Financial Management: Decisions, Costs and Leverage
What this domain tests
Financial Management in Paper 6 checks whether you can compute and then interpret a firm's four core decisions - investment, financing, dividend and working capital. Expect 5–10 mark computational items plus short theory on objectives and policy, where the marks sit as much in the reasoning as in the final figure.
Core rules and concepts
- Objective: maximise shareholder wealth (market price per share), not accounting profit - profit ignores timing, risk and cash flow.
- Cost of capital: use after-tax component costs and market-value weights. Kd = I(1 − t)/net proceeds; Kp = preference dividend/net proceeds; Ke = D1/P0 + g or CAPM. WACC = Σ(Wi × Ki).
- Leverage: OL = Contribution/EBIT; FL = EBIT/(EBIT − Interest − Dp/(1 − t)); CL = OL × FL. High FL raises financial risk only; OL drives business risk.
- Capital budgeting: accept if NPV > 0, IRR > k, PI > 1, discounted payback within cut-off. IRR and NPV can rank mutually exclusive projects differently because of scale and timing.
- Working capital: build the estimate from the operating cycle; distinguish gross from net working capital.
- Dividend: Walter and Gordon link payout to Ke and r; M-M gives irrelevance under perfect markets.
Worked example
Capital: equity ₹60 lakh (Ke 15%), debt ₹30 lakh at 10% pre-tax, preference ₹10 lakh (Kp 12%), tax 30%. After-tax Kd = 10% × 0.7 = 7%. WACC = (0.6 × 15) + (0.3 × 7) + (0.1 × 12) = 9.0 + 2.1 + 1.2 = 12.3%. Reasoning: weights must total 1, debt cost must be tax-adjusted, and 12.3% is the hurdle rate for a project of average risk - not for a venture into a new line of business.
Traps that cost marks
- Feeding pre-tax Kd into WACC.
- Using book-value weights when the question supplies market values.
- Deducting preference dividend without the 1/(1 − t) grossing-up in the FL denominator.
- Quoting historical WACC when the question asks for the marginal cost of additional funds.