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Financial Management

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Financial Management
Prescribed Text Book:
Corporate Finance by Ross, S. A.Westerfield, R. W. and
Jaffe, J., The McGraw-Hill Companies, 2010.
Other Reference/Suggested Books:
Corporate Finance by Ross, S. A.Westerfield, R. W.-Jaffe, J. and
Kakani, R. K., The McGraw-Hill Education (India) Pvt. Ltd, 2014.
Corporate Finance: A Focussed Approach by Brigham, E. and
Ehrhardt, M. C., South Western Cengage Learning, 2013.
Financial Management by Khan, M. Y. and Jain, P. K., McGraw-Hill
Education (India) Pvt. Ltd, 2014.
Principles of Corporate Finance by Brealey, R.-Myers, S. and Allen,
F. The McGraw-Hill Companies, 2014.
Corporate Financial Analysis with Microsoft Excel by Francis J.
Clauss, The McGraw-Hill Companies, 2010.
Financial Management:
An Overview
Finance
Finance may be defined as the art and science of managing
money. The major areas of finance are:

1. Financial Services
Financial services is concerned with the design and delivery of advice and
financial products to individuals,
business and governments.

2. Financial Management
Financial Management is that managerial activity which is concerned
with planning, controlling and managing the financial resources of a
given firm.

Financial managers actively manage the financial affairs of any type of


business, namely, financial and non-financial, private
and public, large and small, profit-seeking and not-for-profit.
Finance and Related Disciplines
Finance and Economics
Finance is closely related to both macroeconomics and
microeconomics.
Macroeconomics provides an understanding of the institutional
structure in which the flow of finance takes place.
Microeconomics provides various profit maximization strategies
based on the theory of the firm.
One of the fundamental principle of financial management
suggests that financial decisions should be based on Marginal
Analysis.
Marginal Analysis suggests that financial decisions should be
made on the basis of comparison of marginal revenues and
marginal costs/added benefits exceed added costs.
A financial manager uses these to run the firm efficiently and
effectively.
Illustration of a Financial Decision using Marginal Analysis

A financial manager of a department store is


contemplating to replace one of its online computers
with a new, more sophisticated one that would both
speed up processing time and handle a large volume of
transactions. The new computer would require a cash
outlay of Rs 8,00,000 and the old computer could be sold
to net Rs 2,80,000. The total benefits from the new
computer and the old computer would be Rs 10,00,000
and Rs 3,50,000 respectively. Should the manager
replace the old computer by the new one?
Illustration of a Financial Decision using Marginal Analysis

Benefits with new computer Rs 10,00,000


Less: Benefits with old computer 3,50,000
Marginal Revenue (a) Rs 6,50,000
Cost of new computer 8,00,000
Less: Proceeds from sale of old 2,80,000
computer

Marginal Cost (b) 5,20,000


Net Benefits [(a) (b)] 1,30,000
As the store would get a net benefit of Rs 1,30,000, the old computer should
be replaced by the new one.
Finance and Accounting
Accounting generates information/data to
operations/activities of a firm. The end product of
accounting is the generation of financial statements of
a firm.
A financial manager depends on these financial
statements as a source of information/data relating to
the past, present and future financial position of the
firm for making any financial decision.
However, finance and accounting differ in two ways:
1. Treatment of Funds and
2. Decision Making.
Finance and Accounting
Treatment of Funds: The measurement of funds in
accounting is based on the accrual principle where as
the in finance it is based on cash flows.
Accrual method recognizes revenue at the point of sale
and not when collected and expenses when they are
incurred rather than when actually paid.
Cash flows method recognizes revenues and expenses
only with respect to actual inflows (when cash is
actually received) and outflows of cash (when cash is
actually paid).
To illustrate, total sales of a trader during the year amounted to Rs
10,00,000 while the cost of sales was Rs 8,00,000. At the end of the
year, it has yet to collect Rs 8,00,000 from the customers. The
accounting view and the financial view of the firms performance during
the year are given below.
Accounting view Financial view

(Income statement) (Cash flow statement)

Sales Rs 10,00,000 Cash inflow Rs 2,00,000


Less: Costs 8,00,000 Less: Cash outflow 8,00,000
Net profit 2,00,000 Net cash outflow (6,00,000)
Finance and Accounting
Decision Making: The focus of finance is on the
decision making where as accounting concentrates on
collection, compilation and presentation of financial
data.

