FINANCIAL MANAGEMENT

Fundamental Concepts

Agenda
1. 2. 3. 4. Introduction to Financial Management Time value of Mooney Risk and Return Cost of capital

1. Introduction to Financial Management

1. Finance Function 2. Goals of financial management 3. Understand the conflicts of interest that can arise between owners and managers 4. Ethical Behavior and Long Term Profitability 5. Case Study : Stakeholders Management in Power Sector

Finance is the life-blood of business

It is required not only at the time of setting up business but at every stage during existence of business.

Financial Management

Management of Money Systematic efforts of the management to efficiently manage its finances Application of general management principles to particular financial operation

Note There is difference Between Finance & Accounting

Accounting Accounting Profit Total Flow Finance Cash Flow Incremental cash Flow Time value of Money

Key Financial Decisions in a firm

Capital Budgeting

Working capital Management

Dividend Decision

Purpose of Financial Management

Create Wealth

Objectives of Financial Management

Goal of the Firm

Profit Maximization

Shareholder Wealth Maximization

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Fundamental Principle of Finance

Will the decision raise the market value of the firm?

Cash Alone Matters

Risk Return Trade off

Agency Problem
Agency problem : The possibility of conflict of interest between stockholders and management of a firm. Conflicts of interest among stockholders, bondholders, and managers

How to mitigate agency problem ?

Incentives - Managerial Compensation plans Direct Intervention by Shareholders Threat of Sacking Threat of Takeover Corporate governance regulations

Business Ethics & Social Responsibility

Ethical Behaviour Long term profitability
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2. Time value of Money

What is Time Value of Money ?

The Time Value of Money (TMV) is based on the concept that a rupee today is worth more than it would be tomorrow.

Two ways of looking at TVM

FV

TVM

PV

What is Future Value?

FV = PV+ Interest (PV*r) = PV (1+r) =PV ( 1 + r )n

We can use FV concept for decision making

What is PV?
Present Value is a value today of a sum of money to be received at a future points of time. We know that FV=PV ( 1 + r )n
So, PV = FVn / ( 1 + r)n Finding the PV of a cash flow or series of cash flows when compound interest is applied is called discounting (the reverse of compounding).

Worth of a Firm
Conceptually, a firm should be worth the present value of the firms cash flows. The tricky part is determining the size, timing, and risk of those cash flows.

Risk & Return

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What is return ?
Return is difference between an investment amount today and when initially invested
Invested Rs. 1000 one year ago Today that investment is worth Rs.1200 Return ? Return is Rs.200

Expected Return
Expected Return is a weighted average of the individual possible returns

r j pj r
j 1

The symbol for expected return, r, is called r hat. r = Sum (all possible returns their probability)

Expected Return is based on probability Distribution

Risk

Risk refers to the potential variability of returns from a project or portfolio of projects

Risk Premium
Risk Premium is the difference between the expected return on the proposed investment and the risk free rate.

Total risk of any investment

Total risk = Systematic risk + Unsystematic risk (market risk) (diversifiable)

Risk & Beta

The systematic risk, or market risk, can affect all market investments. (A recession or a war, for example, might impact all investments in a portfolio.) We measure the systematic risk by the beta coefficient, or .

Calculating Beta / Expected Return on a Security

For calculating the beta of a security, the following market model is employed:

(This Model is called the Capital Asset Pricing Model (CAPM):

R i RF i ( R M RF )
Expected return on a security RiskBeta of the = + free rate security

ej

Market risk premium

ej

=>

random error term

General rule for

The general rule for is as follows:
If = 1.0 then the investment has "normal" market risk If < 1.0 then the investment has below normal market risk (for example U.S. securities' = 0 or zero risk) If > 1.0 then the investment has a greater than normal market risk (higher risk)

Cost of Capital

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Agenda
Cost of Debt and
Cost of Preference

Cost of Equity
Weighted Average Cost of Capital

Note
Cost of capital is also called as
hurdle rate, cut-off rate, target rate, minimum required rate of return, standard return

As an operational criterion it is related to the firms objective of wealth maximization.

Cost of Debt
kd after taxes = kb (1 tax rate) where kb is before tax cost of debt and kd is after tax cost of debt.

Cost of Equity Capital

Cost of equity is determined by calculating the return on equity. Return on equity comes from two sources:
(a) Dividend (b) Capital gain

Capital Asset Pricing Model (CAPM)

CAPM is the most widely used method to calculate the cost of equity. According to the CAPM approach, there exists a linear relationship between risk and expected return. CAPM calculates the cost of equity by considering the risk-free rate prevalent in the economy and the riskfree premium desired by the investor.

Cost of Retained Earnings

The cost of retained earnings (internal funds) is similar to the cost of equity. Because shareholders forego their current income when they allow the company to use the retained earnings in profitable investments

Weighted Average Cost of Capital (WACC)

WACC is calculated by multiplying the cost of each capital component by its proportional weighting and then summing them.

Ends..