Financial Management

UNIT -1
Financial Management:
Financial management is strategic planning, organising, directing, and controlling of financial
undertakings in an organisation or an institute. It also includes applying management principles to
the financial assets of an organisation, while also playing an important part in fiscal management.

The objectives involved in financial management include:

 Maintaining enough supply of funds for the organisation;

 Ensuring shareholders get good returns on their investment;

 Optimum and efficient utilisation of funds;

 Creating real and safe investment opportunities.

Why is financial management important?

This form of management is important for various reasons. 

 Helps organisations in financial planning and acquisition of funds;

 Aids organisations to effectively utilise and allocate the funds received or acquired;
 Supports organisations in making critical financial decisions;
 Helps in improving the profitability of organisations;
 Increases the overall value of organisations;
 Provides economic stability.

Scope of Financial Management

After understanding what financial management is, we'll now understand the different scope of
financial management. 

1. Capital Budgeting

The company's financial management executives are responsible for making predictions
regarding all the business transactions and costs of operations. Based on this estimate, they
generate the probable estimate of fixed capital and working capital required by the company in
a particular period. Moreover, the financial professionals also have to make projections for any
additional funds the company may receive from investors. Accordingly, they create a budget for
the allocation of those funds.  
2. Capital Structure

After projecting the financial budget, the financial management experts must formulate a plan
for structuring this capital. First, they have to control the transactions and divide the available
money into different parts, such as the owner's risk capital, borrowed capital, and short-term
and long-term debt-equity ratio. Subsequently, the executives also have to consider various
financial components like the cost of assembling the capital from investors and other external
sources and the amount of time for which this capital will be utilized.

3. Financial Decision

Financial decisions include all sorts of choices regarding sources to generate funds, investment
decisions, and cash flow management. The business can raise funds from different sources like
investors, shareholders, banks, public deposits, and other financial lenders. The financial
management department scrutinizes all these sources and chooses the source with maximum
profit and minimum liability. In addition to generating funds, financial professionals also make
plans for wise investment of these funds to improve the company's return on investment. They
carry out capital budgeting through opportunity cost analysis and make investments while
ensuring the business's safety, liquidity, and profitability. 

4. Working Capital Management

Working capital management is an important element of financial management. It requires

three primary tasks to maintain a solid financial position for the company:

First, financial executives record the company's assets and liabilities to ascertain the cash flow.
This cash flow is used to cover short-term operational costs and short-term liabilities.

The finance department scans different ratios to manage the working capital. These include the
working capital ratio, the collection ratio, and the inventory ratio. The results obtained after the
study help professionals carry out smooth operations in the business.

Proper working capital management enables cash flow and revenue maintenance, allowing the
organization to utilize its resources in profitable directions.  
5. Dividend Decision

A company has two options: pay dividends to shareholders or hold on to the profits.
Financial management meaning focuses on the decision between these two options that will
support the company's growth. The main aim of a financial manager is to optimize the
shareholder's wealth as it works in the company's goodwill. The dividend decision is the
essential scope of financial management. Dividends are payouts to shareholders and are
calculated using Earning Per Share. The distributed amount is directly proportional to the
shareholder's favor and the company's right set of investment conditions.  

6. Profit management

The financial management has to take steps to distribute the company's revenues and profits
appropriately. The company has various debatable requirements, and the funds must be
assembled according to priorities and returns. Sometimes, companies keep aside some funds as
a reserve. This is taken from the business's earnings. In addition, some amount of funds is either
pulled out or reinvested. The financial department's responsibility is to draw out the strengths
and shortcomings of different sources for using the company's profits and earnings before
coming to a conclusion.

Objectives of Financial Management

1. Assessing Capital Needs

Financial professionals' duties entail them to get a measure of certain attributes. These
attributes include the cost of current fixed assets, the cost of promotions, the requirement, and
measure of buffer capital, long-term expenses, and human resource operations. As a result,
organizations that constantly develop in the financial domain have predefined their short-term
and long-term finances and conduct their business according to these estimates.  

2. Capital Structure

Suppose a company has a solid capital structure. In that case, it means that there is sustainable
groundwork for financial decision-making, like projections of debt-equity ratio in the short-term
and long-term.  

3. Business Survival

According to the exceptionally renowned scientist Charles Darwin, the phrase 'survival of the
fittest' warrants adapting to one's surroundings to persist through life. The same goes for
business decisions. A company endures and abides by market conditions with the help of secure
financial management.  

4. Balanced Structure

Maintaining a balance is crucial to keep running smoothly under any circumstances. When
pertaining to business, the role of financial executives is to ensure this structure by fabricating a
plausible capital strategy. This is possible after considering all capital sources and assessing the
business's liquidity, current economic conditions, and financial stability.  

5. Effective Financial Policies

Apart from making sound financial decisions, it is also essential for the funds' manager to create
profitable financial policies that administer cash flow and lending and borrowing procedures.  
6. Resource Optimization

The best financial management executives have the skill and efficiency to use all obtainable
financial resources and maximize their ratio. This results in little expense and an exponential
rise in cash flow to produce a greater return on investment.  

7. Profit Maximization

Profit maximization is probably one of financial management's most important and tricky
attributes. The company has to frame means to generate profits in the short-term and long-
term. As a result, a financial manager has to focus more on profit optimization and ensure that
all business operations' actions are sustainable and correct.  

8. Proper Mobilization

Mobilizing profits is as critical as maximizing them. One does not simply spend all their earnings
without creating separate criteria for savings. In a business, the financial management
department has to assess and project the allocation and application of available funds. This is
achieved through investment in shares, new products, or acquiring a portion of small
companies. However, there are various factors to evaluate before coming to these decisions.  

9. High Efficiency

The meaning and definition of financial management entail the creation of a stable work
relationship with other company departments. It tries to improve performance by appropriate
allocation of funds to different departments. This distribution is carried out considering the
resources and effort required to amplify the company's efficiency.  

10. Reduce Risks

Along with maintaining the performance, it is also necessary to minimize the risks. Risks often
present themselves in unforeseen circumstances or unexpected market conditions. Financial
managers need to have a fool proof plan against such situations. In addition, they must
calculate potentially risky situations beforehand with the help of professionals and try to steer
clear of those.  

Functions of Financial Management

1. Financial Planning and Forecasting 

For social and non-profit organizations, the ultimate goal of running a business is the greater
good of society. But most companies have the objective of getting more return on investment.
These profits act as a buffer between the current financial status of the company and its future
standing. An appropriate allocation of funds enables the financial management to plan and
forecast the company's future. It allows them to make decisions regarding the generated
profits, whether an organization will benefit from pulling out the funds and procuring assets or
reinvesting the profits in the company and improving marketing strategies.  

2. Cash Management 

The financial department is in control of all the cash flow operations. A company needs cash for
several reasons, such as paying salaries, electricity bills, property bills, purchasing goods, and
maintaining storage space. 

3. Estimating Capital Expenses 

The financial executive must devise projections for the capital needed to run daily operations.
These projections include cost estimates, profits, future expenses, and a window for plausible
losses. The capital expenses are calculated so that the company's revenue grows
uninterruptedly.  

4. Determining Capital Structure 

After creating the framework for capital expenses, the financial management creates a capital
structure. The capital structure portrays the debt analysis in the short-term and long-term
future. Therefore, it is directly proportional to the available financial resources and the
potential procurement of funds.  

5. Procurement of Funds 

The following function of financial management is to devise strategies to procure funds for the
organization. A business needs credibility in the market to ensure stable cash fluidity. Thus, a
company procures funds with the help of equity or debt financing.  
6. Investment of Funds 

Once the organization has acquired funds, it needs to allocate them to efficient businesses that
help grow the business and give profitable returns with a window for safety.  

7. Surplus Disposal 

Every company reaches a point where it has a surplus amount of funds after the allocation and
smooth operation. Financial management is responsible for strategically taking care of the
earned and capital surplus.

Financial Planning and Control

A major task for every manager is to choose financial alternatives. The motivation behind analyzing
various alternatives is to utilize the funds available for getting a particular job done in the most
cost-effective manner. Some typical problems are as follows:

 Whether to contract certain services, such as elevator maintenance, or to use in-house

crews
 Whether to buy certain equipment that will make maintenance more productive
 Whether to generate utilities or buy from a utility company
 Whether to purchase computers and other equipment or lease from a third party
 How frequently and in what quantities stock items should be ordered

Principles of Financial Controls

In past decades, the topic of financial controls has received a lot of attention. One of the main
events that emphasized this topic was the passage of the Sarbanes-Oxley Act of 2002 (SOX).
Although this legislation primarily affected publicly traded companies, its impact has indirectly
been felt by universities as well. A number of states issued legislation similar to SOX, but more
important, financial auditing firms began to examine their roles more closely after the demise of
major accounting firm Arthur Andersen. Therefore, a better knowledge of internal controls of
financial systems has become increasingly important.

The most well known and highly respected internal control framework was developed by the
Committee of Sponsoring Organizations of the Treadway Commission (COSO) in 1992. This
integrated framework established effective internal controls that have served most industries well.
This section provides an overview of these principles.

