Unit 5 is the second half of finance. It mixes formula-based questions with theory questions on capital structure and dividends. Remember each theory together with its author and year; examiners love that pairing.
1. Time Value of Money
- Future value: FV = PV × (1 + r)ⁿ. Present value: PV = FV ÷ (1 + r)ⁿ.
- Perpetuity: PV = C ÷ r. Growing perpetuity: PV = C₁ ÷ (r − g).
- Rule of 72: years to double ≈ 72 ÷ interest rate.
2. Valuation of Bonds and Shares
- Bond value = PV of coupons + PV of the redemption value.
- Current yield = Annual coupon ÷ Market price; YTM is the IRR of the bond.
- Bond prices move inversely to interest rates.
- Gordon growth model: P₀ = D₁ ÷ (kₑ − g).
- Macaulay duration measures a bond’s interest-rate sensitivity.
3. Risk, Return and Portfolio Theory
- Systematic risk (market risk) cannot be diversified away; unsystematic risk (company-specific) can.
- Markowitz (1952) founded modern portfolio theory.
- CAPM: Kₑ = R_f + β (R_m − R_f). The SML plots return against beta; the CML plots return against total risk (σ) for efficient portfolios.
- Arbitrage Pricing Theory (Stephen Ross, 1976) uses multiple factors.
- Performance measures: Sharpe ratio = (R_p − R_f) ÷ σ_p; Treynor ratio = (R_p − R_f) ÷ β; Jensen’s alpha measures excess return over CAPM.
4. Capital Budgeting
- Payback ignores the time value of money and cash flows after payback.
- NPV assumes reinvestment at the cost of capital; IRR assumes reinvestment at the IRR. MIRR corrects this.
- Under capital rationing, rank projects by the profitability index.
5. Cost of Capital and Capital Structure
- Cost of debt (after tax) = K_d × (1 − t). WACC weights each source by its share in the capital structure.
|
Theory |
Proponent |
View |
| Net Income approach | David Durand | Debt increases firm value |
| Net Operating Income approach | David Durand | Capital structure is irrelevant |
| Traditional approach |
– |
An optimum capital structure exists |
| MM without taxes (1958) | Modigliani and Miller | Capital structure is irrelevant |
| MM with taxes (1963) | Modigliani and Miller | V_L = V_U + tD; debt adds value through the tax shield |
| Pecking order (1984) | Myers and Majluf | Internal funds first, then debt, then equity |
6. Dividend Policy
- Walter’s model: if r > k, retain earnings; if r < k, pay out; if r = k, the policy is irrelevant.
- Gordon’s model: the “bird-in-hand” argument; investors prefer current dividends.
- MM (1961): dividend policy is irrelevant in perfect markets.
- Lintner (1956): firms prefer stable dividends and adjust them gradually.
7. Working Capital Management
- Operating cycle = Raw material period + WIP period + Finished goods period + Debtors period − Creditors period.
- Financing approaches: conservative, aggressive and matching (hedging).
- Cash models: Baumol and Miller–Orr. EOQ = √(2AO ÷ C), where A is annual demand, O the ordering cost and C the carrying cost per unit.
- Factoring finances receivables; forfaiting finances medium-term export receivables without recourse.
8. Financial Markets in India
- Money market instruments: treasury bills (91, 182 and 364 days), commercial paper, certificates of deposit and call money.
- Capital market: the primary market issues new securities; the secondary market trades existing ones.
- SEBI was set up in 1988 and given statutory powers in 1992.
- Depositories: NSDL (1996) and CDSL (1999).
- Efficient market hypothesis (Eugene Fama, 1970): weak form (past prices), semi-strong form (all public information) and strong form (all information, including private).
9. Mergers, Derivatives and Forex
- Mergers: horizontal, vertical and conglomerate.
- Takeover defences: poison pill, white knight, crown jewel, Pac-Man defence and golden parachute.
- Derivatives: forwards, futures, options and swaps. A call gives the right to buy; a put, the right to sell. American options can be exercised at any time before expiry; European options only at expiry.
- Exchange-rate theories: interest rate parity and purchasing power parity.
10. Leasing and Venture Capital
- Operating lease: short-term and cancellable, with risks staying with the lessor. Finance lease: long-term, transferring most risks and rewards to the lessee.
- Venture capital stages: seed, start-up, early growth, expansion and bridge (pre-IPO) financing.
- Angel investors are individuals who fund very early-stage ventures, usually before venture capital funds.
Common Exam Traps
- The SML uses beta; the CML uses standard deviation.
- MM’s 1958 paper ignores taxes; the 1963 correction adds the corporate tax shield.
- Forfaiting is without recourse and for export receivables; factoring may be with or without recourse.
Practice MCQs
- Under Walter’s model, a firm with r > k should: (a) Pay all earnings as dividends (b) Retain all earnings (c) Pay half (d) Dividend policy is irrelevant
- Arbitrage Pricing Theory was developed by: (a) Sharpe (b) Ross (c) Markowitz (d) Lintner
- The Treynor ratio uses which risk measure? (a) Standard deviation (b) Variance (c) Beta (d) Coefficient of variation
- Annual demand 2,000 units, ordering cost ₹50 per order, carrying cost ₹2 per unit. EOQ is: (a) 100 (b) 200 (c) 316 (d) 400
- Which theory says firms prefer internal funds, then debt, then equity? (a) Trade-off theory (b) NOI approach (c) Pecking order theory (d) MM 1963
Answers: 1 (b); 2 (b); 3 (c); 4 (c), √(2 × 2,000 × 50 ÷ 2) = √1,00,000 ≈ 316; 5 (c).
Disclaimer: This study material is for educational and exam-preparation purposes only. Facts and figures are based on sources available as of October 2026; aspirants should verify them against the latest official syllabus, notifications and standard textbooks before the exam.