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UNIT ONE CORE CONCEPTS OF FINANCIAL MANAGEMENT

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UNIT ONE

CORE CONCEPTS

OF FINANCIAL MANAGEMENT

UNIT ONE

CHAPTER ONE

INTRODUCTION

Lesson 1

Chapter 1

Introduction

Unit 1

Core concepts in financial management

After reading this lesson you will be able to understand the following: -

Concept of ‘Finance’ under different approaches.

Significance of ‘Finance’.

Nature of financial management.

Relationship between finance and other important functions of the organization.

Role of a Finance Manager in an organization.

New challenges faced by the finance manager.

A very warm welcome to all my students in second semester of MBA course. I will be

teaching you financial management; I must tell you that I find this subject as the most

interesting subject and all my efforts will be to make it very interesting for you as well.

Lets discuss

Almost every firm, government agency, and organization has one or more financial

managers who oversee the preparation of financial reports, direct investment activities,

and implement cash management strategies. As computers are increasingly used to record

and organize data, many financial managers are spending more time developing strategies

and implementing the long-term goals of their organization.

The duties of financial managers vary with their specific titles, which include controller,

treasurer or finance officer, credit manager, cash manager, and risk and insurance

manager. Controllers direct the preparation of financial reports that summarize and

forecast the organization’s financial position, such as income statements, balance sheets,

and analyses of future earnings or expenses. Regulatory authorities also in charge of

preparing special reports require controllers. Often, controllers oversee the accounting,

audit, and budget departments. Treasurers and finance officers direct the organization’s

financial goals, objectives, and budgets. They oversee the investment of funds and

manage associated risks, supervise cash management activities, execute capital-raising

strategies to support a firm’s expansion, and deal with mergers and acquisitions. Credit

managers oversee the firm’s issuance of credit. They establish credit-rating criteria,

determine credit ceilings, and monitor the collections of past-due accounts. Managers

specializing in international finance develop financial and accounting systems for the

banking transactions of multinational organizations.

Cash managers monitor and control the flow of cash receipts and disbursements to meet

the business and investment needs of the firm. For example, cash flow projections are

needed to determine whether loans must be obtained to meet cash requirements or

whether surplus cash should be invested in interest-bearing instruments. Risk and

insurance managers oversee programs to minimize risks and losses that might arise from

financial transactions and business operations undertaken by the institution. They also

manage the organization’s insurance budget.

Financial institutions, such as commercial banks, savings and loan associations, credit

unions, and mortgage and finance companies, employ additional financial managers who

oversee various functions, such as lending, trusts, mortgages, and investments, or

programs, including sales, operations, or electronic financial services. These managers

may be required to solicit business, authorize loans, and direct the investment of funds,

always adhering to Federal and State laws and regulations.

Branch managers of financial institutions administer and manage all of the functions of a

branch office, which may include hiring personnel, approving loans and lines of credit,

establishing a rapport with the community to attract business, and assisting customers

with account problems. Financial managers who work for financial institutions must keep

abreast of the rapidly growing array of financial services and products.

In addition to the general duties described above, all financial managers perform tasks

unique to their organization or industry. For example, government financial managers

must be experts on the government appropriations and budgeting processes, whereas

healthcare financial managers must be knowledgeable about issues surrounding

healthcare financing. Moreover, financial managers must be aware of special tax laws

and regulations that affect their industry.

Financial managers play an increasingly important role in mergers and consolidations,

and in global expansion and related financing. These areas require extensive, specialized

knowledge on the part of the financial manager to reduce risks and maximize profit.

Financial managers increasingly are hired on a temporary basis to advise senior managers

on these and other matters. In fact, some small firms contract out all accounting and

financial functions to companies that provide these services.

The role of the financial manager, particularly in business, is changing in response to

technological advances that have significantly reduced the amount of time it takes to

produce financial reports. Financial managers now perform more data analysis and use it

to offer senior managers ideas on how to maximize profits. They often work on teams,

acting as business advisors to top management. Financial managers need to keep abreast

of the latest computer technology in order to increase the efficiency of their firm’s

financial operations.

We all have heard about the term finance, let us discuss on what does it mean and why

do you as a student of MBA want to study it?

