Financial Management
Financial management questions test the three decisions, capital structure, working capital and the trading-on-equity effect.
Objectives and decisions
Objective: wealth maximisation for shareholders, preferred over profit maximisation because it accounts for risk and timing. Three decisions:
- Investment: capital budgeting and fixed capital.
- Financing: debt versus equity, that is capital structure.
- Dividend: distribute or retain. Fixed capital need depends on nature of business, scale, technology and growth plans. Working capital = current assets minus current liabilities, affected by the operating cycle, credit terms and seasonality.
Trading on equity
Using debt at a fixed interest cost magnifies return on equity when return on capital exceeds the interest rate; otherwise it is adverse and raises financial risk.
Worked example
Project cost ₹50 lakh; EBIT ₹8 lakh; tax 30%. All-equity: PAT = 8 − 2.4 = ₹5.6 lakh; ROE = 5.6/50 = 11.2%. Debt ₹30 lakh at 10%, equity ₹20 lakh: interest ₹3 lakh; PBT ₹5 lakh; tax ₹1.5 lakh; PAT ₹3.5 lakh; ROE = 3.5/20 = 17.5%. Reasoning: return on capital is 8/50 = 16%, above the 10% interest, so leverage raises ROE; the answer must also note the added financial risk.
Traps
- Forgetting tax while computing PAT.
- Comparing PAT in rupees instead of ROE percentages.
- Claiming debt is always cheaper and therefore always better.
- Confusing working capital with fixed capital.