Module 1

Financial management

Financial management means planning, organizing, directing and controlling the financial
activities such as procurement and utilization of funds of the enterprise. It means applying
general management principles to financial resources of the enterprise.

In simple terms objective of Financial Management is to maximize the value of firm,

however it is much more complex than that. The management of the firm involves many
stakeholders, including owners, creditors, and various participants in the financial market.
The same is shown in below diagram:

Effective procurement and efficient use of finance lead to proper utilization of the finance by
the business concern. It is the essential part of the financial manager. Hence, the financial
manager must determine the basic objectives of the financial management.

Objectives of FM

1. Profit maximization

Main aim of any kind of economic activity is earning profit. A business concern is also
functioning mainly for the purpose of earning profit. Profit is the measuring techniques to
understand the business efficiency of the concern.

The finance manager tries to earn maximum profits for the company in the short-term and the
long-term. He cannot guarantee profits in the long term because of business uncertainties.
However, a company can earn maximum profits even in the long-term, if:

• The Finance manager takes proper financial decisions

• He uses the finance of the company properly
2. Wealth maximization

• Wealth maximization (shareholders’ value maximization) is also a main objective of

financial management. Wealth maximization means to earn maximum wealth for the
shareholders. So, the finance manager tries to give a maximum dividend to the
shareholders. He also tries to increase the market value of the shares. The market
value of the shares is directly related to the performance of the company. Better the
performance, higher is the market value of shares and vice-versa. So, the finance
manager must try to maximize shareholder’s value

3. Proper estimation of total financial requirements

• Proper estimation of total financial requirements is a very important objective of

financial management. The finance manager must estimate the total financial
requirements of the company. He must find out how much finance is required to start
and run the company. He must find out the fixed capital and working
capital requirements of the company. His estimation must be correct. If not, there will
be shortage or surplus of finance. Estimating the financial requirements is a very
difficult job. The finance manager must consider many factors, such as the type of
technology used by company, number of employees employed, scale of operations,
legal requirements, etc.

4. Proper mobilization

• Mobilization (collection) of finance is an important objective of financial

management. After estimating the financial requirements, the finance manager must
decide about the sources of finance. He can collect finance from many sources such as
shares, debentures, bank loans, etc. There must be a proper balance between owned
finance and borrowed finance. The company must borrow money at a low rate of
interest.

5. Proper utilization of finance

• Proper utilization of finance is an important objective of financial management. The

finance manager must make optimum utilization of finance. He must use the finance
profitable. He must not waste the finance of the company. He must not invest the
company’s finance in unprofitable projects. He must not block the company’s finance
in inventories. He must have a short credit period.

6. Maintaining proper cash flow

• Maintaining proper cash flow is a short-term objective of financial management. The

company must have a proper cash flow to pay the day-to-day expenses such as
purchase of raw materials, payment of wages and salaries, rent, electricity bills, etc. If
the company has a good cash flow, it can take advantage of many opportunities such
as getting cash discounts on purchases, large-scale purchasing, giving credit to
customers, etc. A healthy cash flow improves the chances of survival and success of
the company
7. Survival of company

• Survival is the most important objective of financial management. The company must
survive in this competitive business world. The finance manager must be very careful
while making financial decisions. One wrong decision can make the company sick,
and it will close down.

8. Creating reserves

• One of the objectives of financial management is to create reserves. The company

must not distribute the full profit as a dividend to the shareholders. It must keep a part
of it profit as reserves. Reserves can be used for future growth and expansion. It can
also be used to face contingencies in the future.

9. Proper coordination

• Financial management must try to have proper coordination between the finance
department and other departments of the company.

10. Create goodwill

• Financial management must try to create goodwill for the company. It must improve
the image and reputation of the company. Goodwill helps the company to survive in
the short-term and succeed in the long-term. It also helps the company during bad
times.

Importance of Time Value of Money(TVM) in Financial decision

The recognition of the time value of money and risk is extremely vital in financial
decision making. If the timing and risk of cash flows are not considered, the firm may
make decisions which may allow it to miss its objectives of maximizing the owners
welfare.
We prefer todays money to that of tomorrow due to our pressing needs for consumption
and cost of abstinence form the present consumption, fall in the value of money tomorrow
due to inflation and possible use of money when exchanged for tomorrows money.

