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 Financial Management Theory Questions

Unit 1: Introduction to Financial Management

Concept and Scope of Financial Management

Financial Management is decision-making process of these managerial decisions: investment decision, financing decision and
asset management decision.
Scope of Financial Management are:
Financial management encompasses several key areas:
• Planning: Financial managers project the company’s financial needs, allocate funds for growth, and prepare for unexpected
events. They share this information with colleagues.
• Wealth Maximization: Financial management involves strategies for current investments and future returns, enabling
informed capital investments and market expansion.
• Resource Utilization: It ensures efficient allocation of resources based on requirements and needs.
• Risk Management: Financial managers track liquidity, cash flow, and compliance with regulations.
• Financial Scenarios: These scenarios consider a wide range of outcomes based on market conditions.
• Relationship Management: Effective communication with investors and boards of directors.
Importance of Financial Management
• Helps setting clear goal. (maximization of shareholder wealth)
• Helps efficient utilization of resources. (Capital budgeting technique helps to answer the questions like which assets to buy,
when to buy and whether to replace the existing asset with the new one or not.
• Helps deciding sources of financing.
• Helps making dividend decisions.
Financial Management Decisions
Financial management decisions are mainly focused on raising and allocation of funds.
• Investment Decisions
= known as capital budgeting. Shareholder wealth is maximized only if the present value of benefits from the investment
proposal exceeds the present value of cost.
• Financing Decision
= determining the sources of funds and deciding upon the proportionate mix of funds from different sources.
“The use of debt in capital structure is beneficial because the interest expenses on debt capital is tax deductible and the
effective cost of debt capital is lower than other sources.”
• Dividend Decision
Three alternatives regarding dividend decision:
o Pay all the earnings as dividend.
o Retain all earnings for reinvestment.
o Pay certain percentage of earnings and retain the rest for reinvestment.
• Working Capital Decision
Financial Manager’s Responsibilities
Financial Manager is the financial staff responsible for investment, financing, dividend and working capital management
decisions.
• Analysis of financial aspects of all decisions
• Analysis of investment decision
• Analysis of financing decision
• Analysis of dividend policy decision
• Analysis of financial condition of the firm
• Analysis of financial markets
• Analysis of risk
Forms of Business Organization
Sole proprietorship: This is a business owned and operated by one person, who is responsible for all the profits and losses of the
business. Some advantages of sole proprietorships are:
• Easy and inexpensive to start and run.
• Full control and decision-making power over the business
• No need to share profits with anyone else.
Some disadvantages of sole proprietorships are:
• Unlimited personal liability for the debts and obligations of the business
• Limited access to capital and resources
• Difficulty in transferring or selling the business.
Partnership: This is a business owned and operated by two or more people, who share the profits and losses of the business
according to a partnership agreement. Some advantages of partnerships are:
• More capital and resources available than a sole proprietorship
• Shared workload and responsibilities
• Diversified skills and expertise among the partners
Some disadvantages of partnerships are:
• Unlimited personal liability for the debts and obligations of the business, unless it is a limited liability partnership (LLP)
• Potential for conflicts and disagreements among the partners
• Difficulty in transferring or selling the business, unless it is a limited liability partnership (LLP)
Corporation: This is a business that is legally separate from its owners, who are called shareholders. A corporation has its own
rights and obligations and can sue and be sued. Some advantages of corporations are:
• Limited liability for the shareholders, who are only liable for the amount they invested in the business.
• Easier to raise capital and resources by issuing shares or bonds.
• Easier to transfer or sell the business by transferring or selling the shares.
Some disadvantages of corporations are:
• More complex and expensive to start and run than a sole proprietorship or a partnership.
 • Double taxation of the profits, as the corporation pays corporate tax, and the shareholders pay personal income tax on
the dividends.
• Less control and decision-making power for the shareholders, who have to follow the rules and regulations of the
corporation.

