## Intensive Exam Prep Notes on Financial Management

### 1. Valuation of Shares and Debentures

#### Valuation of Shares
- **Intrinsic Value vs. Market Value**
- Intrinsic Value: Present value of future cash flows.
- Market Value: Current trading price on the stock market.
- **Dividend Discount Model (DDM)**
- Zero Growth Model: \( P_0 = \frac{D}{r} \)
- Constant Growth Model (Gordon Growth Model): \( P_0 = \frac{D_0(1+g)}{r-g} \)
- Multi-Stage Growth Model: Incorporates multiple phases of growth.
- **Price-Earnings Ratio (P/E Ratio)**
- \( P_0 = \text{Earnings per Share (EPS)} \times \text{P/E Ratio} \)
- **Free Cash Flow to Equity (FCFE) Model**
- \( P_0 = \frac{FCFE}{r_e} \)
#### Valuation of Debentures
- **Bond Pricing Formula**
- Present value of coupon payments + Present value of face value.
- \( P = \sum_{t=1}^{n} \frac{C}{(1+r)^t} + \frac{F}{(1+r)^n} \)
- **Yield to Maturity (YTM)**
- The internal rate of return (IRR) for the bond.
- **Current Yield**
- \( \text{Current Yield} = \frac{\text{Annual Coupon Payment}}{\text{Current Market Price}} \)

### 2. The Management of Accounts Receivables

#### Credit Policy
- **Components of Credit Policy**
- Credit Terms: Length of credit period, cash discounts.
- Credit Standards: Minimum criteria for creditworthiness.
- Collection Policy: Procedures for collecting overdue accounts.