Before considering COSO principles, one should examine the following key fiduciary responsibilities
of a board of directors:

 Set strategic directions

 Protect the owners and other key stakeholders
 Monitor financial health of the organization
  Evaluate the work of outside auditors
 Overall duty of care, loyalty and confidentiality

It is important for board members to recognize their personal responsibility and liability. The
passage of SOX unequivocally made this duty clear. Within such a framework is internal control; a
collection of processes that are designed to give reasonable assurance about:

 Efficiency and effectiveness of operations

 Reliability of financial statements
 Compliance with laws and regulations

In other words, management must provide reasonable assurance that the organizational
objectives will be met in a safe and cost-effective manner. Internal controls are procedures that
are performed every day, and therefore should be:

 A means, and not an end

 Affected by people
 Not merely policies and procedures
 Integral to every aspect of the business
 Built into, not onto, business processes

The COSO framework illustrates internal controls in a three-dimensional cube as shown below:

Figure 1. COSO Framework: Three-dimensional criteria for evaluating internal controls

(Copied from COSO’s Integrated Framework)

The first dimension of the framework provides three categories of objectives: operations,
reporting and compliance.

 For operations, the organization must provide reasonable assurance to the board of
directors and management that the entities’ operations are being achieved.
 For compliance, the organization must provide reasonable assurance to the board of
directors and management that the entity is in compliance with applicable laws and
regulations.
 For reporting, the organization must provide reasonable assurance to the board of
directors and management that the published financial statements are prepared reliably.
The board, and in most cases the financial committees of the board and management,
should review all financial reports for accuracy and completeness in order to:
o Establish and maintain disclosure control and procedures
o Ensure inclusion of all material information
o Evaluate the effectiveness of disclosure control and procedures

More important, the financial statement is required to disclose to auditors and audit committees:

 All significant deficiencies in design of internal controls

 Any material weakness or significant changes in internal controls
 Any fraud

The 5 components, representing the second dimension, relate to internal control:

 Control environment
 Risk assessment
 Control activities
 Information/communication
 Monitoring activities

Control Environment
The control environment sets the tone of the organization, influencing the control consciousness
of everyone and providing discipline and structure. Key factors include:

 Integrity and ethical values

 Commitment to competence
 Management philosophy and style
 Organizational structure
 Assignment of authority and responsibility
 Human resources policies and procedures
 Audit committees

The responsibilities of an audit committee are as follows:

  Members may not accept consulting, advisory, or other compensatory fees, other than
normal Director fees
 Directly responsible for appointment, compensation, retention, and oversight of those
preparing audit reports and related activities
 Establish procedures for receiving, retaining, and addressing complaints
 Have authority to engage independent counsel
 Board must provide audit committee the resources necessary to fulfill its responsibilities

Another important element of control environment is having code of conduct, code of ethics, and
conflict of interest statements for the organization. These documents must be filed annually and
apply to all employees who have direct or indirect financial responsibilities.

Risk Assessment
Risk assessment relates to identification and analysis of risk in key processes, such as accounts
receivable, accounts payable, payroll, procurement, and technology changes. Some common
strategic risk factors include the following:

 Planning
 Resource allocation
 Leadership and vision
 Authority and accountability
 Ethics and values
 Illegal acts
 Compliance with laws and regulations
 Competition
 Politics

The universal business risk categories include the following:

 Overpaying
 No or inappropriate policies, procedures and/or training
 Non-compliance with management policies and procedures
 Erroneous data/info
 Employee safety
 Business interruption
 Natural or human-made disasters
 Fraud/conflict of interest

Risk management activities can be divided into the following four categories:

 Accept (monitor)
 Avoid (eliminate)
 Reduce (institute control)
 Share (partner, such as through insurance)
A simple way to examine these categories is to plot the probability of occurrence against the
impact in a graph, as shown below.

Examples of policies and procedures that help management directives are carried out in the
following key functions:

 Approvals
 Authorizations
 Verifications
 Reconciliations
 Review of operating performance
 Segregation of duties
 Security of assets

Control Activities
Control activities encompasses the policies and procedures companies establish to mitigate risks
and ensure institutional objectives are realized. Control activities may be preventive or detective in
nature. A “segregation of duties” policy that requires approval from both the initiating department
and a finance officer on all purchase orders over $5000 is an example of a control activity.

Information and Communication

This requirement implies that pertinent information must be identified, captured, and
communicated in a form and timeframe that enables people to carry out their responsibilities. Key
information qualities include timeliness, accuracy, currency, and accessibility. An additional factor
that should be kept in mind is information security. This topic is covered in more detail in other
parts of the manual.
Monitoring Activities
Monitoring requires having a process that assesses the quality of system’s performance over time
through a combination of ongoing and separate evaluation activities.

The third dimension of the COSO framework deals with applying the above criteria for every
organizational sector and in every activity. This approach is helpful for business processes such as
the following:

 Cash
 Investments
 Donations, program service fees, and other income
 Receivables (including pledges)
 Procurement
 Payroll
 Property and equipment
 Debt and other liabilities
 Reserves and net assets
 Computer controls

In conclusion, internal financial control is essential for any organization because it keeps the
organization on course, plays a critical role in achieving the organization’s mission, minimizes
surprises, improves an organization’s capability to deal with a changing environment, and provides
a standard for assessment and improvement. In the wake of the global financial meltdown of
2008, COSO issued updates to its internal control framework in May 2013.  Further, new federal,
state, and local legislation may be passed to address the efficacy of organizations’ current internal
financial controls.

Control is so closely interlinked with planning that the two are virtually inseparable. Planning is the
process of deciding what needs to be done and anticipating the steps needed to produce the
desired outcome. Control involves implementing the planning decision, comparing actual results
with what was planned, and taking corrective action if there is an unacceptable deviation. This
close relationship is illustrated by the planning and control cycle, which continues until goals are
achieved:

 Goals are set.

 Steps to achieve the goals are chosen.
 Actual performance occurs, either according to plan or with variation.
 Performance is monitored through feedback mechanisms.
 Adjustments are made to goals, plans, or actions.
 Additional feedback is received.
 Additional adjustment takes place.

Control
To control, it is necessary to have a way of measuring performance and a standard to which that
performance will be compared. The cost accounting system, when properly structured, provides a
means of measuring cost performance. The standards for comparison can take many forms. The
two most common comparisons are present versus past and actual versus budget.

Present-Versus-Past Comparison
Even the most rudimentary accounting systems permit a comparison of present to past costs for
the same time period. If conditions are generally the same and the account breakdown is
sufficiently detailed, this can be an effective control method. Even in the presence of other, more
sophisticated techniques, a present-versus-past comparison is usually useful. Its usefulness is
enhanced if trend lines are established that depict performance over a series of time periods.

The chief difficulty with using past performance as a standard is that there is no indication of what
performance should have been. Historical data could represent excellent or poor performance.
Unless past conditions are known, a standard may be adopted that contains inefficiency and
extraordinary costs.

Although present-versus-past comparisons should not be dismissed entirely, they must be used
with extreme caution and skepticism. They are most valuable when used in conjunction with other
indicators.

Actual-Versus-Budget Comparison
Comparison of actual costs to budget is perhaps the most important technique available to the
facilities manager. It is generally superior to comparisons against past performance because of the
characteristics of budgets in general and the unique role they play in nonprofit organizations.
When properly prepared, budgets represent the plan, stated in monetary terms, that has been
formulated to meet the objectives of the organization. As such, they force the manager to
anticipate changes.

In nonprofit organizations, budgets play an even more important role in management control. In
such organizations, control is generally viewed to be more difficult because of the absence of profit
as an objective, as a criterion for appraising alternative courses of action, and as a measure of
performance. This shifts the focus from profits to plans and budgets and makes the budget the
principal means of overall control.

When budgets are used, cost control will be much more effective if the cost accounting system is
designed to be consistent with the budget, and vice versa. Unless the two are stated in the same
terms and structured similarly, there is no way of determining whether spending occurred
according to the budget plan. This does not mean that a budget should be set for each detail
account, but it does mean that there should be accounts in the cost accounting system that match
each line item in the budget so that a direct comparison can be made.

Types of Analysis
There are many different types of analysis that can be performed to get better insight into the
effect of management on the institution’s financial performance. The most common ones are
comparative analysis, constant dollar analysis, performance analysis, ratio analysis, variance
analysis, and exception analysis.
Comparative Analysis
Comparative analysis involves comparing specific internally stipulated objectives against those of
other similar institutions. However, because of the inconsistency of interinstitutional data, the
validity of this technique is questionable. Most managers are interested in how their operations
compare with those at other universities, or with the average of those at other universities, and
seek performance measures common to all facilities. For example, the time required to run 100 ft.
of electrical conduit can be measured on an absolute basis. The task should take the same amount
of time anywhere, assuming that workers of equal ability do the job and similar conditions exist.
However, few absolute measures exist against which actual performance can be compared. Most
measurements are relative to past performance, are in index or ratio form, and are most
meaningfully analyzed using trend lines and charts.

Every year, APPA: The Association of Higher Education Facilities Officers surveys its members and
publishes the results in its Facilities Performance Indicators report (FPI.). The information reported
by each participating institution includes the following:

 Full-time equivalent (FTE) student enrollment

 Total gross square footage of all buildings
 Gross square footage maintained in facilities budget
 Ground acreage
 Administrative cost per gross square foot
 FTE administrators
 Engineering cost per gross square foot
 FTE engineering personnel
 Maintenance cost per gross square foot
 FTE maintenance employees
 Custodial cost per gross square foot
 FTE custodial personnel
 Landscape and grounds cost per gross square foot
 FTE landscape and grounds personnel

The report presents this information in a format that permits comparisons. Managers can compare
their institution’s performance with those of institutions of similar size, type, and educational
purpose.