The Agency Problem

The conflict of interest between the shareholders and managers, shareholders and creditors is called agency problems.
Agency Problem: Stockholders versus Managers
The agency problem of stockholders versus managers is a common issue in corporate finance. It occurs when the managers of a
company, who are hired by the stockholders to act in their best interests, pursue their own personal goals instead of maximizing
the value of the company for the stockholders. This can lead to inefficiencies, conflicts, and reduced profits for the company.
Some examples of the agency problem are:
• Managers may take excessive risks or invest in projects that benefit themselves rather than the stockholders, such as
acquiring other companies, expanding their own power, or increasing their own compensation.
• Managers may avoid taking risks or innovating, preferring to maintain the status quo and avoid accountability, even if it
means missing out on profitable opportunities for the company.
• Managers may manipulate the financial reports or accounting practices of the company to make the performance look better
than it is, or to hide losses or frauds.
• Managers may resist or sabotage the efforts of the stockholders to monitor or replace them, such as by withholding
information, influencing the board of directors, or creating loyal factions within the company.
To reduce the agency problem, the stockholders can use various mechanisms to align the interests of the managers with their
own, such as:
• Offering performance-based incentives, such as stock options, bonuses, or profit-sharing, that reward the managers for
increasing the value of the company and penalize them for decreasing it.
• Implementing corporate governance practices, such as independent audits, transparent disclosures, shareholder voting
rights, or board oversight, that ensure the accountability and integrity of the managers and protect the rights of the
stockholders.
• Enforcing legal and ethical standards, such as fiduciary duties, contracts, regulations, or codes of conduct, that prevent or
punish the managers for engaging in illegal or unethical behavior that harms the company or the stockholders.
(Managerial Compensation – Direct intervention by shareholders – The threat of firing – The threat of hostile takeover)
Agency Problem: Stockholders versus Creditors
The agency problem of stockholders versus creditors is another type of conflict of interest that arises in corporate finance. It
occurs when the stockholders of a company, who are the residual claimants of the company's assets and cash flows, act in
ways that harm the interests of the creditors, who are the fixed claimants of the company's obligations.
Some examples of the agency problem of stockholders versus creditors are:
• Stockholders may increase the leverage or debt of the company to finance risky projects that have high potential returns, but
also high default risk. This transfers wealth from the creditors to the stockholders, as the creditors bear the downside risk
while the stockholders enjoy the upside potential.
• Stockholders may pay excessive dividends or repurchase shares to reduce the cash or assets available to the creditors in the
event of bankruptcy or liquidation. This lowers the value of the creditors' claims and increases the likelihood of default.
• Stockholders may engage in asset substitution, which means replacing the existing assets of the company with more risky or
less valuable ones, without the consent of the creditors. This reduces the collateral value of the assets and exposes the
creditors to higher risk.

To mitigate the agency problem of stockholders versus creditors, the creditors can use various mechanisms to protect their
interests, such as:
• Imposing restrictive covenants in the debt contracts, such as limits on dividend payments, debt issuance, asset sales, or
mergers and acquisitions, that constrain the actions of the stockholders and the managers.
• Charging higher interest rates or requiring higher collateral to reflect the riskiness of the company and the possibility of
agency costs.
• Monitoring the financial performance and the activities of the company and enforcing their rights through legal actions or
negotiations if the stockholders or the managers violate the debt agreements.
Business Ethics and Social Responsibility
Ethics refers to a moral principle that control or influence a person’s behavior.
Business Ethics refers to a company’s attitude and conduct towards its employees, customers, community, and stockholders.
Basically, there are three areas of concern for business ethics:
✓ How a corporation treats its employees
✓ How employees treat the organization
✓ How the organization treats other stakeholders
Corporate Social Responsibility is a concept advocating that business should be actively concerned with the welfare of society
at large.
Approaches of social responsibility:
✓ Social obstruction approach (a firm do as little as possible to solve social and environmental problems)
✓ Social obligation approach (they will do everything that is required by law but nothing more)
✓ Social response approach (firm meets its basic legal and ethical obligations and also goes beyond these requirements in
selected cases)
✓ Social contribution approach (Firms adopting this approach view themselves as citizen in a society and proactively seek
opportunities to contribute)
Financial Innovation
• Financial innovation refers to the process of creating new financial or investment products, services, or processes.
• These changes can include updated technology, risk management, risk transfer, credit, and equity generation, as well as
many other innovations.
• Recent financial innovations have included crowdfunding, mobile banking technology, and remittance technology.
Unit 2: Financial Planning and Forecasting