#### Credit Evaluation

- **Five Cs of Credit**
- Character, Capacity, Capital, Conditions, Collateral.
- **Credit Analysis Techniques**
- Financial Ratios: Liquidity ratios, solvency ratios.
- Credit Scoring Models.
#### Managing Receivables
- **Aging Schedule**
- Classifies accounts receivable by age.
- **Receivables Turnover Ratio**
- \( \text{Receivables Turnover} = \frac{\text{Net Credit Sales}}{\text{Average Accounts
Receivable}} \)
- **Days Sales Outstanding (DSO)**
- \( DSO = \frac{\text{Accounts Receivable}}{\text{Total Credit Sales}} \times 365 \)
### 3. Capital Budgeting and Cash Flow Principles
#### Cash Flow Estimation
- **Types of Cash Flows**
- Initial Outlay: Initial investment.
- Operating Cash Flows: Incremental cash flows from operations.
- Terminal Cash Flow: Salvage value, net working capital recovery.
#### Principles of Cash Flow Estimation
- **Incremental Cash Flows**
- Only consider additional cash flows.
- **Sunk Costs**
- Ignore sunk costs.
- **Opportunity Costs**
- Include opportunity costs.
- **Working Capital Management**
- Include changes in working capital.
### 4. Capital Budgeting Techniques
#### Net Present Value (NPV)
- **Formula**: \( NPV = \sum_{t=0}^{n} \frac{CF_t}{(1+r)^t} \)
- **Decision Rule**: Accept if NPV > 0.
#### Internal Rate of Return (IRR)
- **Definition**: Discount rate at which NPV = 0.
- **Decision Rule**: Accept if IRR > required rate of return.
#### Payback Period
- **Formula**: Time taken to recover the initial investment.
- **Decision Rule**: Accept if payback period < target period.
#### Discounted Payback Period
- **Formula**: Time taken to recover the initial investment in present value terms.
- **Decision Rule**: Accept if discounted payback period < target period.
#### Profitability Index (PI)
- **Formula**: \( PI = \frac{\text{Present Value of Future Cash Flows}}{\text{Initial Investment}} \)
- **Decision Rule**: Accept if PI > 1.
### 5. Risk Adjustments and Other Refinements to Capital Budgeting
#### Risk Analysis Techniques
- **Sensitivity Analysis**
- Examines how NPV or IRR changes with variations in key assumptions.
- **Scenario Analysis**
- Evaluates different possible outcomes (best case, worst case, most likely case).
- **Monte Carlo Simulation**
- Uses probability distributions to simulate a range of possible outcomes.
#### Adjusting for Risk
- **Risk-Adjusted Discount Rate**
- Higher discount rates for riskier projects.
- **Certainty Equivalent Approach**
- Adjust cash flows for risk instead of the discount rate.
### 6. The Cost of Capital
#### Components of Cost of Capital
- **Cost of Debt (Kd)**
- After-tax cost: \( Kd (1 - T) \)
- **Cost of Equity (Ke)**
- CAPM: \( Ke = R_f + \beta (R_m - R_f) \)
- Dividend Discount Model: \( Ke = \frac{D_1}{P_0} + g \)
- **Cost of Preferred Stock (Kps)**
 - \( Kps = \frac{D}{P_0} \)
#### Weighted Average Cost of Capital (WACC)
- **Formula**: \( WACC = \frac{E}{V}Ke + \frac{D}{V}Kd (1 - T) \)
- Where E is equity, D is debt, V is total value (E + D), T is the tax rate.
### 7. Leverage and Capital Structure
#### Types of Leverage
- **Operating Leverage**
- Degree of Operating Leverage (DOL): Sensitivity of EBIT to changes in sales.
- \( DOL = \frac{\% \Delta \text{EBIT}}{\% \Delta \text{Sales}} \)
- **Financial Leverage**
- Degree of Financial Leverage (DFL): Sensitivity of EPS to changes in EBIT.
- \( DFL = \frac{\% \Delta \text{EPS}}{\% \Delta \text{EBIT}} \)
- **Combined Leverage**
- Degree of Combined Leverage (DCL): Sensitivity of EPS to changes in sales.
- \( DCL = DOL \times DFL \)
#### Capital Structure Theories
- **Net Income (NI) Approach**
- Suggests capital structure affects value of firm.
- **Net Operating Income (NOI) Approach**
- Suggests capital structure is irrelevant.
- **Modigliani and Miller (MM) Proposition**
- Without taxes: Capital structure is irrelevant.
- With taxes: Firm value increases with debt due to tax shield.
### 8. Dividend Policy
#### Types of Dividend Policies
- **Stable Dividend Policy**
- Fixed dividends irrespective of earnings fluctuations.
- **Constant Payout Ratio**
- Fixed percentage of earnings paid as dividends.
- **Residual Dividend Policy**
- Dividends paid from residual or leftover equity after all suitable investment opportunities are
financed.
#### Theories of Dividend Policy
- **Irrelevance Theory (Miller and Modigliani)**
- Dividend policy has no effect on firm value.
- **Bird-in-the-Hand Theory**
- Investors prefer certain dividends over uncertain future capital gains.
- **Tax Preference Theory**
- Investors prefer capital gains over dividends due to tax advantages.
#### Factors Influencing Dividend Policy
- **Legal Constraints**
- Dividends must comply with legal restrictions.
- **Liquidity Constraints**
- Availability of cash.
- **Access to Capital Markets**
- Ability to raise funds externally.
- **Growth Opportunities**
- Need to reinvest earnings for growth.
- **Shareholder Preferences**
- Preferences of the firm’s investors.
--Certainly! Let's break down each chapter and its subtopics extensively to give you a solid
understanding of financial management principles.
## 1. Valuation of Shares and Debentures
### Valuation of Shares
#### a. Intrinsic Value vs. Market Value
- **Intrinsic Value:** The actual worth of a share based on fundamental analysis, including dividends,
future growth, and the company's financial health.
- **Market Value:** The current price of a share in the stock market, influenced by supply and
demand.
#### b. Dividend Discount Model (DDM)
- **Zero Growth Model:** Assumes dividends remain constant. Value of share = Dividend / Required
rate of return.
- **Constant Growth Model (Gordon Growth Model):** Assumes dividends grow at a constant rate.
Value of share = Dividend next year / (Required rate of return - Growth rate).
- **Variable Growth Model:** Dividends grow at different rates during different periods.
#### c. Price/Earnings (P/E) Ratio
- **P/E Ratio:** Price per share / Earnings per share (EPS). It reflects how much investors are willing
to pay for each dollar of earnings.
### Valuation of Debentures
#### a. Present Value of Future Cash Flows
- **Coupon Payments:** Regular interest payments.
- **Face Value:** The amount paid back at maturity.
- **Discount Rate:** The required rate of return, considering the risk and time value of money.
- **Formula:** \( \text{Value of Debenture} = \sum \left( \frac{Coupon}{(1 + r)^t} \right) + \
frac{Face \ Value}{(1 + r)^n} \)
#### b. Yield to Maturity (YTM)
- **YTM:** The internal rate of return (IRR) if the debenture is held until maturity.
## 2. The Management of Accounts Receivables
### a. Credit Policy
- **Credit Standards:** Criteria to determine creditworthiness of customers.
- **Credit Terms:** Conditions under which credit is extended (e.g., 2/10, net 30).
- **Credit Limits:** Maximum credit extended to a customer.
### b. Credit Analysis
- **5 Cs of Credit:** Character, Capacity, Capital, Collateral, and Conditions.
- **Credit Scoring:** Quantitative assessment of credit risk.
### c. Collection Policy
- **Collection Procedures:** Steps to collect overdue accounts.
- **Aging Schedule:** Categorizes receivables based on how long they’ve been outstanding.
### d. Monitoring Receivables
- **Accounts Receivable Turnover Ratio:** Net credit sales / Average accounts receivable.
- **Days Sales Outstanding (DSO):** (Accounts receivable / Total credit sales) * Number of days.