Other information, although not nearly as comprehensive as APPA’s report, is published

periodically in various trade journals. For example, American School & University magazine
annually publishes a maintenance and operations cost survey, with costs analyzed as follows:

 Custodial salaries, stated in dollars per student and per square foot
 Maintenance salaries, stated in dollars per student and per square foot
 Heat, other utilities, and other costs, stated in dollars and per square foot
 Average custodial and maintenance salaries
 Square feet per custodian
 The above data are presented for each of ten regions of the United States, including Alaska
and Hawaii
At best, published indicators can serve only as a guide. Large differences are often noticeable, even
among similar organizations. These wide variations reflect the differences not only in costs but also
in methods of accounting for costs. For this reason, caution is required in using such comparative
data.

A better approach to comparative analysis is benchmarking, which is discussed later in this

chapter.

Constant-Dollar Analysis
This analysis is a primary concern for institutions and indicates the impact of inflation on the
institution’s budget. These are several sources that can be used for comparison; an example is the
Higher Education Price Index, from which an institution-specific cost index can be developed.

Performance Analysis
This analysis seeks to establish standards other than budgets against which to measure and
compare actual performance. These standards are frequently nonmonetary and are intended to
complement, not replace, budgets. In many cases, these standards provide the detail on which
budgets are built.

Performance standards may be generated internally, or they may come from outside sources. Both
are useful. Internal standards usually relate to the budget in some way or to an individual
department’s unique goals and objectives. Examples of internal standards are the following:

 A 20-day backlog of work should be maintained at all times.

 Actual job costs should be within 10 percent of the estimates.
 Actual labor performance should be from 95 to 105 percent of standard labor.
 Energy use should not exceed 100,000 Btus per square foot per year.

Ratio Analysis
This constitutes trending ratios of key financial indicators over time to determine their stability or
instability over time. The following are some examples of these ratios:

 Current asset/current liability

 Long-term asset/long-term liability
 Fund balances/debt
 Fund balances/types of expenditures and mandatory transfer
 Creditworthiness ratios
 Return-on-investment ratios

Variance Analysis
Deviation from a standard is known as variance. The standard can be historical data, comparable
data from another university, or any other predetermined yardstick.

For cost control, it is of little use to know only the dollar amount of the variance, especially if many
factors are at work to influence cost. To take effective action, it is necessary to break down the
total difference into its individual elements using variance analysis.
There are basically two types of variance: price and quantity. Several other variances can be
developed for specialized purposes, but each one is ultimately traceable to variations in price,
variations in quantity used, or a combination of the two.

Any cost can be stated in terms of price and quantity, as follows:

Cost = Price x Quantity

If two costs are involved, one can be considered the standard and the other, the actual. The
difference between them represents the variance. From this come the basic definitions of price
and quantity variances:

 Price variance VP = the difference between actual price (PA) and standard price (PS)
multiplied by the actual quantity (QA):

 Quantity variance VQ = the difference between actual quantity (QA) and standard quantity
(QS) multiplied by the standard price (PS):

Exception Analysis
A cost control system operated on the exception principle is one in which management’s attention
is focused on the relatively small number of items for which actual performance is significantly
different from the standard. This principle acknowledges that management time is a scarce
resource that should be applied to problems that have the greatest impact on the organization.
The relatively large number of minor variances from standard are either ignored or left to become
the priority concern of a lower level manager in the responsibility accounting hierarchy.

Indian Financial System – An Overview

The services that are provided to a person by the various Financial Institutions including banks,
insurance companies, pensions, funds, etc. constitute the financial system. 
Given below are the features of the Indian Financial system:

 It plays a vital role in the economic development of the country as it encourages both
savings and investment
 It helps in mobilising and allocating one’s savings
 It facilitates the expansion of financial institutions and markets
 Plays a key role in capital formation
 It helps form a link between the investor and the one saving
 It is also concerned with the Provision of funds
 Regulatory Bodies In Indian Financial System
Briefs about various regulators who regulate and contribute towards the development of the
financial market are given below:
Table of Contents

 1. Securities and Exchange Board of India (SEBI)

 2. Reserve Bank of India (RBI)
 3. Insurance Regulatory and Development Authority of India (IRDAI)  
 4. Pension Funds Regulatory and Development Authority (PFRDA)
 5. Association of Mutual Funds in India (AMFI)
 6. Ministry of Corporate Affairs (MCA)

1. Securities and Exchange Board of India (SEBI)

The Securities and Exchange Board of India (SEBI) is a statutory body established under the SEBI
Act of 1992, as a response to prevent malpractices in the capital markets that were negatively
impacting people’s confidence in the market. Its primary objective is to protect the interest of the
 investors, prevent malpractices, and ensure the proper and fair functioning of the markets. SEBI
has many functions, they can be categorized as:
1. Protective functions: To protect the interests of the investors and other market participants. It
includes – preventing insider trading, spreading investor education and awareness, checking for
price rigging, etc.
2. Regulatory functions: These are performed to ensure the proper functioning of various activities in
the markets. It includes – formulating and implementing a code of conduct and guidelines for all
types of market participants, conducting an audit of the exchanges, registration of intermediaries
like brokers, and investment bankers, and levying fees, and fines against misconduct.
3. Development functions: These are performed to promote the growth and development of the
capital markets. It includes – Imparting training to various intermediaries, conducting research,
promoting self-regulation of organizations, facilitating innovation, etc.
To perform its functions and achieve its objectives, SEBI has the following powers:
1. To change laws relating to the functioning of the stock exchange
2. To access records and financial statements of the exchanges
3. To conduct hearings and give judgments on cases of malpractice in the markets.
4. To approve the listing and force the delisting of companies from any exchanges.
5. To take disciplinary actions like fines and penalties against participants who involve in malpractice.
6. To regulate various intermediaries and middlemen like brokers.

2. Reserve Bank Of India (RBI)

The Reserve Bank of India (RBI) is India’s central bank and was established under the Reserve Bank
of India Act in 1935. The primary purpose of RBI is to conduct the monetary policy and regulate
and supervise the financial sector, most importantly the commercial banks and non-banking
 financial companies. It is responsible to maintain price stability and the flow of credit to different
sectors of the economy.
Some of the main functions of  RBI are:
1. It issues the license for opening banks and authorizes bank branches.
2. It formulates, implements, and reviews prudential norms like the Basel framework.
3. It maintains and regulates the reserves of the banking sector by stipulating reserve requirement
ratios.
4. It inspects the financial accounts of the banks and keeps track of the overall stress in the banking
sector.
5. It oversees the liquidation, amalgamation, or reconstruction of financial companies.
6. It regulates the payment and settlement systems and infrastructure.
7. It prints, issues, and circulates the currency throughout the country.
The RBI is the banker to the government and manages its debt issuances, it is also responsible to
maintain orderly conditions in the government securities markets (G-Sec). RBI manages foreign
exchange under the Foreign Exchange Management Act, of 1999. It intervenes in the FX markets to
stabilize volatility that facilitates international payments and trade, and the development of the
foreign exchange market in India.

3. Insurance Regulatory and Development Authority of India (IRDAI) 

The Insurance Regulatory and Development Authority of India (IRDAI) is an independent statutory
body that was set up under the IRDA Act, of 1999. Its purpose is to protect the interests of the
insurance policyholders and to develop and regulates the insurance industry.  It issues advisories
regularly to insurance companies regarding the changes in rules and regulations.
It promotes the insurance industry but also controls the various charges and rates related to
insurance. As of 2020, there are about 31 general insurance and 24 life insurance companies in
India, that are registered with IRDA.
The three main objectives of IRDA are:
1. To ensure fair treatment and protect the interests of the policyholder.
2. To regulate the insurance companies and ensure the industry’s financial soundness.
3. Formulate standards and regulations so that there is no ambiguity.
Some important functions of IRDA are:
1. Granting, renewing, canceling, or modifying the registration of insurance companies.
2. Levying charges and fees as per the IRDA Act.
3. Conducting investigation, inspection, audit, etc. of insurance companies and other organizations in
the insurance industry.
4. Specifying the code of conduct and providing qualifications and training to intermediaries,
insurance agents, etc.
5. Regulating and controlling the insurance premium rates, terms and conditions, and other benefits
offered by insurers.
6. Provides a grievance redressal forum and protects the interests of the policyholder.

4. Pension Funds Regulatory and Development Authority (PFRDA)

The Pension Fund Regulatory and Development Authority (PFRDA) is a statutory body, which was
established under the PFRDA Act, 2013. It is the sole regulator of the pension industry in India.
Initially, PFRDA covered only employees in the government sector but later, its services were
extended to all citizens of India including NRI’s. Its major objectives are – to provide income
security to the old aged by regulating and developing pension funds and to protect the interest of
subscribers to pension schemes.
The National Pension System (NPS) of the government is managed by the PFRDA. It is also
responsible for regulating custodians and trustee banks. The Central Record Keeping Agency (CRA)
of the PFRDA performs record keeping, and accounting and provides administration and customer
services to subscribers of the pension fund.
Some functions of PFRDA are:
1. Conducting inquiries and investigations on intermediaries and other participants.
2. Increasing public awareness and training intermediaries about retirement savings, pension
schemes, etc.
3. Settlements of disputes between intermediaries and subscribers of pension funds.
4. Registering and regulating intermediaries.
5. Protecting the interest of pension fund users.
6. Stipulating guidelines for investment of pension funds.
7. Formulating a code of conduct, standards of practice, terms, and norms for the pension industry.
5. Association of Mutual Funds in India (AMFI)
The Association of Mutual Funds in India (AMFI) was set up in 1995. It is a non-profit organization
that is self-regulatory and works for the development of the mutual fund industry by improving
professional and ethical standards, thus aiming to make mutual funds more accessible and
transparent to the public. It provides spreads awareness and vital information about mutual funds
to Indian investors.
AMFI ensures the smooth functioning of the mutual fund industry by implementing high ethical
standards and protects the interests of both – the fund houses and investors. Most asset
management companies, brokers, fund houses, intermediaries, etc in India are members of the
AMFI. Registered AMCs are required to follow the code of ethics set by the AMFI. These codes of
ethics are – integrity, due diligence, disclosures, professional selling, and investment practice.
The AMFI updates the Net Asset Value of funds on a daily basis on its website for investors and
potential investors. It has also streamlined the process of searching for mutual fund distributors.
6. Ministry of Corporate Affairs (MCA)

The Ministry of Corporate Affairs (MCA) is a ministry within the government of India. It regulates
the corporate sector and is primarily concerned with the administration of the Companies Act, of
1956, 2013, and other legislations. It frames the rules and regulations to ensure the functioning of
the corporate sector according to the law.
The objective of MCA is to protect the interest of all stakeholders, maintain a competitive and fair
environment and facilitate the growth and development of companies. The Registrar of Companies
(MCA), is a body under the MCA that has the authority to register companies and ensure their
functioning as per the provisions of the law. The issuance of securities by the companies also
comes under the purview of the Companies Act.