Concept of financial planning and forecasting

Financial Planning refers to the process of projecting some future financial actions based on predetermined standard and
identifying and adjusting the process that may be helpful to improve the financial performance.
Process of financial planning
• Assessing the operating environment of the firm.
• Confirming mission, vision and objectives of the firm.
• Identifying the types of resources needed to achieve firm’s objectives.
• Quantifying the amount of resource needed such as labor, equipment, materials, technology, information and so on.
• Estimating the cost of acquiring and using these different resources.
• Summarizing the operating and financing costs to provide an overall estimate of planned tasks.
Financial Forecasting is simply an integral part of financial planning. It is the process of projecting future financial requirements
of a firm. It is an act of deciding in advance the quantum of funds requirement of firm and the time pattern of such requirements.
Strategic Planning
Mission statement reveals the long-term vision of a corporation in terms of what it wants to be and whom it wants to serve.
It is a condensed version of strategic plan.
Strategic planning is a process that helps an organization define and share its vision, mission, and goals for the future. It involves
analyzing the current situation, identifying the key drivers and assumptions, building and testing a forecast model, generating and
communicating the forecast results, and monitoring and updating the forecast. Strategic planning can help with goal setting,
decision making, risk management, and performance evaluation.
Strategic plan is a document that outlines the vision, mission, goals, and strategies of an organization for the future. It helps the
organization align its actions with its purpose and communicate its direction and priorities to its stakeholders.
The basic elements of strategic plans are corporate purpose, corporate scope, corporate objectives and corporate strategies.
Corporate purpose: This is the reason why the organization exists, and what it aims to achieve in the long run. It includes the
vision, mission, and values of the organization. For example, Microsoft’s corporate purpose is to “empower every person and
every organization on the planet to achieve more”.
Corporate scope: This is the range of markets and products that the organization operates in, or intends to operate in. It defines
the boundaries and focus of the organization. For example, Amazon’s corporate scope is to “offer our customers the lowest
possible prices, the best available selection, and the utmost convenience”.
Corporate objectives: These are the specific and measurable goals that the organization sets to achieve its corporate purpose
and scope. They are usually aligned with the key performance indicators (KPIs) of the organization. For example, Tesla’s corporate
objective is to “accelerate the world’s transition to sustainable energy”.
Corporate strategies: These are the plans and actions that the organization develops and implements to achieve its corporate
objectives. They include the competitive advantages, resources, capabilities, and trade-offs that the organization leverages. For
example, Netflix’s corporate strategy is to “grow our streaming membership business globally within the parameters of our
consolidated net income and operating segment contribution profit (loss) targets”.
Operating plan
Operating plan is a detail guideline for effective implementation of corporate strategies, which helps achieve corporate objectives.
Operating plan could be formulated for any time horizon; however, five-year planning horizon is the most common in practice.
These plans are formulated at departmental level to facilitate corporate plans. For example, to shape out the sound dividend policy
is the strategic issue of corporate level, and finance department may develop several other plans and strategies to achieve this.
Sales Forecast
Sales forecast is simply a forecast of firm’s future sales both is terms of volume and value. The sales forecast always begins with
analyzing the historical trends in sales over the past years. It also takes into consideration the future economic prosperity of given
line of business.
Methods of sales forecast
• Salespersons
• Customer survey
• Time series model
• Econometric model
Financial forecasting: AFN Equation
Step 1: Determine the required increase in assets.

Step 2: Determine the spontaneous amount of financing.

Step 3: Determine the addition to retained earnings.