Thus, when we lend money, we forego all the advantages of liquidity, ready usability,
safety etc. we abstain from present consumption when lent to somebody or invested. All
these will lead to what is called the time preference for money. To compensate for that,
future money will have to be discounted to the present time. Tomorrow’s money or
money a year hence has to be discounted to the present day by discount rate suitable as a
reward for the above sacrifices. This is called discounting, used for cash flows or
dividends to be received in future and to be calculated for the present.

Similarly an investment of today, if it is to be returned after a year or so, todays money

has to be compounded by a discount rate to equate to the future funds likely to be
available in return. This is called compounding. Compounding and discounting are thus
tow major methods of analyzing the time value of money.
 Module 2
Capital budgeting
Capital budgeting is the process a business undertakes to evaluate potential major projects or
investments. Construction of a new plant or a big investment in an outside venture are
examples of projects that would require capital budgeting before they are approved or
rejected.

As part of capital budgeting, a company might assess a prospective project's lifetime cash
inflows and outflows to determine whether the potential returns that would be generated meet
a sufficient target benchmark. The process is also known as investment appraisal.

Project appraisal methods

Project appraisal methodologies are methods used to access a proposed project's potential
success and viability. These methods check the appropriateness of a project considering
things such as available funds and the economic climate. A good project will service debt and
maximize shareholders' wealth.

1. Net Present Value

A project's net present value is determined by summing the net annual cash flow, discounted
at the project's cost of capital and deducting the initial outlay. Decision criteria are to accept a
project with a positive net present value. Advantages of this method are that it reflects the
time value of money and maximizes shareholder's wealth. Its weakness is that its rankings
depend on the cost of capital; present value will decline as the discount rate increases.
2. Payback Method
A company chooses the expected number of years required to recover an original investment.
Projects will only be selected if initial outlay can be recovered within a predetermined period.
This method is relatively easy since the cash flow doesn't need to be discounted. Its major
weakness is that it ignores the cash inflows after the payback period, and does not consider
the timing of cash flows.
3. Internal Rate of Return
This method equates the net present value of the project to zero. The project is evaluated by
comparing the calculated Internal rate of return to the predetermined required rate of return.
Projects with Internal rate of return that exceed the predetermined rate are accepted. The
major weakness is that when evaluating mutually exclusive projects, use of Internal rate of
return may lead to selecting a project that does not maximize the shareholders' wealth.
4. Profitability Index (PI)
This is the ratio of the present value of project cash inflow to the present value of initial cost.
Projects with a Profitability Index of greater than 1.0 are acceptable. The major disadvantage
in this method is that it requires cost of capital to calculate and it cannot be used when there
are unequal cash flows. The advantage of this method is that it considers all cash flows of the
project.
5. ARR
The accounting rate of return (ARR) is the percentage rate of return expected on investment
or asset as compared to the initial investment cost. ARR divides the average revenue from an
 asset by the company's initial investment to derive the ratio or return that can be expected
over the lifetime of the asset or related project. ARR does not consider the time value of
money or cash flows, which can be an integral part of maintaining a business.
6. NTV

The terminal value method is an improvement over the net present value method of making
capital investment decisions. Under this method, it is assumed that each of the future cash
flows is immediately reinvested in another project at a certain (hurdle) rate of return until the
termination of the project. In other words, the net cash flows and outlays are compounded
forward rather than discounting them backward as followed in net present value (NPV)
method. In case of a single project, the project is accepted if the present value of the total of
the compounded reinvested cash inflows is greater than the present value of the outlays,
otherwise it is rejected. In case of mutually exclusive projects, the project with higher present
value of the total of the compounded cash flows is accepted.

Module 3

Cost of capital

The cost of capital concept is also widely used in economics and accounting. Another way to
describe the cost of capital is the opportunity cost of making an investment in a business.
Wise company management will only invest in initiatives and projects that will provide
returns that exceed the cost of their capital.

Cost of capital, from the perspective on an investor, is the return expected by whoever is
providing the capital for a business. In other words, it is an assessment of the risk of a
company's equity. In doing this an investor may look at the volatility (beta) of a company's
financial results to determine whether a certain stock is too risky or would make a good
investment.

Components of cost of capital

1. Cost of Debt

2. Cost of Preference Capital

3. Cost of Equity Capital

4. Cost of retained earnings

Long-term financing sources

• Share Capital or Equity Shares.
• Preference Capital or Preference Shares.
• Retained Earnings or Internal Accruals.
• Debenture / Bonds.
• Term Loans from Financial Institutes, Government, and Commercial Banks.
• Venture Funding.
Capital structure
The capital structure is the particular combination of debt and equity used by a company
to finance its overall operations and growth. Debt comes in the form of bond issues or loans,
while equity may come in the form of common stock, preferred stock, or retained
earnings. Short-term debt such as working capital requirements is also considered to be part
of the capital structure.