Finance can be defined as the art and science of managing money. Virtually all

individuals and organizations earn or raise money and spend or invest money.

Finance is concerned with the process, institutions, markets, and instruments

involved in the transfer of money among and between individuals, businesses, and

governments.

Why study finance?

An understanding of the concepts, techniques, and practices presented in this

course will fully acquaint you with the financial manager's activities. Because

most business decisions are measured in financial terms, the financial manager

plays a key role in the operation of the firm. People in all areas of responsibility

accounting, information systems, management, marketing, and operations- need a

basic understanding of the managerial finance function. All managers in the firm,

regardless of their job descriptions, work with financial personnel to justify

personnel requirements, negotiate operating budgets, deal with financial

performance appraisals, and sell proposals based at least in part on their financial'

merits. Clearly, those managers who understand the financial decision- making

process will be better able to address financial concerns, and will therefore more

often get the resources they need to accomplish their own goals.

To make informed decisions about where to get and put money in order to maximize

value in both personal and business decisions.

I know you want to ask the following question: -

If I have no intention of becoming a financial manger, why do I need to understand

financial management?

One good reason is “ to prepare yourself for the workplace of the future”. More and more

businesses are reducing management jobs and squeezing together the various layers of

the corporate pyramid. This is being done to reduce costs and boost productivity. As a

result, the responsibilities of the remaining management positions are being broadened.

The successful manager will need to be much more of a team player that has the

knowledge and ability to move not just vertically within an organization but horizontally

as well. Developing cross-functional capabilities will be the rule, not the exception. Thus,

a mastery of basic financial management skills is key ingredient that will be required in

the work place of your not too distant future.

Finance is the study of money management, the acquiring of funds (cash) and

the directing of these funds to meet particular objectives. Good financial management

helps businesses to maximize returns while simultaneously minimizing risks.

Hardly anybody wants to work in a field where there is no room for experience,

creativity, judgment and a pinch of luck but study of finance is not so. There are many

reasons that the financial manager’s job is challenging and interesting. Here are four

important ones.

-Securities Markets

-Understanding Values

-Time and uncertainty

-Understanding People.

I. Securities Markets include Money Markets and Capital Markets.

Money Markets includes:

* Markets for short-term claims with original maturity of one year or less.

* High-grade securities with little or no risk of default.

* Examples:

1.Treasury Bills.

2. Commercial Paper.

3.Certificates of Deposit.

Capital markets include:

* Market for long-term securities with original maturity of more than one year.

*Securities may be of considerable risk.

*Example:

1.Stocks

2.Corporate bonds

3.Government bonds

Primary Markets

A primary market is a market for newly created securities. The proceeds from the sale of

securities in primary markets go to the issuing entity. A security can trade only once in

the primary market.

Secondary Markets

A secondary market is a market for previously issued securities. The issuing firm is not

directly affected by transactions in the secondary markets. A security can trade an

unlimited number of times in secondary markets. The volume of trade in secondary

markets is such higher than in primary markets.

Investment Bankers

An investment banker specializes in marketing new securities in the primary market.

Examples of Investment bankers are: Merrill Lynch, Sigma Manufactures Merchant

Bank, etc.

Brokers and Dealers

These generally participate in the secondary markets. A broker helps investors in buying

or selling securities. A broker charges commissions, but never takes title to the security.

A dealer buys securities from sellers, and sells them to buyers.

Financial Intermediaries

These are institutions that assist in the financing of firms. Example include; commercial

banks and pension funds. These institutions invest in securities of other firms, but they

are themselves financed by other financial claims. On the other hand, it is a sort of

indirect financing in which savers deposit funds with the banks and financial institutions

rather than directly buying bonds or shares and the financial institutions, in turn lend the

money to ultimate borrowers. The Commercial Banks, Financial Institutions, Finance and

Investment Companies, Insurance Companies, Unit Trust, Pension Funds etc., are

examples of financial intermediaries.

II. Understanding Value

Understanding how capital markets work amounts to understanding how financial

assets are valued. This is a subject on which there has been remarkable progress over the

past 10 to 20 years. New theories have been developed to explain the prices of bonds and

stocks. And, when put to the test, these theories have worked well. I, therefore, would

like to give more stress in this area because the implication of this is applying in almost

all parts of the corporate finance.