UNIT -2

What Is the Time Value of Money (TVM)?

The time value of money (TVM) is the concept that a sum of money is worth more now than the
same sum will be at a future date due to its earnings potential in the interim. The time value of
money is a core principle of finance. A sum of money in the hand has greater value than the same
sum to be paid in the future. The time value of money is also referred to as the present
discounted value.

KEY TAKEAWAYS

 The time value of money means that a sum of money is worth more now than the same
sum of money in the future.
 The principle of the time value of money means that it can grow only through investing so
a delayed investment is a lost opportunity.
 The formula for computing the time value of money considers the amount of money, its
future value, the amount it can earn, and the time frame.
 For savings accounts, the number of compounding periods is an important determinant as
well.
 Inflation has a negative impact on the time value of money because your purchasing
power decreases as prices rise.

Understanding the Time Value of Money (TVM)

Investors prefer to receive money today rather than the same amount of money in the future
because a sum of money, once invested, grows over time. For example, money deposited into
a savings account earns interest. Over time, the interest is added to the principal, earning more
interest. That's the power of compounding interest. 

If it is not invested, the value of the money erodes over time. If you hide $1,000 in a mattress for
three years, you will lose the additional money it could have earned over that time if invested. It
will have even less buying power when you retrieve it because inflation reduces its value.

As another example, say you have the option of receiving $10,000 now or $10,000 two years from
now. Despite the equal face value, $10,000 today has more value and utility than it will two years
from now due to the opportunity costs associated with the delay. In other words, a delayed
payment is a missed opportunity.

The time value of money has a negative relationship with inflation. Remember that inflation is an
increase in the prices of goods and services. As such, the value of a single dollar goes down when
prices rise, which means you can't purchase as much as you were able to in the past.

Time Value of Money Formula

The most fundamental formula for the time value of money takes into account the following:
the future value of money, the present value of money, the interest rate, the number of
compounding periods per year, and the number of years.

Based on these variables, the formula for TVM is:

��=��(1+��)�×�where:��=Future value of money��=Present value of money�=Int
erest rate�=Number of compounding periods per year�=Number of yearsFV=PV(1+ni
)n×twhere:FV=Future value of moneyPV=Present value of moneyi=Interest raten=Number of com
pounding periods per yeart=Number of years

Keep in mind, though that the TVM formula may change slightly depending on the situation. For
example, in the case of annuity or perpetuity payments, the generalized formula has additional or
fewer factors.

 
The time value of money doesn't take into account any capital losses that you may incur or any
negative interest rates that may apply. In these cases, you may be able to use negative growth
rates to calculate the time value of money

Examples of Time Value of Money

Here's a hypothetical example to show how the time value of money works. Let's assume a sum
of $10,000 is invested for one year at 10% interest compounded annually. The future value of that
money is:

��=$10,000×(1+10%1)1×1=$11,000FV=$10,000×(1+110%)1×1=$11,000

The formula can also be rearranged to find the value of the future sum in present-day dollars. For
example, the present-day dollar amount compounded annually at 7% interest that would be
worth $5,000 one year from today is:

��=[$5,000(1+7%1)]1×1=$4,673PV=[(1+17%)$5,000]1×1=$4,673

Effect of Compounding Periods on Future Value

The number of compounding periods has a dramatic effect on the TVM calculations. Taking the
$10,000 example above, if the number of compounding periods is increased to quarterly,
monthly, or daily, the ending future value calculations are:

 Quarterly Compounding:��=$10,000×(1+10%4)4×1=$11,038FV=$10,000×(1+410%
)4×1=$11,038
 Monthly Compounding:��=$10,000×(1+10%12)12×1=$11,047FV=$10,000×(1+1210%
)12×1=$11,047
 Daily Compounding:��=$10,000×(1+10%365)365×1=$11,052FV=$10,000×(1+36510%
)365×1=$11,052

This shows that the TVM depends not only on the interest rate and time horizon but also on how
many times the compounding calculations are computed each year.

How Does the Time Value of Money Relate to Opportunity Cost?

Opportunity cost is key to the concept of the time value of money. Money can grow only if it is
invested over time and earns a positive return. Money that is not invested loses value over time.
Therefore, a sum of money that is expected to be paid in the future, no matter how confidently it
is expected, is losing value in the meantime.

Why Is the Time Value of Money Important?

The concept of the time value of money can help guide investment decisions. For instance,
suppose an investor can choose between two projects: Project A and Project B. They are identical
except that Project A promises a $1 million cash payout in year one, whereas Project B offers a $1
million cash payout in year five. The payouts are not equal. The $1 million payout received after
one year has a higher present value than the $1 million payout after five years.

Long-term finance
can be defined as any financial instrument with maturity exceeding one year (such as bank loans,
bonds, leasing and other forms of debt finance), and public and private equity instruments.
Maturity refers to the length of time between origination of a financial claim (loan, bond, or other
financial instrument) and the final payment date, at which point the remaining principal and
interest are due to be paid. Equity, which has no final repayment date of a principal, can be seen as
an instrument with nonfinite maturity. The one year cut-off maturity corresponds to the definition
of fixed investment in national accounts. The Group of 20, by comparison, uses a maturity of five
years more adapted to investment horizons in financial markets (G-20 2013). Depending on data
availability and the focus, the report uses one of these two definitions to characterize the extent of
long-term finance. Moreover, because there is no consensus on the precise definition of long-term
finance, wherever possible, rather than use a specific definition of long-term finance, the report
provides granular data showing as many maturity buckets and comparisons as possible.

The primary instruments of financing are those whose pricing is directly affected by the market. Primary
instruments used for long-term financing include shares, debentures, bonds, and convertibles.

 Shares are units of ownership of a company. Holder of each share is called a shareholder, and each
shareholder is an owner of the corporation. Shares have a face value and a market value at which
they are traded publicly.
 Debentures are instruments of long-term debt issued by the company in the form of units. The
purchaser of debentures actually lend the money to the company and receive fixed periodic
interest.
 Bonds are also long-term debt instruments that pay fixed periodic interest to bond-holders. They
have a maturity period and can also be called before the maturity period, after which the
bondholders get their money back. The face value is the maturity value.
 Convertibles are a hybrid instrument as they have the features of both debt and equity shares. They
are basically bonds or preference shares that can be converted into a specific number of equity
shares at an agreed-upon price when they mature.

Importance of long-term finance

Extending the maturity structure of finance is often considered to be at the core of sustainable
financial development. Long-term finance contributes to faster growth, greater welfare, shared
prosperity, and enduring stability in two important ways: by reducing rollover risks for borrowers,
thereby lengthening the horizon of investments and improving performance, and by increasing the
availability of long-term financial instruments, thereby allowing households and firms to address
their life-cycle challenges (Demirgüç-Kunt and Maksimovic 1998, 1999; Caprio and Demirgüç-Kunt
1998; de la Torre, Ize, and Schmukler, 2012).

The term of the financing reflects the risk-sharing contract between providers and users of
finance. Long-term finance shifts risk to the providers because they have to bear the fluctuations in
the probability of default and other changing conditions in financial markets, such as interest rate
risk. Often providers require a premium as part of the compensation for the higher risk this type of
financing implies.  On the other hand, short-term finance shifts risk to users as it forces them to
roll over financing constantly.

The amount of long-term finance that is optimal for the economy as a whole is not clear.   In well-
functioning markets, borrowers and lenders will enter short- or long-term contracts depending on
their financing needs and how they agree to share the risk involved at different maturities. What
matters for the economic efficiency of the financing arrangements is that borrowers have access to
financial instruments that allow them to match the time horizons of their investment opportunities
with the time horizons of their financing, conditional on economic risks and volatility in the
economy (for which long-term financing may provide a partial insurance mechanism). At the same
time, savers would need to be compensated for the extra risk they might take.

Where it exists, the bulk of long-term finance is provided by banks; use of equity, including private
equity, is limited for firms of all sizes. As financial systems develop, the maturity of external finance
also lengthens. Banks’ share of lending that is long term increases with a country’s income and the
development of banking, capital markets, and institutional investors. Long-term finance for firms
through issuances of equity, bonds, and syndicated loans has also grown significantly over the past
decades, but only very few large firms access long-term finance through equity or bond markets.
The promotion of nonbank intermediaries (pension funds and mutual funds) in developing
countries such as Chile has not always guaranteed an increased demand for long-term assets
(Opazo, Raddatz and Schmukler, 2015; Stewart, 2014).