• Capital structure is how a company funds its overall operations and growth.
• Debt consists of borrowed money that is due back to the lender, commonly with
interest expense.
• Equity consists of ownership rights in the company, without the need to pay back any
investment.
• The Debt-to-Equity (D/E) ratio is useful in determining the riskiness of a company's
borrowing practices.

• Capital structure is how a company funds its overall operations and growth.
• Debt consists of borrowed money that is due back to the lender, commonly with
interest expense.
• Equity consists of ownership rights in the company, without the need to pay back any
investment.
• The Debt-to-Equity (D/E) ratio is useful in determining the riskiness of a company's
borrowing practice

s.
Determinants of Capital Structure

1. Financial Leverage or Trading on Equity: The use of long term fixed interest bearing
debt and preference share capital along with equity share capital is called financial
leverage or trading on equity. Effects of leverage on the shareholders return or earnings.
2. Growth and Stability of Sales: The capital structure of a firm is highly influenced by the
growth and stability of its sales. If the sales of a firm are expected to remain fairly stable,
it can raise a higher level of debt. Stability of sales ensures that the firm will not face any
difficulty in meeting its fixed commitments of interest payment and repayments of debt.
Similarly, the rate of growth in sales also affects the capital structure decision
3. Cost of Capital: Every dollar invested in a firm has a cost. Cost of capital refers to the
minimum return expected by its suppliers. The expected return depends on the degree of
risk assumed by investors. A high degree of risk is assumed by shareholders than debt-
 holders. The capital structure should provide for the minimum cost of capital. Measuring
the costs of various sources of funds is a complex subject and needs a separate treatment.
4. Risk: There are two types of risk that are to be considered while planning the capital
structure of a firm via (i) business risk and (ii) financial risk. Business risk refers to the
variability to earnings before interest and taxes. Business risk can be internal as well as
external. Internal risk is caused due to improper products mix non availability of raw
materials, incompetence to face competition, absence of strategic management etc.
internal risk is associated with efficiency with which a firm conducts it operations within
the broader environment thrust upon it. External business risk arises due to change in
operating conditions caused by conditions thrust upon the firm which are beyond its
control e.g. business cycle.
5. Cash Flow: One of the features of a sound capital structure is conservation. Conservation
does not mean employing no debt or a small amount of debt. Conservatism is related to
the assessment of the liability for fixed charges, created by the use of debt or preference
capital in the capital structure in the context of the firm’s ability to generate cash to meet
these fixed charges. The fixed charges of a company include payment of interest,
preference dividend and principal. The amount of fixed charges will be high if the
company employs a large amount of debt or preference capital. Whenever a company
thinks of raising additional debt, it should analyses its expected future cash flows to meet
the fixed charges
6. Nature and Size of a Firm: Nature and size of a firm also influence its capital structure.
All public utility concern has different capital structure as compared to other
manufacturing concern. Public utility concerns may employ more of debt because of
stability and regularity of their earnings. On the other hand, a concern which cannot
provide stable earnings due to the nature of its business will have to rely mainly on equity
capital. The size of a company also greatly influences the availability of funds from
different sources
7. Control: Whenever additional funds are required by a firm, the management of the firm
wants to raise the funds without any loss of control over the firm. In case the funds are
raised though the issue of equity shares, the control of the existing shareholder is diluted.
Hence they might raise the additional funds by way of fixed interest bearing debt and
preference share capital. Preference shareholders and debenture holders do not have the
voting right. Hence, from the point of view of control, debt financing is recommended.
But, depending largely upon debt financing may create other problems, such as, too much
restrictions imposed upon imposed upon by the lenders or suppliers of finance and a
complete loss of control by way of liquidation of the company.
8. Flexibility: Flexibility means the firm’s ability to adapt its capital structure to the needs
of the changing conditions. The capital structure of a firm is flexible if it has no difficulty
in changing its capitalization or sources of funds. Whenever needed the company should
be able to raise funds without undue delay and cost to finance the profitable investments.
The company should also be in a position to redeem its preference capital or debt
whenever warranted by future conditions. The financial plan of the company should be
flexible enough to change the composition of the capital structure. It should keep itself in
a position to substitute one form of financing for another to economies on the use of
funds.
9. Requirement of Investors: The requirements of investors are another factor that
influence the capital structure of a firm. It is necessary to meet the requirements of both
institutional as well as private investors when debt financing is used. Investors are
generally classified under three kinds, i.e. bold investors, cautions investors and less
cautions investor.
10. Capital Market Conditions (Timing): Capital Market Conditions do no remain the
same forever sometimes there may be depression while at other times there may be boom
in the market is depressed and there are pessimistic business conditions, the company
should not issue equity shares as investors would prefer safety.
11. Marketability: Marketability here means the ability of the company to sell or market
particular type of security in a particular period of time which in turn depends upon -the
readiness of the investors to buy that security. Marketability may not influence the initial
capital structure very much but it is an important consideration in deciding the
appropriate timing of security issues. At one time, the market favors debenture issues and
at another time, it may readily accept ordinary share issues. Due to the changing market
sentiments, the company has to decide whether to raise funds through common shares or
debt. If the share market is depressed, the company should not issue ordinary shares but
issue debt and wait to issue ordinary shares till the share market revives. During boom
period in the share market, it may not be possible for the company to issue debentures
successfully. Therefore, it should keep its debt capacity unutilized and issue
ordinary shares to raise finances.
12. Floatation Costs: Floatation costs are incurred when the funds are raised. Generally, the
cost of floating a debt is less than the cost of floating an equity issue. This may encourage
a company to use debt rather than issue ordinary shares. If the owner’s capital is increased
by retaining the earnings, no floatation costs are incurred. Floatation cost generally is not
a very important factor influencing the capital structure of a company except in the case
of small companies

