Financial management answers three questions: what to invest in (investment decision), how to fund it (financing decision) and what to return to owners (dividend decision), while keeping the firm liquid day to day (working capital). The guiding goal is wealth maximisation, raising the value of the owners’ shares, rather than short-term profit alone.
1. Goals and the finance function
Profit maximisation ignores risk, timing and cash; wealth maximisation considers all three. Agency problems arise when managers do not act in owners’ interest; remedies are incentives (stock options), monitoring (boards, audit) and market discipline. The finance manager also coordinates with banks, investors and regulators (SEBI regulates securities markets in India; RBI regulates banks).
2. Time value of money
A rupee today is worth more than a rupee later because it can earn a return.
| Formula | Meaning |
|---|---|
| Future value | FV = PV × (1 + r)ⁿ |
| Present value | PV = FV ÷ (1 + r)ⁿ |
| Annuity PV | PV = C × [1 − (1 + r)⁻ⁿ] ÷ r |
| Perpetuity | PV = C ÷ r |
| Effective annual rate | (1 + r/m)ᵐ − 1 for m compounding periods |
Example: ₹1,00,000 at 10% for 3 years grows to 1,00,000 × 1.331 = ₹1,33,100. The present value of ₹1,00,000 due in 3 years at 10% is 1,00,000 ÷ 1.331 ≈ ₹75,131. The rule of 72 gives doubling time ≈ 72 ÷ rate %. EMI on a loan is an annuity payment solved for C.
In the real world: a home loan EMI, a mutual fund SIP, and the price of a bond are all time-value calculations. Compounding is why starting retirement savings early matters so much.
3. Risk and return
Return = (dividend + price change) ÷ initial price. Risk is variability of returns, measured by standard deviation. Diversification reduces unsystematic (company-specific) risk; systematic (market) risk remains and is measured by beta (β): a stock with β = 1.2 moves 20% more than the market.
The Capital Asset Pricing Model (CAPM): required return = Rf + β × (Rm − Rf). Example: risk-free 7%, market return 12%, β = 1.2 gives 7 + 1.2 × 5 = 13%. Portfolio theory (Markowitz) shows that combining imperfectly correlated assets gives a better risk–return trade-off.
Valuation basics: bond price = PV of coupons + PV of face value; a share is worth the PV of its future dividends (Gordon model: P = D₁ ÷ (r − g)).
4. Capital budgeting
Capital budgeting chooses long-term investments. Cash flows matter (incremental, after tax, ignoring sunk costs, including working capital and opportunity costs).
| Method | Rule | Note |
|---|---|---|
| Payback period | Years to recover the investment | Simple; ignores time value and later cash flows |
| Discounted payback | Payback on discounted flows | Still ignores flows after payback |
| Net present value (NPV) | Accept if NPV > 0 | Best theoretical measure; shows value added |
| Internal rate of return (IRR) | Accept if IRR > cost of capital | Can mislead with unusual cash flows or mutually exclusive projects |
| Profitability index | PV of inflows ÷ investment; accept if > 1 | Useful under capital rationing |
| ARR | Average accounting profit ÷ investment | Ignores time value |
Worked example. Invest ₹10 lakh now, receive ₹4 lakh a year for 4 years, cost of capital 10%. PV of inflows = 4 × 3.1699 = ₹12.68 lakh, so NPV = ₹2.68 lakh > 0: accept. Payback = 2.5 years. IRR is about 21.9%. Sensitivity and scenario analysis and real options deal with risk.
In the real world: a telecom firm rolling out 5G, a cloud provider building a data centre, or a company buying a plant all weigh NPV and risk; many of these have long paybacks, so the discount rate matters a lot.