Definition of Cost of Capital

Cost of Capital is the rate of return the firm expects to earn from its investment in order to increase the
value of the firm in the market place. In other words, it is the rate of return that the suppliers of capital
require as compensation for their contribution of capital. 

Sources of Capital
Businesses can raise capital either through debt, equity, or a combination of both.

Debt

Debt is an amount of money borrowed from one party on the condition that the amount borrowed
(principal) is repaid later. The providers of debt capital expect to be compensated through periodic or
scheduled interest payments and the repayment of principal. Debt is considered a cheaper form of
financing than equity.

Equity

Equity financing involves firms raising capital by selling shares or an ownership stake in their company.
There are many sources of equity financing, such as the personal capital of the business founders, equity
capital markets, institutional investors, corporate investors, angel investors, venture capital firms,
crowdfunding platforms, etc.

The two advantages of raising capital through equity financing are: first, companies do not have an
obligation to repay shareholders the money raised from investors, and second, there are no fixed costs
from having raised equity, whereas there is the cost of interest expense related to debt.

Capital Structure
The capital structure is the proportion of debt and equity (i.e. mix of capital) used by a business to finance
its overall operations, capital expenditure, investments and other acquisitions. Often, the optimal capital
structure of a company is defined as the mix of capital that results in the lowest weighted average of capital
(WACC).

Startup/high-growth companies are financed mostly with equity, as they are too risky for banks to lend to.
On the other hand, mature companies tend to have a higher proportion of debt in their capital structure, as
they have proven their ability to generate cash flows with which they can pay off the debt.

The Cost of Capital

The cost of capital is based on the source of capital. The cost of equity refers to the required return from
shareholders, and the cost of debt refers to the required return from debtholders. Most companies use a
mix of debt and equity capital for operating and growing their business. In such cases, the cost of capital is
calculated as the weighted average cost of debt and equity, known as the weighted average cost of capital
(WACC).

The WACC has multiple applications, including in discounted cash flow (DCF) analysis. The valuation of a
business using the DCF method is very sensitive to the WACC. A higher WACC would mean a lower valuation
and vice versa.

In investment analysis, WACC is used in conjunction with another metric, return on invested capital (ROIC).
ROIC is a useful measure of the operational profitability and the efficiency of a business.

If the ROIC of a company is higher than its WACC, this suggests that the company is making returns to
investors in excess of its costs, and creating value. It is an indicator of the company investing in value-
creating projects i.e. the company is healthy and growing. Investors may want to invest in such a company.
On the other hand, if the ROIC is lower than the WACC, it suggests that the company is eroding value and it
may be better for investors to invest somewhere else.
Example: Cost of Capital
Let’s calculate a WACC and compare it to the ROIC of a business. Such a comparison helps to determine if
an investor should invest in a company or not.

The WACC is calculated as follows:

WACC = ((Cost of debt * Proportion of debt) + (Cost of equity * Proportion of equity))

The proportion of debt is the percentage of debt in the total capital. It is calculated by dividing debt by total
capital. The proportion of equity is calculated similarly.

What is EBIT-EPS Analysis?

The EBIT-EPS analysis gives the best ratio of debttoequity which the businesses can use to find an optimum
balance in their debt and equity financing. The analysis shows the effect of the balance sheet’s structure on
the company’s earnings.

Basics of EBIT-EPS Approach

It is important to understand what EBIT and EPS mean to understand what the analysis is meant to be.
 EBIT refers to earnings before interest and tax. The metric makes interest and taxes irrelevant.
Therefore, an investor can understand how the company is performing out of the balance sheet’s
composition which essentially makes interest and taxes the focal point of consideration. In terms of
EBIT, there is no difference if a company has huge debt or no debt at all. The repercussions will be
the same.
 EPS or earnings per share is the metric that shows a company’s earnings including interests and
taxes. It is an important metric because it shows the earnings on a per-share basis which helps the
investors understand how a company performs on an overall basis. If a company’s overall profit
soars high but the payment to investors is low, it is a bad gesture for investors owning a fixed
number of shares. EPS shows this dynamic rule simply and in a clear manner.
The ratio between these two metrics can show how the bottom line results, the company’s EPS, are related
to its performance irrespective of its capital structure, the EBIT.

Limitations of EBIT-EPS Analysis

Although EBIT-EPS analysis is a good way to check the earning sensitivity of a company, it has certain
limitations too.
No Consideration of Risk 
The EBIT-EPS analysis does not consider the risk associated with a business project. It simply shows
whether the earnings are enough for a corporation. It is not needed in case of a profit larger than returns,
but it can be hurting if the opposite situation is there. When the profits are low, but the interest is high,
then businesses may be in turmoil.
Contradictory Results
When new equity shares are not considered in a different alternative financial plan, the results arising out
of this can get erroneous. The comparison of plans also becomes difficult when the number of alternatives
increases.
Over-capitalization of Funds
This analysis ignores the over-capitalization of the funds. Beyond a certain point, additional capital should
not be employed to generate a return in excess of the payments that should be made for its use. The
analysis does not address such cases.

Operating & Financial Leverage

Operating leverage and financial leverage are two different metrics used to determine the financial health
of a company.

Operating leverage is an indication of how a company's costs are structured. The metric is used to
determine a company's breakeven point, which is when revenue from sales covers both the fixed and
variable costs of production. Financial leverage refers to the amount of debt used to finance the operations
of a company.

KEY TAKEAWAYS

 Operating leverage and financial leverage both tell you different things about a company's financial
health.
 Operating leverage is an indication of how a company's costs are structured and also is used to
determine its breakeven point.
 Financial leverage refers to the amount of debt used to finance the operations of a company.

Operating Leverage and Fixed Costs

Operating leverage measures the extent to which a company or specific project requires some aggregate of
both fixed and variable costs. Fixed costs are those costs or expenses that do not fluctuate regardless of the
number of sales generated by a company. Some examples of fixed costs include:

 salaries
 rent
 utilities
 interest expense
 depreciation

Operating Leverage and Variable Costs

Variable costs are expenses that vary in direct relationship to a company’s production. Variable costs rise
when production increases and fall when production decreases. For example, inventory and raw materials
are variable costs while salaries for the corporate office would be a fixed cost.

Operating leverage can help companies determine what their breakeven point is for profitability. In other
words, the point where the profit generated from sales covers both the fixed costs as well as the variable
costs.
 A manufacturing company might have high operating leverage because it must maintain the plant and
equipment needed for operations. On the other hand, a consulting company has fewer fixed assets such as
equipment and would, therefore, have low operating leverage.

Using a higher degree of operating leverage can increase the risk of cash flow problems resulting from
errors in forecasts of future sales.

Financial Leverage Explained

Financial leverage is a metric that shows how much a company uses debt to finance its operations. A
company with a high level of leverage needs profits and revenue that are high enough to compensate for
the additional debt it shows on its balance sheet.

Investors look at a company's leverage because it is an indicator of the solvency of the company. Also, debt
can help magnify earnings and earnings per share. However, there is a cost associated with leverage in the
form of interest expense.

When a company's revenues and profits are on the rise, leverage works well for a company and investors.
However, when revenues or profits are pressured or falling, the debt and interest expense must still be paid
and can become problematic if there is not enough revenue to meet debt and operational obligations.

Operating Leverage vs. Financial leverage (Comparison Table)

Basis for Comparison between

Financial Leverage vs. Operating Operating Leverage Financial Leverage
Leverage

Operating leverage can be defined as a Financial leverage can be defined as a

1.    Meaning firm’s ability to use fixed costs to firm’s ability to use capital structure to
generate more returns. earn better returns and to reduce taxes.

2.    What it’s all about? It’s about the capital structure of the firm.
It’s about the fixed costs of the firm.

Operating leverage measures the Financial leverage measures the financial

3.    Measurement
operating risk of a business. risk of a business.

Operating leverage can be calculated

Financial leverage can be calculated when
4.    Calculation when we divide contribution by EBIT of
we divide EBIT by EBT of the firm.
the firm.

5.    Impact When the degree of operating leverage When the degree of financial leverage is
is higher, it depicts more operating risk higher, it depicts more financial risk for
 for the firm and vice versa. the firm and vice versa.

The degree of operating leverage is Financial leverage has a direct relationship

6.    In relation with
usually higher than Break Even Point. with the liability side of the balance sheet.

7.    How much is it preferred? The preference is lower. The preference is much higher.

Problems:

Attached separately

UNIT -3
Investment & Capital Structure decisions
Investment decision refers to selecting and acquiring the long-term and short-term assets in which funds
will be invested by the business.
(i) Cash flow of the project: Capital budgeting considers factors associated with nature of the industry,
taxation, policy and regulatory structures, political and social stability, etc., to make decisions related to
expected-cash flows for huge investments.
(ii) Returns from investment: The selection of projects requiring investments are identified based on
possible benefits or returns a business will obtain by preparing appraisal reports. These reports determine
the amount of investments required and the availability of possible returns against the required amount.
(iii) Trade-off between profitability and liquidity: If a business should have continuous liquidity or enough
working capital for continuing operations that generate sales and cater to current obligations. Lack of
working capital for current assets would make the business illiquid and lead to losses.