Leverage Analysis
Leverage results from using borrowed capital as a funding source when investing to expand
the firm's asset base and generate returns on risk capital. Leverage is an investment strategy
of using borrowed money—specifically, the use of various financial instruments or borrowed
capital—to increase the potential return of an investment. Leverage can also refer to the
amount of debt a firm uses to finance assets. When one refers to a company, property
or investment as "highly leveraged," it means that item has more debt than equity.
Operating Leverage:
Operating leverage refers to the use of fixed operating costs such as depreciation, insurance
of assets, repairs and maintenance, property taxes etc. in the operations of a firm. But it does
not include interest on debt capital. Higher the proportion of fixed operating cost as compared
to variable cost, higher is the operating leverage, and vice versa

The importance of operating leverage:

1. It gives an idea about the impact of changes in sales on the operating income of the firm.

2. High degree of operating leverage magnifies the effect on EBIT for a small change in the
sales volume.

3. High degree of operating leverage indicates increase in operating profit or EBIT.

4. High operating leverage results from the existence of a higher amount of fixed costs in the
total cost structure of a firm which makes the margin of safety low.

5. High operating leverage indicates higher amount of sales required to reach break-even
point.

6. Higher fixed operating cost in the total cost structure of a firm promotes higher operating
leverage and its operating risk.

7. A lower operating leverage gives enough cushion to the firm by providing a high margin of
safety against variation in sales.

8. Proper analysis of operating leverage of a firm is useful to the finance manager

Financial Leverage:
Financial leverage is primarily concerned with the financial activities which involve rising of
funds from the sources for which a firm has to bear fixed charges such as interest expenses,
loan fees etc. These sources include long-term debt (i.e., debentures, bonds etc.) and
preference share capital. Long term debt capital carries a contractual fixed rate of interest and
its payment is obligatory irrespective of the fact whether the firm earns a profit or not.

As debt providers have prior claim on income and assets of a firm over equity shareholders,
their rate of interest is generally lower than the expected return in equity shareholders.
Further, interest on debt capital is a tax deductible expense. These two facts lead to the
magnification of the rate of return on equity share capital and hence earnings per share. Thus,
the effect of changes in operating profits or EBIT on the earnings per share is shown by the
financial leverage.

The importance of financial leverage:

1. It helps the financial manager to design an optimum capital structure. The optimum capital
structure implies that combination of debt and equity at which overall cost of capital is
minimum and value of the firm is maximum.
2. It increases earning per share (EPS) as well as financial risk.

3. A high financial leverage indicates existence of high financial fixed costs and high
financial risk.

4. It helps to bring balance between financial risk and return in the capital structure.

5. It shows the excess on return on investment over the fixed cost on the use of the funds.

6. It is an important tool in the hands of the finance manager while determining the amount of
debt in the capital structure of the firm.

Combined Leverage:
Operating leverage shows the operating risk and is measured by the percentage change in
EBIT due to percentage change in sales. The financial leverage shows the financial risk and is
measured by the percentage change in EPS due to percentage change in EBIT.