## 3. Capital Budgeting and Cash Flow Principles

### a. Cash Flow Estimation
- **Initial Outlay:** Initial investment required.
- **Operating Cash Flows:** Net cash inflows from operations.
- **Terminal Cash Flows:** Cash inflows at the end of the project, including salvage value.
### b. Time Value of Money
- **Present Value (PV):** Value today of future cash flows discounted at the required rate of return.
- **Future Value (FV):** Value of an investment after a specified time period, considering interest.
## 4. Capital Budgeting Techniques
### a. Net Present Value (NPV)
- **NPV:** Sum of present values of cash inflows and outflows. \( NPV = \sum \left( \frac{Cash \
Inflows}{(1 + r)^t} \right) - Initial \ Investment \)
- **Decision Rule:** Accept if NPV > 0.
### b. Internal Rate of Return (IRR)
- **IRR:** Discount rate that makes NPV = 0.
- **Decision Rule:** Accept if IRR > required rate of return.
### c. Payback Period
- **Payback Period:** Time required to recover initial investment.
- **Decision Rule:** Accept if payback period < maximum acceptable period.
### d. Profitability Index (PI)
- **PI:** PV of future cash flows / Initial investment.
- **Decision Rule:** Accept if PI > 1.
## 5. Risk Adjustments and Other Refinements to Capital Budgeting
### a. Risk-Adjusted Discount Rate
- **RADR:** Adjust discount rate upward for riskier projects.
### b. Sensitivity Analysis
- **Sensitivity Analysis:** Evaluates how changes in key assumptions affect project outcomes.
### c. Scenario Analysis
- **Scenario Analysis:** Examines different possible outcomes (best, worst, most likely).
### d. Simulation
- **Monte Carlo Simulation:** Uses random variables to model uncertainty in project outcomes.
## 6. The Cost of Capital
### a. Components of Cost of Capital
- **Cost of Debt (Kd):** After-tax cost of borrowing.
- **Cost of Equity (Ke):** Required return by equity investors.
- **Cost of Preferred Stock (Kp):** Required return by preferred stock investors.
### b. Weighted Average Cost of Capital (WACC)
- **WACC Formula:** \( WACC = \left( \frac{E}{V} \times Ke \right) + \left( \frac{D}{V} \times
Kd \times (1 - Tax \ Rate) \right) + \left( \frac{P}{V} \times Kp \right) \)
 where E = market value of equity, D = market value of debt, P = market value of preferred stock, V =
E + D + P.
## 7. Leverage and Capital Structure
### a. Types of Leverage
- **Operating Leverage:** Degree to which fixed costs are used in production.
- **Financial Leverage:** Degree to which debt is used in the capital structure.
- **Combined Leverage:** Combined effect of operating and financial leverage.
### b. Capital Structure Theories
- **Trade-Off Theory:** Balances the tax benefits of debt with bankruptcy costs.
- **Pecking Order Theory:** Firms prefer internal financing, then debt, then equity.
- **Modigliani-Miller Theorem:** In a perfect market, capital structure is irrelevant.
## 8. Dividend Policy
### a. Types of Dividend Policies
- **Stable Dividend Policy:** Regular dividends with gradual increases.
- **Constant Payout Ratio:** Fixed percentage of earnings paid as dividends.
- **Residual Dividend Policy:** Dividends based on earnings left after funding optimal investment
opportunities.
### b. Factors Influencing Dividend Policy
- **Earnings Stability:** Stable earnings lead to higher dividends.
- **Growth Opportunities:** Firms with high growth opportunities might retain earnings.
- **Cash Flow Considerations:** Availability of cash affects dividend payments.
- **Tax Considerations:** Tax rates on dividends vs. capital gains can influence policy.
### c. Dividend Theories
- **Dividend Irrelevance Theory (MM):** In perfect markets, dividend policy does not affect firm
value.
- **Bird-in-the-Hand Theory:** Investors prefer certain dividends over uncertain future gains.
- **Tax Preference Theory:** Investors prefer lower dividends due to tax advantages on capital gains.