial Management: According to S.N. Maheswari:
Financial management is concerned with raising financial resources and their effective utilisation towards
achieving the organizational goals
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? According to Richard.A. Brealey: Financial management is the process of putting the availablefunds to the best advantage from the long term point of view of business objectives."
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