Both operating and financial leverages are closely concerned with ascertaining the firm’s
ability to cover fixed costs or fixed rate of interest obligation, if we combine them, the result
is total leverage and the risk associated with combined leverage is known as total risk. It
measures the effect of a percentage change in sales on percentage change in EPS.

The importance of combined leverage is:

It indicates the effect that changes in sales will have on EPS.

2. It shows the combined effect of operating leverage and financial leverage.

3. A combination of high operating leverage and a high financial leverage is very risky
situation because the combined effect of the two leverages is a multiple of these two
leverages.

4. A combination of high operating leverage and a low financial leverage indicates that the
management should be careful as the high risk involved in the former is balanced by the later.

5. A combination of low operating leverage and a high financial leverage gives a better
situation for maximising return and minimising risk factor, because keeping the operating
leverage at low rate full advantage of debt financing can be taken to maximise return. In this
situation the firm reaches its BEP at a low level of sales with minimum business risk.

6. A combination of low operating leverage and low financial leverage indicates that the firm
losses profitable opportunities.
 Module 4
Dividend Decision
The Dividend Decision is one of the crucial decisions made by the finance manager relating
to the payouts to the shareholders. The payout is the proportion of Earning Per Share given
to the shareholders in the form of dividends.
The companies can pay either dividend to the shareholders or retain the earnings within the
firm. The amount to be disbursed depends on the preference of the shareholders and the
investment opportunities prevailing within the firm
The optimal dividend decision is when the wealth of shareholders increases with the increase
in the value of shares of the company. Therefore, the finance department must consider all
the decisions viz. Investment, Financing and Dividend while computing the payouts.

If attractive investment opportunities exist within the firm, then the shareholders must be
convinced to forego their share of dividend and reinvest in the firm for better future returns.
At the same time, the management must ensure that the value of the stock does not get
adversely affected due to less or no dividends paid out to the shareholders.

Dividend types

• Cash dividend. The cash dividend is by far the most common of the dividend types used. ...
• Stock dividend. A stock dividend is the issuance by a company of its common stock to its
common shareholders without any consideration. ...
• Property dividend. ...
• Scrip dividend. ...
• Liquidating dividend.

Dividend decision theories

Modigliani – Miller theory
Modigliani – Miller theory is a major proponent of ‘Dividend Irrelevance’ notion. According
to this concept, investors do not pay any importance to the dividend history of a company and
thus, dividends are irrelevant in calculating the valuation of a company. This theory is in
direct contrast to the ‘Dividend Relevance’ theory which deems dividends to be important in
the valuation of a company.

Assumptions of Miller and Modigliani approach

1. There is a perfect capital market, i.e. investors are rational and have access to all the
information free of cost. There are no floatation or transaction costs, no investor is large
enough to influence the market price, and the securities are infinitely divisible.
2. There are no taxes. Both the dividends and the capital gains are taxed at the similar rate.
3. It is assumed that a company follows a constant investment policy. This implies that there is
no change in the business risk position and the rate of return on the investments in new
projects.
4. There is no uncertainty about the future profits, all the investors are certain about the
future investments, dividends and the profits of the firm, as there is no risk involved.

Walter’s Model
Definition: According to the Walter’s Model, given by prof. James E. Walter, the dividends
are relevant and have a bearing on the firm’s share prices. Also, the investment policy cannot
be separated from the dividend policy since both are interlinked

Walter’s Model shows the clear relationship between the return on investments or internal
rate of return (r) and the cost of capital (K). The choice of an appropriate dividend policy
affects the overall value of the firm. The efficiency of dividend policy can be shown through
a relationship between returns and the cost.

Gordons model
The Gordon's theory on dividend policy states that the
company's dividend payout policy and the relationship between its rate of return (r) and the
cost of capital (k) influence the market price per share of the company

Module 5
Working capital management is a business strategy designed to ensure that a company
operates efficiently by monitoring and using its current assets and liabilities to the best effect.
The primary purpose of working capital management is to enable the company to maintain
sufficient cash flow to meet its short-term operating costs and short-term debt obligations. A
company's working capital is made up of its current assets minus its current liabilities.

• Working Capital Management requires monitoring a company's assets and liabilities

to maintain sufficient cash flow.
• The strategy involves tracking three ratios: the working capital ratio, the collection
ratio, and the inventory ratio.
• Keeping those three ratios at optimal levels ensures efficient working capital
management.