Addition to retained earnings = M x RR x S1
Step 4: Determine the additional funds needed.
Unit 3: Capital Budgeting
Concept of Capital Budgeting
Capital budgeting is the process of acquiring the fixed assets or process of investment in capital projects. The process of capital
budget includes the identification of the investment opportunity, estimation of relevant cost and benefits of the identified
projects, evaluation of the projects, approval and monitoring of the projects.
Characteristics of capital budgeting
• Not easily revocable.
• Involves in substantial amount of funds.
• Not flexible.
• Increase the market share.
Capital Budgeting Decision Process
• Generating investment proposals.
• Estimating cash flows for the proposals.
• Evaluating the proposals.
• Approval of the proposal.
Types of Capital Budgeting Projects
• Independent Projects (Projects whose cash flows are independent on each other. For example, installation of brick
factory and installation of sugar mills are independent projects)
• Dependent Projects (Project whose cash flows are dependent on each other. Decision on such projects cannot be
made independently. For example, construction of dam and canal in irrigation projects)
• Mutually Exclusive Projects (In the case of mutually exclusive projects, acceptance of one project implies the rejection
of another one. For example, labor intensive production process versus capital intensive production process,
mechanical waste lifting truck versus manual waste lifting truck)
• Replacement Projects (Project that replaces the existing plant and equipment)
• Expansion Projects (Project that adds the capacity to the existing one to increase the output for increase the
distribution channel.)
• Diversification Projects (The project that either diversifies the products or markets.)
Capital Budgeting Decision technique.
Payback period
Definition: It is the minimum no. of years required to recover the initial investment of a project.
Formula:
For even cash flow,
𝐶𝑜𝑠𝑡 𝑜𝑓 𝑃𝑟𝑜𝑗𝑒𝑐𝑡
PBP = 𝐴𝑛𝑛𝑢𝑎𝑙 𝐶𝑎𝑠ℎ 𝐹𝑙𝑜𝑤
For uneven cash flow,
PBP = 𝑀𝑖𝑛𝑖𝑚𝑢𝑚 𝑌𝑒𝑎𝑟 + 𝑈𝑛𝑟𝑒𝑐𝑜𝑣𝑒𝑟𝑒𝑑 𝐴𝑚𝑜𝑢𝑛𝑡
𝑁𝑒𝑥𝑡 𝑌𝑒𝑎𝑟 ′𝑠 𝐶𝐹𝐴𝑇
Advantages:
• It is easy to calculate and understand.
• It uses the cash flow of a project.
Disadvantages:
• It does not consider the time value of money.
• It does not consider the cash flow occurred beyond the payback period. (once pay back)
Decision Criteria:
• If PBP < or = Maximum Acceptable PBP, then accept the project.
• If PBP > Maximum Acceptable PBP, then reject the project.
• If projects are mutually exclusive, select the only one project having lowest PBP.
Discounted Payback period
Definition: It is the minimum no. of years or time required to recover the initial investment of a project based on the discounted
cash flow method (Based on the present value).
Formula:
For even and uneven cash flow: DPBP = 𝑀𝑖𝑛𝑖𝑚𝑢𝑚 𝑌𝑒𝑎𝑟 + 𝑈𝑛𝑟𝑒𝑐𝑜𝑣𝑒𝑟𝑒𝑑 𝑃𝑉 𝑜𝑓 𝐶𝐹
𝑃𝑉 𝑜𝑓 𝑁𝑒𝑥𝑡 𝑌𝑒𝑎𝑟 ′𝑠 𝐶𝐹

Advantages:
• It considers the time value of money.
• It uses the discounted cash flow (which is better than non-discounted cash flow)
Disadvantages:
• It is difficult to calculate.
• It also doesn’t consider the cash flows occurs beyond the discounted pay back period (once pay back).
• Difficult to determine the maximum acceptable payback period.
Decision criteria: Same as PBP.
Net Present Value
Definition: Net present value (NPV) is the difference between the present value of cash inflows and the present value of cash
outflows over a period of time. NPV is used in capital budgeting and investment planning to analyze the profitability of a projected
investment or project.
Formula:
For uneven cash flow,

For even cash flow,

Advantages:
• It considers the time value of money.
• It considers the firm’s wealth maximization objectives.
• It uses the cash flow after tax.
• It uses the firm’s cost of capital to discount the cash flows.
Disadvantages:
• Calculating NPV at various rates is difficult.
• Sensitive to discount rate.
Decision criteria:
• If NPV >0, Accept the project.
• If NPV < 0, Reject the project.
• If projects are mutually exclusive, select the project having highest NPV.
Internal Rate of Return
Definition: The IRR is the discount rate that makes the present value of cash inflows equals to the present value of cash outflow
of a project. In other words, it is a discount rate at which a project’s NPV will be 0.
Formula:

