Unit 1: Introduction to financial management & cost of capital
Financial Management notes · PTU syllabus (BCOM 501-18)
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Unit summary
Financial management decides how a firm raises money, where it invests and how much it returns to owners. This unit covers the meaning, scope and objectives of financial management, the functions and role of a financial manager, the time value of money — compounding and discounting — and the meaning and computation of the cost of capital.
After this unit you can
- Explain the meaning, scope and objectives of financial management
- Describe the functions and role of a financial manager
- Apply compounding and discounting techniques
- Compute the cost of debt, preference, equity and the weighted average cost of capital
PTU syllabus topics
- Meaning
- scope and objectives of financial management
- functions and role of a financial manager
- time value of money — compounding and discounting techniques
- meaning and determination of cost of capital
Future value
FV = PV (1 + r)ⁿ
Present value
PV = FV / (1 + r)ⁿ
Annuity future value
A [(1 + r)ⁿ − 1] / r
Annuity present value
A [1 − (1 + r)⁻ⁿ] / r
Rule of 72
Years to double ≈ 72 / interest rate
Topic 1
Meaning, scope and objectives
Financial management is the planning, organising, directing and controlling of the financial activities of an enterprise — procurement and utilisation of funds.
Investment decision
Where to invest — capital budgeting and working capital
Financing decision
How to raise funds — debt vs equity mix
Dividend decision
How much profit to distribute vs retain
Liquidity decision
Balance between liquidity and profitability
Goal
Maximise accounting profit
Maximise market value of shares (NPV)
Time value
Ignored
Considered
Risk
Ignored
Considered through discount rate
Concept
Vague (which profit?)
Clear — present value of cash flows
Acceptance
Traditional
Modern, widely accepted
Exam tip
Wealth maximisation is preferred because it considers timing and risk of returns — state the three criticisms of profit maximisation (vague, ignores timing, ignores risk).
Topic 2
Functions and role of the financial manager
- Estimating capital requirements and determining capital structure.
- Choosing sources of funds — shares, debentures, loans, retained earnings.
- Investment of funds — evaluating projects (capital budgeting).
- Dividend decisions and retained earnings.
- Cash management and working capital management.
- Financial controls — ratio analysis, budgets, cost control.
- Relations with banks, investors and capital markets; risk management.
- Modern role: strategic partner in mergers, valuation, treasury, ESG reporting, digital finance.
Topic 3
Time value of money
A rupee today is worth more than a rupee tomorrow because of earning potential, inflation, risk and preference for present consumption.
Future value
FV = PV × (1 + r)^n
Multiple compounding
FV = PV × (1 + r/m)^(m × n)
Present value
PV = FV ÷ (1 + r)^n
FV of an annuity
A × [((1 + r)^n − 1) ÷ r]
PV of an annuity
A × [(1 − (1 + r)^−n) ÷ r]
PV of a perpetuity
A ÷ r
Effective annual rate
(1 + r/m)^m − 1
Example
₹50,000 invested at 10% compounded half-yearly for 2 years: FV = 50,000 × (1.05)^4 = 50,000 × 1.2155 = ₹60,775.
Example
PV of ₹20,000 received annually for 3 years at 10% = 20,000 × 2.4869 = ₹49,737.
Topic 4
Cost of capital
Cost of capital is the minimum rate of return a firm must earn on its investments to maintain the market value of its shares — the hurdle rate for capital budgeting.
Cost of irredeemable debt (after tax)
Kd = I (1 − t) ÷ NP
Cost of redeemable debt
Kd = [I (1 − t) + (RV − NP) ÷ n] ÷ [(RV + NP) ÷ 2]
Cost of preference shares
Kp = D ÷ NP (irredeemable); [D + (RV − NP) ÷ n] ÷ [(RV + NP) ÷ 2] (redeemable)
Cost of equity — dividend growth (Gordon)
Ke = D1 ÷ P0 + g
Cost of equity — CAPM
Ke = Rf + β (Rm − Rf)
Cost of retained earnings
Kr = Ke (adjusted for personal tax and floatation, if given)
Weighted average cost of capital
WACC = Σ (Weight × Specific cost)
Example
10% debentures of ₹100 issued at ₹95, redeemable at par in 5 years, tax 30%. Kd = [10 × 0.7 + (100 − 95) ÷ 5] ÷ [(100 + 95) ÷ 2] = (7 + 1) ÷ 97.5 = 8.21%.
| Source | Amount (₹) | Weight | Cost | Weighted cost |
|---|---|---|---|---|
| Equity | 6,00,000 | 0.60 | 15% | 9.0% |
| Preference | 1,00,000 | 0.10 | 11% | 1.1% |
| Debt | 3,00,000 | 0.30 | 7% (after tax) | 2.1% |
| WACC | 10,00,000 | 1.00 | 12.2% |
- Book value weights vs market value weights — market weights are theoretically superior.
- Significance: capital budgeting cut-off, capital structure decisions, evaluating financial performance, dividend decisions.
Key terms
- Wealth maximisation
- Maximising the market value of shareholders' wealth
- Time value of money
- Money today is worth more than the same money in future
- Cost of capital
- Minimum required return on investments
- WACC
- Weighted average of the costs of all sources of finance
- CAPM
- Model linking expected return to systematic risk (beta)
Quick revision
- Decisions: investment, financing, dividend, liquidity.
- Wealth maximisation beats profit maximisation (timing, risk).
- FV = PV(1 + r)^n; PV = FV/(1 + r)^n; annuity factors.
- Kd after tax; Ke by Gordon or CAPM.
- WACC = Σ weight × cost.
Important exam questions
Practice questions written to the PTU exam pattern for this unit's syllabus: short answers (Section A style) and long answers (Sections B and C style).
Short-answer questions
- Q1.Define financial management.
- Q2.Why is wealth maximisation superior to profit maximisation?
- Q3.What is discounting?
- Q4.What is cost of capital?
- Q5.Write the CAPM formula.
- Q6.Why is the cost of debt computed after tax?
Long-answer questions
- Q1.Explain the scope and objectives of financial management.
- Q2.Explain the functions and role of a financial manager.
- Q3.Explain the concept of time value of money with compounding and discounting.
- Q4.Explain the computation of specific costs of capital and WACC.
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