Finance and Other Related Disciplines


Apart from economics and accounting, finance also
drawsfor its day-to-day decisionson supportive
disciplines such as marketing, operations, production, HR
and quantitative methods.
The relationship between Financial
Management and supportive Disciplines

Financial Decision Areas


Primary Disciplines
1. Investment Analysis Accounting
Support
2. Working Capital Management Macroeconomics
3. Sources and Cost of Funds Microeconomics
4. Determination of Capital
Structure Other Related Disciplines
Support
5. Dividend Policy Marketing
6. Analysis of Risks and Returns Production
Operations
Resulting in Quantitative methods
HR
Shareholder Wealth Maximization
Scope of Financial Management
Financial Management addresses the following
three questions:
1. What long-term and short-term investments should
the firm engage in?
2. How can the firm raise the money for the required
investments?
3. What proportion of net profits can be distributed to
the shareholders in the form of dividends and what
proportion can be retained in the business itself ?
Scope of Financial Management
The scope of financial management can be broken down into three major
decisions as functions of finance:
(1) Investment Decision
The investment decision relates to the selection of assets in which funds
will be invested by a firm. The assets which can be acquired fall into two
broad groups: (a) fixed-assets/long-term assets (Capital Budgeting) (b)
short-term /current assets (Working Capital).

(a) Capital Budgeting: Capital budgeting is probably the most crucial


financial decision of a firm. It relates to the selection of an asset or
investment proposal or course of action whose benefits are likely to be
available in future over the lifetime of the project.
(b) Working Capital Management: Working capital management is
concerned with the management of current assets. It is an important and
integral part of financial management as short-term survival is a
prerequisite for long-term success.
(2) Financing Decision
Financing decision relates to the choice of the proportion of debt and equity
sources of financing. While the investment decision is broadly concerned
with the asset-mix or the composition of the assets of a firm, the concern of
the financing decision is with the financing-mix or capital structure or
leverage.
There is one major aspect of the financing decision, called the optimum
capital structure.

(3) Dividend Policy Decision


The dividend decision relates to the distribution and retention of net profits of
a firm.
The two alternatives available with the firm are:
(i) Net profits can be distributed to the shareholders in the form of dividends
or (ii) they can be retained in the business itself. The decision as to which
course should be followed depends largely on a significant element in the
dividend decision, the dividend-pay out ratio, that is, what proportion of net
profits should be paid out to the shareholders and what proportion should be
retained in the business.
The Balance-Sheet Model
of the Firm
Total Firm Value to Investors: Total Value of Assets:
Fixed Assets
Shareholders 1 Tangible
Equity
2 Intangible

Long-Term
Debt
Current Assets

Current
Liabilities
The Balance-Sheet Model
of the Firm
The Capital Budgeting and Working Capital
Decision Fixed Assets
Shareholders
1 Tangible
Equity What Long-term
investments 2 Intangible
should the firm
engage in?

Long-Term Debt

What Short-term
investments
should the firm Current Assets
Current engage in?
Liabilities
The Balance-Sheet Model
of the Firm
The Financing Decision
Fixed Assets
Shareholders
1 Tangible
Equity
2 Intangible

How can the firm


raise the money for
the required
Long-Term Debt investments?