 An investment decision is a well-planned action that allocates financial resources to obtain the highest
possible return. The decision is made based on investment objectives, risk appetites, and the nature of the
investor, i.e., whether they are an individual or a firm.
 Investments are primarily classified into short-term and long-term. Further, they are categorized into a
strategic investment, capital expenditure, inventory, modernization, expansion, replacement, or new
venture investments.
 The investment process involves the following steps: formulating investment objectives, ascertaining the
risk profile, allocating assets, and monitoring performance.
 Process

Investing in an asset, security, or project requires a lot of patience; ideally, the decision-making process
should be analytical. Following is a five-step process decision-making process that guides investors:

1. Analyze Financial Position: For financial management, one has to understand the company or individual’s
current financial condition.
2. Define Investment Objective: Then, investors must set up an investment objective—whether to invest
short-term or long-term. They should also be aware of their risk appetite (level of risk they desire to take).
3. Asset Allocation: Based on the objective, investors must allocate assets into stocks, debentures,
bonds, real estate, options, and commodities.
4. Select Investment Products: After narrowing down on a particular asset class, investors must further select
a particular asset or security. Alternatively, this could be a basket of assets that fit the requirements.
5. Monitor and Due Diligence: Portfolio managers keep an eye on the performance of each investment and
monitor the returns. In case of poor performance, they must take prompt action.

Factors Affecting Investment Decision

An investment is a planned decision, and some of the factors that are responsible for these decisions are as
follows:

 Investment Objective: The purpose behind an investment determines the short-term or long-term fund
allocation. It is the starting point of the decision-making process.
 Return on Investment: Managers prioritize positive returns—they try to employ limited funds in a
profitable asset or security.
 Return Frequency: The number of periodic returns an investment offer is crucial. Financial management is
based on financial needs; investors choose between investments that yield monthly, quarterly, semi-
annual, or annual returns.
 Risk Involved: An investment may possess high, medium, or low risk, and the risk appetite of every investor
and company is different. Therefore, every investment requires a risk analysis.
 Maturity Period or Investment Tenure: Investments pay off when funds are blocked for a certain period.
Thus, investor decisions are influenced by the maturity period and payback period.
 Tax Benefit: Tax liability associated with a particular asset or security is another crucial deciding factor.
Investors tend to avoid investment opportunities that are taxed heavily.
 Safety: An asset or security offered by a company that adheres to regulatory frameworks and has a
transparent financial disclosure is considered safe. Government-backed assets are considered the most
secure.
 Volatility: Market fluctuations significantly affect investment returns and, therefore, cannot be overlooked.
 Liquidity: Investors are often worried about their emergency funds—the provision to withdraw money
before maturity. Hence, investors look at the degree of liquidity offered by a particular asset or security;
they specifically consider withdrawal restrictions and penalties.
 Inflation Rate: In financial management, investors look for investment opportunities where returns surpass
the nation’s inflation rate.

Capital Structure Decision

Capital structure decision is concerned with the sources of long term funds such as debt and equity capital.
Capital structure is defined as the mix of various long term sources of funds broadly classified as debt and
equity. Hence capital structure is also referred to as 'Debt Equity Mix' of a company.

Have attached PDF for further readings’-includes net income approach, net opertaing income approach,mm
approach along with problems.

Capital Budgeting Basics

Capital investments are long-term investments in which the assets involved have useful lives of
multiple years. For example, constructing a new production facility and investing in machinery and
equipment are capital investments. Capital budgeting is a method of estimating the financial
viability of a capital investment over the life of the investment.
Unlike some other types of investment analysis, capital budgeting focuses on cash flows rather
than profits. Capital budgeting involves identifying the cash in flows and cash out flows rather than
accounting revenues and expenses flowing from the investment. For example, non-expense items
like debt principal payments are included in capital budgeting because they are cash flow
transactions. Conversely, non-cash expenses like depreciation are not included in capital budgeting
(except to the extent they impact tax calculations for “after tax” cash flows) because they are not
cash transactions. Instead, the cash flow expenditures associated with the actual purchase and/or
financing of a capital asset are included in the analysis.
Over the long run, capital budgeting and conventional profit-and-loss analysis will lend to similar
net values. However, capital budgeting methods include adjustments for the time value of money
(discussed in AgDM File C5-96, Understanding the Time Value of Money). Capital investments
create cash flows that are often spread over several years into the future. To accurately assess the
value of a capital investment, the timing of the future cash flows are taken into account and
converted to the current time period (present value).
Below are the steps involved in capital budgeting.

1. Identify long-term goals of the individual or business.

2. Identify potential investment proposals for meeting the long-term goals identified in Step
1.
3. Estimate and analyze the relevant cash flows of the investment proposal identified in Step
2.
4. Determine financial feasibility of each of the investment proposals in Step 3 by using the
capital budgeting methods outlined below.
5. Choose the projects to implement from among the investment proposals outlined in Step
4.
6. Implement the projects chosen in Step 5.
7. Monitor the projects implemented in Step 6 as to how they meet the capital budgeting
projections and make adjustments where needed.

There are several capital budgeting analysis methods that can be used to determine the economic
feasibility of a capital investment. They include the Payback Period, Discounted Payment Period,
Net Present Value, Profitability Index, Internal Rate of Return, and Modified Internal Rate of
Return.

Payback Period
A simple method of capital budgeting is the Payback Period. It represents the amount of time
required for the cash flows generated by the investment to repay the cost of the original
investment. For example, assume that an investment of $600 will generate annual cash flows of
$100 per year for 10 years. The number of years required to recoup the investment is six years.
The Payback Period analysis provides insight into the liquidity of the investment (length of time
until the investment funds are recovered). However, the analysis does not include cash flow
payments beyond the payback period. In the example above, the investment generates cash flows
for an additional four years beyond the six year payback period. The value of these four cash flows
is not included in the analysis. Suppose the investment generates cash flow payments for 15 years
rather than 10. The return from the investment is much greater because there are five more years
of cash flows. However, the analysis does not take this into account and the Payback Period is still
six years.
Three capital projects are outlined in Table 1. Each requires an initial $1,000 investment. But each
project varies in the size and number of cash flows generated. Project C has the shortest Payback
Period of two years. Project B has the next shortest Payback (almost three years) and Project A has
the longest (four years). However, Project A generates the most return ($2,500) of the three
projects. Project C, with the shortest Payback Period, generates the least return ($1,500). Thus, the
Payback Period method is most useful for comparing projects with nearly equal lives.

Discounted Payback Period

The Payback Period analysis does not take into account the time value of money. To correct for
this deficiency, the Discounted Payback Period method was created. As shown in Figure 1, this
method discounts the future cash flows back to their present value so the investment and the
stream of cash flows can be compared at the same time period. Each of the cash flows is
discounted over the number of years from the time of the cash flow payment to the time of the
original investment. For example, the first cash flow is discounted over one year and the fifth cash
flow is discounted over five years.
To properly discount a series of cash flows, a discount rate must be established. The discount rate
for a company may represent its cost of capital or the potential rate of return from an alternative
investment.

The discounted cash flows for Project B in Table 1 are shown in Table 2. Assuming a 10 percent
discount rate, the $350 cash flow in year one has a present value of $318 (350/1.10) because it is
only discounted over one year. Conversely, the $350 cash flow in year five has a present value of
only $217 (350/1.10/1.10/1.10/1.10/1.10) because it is discounted over five years. The nominal
value of the stream of five years of cash flows is $1,750 but the present value of the cash flow
stream is only $1,326.

In Table 3, a Discounted Payback Period analysis is shown using the same three projects outlined in
Table 1, except the cash flows are now discounted. You can see that it takes longer to repay the
investment when the cash flows are discounted. For example, it takes 3.54 years rather than 2.86
years (.68 of a year longer) to repay the investment in Project B. Discounting has an even larger
impact for investments with a long stream of relatively small cash flows like Project A. It takes an
additional 1.37 years to repay Project A when the cash flows are discounted. It should be noted
that although Project A has the longest Discounted Payback Period, it also has the largest
discounted total return of the three projects ($1,536).
Net Present Value
The Net Present Value (NPV) method involves discounting a stream of future cash flows back to
present value. The cash flows can be either positive (cash received) or negative (cash paid). The
present value of the initial investment is its full face value because the investment is made at the
beginning of the time period. The ending cash flow includes any monetary sale value or remaining
value of the capital asset at the end of the analysis period, if any. The cash inflows and outflows
over the life of the investment are then discounted back to their present values.
The Net Present Value is the amount by which the present value of the cash inflows exceeds the
present value of the cash outflows. Conversely, if the present value of the cash outflows exceeds
the present value of the cash inflows, the Net Present Value is negative. From a different
perspective, a positive (negative) Net Present Value means that the rate of return on the capital
investment is greater (less) than the discount rate used in the analysis.
The discount rate is an integral part of the analysis. The discount rate can represent several
different approaches for the company. For example, it may represent the cost of capital such as
the cost of borrowing money to finance the capital expenditure or the cost of using the company’s
internal funds. It may represent the rate of return needed to attract outside investment for the
capital project. Or it may represent the rate of return the company can receive from an alternative
investment. The discount rate may also reflect the Threshold Rate of Return (TRR) required by the
company before it will move forward with a capital investment. The Threshold Rate of Return may
represent an acceptable rate of return above the cost of capital to entice the company to make the
investment. It may reflect the risk level of the capital investment. Or it may reflect other factors
important to the company. Choosing the proper discount rate is important for an accurate Net
Present Value analysis.
A simple example using two discount rates is shown in Table 4. If the five percent discount rate is
used, the Net Present Value is positive and the project is accepted. If the 10 percent rate is used,
the Net Present Value is negative and the project is rejected.

Profitability Index
Another measure to determine the acceptability of a capital investment is the Profitability Index
(PI). The Profitability Index is computed by dividing the present value of cash inflows of the capital
investment by the present value of cash outflows of the capital investment. If the Profitability
Index is greater than one, the capital investment is accepted. If it is less than one, the capital
investment is rejected.

