Introduction to Financial Management: formula sheet

Key formulas

Three core decisions

Scope = Investment decision + Financing decision + Dividend decision

Name all three and give one line on each. Liquidity or working capital is often added as a fourth area.

Wealth maximisation (value of the firm)

Value of the firm = Present value of expected future cash flows, discounted at a rate reflecting risk

This is the reason wealth maximisation is better than profit maximisation: it counts timing and risk.

Net wealth created by a project

Net present value = Present value of cash inflows − Initial investment

A project that gives a positive value adds to shareholders' wealth. Use it to link investment decisions to the objective.

Retention and payout link

Retained earnings = Profit after tax − Dividends paid

Shows why dividend and financing decisions are connected.

Wealth of a project (NPV)

NPV = Σ [CFt ÷ (1 + k)^t] − Initial Investment, for t = 1 to n

Accept when NPV > 0. CFt is the cash flow in year t and k is the risk-adjusted discount rate. This is how wealth maximisation is applied.

Shareholder wealth

Shareholder wealth = Number of shares × Market price per share

Market price reflects the expected size, timing and risk of future cash flows.

Earnings per share

EPS = (Profit after tax − Preference dividend) ÷ Number of equity shares

EPS is a profit-based measure. A higher EPS does not always mean a higher share price.

Three core finance decisions

Finance function = Investment decision + Financing decision + Dividend decision

Liquidity or working capital management is often added as a fourth area. Say so in your answer.

Treasurer vs Controller

Treasurer = funds, cash, banking, investors; Controller = accounting, costing, budgeting, control, reporting

Treasurer looks at raising and keeping funds. Controller looks at recording and controlling them.

Finance manager's tasks

Estimate → Raise → Allocate → Control → Report

A simple sequence to organise any list of responsibilities.

Total agency cost

Agency cost = Monitoring cost + Bonding cost + Residual loss

Three components named in agency theory. Residual loss is the value lost even after control measures.

Agency relationship

Principal (shareholders) → hires → Agent (managers)

Remember the direction: the owners are principals, the managers are agents.

Main conflicts

Shareholders–Managers; Shareholders–Creditors; Majority–Minority shareholders

Use this as the framework for any descriptive answer.

Money market vs capital market (maturity rule)

Money market: maturity up to 1 year | Capital market: maturity more than 1 year

Use this as the first test when classifying an instrument. Equity has no fixed maturity and belongs to the capital market.

Components of the financial system

Financial system = Markets + Instruments + Institutions + Services

Use this structure to organise any descriptive answer.

Capital market division

Capital market = Primary market (new issues) + Secondary market (trading of existing securities)

Primary market raises fresh funds for the issuer; secondary market gives liquidity to investors.

Quick revision

• Financial management covers raising, using and controlling funds to achieve the firm's objective.
• The three core decisions are investment, financing and dividend.
• Profit maximisation ignores timing of returns, risk and cash flows.
• Wealth maximisation aims to increase the value of shareholders' wealth, usually seen through the market value of shares.
• Wealth maximisation takes into account time value of money and risk.
• Finance manager's work includes estimating fund needs, raising funds, allocating them, managing working capital and reporting.
• Agency problem arises when managers (agents) act in their own interest rather than the owners' (principals).
• Agency cost is the cost of the conflict, including monitoring, bonding and residual loss.
• Ways to reduce agency conflict include incentives linked to performance, monitoring and disclosure.
• Money market deals in short-term funds; capital market deals in long-term funds.
• Primary market issues new securities; secondary market trades existing securities.
• Link every instrument you study to its tenure: short-term or long-term.

Common mistakes

• Treating financial management as the same as accounting Fix: State that accounting records and reports past data while financial management uses it to plan and decide future raising and use of funds.
• Listing only the raising of funds as the scope Fix: Always include use of funds (investment) and distribution of profit (dividend) along with financing.
• Treating profit maximisation and wealth maximisation as the same thing. Fix: Remember that wealth depends on the timing and risk of cash flows. Two projects with equal profit can have very different values.
• Defining wealth as total profit or total assets. Fix: Define it as the market value of shareholders' equity, which equals the present value of expected future cash flows less costs, adjusted for risk.
• Saying finance function means only accounting and bookkeeping. Fix: State that accounting records past data while finance uses it for decisions on investing, funding and dividends.
• Listing the three decisions without explaining them. Fix: Add one line on what each decision asks and one example, such as choosing between debt and equity for a new plant.
• Reversing principal and agent. Fix: Owners are principals. Managers are hired to act for them, so they are agents.
• Treating agency cost as only the audit fee or monitoring cost. Fix: Always list all three: monitoring, bonding and residual loss.
• Calling equity shares a money market instrument. Fix: Classify by the maturity of the claim, not how fast it trades. Equity is permanent capital, so it is a capital market instrument.
• Treating the primary and secondary markets as the same. Fix: In the primary market the issuer receives the money. In the secondary market one investor pays another and the issuer receives nothing.

Exam tips

• For 'scope' questions, write the three decisions as bold headings. Examiners scan for them first.
• Always compare profit maximisation with wealth maximisation when objectives are asked, and give at least two reasons for preferring wealth.
• In MCQs, watch for options that narrow financial management to raising funds only. These are usually wrong.
• Use a short Indian example under each decision. It turns a list into an answer that earns full marks.
• There is no negative marking in Section A, so attempt every MCQ on this topic even if unsure.
• For a 'differentiate' question, write in a two-column style using lines such as 'Profit maximisation: ... / Wealth maximisation: ...'. Give at least five points.
• In a 'why is wealth maximisation preferred' answer, list the limitations of profit maximisation first, then show how wealth maximisation solves each.
• MCQs often ask which factor profit maximisation ignores. The usual answers are time value of money and risk.