Advantages:
• It considers the time value of money.
• It considers the wealth maximization objective.
• It is based on the CFAT not on the accounting.
• Easy to understand and communicate.
Disadvantages:
• It is difficult to calculate.
• It assumes future cash inflows are reinvested at a rate equal to the IRR itself, which may not be realistic assumptions.
• In the case of unconventional cashflows, a project may produce multiple IRRs, which might be confusing.
• It does not hold the value additivity principles i.e. IRRA + IRRB ≠ IRR (A+B)
Decision criteria:
• If IRR > Cost of capital (k), Accept the project.
• If IRR < Cost of capital (k), Reject the project.
• If projects are mutually exclusive, select the only one project having greater IRR.
Modified Internal Rate of Return
Definition: The MIRR is the discounted rate that equates the present value of a project’s cost to the present value of its terminal
value.
Formula:

Advantages:
• It assumes that cash flows are reinvested at cost of capital. So, MIRR is better than IRR.
• It always gives a single correct answer.
• It considers the time value of money.
• MIRR solved the problem of multiple IRR of the unconventional cash flows.
Disadvantages:
• It also suffers some of the other drawbacks of IRR (doesn’t hold the additivity principle)
• It can lead to an incorrect choice between mutually exclusive projects (selection of loss project)
Decision criteria:
Same as IRR rule.
Profitability Index
Definition: PI is the ratio of the present value of expected future cash flows to the initial investment. In other words, it is the
measurement of relative profitability to the project.
Formula:

Advantages and disadvantages:

Same as NPV.
NPV vs IRR
Q. Which to choose between NPV and IRR in conflicting conditions? Why?

Difference between IRR and MIRR

Unit 4: Risk and Return and Portfolio Theory
Concept of Return
Return is the difference between money received back from an investment and the money originally invested at the beginning.
In other words, return is the increase in after-tax value of initial investment since it also may be defined as positive outcomes of
the investment. An investor can obtain two types of return i.e.,
• Price Appreciation gain, and
• Cash flow from interest or dividend.
1) Absolute Return
The sum of rupee return received from capital gain/price appreciation and cash flow from interest and dividend. Therefore,
it is also known as total rupee return received from an investment.
Rupee Return = Capital gain + Cash receipt
= P1-P0+C1
(C1= Dividend or Interest received)
2) Relative Return
It is the percentage return of absolute rupee return on the initial investment. It is also known as single period rate of return
or holding period rate of return.
𝑃 −𝑃 +𝐶
HPR or r = 1 𝑝0 1
0
3) Average rate of return
Average rate of return is the sum of the returns over the period divided by the number of periods.
Formula:

4) Expected rate of return

The rate of return expected to be realized over some future period of time is known as expected rate of return.
Formula:

Concept and measurement of risk

Risk is the chance that an outcome other than expected will occur. In other words, risk is the difference between expected and
actual outcomes of an investment. Therefore, risk can be defined in the variability in returns.
Risk can be measured by using the statistical tools such as variance, standard deviation and coefficient of variation.
Variance
The variance of an asset’s return is the weighted average of the square deviation from mean and expected rate of return. In other
words, the variance of return is defined as average of the mean squared error terms.

Significance of variance
• Appropriate measure of risk
• Gives more weight for observations that are far away from the mean.
• Measures of total risk.
Limitations of variance
• Appropriate only is case of normally distributed data.
• Difficult to interpret.
Standard Deviation
It is an absolute measure of risk and is calculated as the square root of variance of an asset’s return. It is expressed in the same
unit, as are the original data.
Formula:

Coefficient of variation (CV)

Coefficient of variation is a relative measure of risk. It measures the risk in terms of per unit of return.

Concept of Portfolio
A portfolio is the combination of securities or investment vehicles. Formation of portfolio stabilizes the combined return, hence
reduces the risk. Portfolio theory deals with the selection of efficient portfolio which maximizes return for a given level of risk, or
minimizes the risk for a given level of return.
Portfolio expected return.