III. Time and Uncertainty

The financial manager cannot avoid coping with time and uncertainty. Firms often

have the opportunity to invest in assets which cannot pay their way in the short run and

which expose the firm and its stockholders to considerable risk. The investment, if

undertaken, may have to be financed by debt, which cannot be fully repaid for many

years. The firm cannot walk away from such choices- someone has to decide whether the

opportunity is worth more than it costs and whether the additional debt burden can be

safely borne.

IV. Understanding People

The financial manager needs the opinions and cooperation of many people. For

instance, many new investment ideas come from plant managers. The financial manager

wants these ideas to be presented fairly; therefore, the proposers should have no personal

incentives to be either overconfident or overcautious. Take another example. In some

firms the plant manager needs permissions from the head office to buy a company car but

not to lease it, and the line of least resistance may be to lease the car. In other firms the

plant manager needs permission from the head office to buy or lease, and the line of least

resistance may be to travel everywhere by cab. The financial manager has to be aware of

these effects and has to devise procedures that will avoid as far as possible any conflicts

of interest.

These are not the only reasons that financial management is interesting and also

challenging.

Concept of Finance

Different finance scholars have interpreted the term ‘finance’ in real world variably.

More significantly, as noted at the very outset of this chapter, the concept of finance has

changed markedly with change in times and circumstances. For convenience of analysis

different viewpoints on finance can be categorized into following three major groups:

F.1. The first category incorporates the views of all those who contend that finance

concerns with acquiring funds on reasonable terms and conditions to pay bills

promptly. This approach covers study of financial institutions and instruments from

which funds can be secured, the types and duration of obligations to be issued, the timing

of the borrowing or sale of stocks, the amounts required, urgency of the need and cost.

The approach has the virtue of shedding light on the very heart of finance function.

However, the approach is too restrictive. It lays stress on only one aspect of finance. The

traditional scholars hold this approach of finance

F.2. The second approach holds that finance is concerned with cash. Since almost all

business transactions are expressed ultimately in terms of cash, every activity within the

enterprise is the primary concern of a finance manager. Thus, according to this approach,

finance manager is required to go into details of every functional area of business

activity, be it concerned with purchasing, production, marketing, personnel,

administration, research or other associated activities. Obviously, such a definition is too

broad to be meaningful.

F.3. A third approach to finance, held by modern scholars, looks at finance as being

concerned with procurement of funds and wise application of these funds.

Protagonists of this approach opine that responsibility of a finance manager is not only

limited to acquisition of adequate cash to satisfy business requirements but extends

beyond this to optimal utilisation of funds. Since money involves cost, the central task of

a finance manager while allocating resources is to match the benefits of potential uses

against the cost of alternative sources so as to maximise value of the enterprise. This is

the managerial approach of finance which is also known as problem-centered approach,

since it emphasizes that finance manager in his endeavor to maximise value of the

enterprise has to deal with vital problems of the enterprise, viz., what capital expenditures

should the enterprise make? What volume of the funds should the enterprise invest? How

should the desired funds be obtained?

Let us move on to financial management, you all being students of management know the

meaning of management. So let us discuss financial management now.

Nature of Financial Management Financial management is an integral part of overall management and not merely a staff

function. It is not only confined to fund raising operations but extends beyond it to cover

utilisation of funds and monitoring its uses. These functions influence the operations of

other crucial functional areas of the firm such as production, marketing and human

resources. Hence, decisions in regard to financial matters must be taken after giving

thoughtful consideration to interests of various business activities. Finance manager has

to see things as a part of a whole and make financial decisions within the framework of

overall corporate objectives and policies.

The financial management of a firm affect its very survival because the survival of the

firm depends on strategic decisions made in such important matters such as product

development, market development, entry in new product line, retrenchment of a product,

expansion of the plant, change in location, etc. In all these matters assessment of financial

implications is inescapable.