Determinants of working capital requirement

Nature of business:
It is an important factor for determining the amount of working capital needed by various
companies. The trading or manufacturing concerns will require more amount of working
capital along-with their fixed investment of stock, raw materials and finished products.

Public utilities and railway companies with huge fixed investment usually have the lowest
needs for current assets, partly because of cash, nature of their business and partly due to their
selling a service instead of a commodity. Similarly, basic and key industries or those engaged
in the manufacture of producer’s goods usually have less proportion of working capital to
fixed capital than industries producing consumer goods.

Length of period of manufacture:

The average length of the period of manufacture, i.e., the time which elapses between the
commencement and end of the manufacturing process is an important factor in determining
the amount of the working capital. If it takes less time to make the finished product, the
working capital required will be less. To give an example, a baker requires one night time to
bake his daily quota of bread. His working capital is, therefore, much less than that of a ship-
building concern which takes three to five years to build a ship. Between these two cases may
fall other business concerns with varying periods of manufacture requiring different amounts
of working capital.

Volume of business:
Generally, the size of the company has a direct relation with the working capital needs. Big
concerns have to keep higher working capital for investment in current assets and for paying
current liabilities.

Seasonal Variations:
There are some industries which either produce goods or make sales only seasonally. For
example, the sugar industry produces practically all the sugar between December and April
and the woollen textile industry makes its sales generally during winter.

In both these cases the needs of working capital will be very large, during few months {i.e.,
season). The working capital requirements will gradually decrease as and when the sales are
made.

Terms of Credit:
A company purchasing all raw-materials for cash and selling on credit will be requiring more
amount of working capital. Contrary to this, if the enterprise is in a position to buy on credit
and sell it for cash, it will need less amount of working capital. The length of the period of
credit has a direct bearing on working capital.

Requirements of Cash:
The need to have cash in hand to meet various requirements e.g., payment of salaries, rents,
rates etc., has an effect on the working capital. The more the cash requirements the higher
will be working capital needs of the company and vice versa.

Use of Manual Labour or Mechanization

In labour intensive industries, larger working capital will be required than in the highly
mechanized ones. The latter will have a large proportion of fixed capital. It may be
remembered, however, that to some extent the decision to use manual labour or machinery
lies with the management. Therefore, it is possible in most cases to reduce the requirements
of working capital and increase investments in fixed assets and vice versa.

Other Factors:
In addition to the above mentioned considerations there are also a number of other factors
which affect the requirements of working capital. Some of them are given below.
 (i) Degree of co-ordination between production and distribution policies.

(ii) Specialization in the field of distribution.

(iii) Developments of means of transportation and communications.

(iv) The hazards and contingencies inherent in the type of business

Types of working capital

• Permanent Working Capital. It is otherwise called as Fixed Working Capital. ...
• Temporary Working Capital. It is otherwise called as Fluctuating or Variable Working
Capital. ...
• Gross & Net Working Capital. ...
• Negative Working Capital. ...
• Reserve Working Capital. ...
• Regular Working Capital. ...
• Seasonal Working Capital. ...
• Special Working Capital.

Operating cycle definition

The operating cycle is the time required for a company's cash to be put into its operations and
then return to the company's cash account.
Motives of holding cash

Transaction Motive: The transaction motive refers to the cash required by a firm to meet
the day to day needs of its business operations. In an ordinary course of business, the firm
requires cash to make the payments in the form of salaries, wages, interests, dividends, goods
purchased, etc. Likewise, it also receives cash from its sales, debtors, investments. Often the
firm’s cash inflows and outflows do not match, and hence, the cash is held up to meet its
routine commitments.

Precautionary Motive: The precautionary motive refers to the tendency of a firm to

hold cash, to meet the contingencies or unforeseen circumstances arising in the course of
business. Since the future is uncertain, a firm may have to face contingencies such as an
increase in the price of raw materials, labor strike, lockouts, change in the demand, etc.
Thus, in order to meet with these uncertainties, the cash is held by the firms to have
uninterrupted business operations.

Speculative Motive: The firms hold cash for the speculative purposes to avail the benefit
of bargain purchases that may arise in the future. For example, if the firm feels the prices of
raw material are likely to fall in the future, it will hold cash and wait till the prices actually
fall. Thus, a firm holds cash to exploit the possible opportunities that are out of the normal
course of business. These opportunities could be in the form of the low-interest rate charged
on the borrowed funds, expected fall in the raw material prices or favorable change in the
government policies.