Portfolio average return

It is the weighted average of the average return on the individual assets in the portfolio with the weights being the proportion of
the total portfolio invested in each asset.
Portfolio Risk
Portfolio risk is the function of the standard deviations, their weights and covariance or correlation coefficient. Portfolio risk is
measured by using the portfolio variance, portfolio standard deviation and portfolio correlation coefficient.
Portfolio variance and standard deviation of two risky assets

Remember: More Profitable? => Expected return (high) , Risk => standard deviation (high), Preferable => having less CV
Diversification

There are two types of diversification:

a) Simple Diversification
b) Markowitz Diversification
a) Simple Diversification

The total risk of the portfolio can be divided into two parts. They are:
i) Systematic risk
ii) Unsystematic risk
Total risk = Systematic risk + Unsystematic risk
Market risk Issuer risk
General Specific
Unavoidable Avoidable
Non-diversifiable Diversifiable
 i) Systematic Risk.
The portion of return variability induced by factors impacting all enterprises is referred to as systematic risk. Diversification
will not be able to mitigate such a risk. The following are some examples of systemic risk:
• The government changes the interest rate policy.
• The corporate tax rate is increased.
• The government resorts to massive deficit financing.
• The inflation rate increased.
• The Central Bank of the Country promulgates a restrictive credit policy.
• Government fails to attract FIIs.
ii) Unsystematic Risk.
The unsystematic risk is the variation in the return of an investment owing to factors that are specific to the firm and not to
the market as a whole. Unsystematic, or unique risk, is a type of risk that can be completely mitigated through diversification.
The following are some examples of unsystematic risk:
• Workers declare a strike in a company.
• The R&D expert of the company leaves.
• A formidable competitor enters the market.
• The company loses a big contract in a bid.
• The company makes a breakthrough in process of innovation.
• The government increases custom duty on the material used by the company.
• The company is not able to obtain an adequate quantity of raw material used by the company.
Total risk is equal to systematic risk + non-systematic risk because the two components are additive. In most cases,
systemic risk is calculated by comparing the stock's performance to the market's performance under various scenarios. For
example, if the stock appreciates more than other stocks in the market during a good period and depreciates more than other
stocks in the market during a poor period, the stock's systematic risk is more than the market risk.
b) Markowitz Diversification
Optimal Portfolio Selection
Unit 5: Capital Structure and Leverage
Capital Structure
It is the mix of long-term sources of financing or permanent sources of financing. It includes long term debt, preferred stock
and common equity.
Financial Structure
It is the mix of short term and long-term sources of financing. Since it is also known as liabilities and equity side of balance
sheet.
Optimal Capital Structure
It is also known as targeted capital structure. It is the proportionate mix of long-term sources of financing that minimize the
firm’s WACC and maximizes the firm’s stock price.