Another striking feature of financial management that explains its generic nature is the

imperativeness of the continuous review of the financial decisions. As a matter of fact,

financial decision-making is a continuous decision-making process, which goes on

throughout the corporate life. Since a firm has to operate in an environment that is

dynamic, it has, therefore, to interact constantly with various environmental forces in

addition to changing conditions of the firm and adapt and adjust its objectives and

strategies including financial policies and strategies. A one-time financial plan not

subjected to periodic review and modifications in the context of changed conditions will

be a fiasco because conditions may change to such an extent that the plan is no longer

relevant and acts as a hindrance rather than help. Financial planning should, therefore, not

be static. It has to be continuously adapted to changing conditions.

As you all are MBA students it is essential for you to know the interface between finance

and other functions let us discuss. You all are studying other management subjects also

let us relate those with finance.

Interface between finance and other functions

Till now you might have understood about the pervasive nature of finance. Let us discuss

in greater detail the reasons why knowledge of the financial implications of their

decisions is important for the non-finance managers. One common factor among all

managers is that they use resources and since resources are obtained in exchange for

money, they are in effect making the investment decision and in the process of ensuring

that the investment is effectively utilized they are also performing the control function.

Marketing-Finance Interface There are many decisions, which the Marketing Manager takes which have a significant

impact on the profitability of the firm. For example, he should have a clear understanding

of the impact the credit extended to the customers is going to have on the profits of the

company. Otherwise in his eagerness to meet the sales targets he is liable to extend liberal

terms of credit, which is likely to put the profit plans out of gear. Similarly, he should

weigh the benefits of keeping a large inventory of finished goods in anticipation of sales

against the costs of maintaining that inventory. Other key decisions of the Marketing

Manager, which have financial implications, are:

Pricing

Product promotion and advertisement

Choice of product mix

Distribution policy.

Production-Finance Interface As we all know in any manufacturing firm, the Production Manager controls a major part

of the investment in the form of equipment, materials and men. He should so organize his

department that the equipments under his control are used most productively, the

inventory of work-in-process or unfinished goods and stores and spares is optimized and

the idle time and work stoppages are minimized. If the production manager can achieve

this, he would be holding the cost of the output under control and thereby help in

maximizing profits. He has to appreciate the fact that whereas the price at which the

output can be sold is largely determined by factors external to the firm like competition,

government regulations, etc. the cost of production is more amenable to his control.

Similarly, he would have to make decisions regarding make or buy, buy or lease etc. for

which he has to evaluate the financial implications before arriving at a decision.

Top Management-Finance Interface The top management, which is interested in ensuring that the firm's long-term goals are

met, finds it convenient to use the financial statements as a means for keeping itself

informed of the overall effectiveness of the organization. We have so far briefly reviewed

the interface of finance with the non-finance functional disciplines like production,

marketing etc. Besides these, the finance function also has a strong linkage with the

functions of the top management. Strategic planning and management control are two

important functions of the top management. Finance function provides the basic inputs

needed for undertaking these activities.

Economics - Finance Interface The field of finance is closely related to economics. Financial managers must

understand the economic framework and be alert to the consequences of varying

levels of economic activity and changes in economic policy. They must also be

able to use economic theories as guidelines for efficient business operation. The

primary economic principle used in managerial finance is marginal analysis, the

principle that financial decisions should be made and actions taken only when the

added benefits exceed the added costs. Nearly all-financial decisions ultimately

come down to an assessment of their marginal benefits and marginal costs.

Accounting - Finance Interface

The firm's finance (treasurer) and accounting (controller) activities are typically

within the control of the financial vice president (CFO). These functions are

closely related and generally overlap; indeed, managerial finance and accounting

are often not easily distinguishable. In small firms the controller often carries out

the finance function, and in large firms many accountants are closely involved in

various finance activities. However, there are two basic differences between

finance and accounting; one relates to the emphasis on cash flows and the other to

decision making.

Now that you have related finance with other functions can you discuss on the role of a

financial manager?

Role of a financial manager

Role and responsibilities of a finance manager have undergone a remarkable

transformation during the past four decades. Not too many years ago, finance

manager had a very limited role in a business enterprise. He was responsible only for

maintaining financial records, preparing reports on the company's status and

performance and arranging funds needed by the company so that it could meet its

obligations in time. Finance manager, as a matter of fact, was regarded as specialised

staff officer in the company concerned only with administering sources of funds.