Current Assets
Current
Liabilities
The Balance-Sheet Model
of the Firm
The Net Working Capital Decision
Fixed Assets
Shareholders
1 Tangible
Equity
2 Intangible

Long-Term Debt Net


Working
Current Assets
Capital
Current
Liabilities
Key Activities/Functions of the Financial Manager
1. Performing Financial Analysis and Planning
The concern of financial analysis and planning is with (a) transforming
financial data into a form that can be used to monitor financial condition,
(b) evaluating the need for increased (reduced) productive capacity and
(c) determining the additional/reduced financing required.
2. Making Investment Decisions
Investment decisions determine both the mix and the type of assets held
by a firm. The mix refers to the amount of current assets and fixed
assets.
3. Making Financing Decisions
Financing decisions involve two major areas: first, the most appropriate
mix of short-term and long-term financing; second, the best individual
short-term or long-term sources of financing at a given point of time.
4. Making Dividend Policy Decisions
The dividend decision relates to the distribution and retention of net
profits of a firm (the dividend-pay out ratio).
Separation of Ownership and Control:
Agency Problem

Board of Directors

Debtholders

Shareholders
Management

Debt
Assets
Equity
Agency Problem
An agency problem results when managers as
agents of owners (principal) place personal goals
ahead of corporate goals. Market forces and the
threat of hostile takeover tend to act to
prevent/minimise agency problems. In addition,
firms incur agency costs in the form of monitoring
and bonding expenditures, opportunity costs and
structuring expenditures which involve both
incentive and performance-based compensation
plans to motivate management to act in the best
interest of the shareholders.
Objectives / Goals of the Corporation

1. Profit Maximization (Profit/Earning per Share


(EPS) Maximization---Profit refers to the amount
and share of income which is paid to the owners
of business who supply equity capital)
2. Stockholder Wealth Maximization (Maximizing
the price of the firms common stock)
Objectives / Goals of the Corporation
Profit Maximization v/s Wealth Maximization

Profit Maximization Wealth Maximization


1. Ambiguity 1. No Ambiguity (Concept of cash
(Short-term, long-term, total profit flows generated by the decision
or rate of profit, profit before tax or rather than accounting profit)
after tax, return on total capital
employed or total assets or
shareholder's equity)
2. No Time Value of Money (Ignores 2. Time Value of Money (the value of
the difference in the time pattern of a stream of cash flows is calculated
the benefits received in different time by discounting its element back to
period and treats all benefits the present at a discount rate which
irrespective of the timing as equally reflects both time and risk)
valuable)
Objectives / Goals of the Corporation
Profit Maximization v/s Wealth Maximization

Profit Maximization Wealth Maximization


3. No Quality of Benefits (It 3. Quality of Benefits (The
ignores degree of certainty with discount rate reflects the risk
which benefits can be expected) preference and time of the
owners or suppliers of capital).
Timing of Benefits
A more important technical objection to profit maximisation, as a guide
to financial decision making, is that it ignores the differences in the
time pattern of the benefits received over the working life of the asset,
irrespective of when they were received.

Time-Pattern of Benefits (Profits)


Time Alternative A (Rs in lakh) Alternative B (Rs in lakh)
Period I 50
Period II 100 100
Period III 50 100
Total 200 200
Quality of Benefits
Probably the most important technical limitation of profit maximization
as an operational objective, is that it ignores the quality aspect of
benefits associated with a financial course of action. The term quality
here refers to the degree of certainty with which benefits can be
expected.

Risk and Uncertainty About Expected Benefits (Profits)


State of Economy Profit (Rs crore)
Alternative A Alternative B
Recession (Period I) 9 0
Normal (Period II) 10 10
Boom (Period III) 11 20
Total 30 30
The Firm and the Financial Markets
The Firm and the Financial Markets:

Firm Firm issues securities/shares (A)


Financial
Invests Markets
Retained
in Assets cash flows (E)
(B)
Short-term Debt
Current Assets Cash flow Dividends and Long-term Debt
Fixed Assets from firm (C) debt payments (F)
Equity Shares

Taxes (D)