5. Cost of capital
The weighted average cost of capital (WACC) is the blended cost of the firm’s funds and the hurdle rate for average-risk projects:
WACC = (E ÷ V) × Ke + (D ÷ V) × Kd × (1 − t)
where E and D are equity and debt, V = E + D, Ke is the cost of equity (from CAPM or dividend models), Kd the cost of debt and t the tax rate. Debt is cheaper because interest is tax-deductible. Example: equity 60% at 14%, debt 40% at 9%, tax 25%: WACC = 0.6 × 14 + 0.4 × 9 × 0.75 = 8.4 + 2.7 = 11.1%.
6. Capital structure and leverage
Capital structure is the mix of debt and equity. Debt is cheaper and brings tax savings, but adds financial risk and the chance of distress.
| Theory | Idea |
|---|---|
| Net income (NI) | More debt lowers WACC and raises value |
| Net operating income (NOI) | Value is independent of capital structure |
| Modigliani–Miller | In a perfect market, structure is irrelevant; with taxes, debt adds value |
| Trade-off theory | Balance tax benefit against distress cost; an optimal mix exists |
| Pecking order | Firms prefer internal funds, then debt, then new equity |
Leverage: operating leverage (DOL = % change in EBIT ÷ % change in sales) arises from fixed operating costs; financial leverage (DFL = % change in EPS ÷ % change in EBIT) from fixed interest; combined leverage = DOL × DFL. EBIT–EPS analysis compares financing plans and finds the indifference point.
In the real world: airlines and telecom companies with heavy fixed costs have high operating leverage, so small revenue drops hit profits hard, and high debt on top makes them fragile. Many failed over-leveraged firms show how debt magnifies losses as well as gains.
7. Dividend policy
Choices: pay dividends, retain earnings or buy back shares. Theories: Walter and Gordon (dividends matter, “bird in the hand”), Modigliani–Miller (irrelevant in perfect markets), plus signalling (a dividend change tells investors about management’s confidence) and clientele effect (investors choose firms matching their tax and income needs). Practical factors: profits, cash, growth needs, debt covenants, tax, stability and shareholder expectations. Forms: cash, bonus shares (no cash leaves), stock splits, buybacks.
In the real world: mature cash-rich companies such as large IT-services firms in India pay regular dividends and have used buybacks to return surplus cash, while young high-growth firms retain earnings.
8. Working capital and sources of finance
Working capital = current assets − current liabilities. The cash conversion cycle = inventory days + receivable days − payable days: the time cash is tied up. Example: 40 + 30 − 35 = 35 days. Policies: aggressive (low current assets, higher risk) versus conservative. Tools: EOQ for inventory, credit terms for receivables, cash budgets and cash management (collect faster, pay on time), short-term sources such as trade credit, bank overdraft, working capital loans and commercial paper.
In the real world: Amazon and large retailers often run a negative cash conversion cycle: they sell goods and collect cash before they pay suppliers, funding growth from suppliers’ credit.
Long-term sources: equity shares, preference shares, debentures and bonds, term loans, retained earnings, venture capital and private equity, and IPOs and follow-on offers (the Zomato IPO of 2021 was a widely followed example of a loss-making new-age company listing). Other tools: leasing, hybrid instruments, and derivatives for hedging currency and interest risk.
One-minute recap
| Topic | Key idea | Where you meet it |
|---|---|---|
| Goal | Wealth maximisation, agency | Boards, incentives |
| Time value | PV, FV, annuity, EAR | EMI, SIP, bonds |
| Risk and return | Beta, CAPM, diversification | Portfolios, cost of equity |
| Capital budgeting | NPV, IRR, payback | Plants, data centres |
| Cost of capital | WACC with tax shield | Hurdle rates |
| Capital structure | MM, trade-off, leverage | Debt decisions |
| Dividends | Retain vs pay vs buy back | Payout policy |
| Working capital | Cash conversion cycle, financing sources | Liquidity, IPOs, loans |
Next in MBA Revisited: Human Resource Management.
Written by Claude, Anthropic’s AI assistant, as part of MBA Revisited, a quick refresher of the PGDM subjects one at a time.