He was called upon only when his specialty was needed. For example, when the

company experienced the problem of dearth of funds, the management expected the

finance manager to locate suitable sources of funds and procure additional funds.

However, the finance manager transcended his traditional role of garnering external

funds for the enterprise following technological changes in major industries,

increased business complexities, tightening money market conditions and despondent

state of stock market, and has now become part and parcel of general management.

He occupies the role of an executive who is actively associated with problems and

decisions related to wise application of funds. He deals with the total funds deployed

by the organisation, allocation of funds among varying projects and activities and

with evaluation of results of each allocation. He is, therefore, directly concerned with

production, marketing and other activities within a business enterprise whenever

decisions are made that Involve commitment of funds to new or ongoing uses.

Role of finance managers has increased tremendously and their tasks have become

complicated following cataclysmic changes in recent times in the entire global

economic environment and the world market place resulting in globalisation of

business and increased competitiveness" The multinational corporations of today

conduct their operations world-wide as if the entire world were a single entity with a

major thrust on quality, cost and speed."

So as to cope with challenges stemming out of globalisation of world economy and to

exploit tremendous potential opportunities, most of the developing countries including

India have, of late, decided to liberalise their economic policies and open the floodgates

of their domestic markets to multinationals. Various economic and financial policy

reforms have been introduced with a view to freeing business from the grip of

administered growth and demolishing the protecting walls of yesteryears.

The combined impact of all these measures has resulted in swelling wave of transnational

from Japan, USA, Germany and France pouring in India in every conceivable product

segment posing serious challenges to the very survival of Indian corporate who were

hitherto operating in highly sheltered and closed economy.

In order to face these challenges and to ensure their survival many Indian corporate giants

have desperately formed strategic alliances with global majors and some of them

embarked hurriedly on internal restructuring.

Since ferocity of competition is likely to deepen further, it would be worthwhile for

Indian companies to take strategic measures for their survival and growth. They should

formulate strategy to achieve the competitive advantage and sustain their edge over the

rivals. The focal points of such strategy have to be on quality and cost which together

contribute significantly to organisational effectiveness.

In translating this strategy into action the finance manager has to play a very effective

and integrated role by helping the top management in making financial decisions to

reduce cost, improve productivity and maximise corporate value.

To handle the new responsibilities the finance manager must have clear conception of

the corporate objectives of his organization as he has to act in conformity with these

objectives. Furthermore, he has to evaluate the effectiveness of financial decisions in

the light of some standards. Corporate objectives of the organisation provide such

standards. The finance manager should also have stronger grasp of the nature, functions

and scope of financial management.

Further, he needs a variety of qualitative and quantitative skills so as to carry out his

complex and diverse responsibilities.

We all know it very well that environment keeps changing and thus brings in new

challenges every time, let us discuss on the new challenges been faced by finance

manager.

Finance managers are presently facing some new challenges as

indicated below:

TREASURY OPERATIONS: Short-term fund management must be more

sophisticated. Finance managers could make speculative gains by anticipating

interest rate movements.

FOREIGN EXCHANGE: Finance Managers will have to weigh the costs and

benefits of playing with foreign exchange particularly now that the Indian

economy is going global and the future value of the rupee visa a vis foreign

currency has become difficult to predict.

FINANCIAL STRUCTURING: An optimum mix between debt and equity will

be essential. Firms will have to tailor financial instruments to suit their and

investors' needs. Pricing of new issues is an important task in the Finance

Manager’s portfolio now.

MAINTAINING SHARE PRICES: In the premium equity era, firms must ensure

that share prices stay healthy. Finance managers will have to devise appropriate

dividend and bonus policies.

ENSURING MANAGEMENT CONTROL: Equity issues at premium means

managements may lose control if they are unable to take up their share

entitlements. Strategies to prevent this are vital.