Ultimately, the firm must The cash flows from


be a cash generating the firm must
activity. exceed the cash
Government
flows from the
financial markets.
Time Value of Money
Time Value of Money
(Time Preference for Money)
Time value of money means that the value of a unit of
money is different in different time periods. Money has
time value.
A rupee today is more valuable than a rupee a year hence
or a rupee a year hence has less value than a rupee
today.
Money has, thus, a future value and a present value.
Time Value of Money
(Time Preference for Money)
Time preference for money is a preference for
possession of a given amount of money now, rather than
the same amount at some future time.
Three reasons may be attributed to the time preference
for money:
Risk
Preference for Consumption
Investment Opportunities
Techniques for Time Value Adjustment
1. Discounting Techniques: The process of calculating
present values of cash flows.
2. Compounding Techniques: The process of calculating
future values of cash flows.
Discounting to calculate PV of Compounding to calculate FV
a expected cash flow of a expected cash flow
$?
$1

i i

0 0 t
Year t

$?
$1

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Discounting Technique: Present Value
Present Value: Present value of a future cash flow
is the current value of a future amount.
Discounting: Discounting is the process of
determining the present value of a series of future
cash flows or a lump sum amount.
Discount Rate (Required Rate of Return): It is the
interest rate used for discounting cash flows.
The Discounting Process
1. Estimating the Cash flow
Cash flow: The cash that is expected to be received
each period from investing in a particular financial/real
asset.
Reasons why cash flow of financial/real assets is not known:

1. The issuer of a debt instrument might default


2. Provisions included in most debt instruments grant the
issuer and/or the investor the right to change how the
borrowed funds are repaid
3. The interest rate the issuer pays can change over the
time the borrowed funds are outstanding
4. The project might fail or generate/realize less cash flows
than expected

Example: The holder of common stock of a corporation


faces uncertainty as to the amount and the timing of
dividend payments.

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2. Determine the appropriate Discount Rate for discounting
the future expected cash flow
It is determined by addressing two questions:
1. What is the minimum interest rate the investor
should require?
The interest rate available in the financial market
on a default(risk)-free cash flow
2. How much more than the minimum interest rate
should the investor require? (Premium required for
perceived risk)
Should reflect the risks associated with realizing
the cash flow expected
3. Value of Financial Assets= PV of Expected Cash Flow

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Summary of
Discounting
Process

Required Rate of Return =


Risk-Free Rate + Risk Premium

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Calculation of Present Values

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Present Value:
The One-Period Case (Single Cash Flow)
PV of a single cash flow (lump sum amount) to be received
in future is calculated as follows:

C1
PV =
1+ i
where C1 is cash flow at date 1 and i is the appropriate interest rate
Present Value of a Series of Cash Flows
Multi-Period Case
In many instances, especially in capital budgeting
decisions, we may be interested in the present value of a
series of receipts received by a firm at different time
periods.
n
C1 C2 C3 Cn Ct
PV = + + + ... + =
(1 + i ) (1 + i ) (1 + i )
2 3
(1 + i ) t =1 (1 + i )
n t

Where PV = The sum of the individual present values of cash flows;


C1, C2,C3Cn for time period 1,2,3n
Present Value Tables and Present value interest factor (PVIF)
In order to simplify the present value calculations, present value tables (PV Tables)
are readily available for various ranges of i and n which contain the present value
interest factors (PVIF) at various discount rates and years.
In terms of a formula, it will be:

PV = A (PVIF)
Present value interest factor is the multiplier used to calculate at a specified
discount rate the present value of an amount to be received in a future period.

Example

Mr X wants to find the present value of Rs. 2,000 to be received 5 years


from now, assuming 10 per cent rate of interest. We have to look in the
10 per cent column of the fifth year in Table. The relevant PVIF as per PV
Table is 0.621.
Therefore, Present Value = Rs 2,000 (0.621) = Rs. 1,242.
The PV Function
= PV(rate, nper, pmt, fv, type)
Computes the present value of a series of equal payments for a
specified number of periods at a specified rate of interest.
Payments can be made at either the beginning or end of each
period.
where rate = the interest rate per period (i.e., per
year, month, etc.), which remains constant
throughout the total number of periods
nper= total number of periods (i.e., number of years,
months, etc.)
pmt = the payment made each period. (Periodic
payments, if any, remain constant throughout the
total number of periods.) 45
ContdThe PV Function
= PV(rate, nper, pmt, fv, type)
fv = the future value, or the cash balance you want to
attain after the last payment is made. If future value
is omitted, it is assumed to be zero (e.g., the future
value of a loan is zero).
type = 0 if periodic payments are made at the end of
each period, 1 if periodic payments are made at the
beginning of each period.