A Profitability Index analysis is shown with two discount rates (5 and 10 percent) in Table 5. The
Profitability Index is positive (greater than one) with the five percent discount rate. The
Profitability Index is negative (less than one) with 10 percent discount rate. If the Profitability Index
is greater than one, the investment is accepted. If it is less than one, it is rejected.
The Profitability Index is a variation of the Net Present Value approach to comparing projects.
Although the Profitability Index does not stipulate the amount of cash return from a capital
investment, it does provide the cash return per dollar invested. The index can be thought of as the
discounted cash inflow per dollar of discounted cash outflow. For example, the index at the five
percent discount rate returns $1.10 of discounted cash inflow per dollar of discounted cash
outflow. The index at the 10 percent discount rate returns only 94.5 cents of discounted cash
inflow per dollar of discounted cash outflow. Because it is an analysis of the ratio of cash inflow per
unit of cash outflow, the Profitability Index is useful for comparing two or more projects which
have very different magnitudes of cash flows.
Internal Rate of Return
Another method of analyzing capital investments is the Internal Rate of Return (IRR). The Internal
Rate of Return is the rate of return from the capital investment. In other words, the Internal Rate
of Return is the discount rate that makes the Net Present Value equal to zero. As with the Net
Present Value analysis, the Internal Rate of Return can be compared to a Threshold Rate of Return
to determine if the investment should move forward.
An Internal Rate of Return analysis for two investments is shown in Table 6. The Internal Rate of
Return of Project A is 7.9 percent. If the Internal Rate of Return (e.g. 7.9 percent) is above the
Threshold Rate of Return (e.g. 7 percent), the capital investment is accepted. If the Internal Rate of
Return (e.g. 7.9 percent) is below the Threshold Rate of Return (e.g. 9 percent), the capital
investment is rejected. However, if the company is choosing between projects, Project B will be
chosen because it has a higher Internal Rate of Return.
The Internal Rate of Return analysis is commonly used in business analysis. However, a precaution
should be noted. It involves the cash surpluses/deficits during the analysis period. As long as the
initial investment is a cash outflow and the trailing cash flows are all inflows, the Internal Rate of
Return method is accurate. However, if the trailing cash flows fluctuate between positive and
negative cash flows, the possibility exists that multiple Internal Rates of Return may be computed.

Modified Internal Rate of Return

Another problem with the Internal Rate of Return method is that it assumes that cash flows during
the analysis period will be reinvested at the Internal Rate of Return. If the Internal Rate of Return is
substantially different than the rate at which the cash flows can be reinvested, the results will be
skewed.
To understand this we must further investigate the process by which a series of cash flows are
discounted to their present value. As an example, the third year cash flow in Figure 2 is shown
discounted to the current time period.

However, to accurately discount a future cash flow, it must be analyzed over the entire five year
time period. So, as shown in Figure 3, the cash flow received in year three must be compounded
for two years to a future value for the fifth year and then discounted over the entire five-year
period back to the present time. If the interest rate stays the same over the compounding and
discounting years, the compounding from year three to year five is offset by the discounting from
year five to year three. So, only the discounting from year three to the present time is relevant for
the analysis (Figure 2).
For the Discounted Payback Period and the Net Present Value analysis, the discount rate (the rate
at which debt can be repaid or the potential rate of return received from an alternative
investment) is used for both the compounding and discounting analysis. So only the discounting
from the time of the cash flow to the present time is relevant.
However, the Internal Rate of Return analysis involves compounding the cash flows at the Internal
Rate of Return. If the Internal Rate of Return is high, the company may not be able to reinvest the
cash flows at this level. Conversely, if the Internal Rate of Return is low, the company may be able
to reinvest at a higher rate of return. So, a Reinvestment Rate of Return (RRR) needs to be used in
the compounding period (the rate at which debt can be repaid or the rate of return received from
an alternative investment). The Internal Rate of Return is then the rate used to discount the
compounded value in year five back to the present time.

The Modified Internal Rate of Return for two $10,000 investments with annual cash flows of
$2,500 and $3,000 is shown in Table 7. The Internal Rates of Return for the projects are 7.9 and
15.2 percent, respectively. However, if we modify the analysis where cash flows are reinvested at 7
percent, the Modified Internal Rates of Return of the two projects drop to 7.5 percent and 11.5
percent, respectively. If we further modify the analysis where cash flows are reinvested at 9
percent, the first Modified Internal Rate of Return rises to 8.4 percent and the second only drops
to 12.4 percent. If the Reinvestment Rate of Return is lower than the Internal Rate of Return, the
Modified Internal Rate of Return will be lower than the Internal Rate of Return. The opposite
occurs if the Reinvestment Rate of Return is higher than the Internal Rate of Return. In this case
the Modified Internal Rate of Return will be higher than the Internal Rate of Return.

What Is a Rate of Return (RoR)?

A rate of return (RoR) is the net gain or loss of an investment over a specified time period, expressed as a
percentage of the investment’s initial cost.1 When calculating the rate of return, you are determining the
percentage change from the beginning of the period until the end.

 The rate of return (RoR) is used to measure the profit or loss of an investment over time.
 The metric of RoR can be used on a variety of assets, from stocks to bonds, real estate, and art.
 The effects of inflation are not taken into consideration in the simple rate of return calculation but
are in the real rate of return calculation.
 The internal rate of return (IRR) takes into consideration the time value of money.

Rate of return=[Initial value(Current value−Initial value)]×100
 UNIT -5
What Is a Dividend Policy?

A dividend policy is the policy a company uses to structure its dividend payout to shareholders. Some
researchers suggest the dividend policy is irrelevant, in theory, because investors can sell a portion of their
shares or portfolio if they need funds. This is the dividend irrelevance theory , which infers that dividend
payouts minimally affect a stock's price .

 Dividends are often part of a company's strategy. However, they are under no obligation to repay
shareholders using dividends.
 Stable, constant, and residual are the three types of dividend policy.
 Even though investors know companies are not required to pay dividends, many consider it a
bellwether of that specific company's financial health.

How a Dividend Policy Works

Despite the suggestion that the dividend policy is irrelevant, it is income for shareholders. Company
leaders are often the largest shareholders and have the most to gain from a generous dividend policy.

Most companies view a dividend policy as an integral part of their corporate strategy. Management must
decide on the dividend amount, timing, and various other factors that influence dividend payments. There
are three types of dividend policies—a stable dividend policy, a constant dividend policy, and a  residual
dividend policy.

Types of Dividend Policies

Stable Dividend Policy

A stable dividend policy is the easiest and most commonly used. The goal of the policy is a steady and
predictable dividend payout each year, which is what most investors seek. Whether earnings are up or
down, investors receive a dividend.

The goal is to align the dividend policy with the long-term growth of the company rather than with
quarterly earnings volatility. This approach gives the shareholder more certainty concerning the amount
and timing of the dividend.

Constant Dividend Policy

The primary drawback of the stable dividend policy is that investors may not see a dividend increase in
boom years. Under the constant dividend policy, a company pays a percentage of its earnings as dividends
every year. In this way, investors experience the full volatility of company earnings.

If earnings are up, investors get a larger dividend; if earnings are down, investors may not receive a
dividend. The primary drawback to the method is the volatility of earnings and dividends. It is difficult to
plan financially when dividend income is highly volatile.

Residual Dividend Policy

Residual dividend policy is also highly volatile, but some investors see it as the only acceptable dividend
policy. With a residual dividend policy, the company pays out what dividends remain after the company
has paid for capital expenditures (CAPEX) and working capital.
 This approach is volatile, but it makes the most sense in terms of business operations. Investors do not
want to invest in a company that justifies its increased debt with the need to pay dividends.

Internal financing

 Internal sources of finance refer to generating finance for the company internally from sources like revenue
generated from sales, collection of debtors or loan advances, retained profits to cover the operating
expenses of the company or cash required for investment, growth, and further business.

 Internal sources of finance mean creating internal finance for the company, such as revenue from sales,
collection of debtors or loan advances, retained profits to cover the company’s operating expenses, or cash
required for investment, growth, and more business.
 Examples of internal sources of finance include profit and retained earnings, asset sales, and working capital
reduction.
 Profits are an essential business aspect. A company must have profits to think of internal sources of finance.
 Businesses sell off non-current assets to finance the immediate capital requirement.

There are several types of internal sources of finance a business can raise. They can be raised by the
business itself or by its owners. There are three common types of internal sources of finance:

 Owner's funds
 Retained profits
 Selling unwanted assets

Owner's funds advantages and disadvantages

Advantages Disadvantages

 cheap
 limited amount of funds
 quick
 not suitable for long-term investment
 no interest

Retained profit advantages and disadvantages

Advantages Disadvantages

 Increased capital of the company

 Decreased dividends
 No interest payments
 Decreased earnings
 No third party involved
 Advantages and disadvantages of internal sources of finance

Using internal sources of finance has benefits (see Figure 2) and limitations. Let's take a closer look.

Advantages Disadvantages

 Low cost
 Maintaining ownership  Limited amount of finance
 Immediate availability  Decreased earnings
 No legal obligations  Reduced liquidity
 No influence of third parties

What is Share Valuation? 

Share valuation is a technique of determining the actual worth of a company using quantitative techniques.
Analysts use the company’s financial information, such as current earnings and cashflows, assets, capital
structure, and future cash flows, to determine the company’s current value. 

When is the Valuation of Shares Required? 

