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Core concepts in 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


                          FINANCIAL MANAGEMENT –
                                    JULY 2004 – DEC 2004


                     Instructors:             RU Faculty
                      Lecture Times:

                      As per the time table




                                                           1




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                             COURSE DESCRIPTION & OBJECTIVE

                  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 corporate
                  finance 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.
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                           PRESCRIBED TEXT


                         M Y KHAN & P K JAIN,
                     Financial Management: Text and
                                Problems
                  Tata McGraw-Hill Publishing Company
                               Limited

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                              TEACHING METHODOLOGY
                 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.




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                            POLICIES & GUIDELINES

                  Purpose
                  The 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 & GUIDELINES

                 The Student
                   STUDENTS 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 PowerPoint
                   documents 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 & 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 & GUIDELINES
                 The Faculty
                   The 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 & GUIDELINES

                 Group Work
                   Students 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 CONTENT

                   Core concepts of financial management
                   Long-term investment decisions
                   Financing decision
                   Dividend policy decision
                   Management of Working Capital
                   Recent trends



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