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The NPV Function for a Series of Cash Flows
= NPV(rate, value1, value2, value3)
Computes the present value of a series
(equal/mixed) of cash flows for a specified number
of periods at a specified rate of interest. Payments
can be made at either the beginning or end of each
period, as specified by the value for type.

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Net Present Value
It is the difference between the present value
of cash inflows and the present value of cash
outflows.
NPV is used in capital budgeting to analyze
the profitability of an investment or project.
If the NPV of a prospective project is positive,
it is accepted.
If NPV is negative, the project is probably
rejected because cash flows will also be
negative.

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Net Present Value
n
Ct
NPV = C0 +
t =1 (1 + i )
t

where C0 = Todays cash outflow


Ct = Cash inflow at time t
i = Discount rate

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Calculation of Future Values

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Calculation of Future Values (FV)
The process of going from todays values, or present values
(PVs), to future values (FVs) is called compounding.
Specifically, the process of finding the future values of cash
flows by applying the concept of compound interest.
The general formula for the future value of an investment over
many periods can be written as:
FVn = PV(1 + i)n
where,
PV is cash flow at date 0, r is the appropriate interest rate, and
n is the number of periods over which the cash is invested.

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The FV Function
= FV(rate, nper, pmt, pv, type)
rate = the interest rate per period (i.e., per year,
month, etc.), which remains constant throughout
the total number of periods
nper= total number of periods (i.e., number of
years, months, etc.)
pmt = the payment made each period (periodic
payments, if any, remain constant throughout the
total number of periods)

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The FV Function
= FV(rate, nper, pmt, pv, type)
pv= the present value of an investment, or, if
periodic payments are made, the lump sum
amount that the series of future payments is worth
right now
type = 0 if periodic payments are made at the end
of each period, 1 if periodic payments are made at
the beginning of each period.

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Future (compounded) Value of a Series of Payments
For simplicity, we assume that the compounding time period is one year and payment
is made at the END of each year. Suppose, Mr X deposits each year Rs 500, Rs 1,000,
Rs 1,500, Rs 2,000 and Rs 2,500 in his saving bank account for 5 years. The interest
rate is 5%. He wishes to find the future value of his deposits at the end of the 5th year.
You are required to determine the sum of money he will have.

n nt
FVn = CFt (1 + r )
t =1

where, CF is cash flow at time t, r is the appropriate interest rate, and n is the
number of periods over which the cash is invested.
Comparison of Annual, Semi-annual and Quarterly Compounding
End of year Compounding period
Annual Half-yearly Quarterly
1 Rs 1,060.00 Rs 1,060.90 Rs 1,061.36
2 1,123.60 1,125.51 1,126.49
The effect of compounding more than once a year can also be expressed in the
form of a formula. Earlier equation can be modified as below:
mn
i
FV = PV 1 +
m

in which m is the number of times per year compounding is made and n is the
time period. For semi-annual compounding, m would be 2, while for quarterly
compounding it would equal 4 and if interest is compounded monthly, weekly
and daily, would equal 12, 52 and 365 respectively.
The general applicability of the formula can be shown as follows, assuming the
same figures of Mr Xs savings of Rs 1,000:
1. For semi-annual compounding, Rs 1,000 [1 + (0.06/2)]2x2 = Rs 1,000 (1 +
0.03)4 = Rs 1,125.51
2. For quarterly compounding, Rs 1,000 [1 + (0.06/4)]4x2 = Rs 1,000 (1 +
0.015)8 = Rs 1,126.49
Continuous Compounding
One can compound much more frequently than once a year; one
could compound semiannually, quarterly, monthly, weekly, daily,
hourly, each minute, or even more often. The limiting case would
be to compound multiple times with n is infinite (every
infinitesimal instant), which is commonly called continuous
compounding.
With continuous compounding, the future value at the end of T years is expressed as:

C0(ert)
where C0 is the initial investment, r is the annual interest rate, and T is the number of years
over which the investment runs. The number e is a constant and is approximately equal to
2.718.
Excel Function:
Continuous Compounding Function
=Initial Deposit*EXP(number)
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Continuous Compounding

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Continuous Discounting
One can discount much more frequently than once a year; one
could discount semiannually, quarterly, monthly, weekly, daily,
hourly, each minute, or even more often. The limiting case would
be to discounting multiple times with n is infinite (every
infinitesimal instant), which is commonly called continuous
discounting.
With continuous discounting, the present value at the end of T years is expressed as:

C0(e-rt)
where C0 is the initial investment, r is the annual interest rate, and T is the number of years
over which the investment runs. The number e is a constant and is approximately equal to
2.718.

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Cash Flows: Some Simplifications
Perpetuity
A constant stream of cash flows that lasts forever without
end.
Growing Perpetuity
A stream of cash flows that grows at a constant rate forever.
Annuity
A stream of constant cash flows that lasts for a fixed
number of periods.
Growing Annuity
A stream of cash flows that grows at a constant rate for a
fixed number of periods.
Perpetuity
A constant stream of cash flows that lasts forever without end.

C C C

0 1 2 3

The formula to calculate the present value of a perpetuity is:


Growing Perpetuity
A growing stream of cash flows that lasts forever.
C C(1+g) C (1+g)2

0 1 2 3

The formula for the present value of a growing perpetuity is:


Annuity
A constant stream of cash flows with a fixed maturity.

C C C C

0 1 2 3 T

Note: The present value of receiving the coupons for only T periods
must be less than the present value of a consol, but how much less?
Annuity

Important Observations:
1. Consol 1 is a normal consol with its first payment at date 1. The
first payment of consol 2 occurs at date T+1.
2. The present value of having a cash flow of C at each of T dates is
equal to the present value of consol 1 minus the present value of
consol 2.
Annuity
Important Observations:
3. The present value of consol 1 is given by

4. Consol 2 is just a consol with its first payment at date T+1. From
the perpetuity formula, this consol will be worth C/r at date T.
However, we do not want the value at date T. We want the value
now, in other words, the present value at date 0. We must discount
C/r back by T periods. Therefore, the present value of consol 2 is:
Annuity
Important Observations:
5. The present value of having cash flows for T years is the present
value of a consol with its first payment at date 1 minus the present
value of a consol with its first payment at date at T+1.
6. Thus the present value of an annuity is:

7. This simplifies to the following (Formula for Present Value of


Annuity)
C 1
or PV =
r (1 + r )T
1
Growing Annuity
A growing stream of cash flows with a fixed maturity.
C C(1+g) C (1+g)2 C(1+g)T-1

0 1 2 3 T
C C (1 + g ) C (1 + g )T 1
PV = + ++
(1 + r ) (1 + r ) 2
(1 + r )T
The formula for the present value of a growing annuity:
C 1+ g
T

PV = 1
r g (1 + r )

Growing Annuity: Example
You are evaluating an income property that is providing increasing
rents. Net rent is received at the end of each year. The first year's
rent is expected to be $8,500 and rent is expected to increase 7%
each year. Each payment occur at the end of the year. What is the
present value of the estimated income stream over the first 5 years if
the discount rate is 12%?

$8,500 (1.07) 2 = $8,500 (1.07) 4 =


$8,500 (1.07) = $8,500 (1.07) 3 =
$8,500 $9,095 $9,731.65 $10,412.87 $11,141.77

0 1 2 3 4 5
$34,706.26