Factors affecting Capital Structure

Assets Structure Nature and size of firm
Business Risk Legal requirement
Component cost of capital Management Attitude
Debt Service capacity Control and risk
Growth and stability of sales
Unit 6: Current Assets Management
Current Assets are the significant portion of total assets that must be maintained at optimal level. It is concerned about day-to-
day activities of operations of business. Therefore, current assets management is also known as working capital management.
The major components of current assets are cash, marketable securities, receivables, inventories.
Introduction to cash management
Cash is significant part of current assets that is highly liquid and easily available current assets for payment.
Cash Management is the process of efficient collection and disbursement of cash, investing the surplus cash in marketable
securities and managing the funds to meet the cash deficit and determination and maintenance of optimal level of cash.
Cash, in broader sense, refers to those assets like currency, coins, negotiable money order, cheques, bank balance and near cash
assets.
The balance of cash should be optimal because idle cash earns nothing. Therefore, it should not be excess or shortage.
Significance of cash management
• Management of cash flows
• Meeting obligatory cash flows
• Planning capital expenditure projects
• Favorable external financing
• Advantages of business opportunities
• Investment of surplus cash
Cash management is the process of collecting and managing cash flows to ensure sufficient liquidity and profitability for a
business or an individual. Here are some explanations of the points you mentioned:
Management of cash flows: This involves tracking the inflows and outflows of cash from various sources and uses, such as
sales, expenses, investments, loans, etc. The goal is to optimize the cash cycle and avoid cash shortages or excesses that could
affect the financial performance or stability of the entity.
Meeting obligatory cash flows: This refers to the ability to pay the bills and obligations on time, such as salaries, taxes,
interest, debt repayments, etc. This requires forecasting the cash needs and availability and planning accordingly to ensure
sufficient cash reserves or access to credit facilities.
Planning capital expenditure projects: This involves evaluating and selecting the long-term investments that will generate the
highest returns for the entity, such as buying new equipment, expanding facilities, acquiring new businesses, etc. This requires
estimating the cash outlays and inflows associated with each project, and comparing them using criteria such as net present
value, internal rate of return, payback period, etc.
Favorable external financing: This refers to the ability to obtain funds from external sources, such as banks, investors,
suppliers, etc., at favorable terms and conditions, such as low interest rates, long repayment periods, flexible covenants, etc. This
requires maintaining a good credit rating, a strong financial position, and a positive relationship with the financiers.
Advantages of business opportunities: This refers to the ability to take advantage of the opportunities that arise in the
market, such as launching new products, entering new markets, forming strategic alliances, etc. This requires having enough
cash or access to cash to fund the initiatives and being able to act quickly and decisively.
Investment of surplus cash: This refers to the ability to invest the excess cash that is not needed for immediate or short-term
purposes, in order to earn a return and increase the value of the entity. This requires identifying and choosing the best
investment options, such as bank deposits, money market instruments, bonds, stocks, etc., based on the risk-return trade-off, the
liquidity preference, and the investment horizon.
Motives for Holding Cash (IMP)
• Transaction Motive
• Precautionary Motive
• Speculative Motive
• Compensating Balance Motive
Cash is the most liquid asset that a firm or an individual can hold, and it serves various purposes. Here are the four motives you
mentioned:
Transaction Motive: This is the need to hold cash for everyday transactions or purchases, such as paying bills, salaries, taxes,
etc. Cash inflows and outflows are not always synchronized, so a firm or an individual needs to have enough cash to meet their
current obligations and avoid penalties or defaults.
Precautionary Motive: This is the need to hold cash as a safety margin or a buffer against unexpected events or emergencies,
such as strikes, natural disasters, health issues, etc. Cash provides liquidity and flexibility to cope with these situations and avoid
financial distress or loss of opportunities.
Speculative Motive: This is the need to hold cash to take advantage of favorable market conditions or investment
opportunities, such as buying undervalued assets, selling overvalued assets, exploiting price fluctuations, etc. Cash enables a
firm or an individual to act quickly and decisively when such opportunities arise and earn higher returns.
Compensating Balance Motive: This is the need to hold cash as a requirement or a condition for obtaining credit or other
services from banks or other financial institutions, such as loans, overdrafts, discounts, etc. Cash serves as a collateral or a
guarantee for these transactions and reduces the risk or the cost of borrowing.
Importance of Maintaining Adequate cash
To take advantages of cash discount
𝐷𝑖𝑠𝑐𝑜𝑢𝑛𝑡 % 360
% cost of not taking discount = 100−𝐷𝑖𝑠𝑐𝑜𝑢𝑛𝑡% × 𝐶𝑟𝑒𝑑𝑖𝑡 𝑃𝑒𝑟𝑖𝑜𝑑−𝐷𝑖𝑠𝑐𝑜𝑢𝑛𝑡 𝑃𝑒𝑟𝑖𝑜𝑑
To maintain favorable credit rating
Holding of adequate cash maintains the current and quick ratio at favorable position so that the firm will be able to meet the
standard of credit analysis of the supplier of short-term funds.
Improving the efficiency of cash management
Speeding collection

Controlling Disbursement
• Centralized Payment System
• Payable through draft system
• Zero-balance account system
• Controlled disbursement account system
Concept of Inventory Management
Inventory management is concerned with maintaining optimum investment in inventory and effective control system to
minimize the total inventory cost. An effective inventory management needs to address two important issues:
a) How can a firm maintain adequate inventory for smooth production and sales operations?
b) How can it minimize the investment in inventory to enhance firm’s profitability?
Significance of Inventory management
• It helps to maintain adequate inventory for smooth production and sales operations.
• It avoids stock-out problem that a firm otherwise would face in absence of the efficient inventory management.
• It suggests the proper inventory control system to be applied by a firm to avoid losses, damages and misuses.
• It helps in maintaining a trade-off between carrying costs and ordering costs so as to minimize the total inventory cost.
Maintaining Sufficient Inventory, minimizing cost of inventory, minimizing wastages and losses, Maintaining
Proper storage, Taking Advantages of Quantity discount, maintaining steady production set up.
Objectives of holding adequate inventory
• Avoiding losses of sales
• Gaining quantity discount
• Reducing order costs
• Achieving efficient production run
Basic Inventory Costs
1) Carrying Costs
Carrying costs are variable cost per unit of holding an item of inventory in stock for a specified time period.
Total Carrying Cost (TCC) = Average Inventory x Carrying cost per unit
𝐸𝑂𝑄
= ( 2 + 𝑆)x C
2) Ordering Cost
IT is the fixed cost of placing and receiving an order.
Total Ordering cost (TOC) = No. of order x Ordering cost per order
=
3) Total Inventory Cost
It is the sum of total ordering costs and total carrying costs.
TC or TIC = TOC + TCC
=