The following are the circumstances for Share valuation:

 The owners want to know its true value when selling the company.
 Mergers, acquisitions, or takeovers require share valuation. 
 Banks ask for a valuation to give a loan against the shares the promoters hold.
 During the conversion of preference shares into equity shares.
 Share valuation is necessary during a tax audit.
 In case the company faces litigation, it is important to consider the company’s share valuation.
 When the company is implementing Employee Stock Option Plan (ESOP).
 Analysts use share valuation methods to determine intrinsic value to make investment decisions.

Types of Stock Valuation 

Analysts use two types of stock valuation to determine the intrinsic value, absolute and relative.

Absolute valuation
Absolute valuation uses the company’s financials and fundamentals to determine the intrinsic value of the
company. It uses past financial data such as cashflows, growth, and dividend to determine future cash flows
and values them based on the analysis. Absolute valuation uses the financial data of a single company to
determine the intrinsic value. It doesn’t consider the financials of other companies. Valuation techniques
such as discounted cash flow (DCF), dividend discount model, and asset-based model come under absolute
valuation techniques.

Relative valuation
Relative valuation compares the company’s valuation with other similar companies. Analysts compare the
valuation multiples, like price to earnings (P/E) and dividend yield of similar companies, with the company
being valued. Based on the comparison, they then deduce whether the company is overvalued or
undervalued. The company is considered undervalued if its P/E ratio is lower than its peers or the industry.
In contrast, it is overvalued if its P/E ratio is higher than its peers. Some relative valuation techniques
include the P/E ratio, the price-to-book value (P/B), and enterprise multiple (EV/EBITDA).

Methods Used for Valuation of Shares 

Following are some of the popular share valuation methods that analysts and investors use –

Dividend Discount Model

The dividend discount model is a simple and straightforward method of valuing a company. It uses
dividends to determine the company’s intrinsic value. The model uses dividends to value the company
mainly because dividends are the cashflows to shareholders. Hence, finding out the present value of all
future cashflows will give the company’s actual value. 
First, to calculate the company’s fair value using this model, determine whether the company pays a
dividend. Then check if the dividends are stable and predictable. Only then can you use this model for
valuing the company.

Asset-Based Model
The asset-based model values the company’s assets and liabilities. This model considers all assets and
liabilities, including intangible assets and contingent liabilities. First, determine the net asset value to
calculate the share value. Net assets are excess assets over external liabilities. Then subtract preference
capital from the difference and divide by the total number of outstanding shares to get the value per share.
Value per share = (Net Assets – Preference capital) / Number of equity shares
This method is suitable for manufacturing companies with huge asset base. It is also used as a checking tool
to confirm the results of other valuation methods.

Discounted Cash Flow (DCF)

The discounted cash flow method, popularly known as the DCF method, is an income-based valuation
method. It is a popular metric in the industry to value companies of different sizes from different industries.
The DCF method discounts all future cashflows to determine the company’s fair value as of today. This
model suits only companies with positive and predictable free cash flows. 
Predict future cashflows for five or ten years to find out the company’s true value under the DCF method.
Then calculate the terminal value to account for all future cashflows beyond the forecast period. Then
discount all these cashflows to the present day to estimate the company’s true value.

Price to Earnings (P/E) Ratio

The price-to-earnings (P/E) ratio is a popular relative valuation technique to value companies of the same
size and industry. It indicates the amount an investor is willing to pay for every Rs 1 of earnings. A high P/E
ratio indicates the shares are overvalued, and a low P/E ratio means the shares are undervalued.
The ratio also tells how a company’s shares are valued against the industry and its peers. You can easily
compare the P/E ratios of companies in one industry to determine the fair valuation of shares.

Price to Book Value (P/B) Ratio

The price-to-book value (P/B) ratio is a ratio of a company’s market value and book value. A company’s
book value is the value of its assets as of a date after accounting for depreciation, whereas the share’s price
is its market value. You can use the P/B ratio to determine whether the company’s shares are overvalued or
undervalued. Typically, a good P/B ratio means the value is below one. However, it could also mean
something is wrong with the company’s fundamentals. Hence, it is always better to check a company’s
fundamentals when using this ratio for valuation.
 EV/EBITDA
Popularly known as the enterprise multiple, or EV multiple, EV/EBITDA is a measure to estimate the value of
the company using the company’s market value and profitability. EV or enterprise value is the company’s
total value. You can calculate using market capitalization, total debt, and cash and cash equivalents. The
EBITDA is the company’s profit arising out of the sale of goods and services.
EV multiple = EV/EBITDA
The ratio helps you look at the company the same way a potential buyer would look, considering the debt
and profits.EV multiple is different for different industries. High-growth companies tend to have a high EV
multiple, and low-growth companies have a low EV multiple.

Factors Affecting the Valuation of Shares

 Company’s financials: The company’s financials, such as profits, cashflows, dividends, and assets, all affect
the valuation of its shares.
 Market price: The market price of the share plays an important role in the case of relative valuation.
Multiples such as P/E and P/B use the company’s share price, which depends on demand and supply,
performance, and market sentiment.  
 Economic conditions: Economic conditions of a country also affect the valuation of shares of a company.
For example, in a recessionary environment, the interest rates are high, inflation is high, and demand is low.
In such conditions, it affects the company’s short and medium-term performance. The valuation of the
company changes in the short term and medium term . 

What is CAPM?
The Capital Asset Pricing Model (CAPM) is a model that describes the relationship between the  expected
return and risk of investing in a security. It shows that the expected return on a security is equal to the risk-
free return plus a risk premium, which is based on the beta of that security. Below is an illustration of the
CAPM concept.
CAPM Formula and Calculation

CAPM is calculated according to the following formula:

Where:

Ra = Expected return on a security

Rrf = Risk-free rate
Ba = Beta of the security
Rm = Expected return of the market

Note: “Risk Premium” = (Rm – Rrf)

The CAPM formula is used for calculating the expected returns of an asset. It is based on the idea of
systematic risk (otherwise known as non-diversifiable risk) that investors need to be compensated for in the
form of a risk premium. A risk premium is a rate of return greater than the risk-free rate. When investing,
investors desire a higher risk premium when taking on riskier investments.

The CAPM formula is widely used in the finance industry. It is vital in calculating the  weighted average cost
of capital (WACC), as CAPM computes the cost of equity.

WACC is used extensively in financial modeling.  It can be used to find the net present value (NPV) of the
future cash flows of an investment and to further calculate its enterprise value and finally its equity value.

CAPM Example – Calculation of Expected Return

Let’s calculate the expected return on a stock, using the Capital Asset Pricing Model (CAPM) formula.
Suppose the following information about a stock is known:

 It trades on the NYSE and its operations are based in the United States
 Current yield on a U.S. 10-year treasury is 2.5%
 The average excess historical annual return for U.S. stocks is 7.5%
 The beta of the stock is 1.25 (meaning its average return is 1.25x as volatile as the S&P500 over the
last 2 years)
What is the expected return of the security using the CAPM formula?

Let’s break down the answer using the formula from above in the article:

 Expected return = Risk Free Rate + [Beta x Market Return Premium]

 Expected return = 2.5% + [1.25 x 7.5%]
 Expected return = 11.9%

What Is Financial Modelling?

Financial modelling is the process of creating a summary of a company's expenses and earnings in the form
of a spreadsheet that can be used to calculate the impact of a future event or decision.

A financial model has many uses for company executives. Financial analysts most often use it to analyse
and anticipate how a company's stock performance might be affected by future events or executive
decisions.

 Financial modeling is a numerical representation of some or all aspects of a company's

operations.
 Financial models are used to estimate the valuation of a business or to compare
companies to their industry competitors.
 Various models exist that may produce different results. A model is only as good as the
inputs and assumptions that go into it.

Understanding Financial Modeling

Financial modeling is a representation in numbers of a company's operations in the past, present, and the
forecasted future. Such models are intended to be used as decision-making tools. Company executives
might use them to estimate the costs and project the profits of a proposed new project.

Financial analysts use them to explain or anticipate the impact of events on a company's stock, from
internal factors such as a change of strategy or business model to external factors such as a change in
economic policy or regulation.

Financial models are used to estimate the valuation of a business or to compare businesses to their peers
in the industry. They also are used in strategic planning to test various scenarios, calculate the cost of new
projects, decide on budgets, and allocate corporate resources.1

Examples of financial models may include discounted cash flow analysis, sensitivity analysis, or in-depth
appraisal.

What Is Financial Modeling Used For?

A financial model is used for decision-making and financial analysis by people inside and outside of
companies. Some of the reasons a firm might create a financial model include the need to raise capital,
grow the business organically, sell or divest business units, allocate capital, budget, forecast, or value a
business.

What Information Should Be Included in a Financial Model?

To create a useful model that's easy to understand, you should include sections on assumptions and
drivers, an income statement, a balance sheet, a cash flow statement, supporting schedules, valuations,
sensitivity analysis, charts, and graphs.

What Types of Businesses Use Financial Modeling?

Professionals in a variety of businesses rely on financial modeling. Here are just a few examples: Bankers
use it in sales and trading, equity research, and both commercial and investment banking, public
accountants use it for due diligence and valuations, and institutions apply financial models in private
equity, portfolio management, and research.

How Is a Financial Model Validated?

Errors in financial modeling can cause expensive mistakes. For this reason, a financial model may be sent
to an outside party to validate the information it contains. Banks and other financial institutions, project
promoters, corporations seeking funds, equity houses, and others may request model validation to
reassure the end-user that the calculations and assumptions within the model are correct and that the
results produced by the model are reliable.