IMPORTANT Slide 1

1

Instructors: Instructors: RU FacultyRU Faculty

Lecture Times:

As per the time table

FINANCIAL MANAGEMENT FINANCIAL MANAGEMENT ––JULY 2004 JULY 2004 –– DEC 2004DEC 2004

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The main objective is to provide an understanding of financial decision making and financial theory from the point of view of corporate financial managers in competitive financial markets. This course serves as an introduction to business finance (corporate financial management and investments) for both non-finance concentration students and those electing a finance concentration preparing for upper-level course work. The course’s objective is to provide a framework, concepts, and tools for analyzing corporatefinance problems and issues, based on fundamental principles of modern financial theory, with an understanding of application to“real-world” scenarios. The approach is rigorous and analytical. Topics covered include discounted cash flow techniques; corporate capital budgeting and valuation; investment decisions under uncertainty; including capital structure, cost of capital, dividend policy, and working capital management.

COURSE DESCRIPTION & OBJECTIVECOURSE DESCRIPTION & OBJECTIVE

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Slide 3

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M Y KHAN & P K JAIN,

Financial Management: Text and Problems

Tata McGraw-Hill Publishing Company Limited

PRESCRIBED TEXTPRESCRIBED TEXT

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Lecture presentations will generally consist of notes (presentation, slides, and whiteboard) and in-class discussions and problem solving. The course pedagogy will involve the use of the case method. Problems and selected solutions will also be given to students. Suggested practice problems from the end of chapter questions in the text are identified in the detailed course outline. Students are required to read all assigned chapters prior to the lecture period during which the topic is to be discussed.

TEACHING METHODOLOGYTEACHING METHODOLOGY

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POLICIES & GUIDELINESPOLICIES & GUIDELINES

PurposeThe purposes of these Guidelines are:

To provide students with an input into the structure and content of the course;To focus on the rights and obligations of both student and instructor;To foster collaborative learning and to encourage individuals to take responsibility for their learning both during and after the completion of the course.

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POLICIES & GUIDELINESPOLICIES & GUIDELINES

The StudentSTUDENTS ACCEPT the individual and collective responsibility of obtaining and becoming familiar with a copy of the Course Outline. STUDENTS AGREE to avail themselves of copies of the required readings and to duly undertake the assigned readings.STUDENTS AGREE to be in possession of the computer skills necessary to send and retrieve MS Word, Excel, and PowerPointdocuments via the Internet.STUDENTS AGREE to regularly conduct searches via the World Wide Web or journals maintained by the library of the University.

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POLICIES & GUIDELINESPOLICIES & GUIDELINES

STUDENTS AGREE to visit suggested web sites as necessary to obtain materials relevant to the course.STUDENTS AGREE to read the recommended material prior to each class.STUDENTS AGREE to attend all classes in the absence of extenuating circumstances.STUDENTS AGREE to participate as fully as possible in class discussions.STUDENTS AGREE to share all relevant information with other members of the class.STUDENTS RECOGNIZE that the presentation of other people’s work as their own represents the worst form of academic misconduct.

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POLICIES & GUIDELINESPOLICIES & GUIDELINES

The FacultyThe Faculty AGREES to treat each student fairly and impartially.The Faculty AGREES to respect the opinions and ideas of all students.The Faculty AGREES to make himself/herself available for consultation with individual students or groups of students as necessary.The Faculty AGREES at all times to ensure that the course is delivered at the highest possible academic standard. The Faculty AGREES to ensure that sufficient and relevant material is made available for students.The Faculty AGREES except in extenuating circumstances to be punctual at all times and where this is not possible to explain his/her tardiness.The Faculty AGREES to maintain ongoing consultation with the students to ensure that the course is at all times meeting the needs of the students.

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POLICIES & GUIDELINESPOLICIES & GUIDELINES

Group WorkStudents will form themselves into groups for purposes of doing their course assignments and for purposes of collaborative learning.Each member will fully participate in the work of the group ensuring that (s)he makes an equitable contribution to the work of the group.Each group member will honestly, fairly, and independently evaluate his work and that of her/his fellow group members using forms provided by the instructor and will return those forms to the instructor at the time prescribed by the course outline.

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COURSE CONTENTCOURSE CONTENT

Core concepts of financial managementLong-term investment decisionsFinancing decisionDividend policy decisionManagement of Working Capital Recent trends

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