TC with purchase price

TC =

TC with discount offer

TC =
Inventory Management Technique
1) EOQ Model
EOQ is the order size of inventory at which total inventory costs remains the minimum as well as total carrying cost and
total ordering cost will be equal. EOQ can be found by using three methods:
a) By using formula method.
b) By using tabulation method.
c) By using graphical method
Reorder Level / Point (ROL)
It is the level of inventory in stock as per previous order at which a reorder should be placed.

Workings for GIT

1) No. of order (N) = A/EOQ
2) Ordering Cycle (OC) = 𝐷𝑎𝑦𝑠 𝑜𝑟 𝑚𝑜𝑛𝑡ℎ𝑠 𝑜𝑟𝑁 𝑤𝑒𝑒𝑘𝑠 𝑖𝑛 𝑎 𝑦𝑒𝑎𝑟
3) Check whether there is GIT or not,
If LT < OC, then there is GIT.
If LT > OC, then there is not GIT.
4) No. of order in transit = LT/OC
5) GIT = No. of order in transit x EOQ
Note:
• If no. of order in transit is above 1 and up to 2, (i.e., 1.1,1. 2…...2), then take 1 time.
• If no. of order in transit is above 2 and up to 3, (i.e., 2.1,2. 2….3), then take 2 times.
Minimum stock level = Safety Stock (S)
Maximum stock level = Safety Stock + EOQ
Nature and Purpose of Receivable Management
Receivable management is an aspect of firm’s current assets management, which is concerned with promoting company’s
sales and profit to the extent where return on investment in accounts receivable remains greater than the costs of receivable.
Purpose of receivable management
• To evaluate the creditworthiness of customers before granting or extending the credit.
• To minimize the cost of investment in receivables.
• To minimize the possible bad debt losses.
• To formulate the credit terms in such a way that results into maximization of sales revenue and still maintaining
minimum investment in receivables.
• To minimize the cost of running credit and collection department.
• To maintain a trade-off between costs and benefits associated with credit policy.
Costs of Maintaining Receivables
Maintaining receivables bears cost. It includes cost of investment in receivables, bad debt losses, collection expenses, and cash
discounts.
Cost of investment in Receivables
This is the opportunity cost of funds being tied up in receivables, which would otherwise have not been incurred if all sales were
in cash.
Cost of receivables = 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝑖𝑛 𝑅𝑒𝑐𝑒𝑖𝑏𝑎𝑏𝑙𝑒𝑠 × 𝑂𝑝𝑝𝑜𝑟𝑡𝑢𝑛𝑖𝑡𝑦 𝑐𝑜𝑠𝑡𝑠 (𝑘)
𝐹𝐶+𝑉𝐶
Investment in receivables = 𝐷𝑎𝑦𝑠 𝑖𝑛 𝑦𝑒𝑎𝑟
× 𝐷𝑆𝑂

Investment in receivables = 𝐴𝑛𝑛𝑢𝑎𝑙 𝐶𝑟𝑒𝑑𝑖𝑡 𝑆𝑎𝑙𝑒𝑠

𝐷𝑎𝑦𝑠 𝑖𝑛 𝑦𝑒𝑎𝑟
× 𝐷𝑆𝑂 × 𝑉𝐶𝑅

Bad Debt Losses = Annual credit sales x % default customer

Discount cost = Annual credit sales x % discount customer x % cash discount
Elements of Credit Policy
Credit Policy refers to a firm’s policy on granting and collecting credit. It is a credit decision policy of the firm, which provides
guidelines for determining whether to extend credit to a customer and how much credit to extend.
Credit standards are the minimum criteria for the extension of credit of a customer.
Credit term establishes how a firm proposes to sell its product.