Introduction to Financial Management

I am saving for retirement. Should I use a

pension fund, mutual fund, direct stock
market investment ?
I want that new car. Should I use my cash
saving, lease, borrow?
Which is the best way to pay for my holidays,
for my house?
Im thinking about starting a new business.
Will it reward me adequately?
A Company has asked for major project
financing. Should my organization provide
the funds?

 to

run a business.
For input operations.
For managerial activities.

DEFINITION:

Finance may be defined as the position of

money at the time it is wanted
-----according to F.W. Paish.

 Financial

means procuring sources of money

supply and allocation of these sources on the
basis of forecasting monetary requirements
of the business.
Management refers to planning ,
organization, coordination and control of
human activities and physical resources for
achieving the objectives of an enterprise

 The

traditional approach.
The modern approach.

 Under

this approach financial management

was consider as corporation finance.
The following three things were to be
studied for procurement of finances:1. institutional sources of finance.
2. issue of financial instrument to collect
necessary funds from capital market.
3. legal and accounting relationship between
business and sources of finance.

 Estimating

financial requirements.
Deciding capital structure.
Selecting a source of finance.
Selecting a pattern of investment.
Proper cash management.
Implementing financial control.
Proper use of surpluses.

 The

focus of this approach is on the following

questions:What is the total amount of funds an
enterprise should commit?
What specific assets an enterprise should
acquire?
How should the funds required to raised?
Fund requirement decision.
Financing decision.
Investment decision.
Dividend decision.

 Introduction
Present

and future values

Present and future value factors
Compounding
Growing income streams

 Time

has a value

If we owe, we would prefer to pay money later

If we are owed, we would prefer to receive
money sooner
The longer the term of a single-payment loan,
the higher the amount the borrower must repay

10

 Basic

time value of money relationships:

PV FV DF
FV PV CF

where PV = present value;

FV = future value;
DF = discount factor = 1/(1 R)t
CF = compounding factor = (1 R)t
R = interest rate per period; and
t = time in periods
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present value is the discounted value of

one or more future cash flows
A future value is the compounded value of a
present value
The discount factor is the present value of a
dollar invested in the future
The compounding factor is the future value
of a dollar invested today

12

 Why

is a dollar today worth more than a

dollar tomorrow?

The discount factor:

Decreases as time increases

The farther away a cash flow is, the more we
discount it
Decreases as interest rates increase
When interest rates are high, a dollar today is worth
much more than that same dollar will be in the
future

13

 Situations:

Know the future value and the discount factor

Know the future value and present value

Like solving for the theoretical price of a bond

Like finding the yield to maturity on a bond

Know the present value and the discount rate

Like solving for an account balance in the future

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 Single

sum factors
How we get present and future value tables
Ordinary annuities and annuities due

15

 Present

value interest factor and future

value interest factor:

PV FV PVIF
FV PV FVIF
where
1
PVIF
t
(1 R)
FVIF (1 R)t
16

Example
You just invested $2,000 in a three-year bank
certificate of deposit (CD) with a 9 percent
interest rate.
How much will you receive at maturity?

17

Example (contd)
Solution: Solve for the future value:

FV $2, 000 1.093

$2, 000 1.2950
$2,590

18

 Standard

time value of money tables present

factors for:

Present value of a single sum

Present value of an annuity
Future value of a single sum
Future value of an annuity

19

 Relationships:

You can use the present value of a single sum to

obtain:

The present value of an annuity factor (a running total

of the single sum factors)
The future value of a single sum factor (the inverse of
the present value of a single sum factor)

20

 An

annuity is a series of payments at equal

time intervals

An

ordinary annuity assumes the first

payment occurs at the end of the first year

An

annuity due assumes the first payment

occurs at the beginning of the first year

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Example
You have just won the lottery! You will receive
$1 million in ten installments of $100,000 each.
You think you can invest the $1 million at an 8
percent interest rate.

What is the present value of the $1 million if the

first $100,000 payment occurs one year from
today? What is the present value if the first
payment occurs today?
22

Example (contd)
Solution: These questions treat the cash flows as
an ordinary annuity and an annuity due,
respectively:

PV of ordinary annuity $100, 000 6.7100 $671, 000

PV of annuity due $100, 000 ($100, 000 6.2468) $724, 680

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 Definition
Discrete

versus continuous intervals

Nominal versus effective yields

24

 Compounding

refers to the frequency with

which interest is computed and added to the
principal balance

The more frequent the compounding, the higher

the interest earned

25

 Discrete

compounding means we can

count the number of compounding periods
per year

E.g., once a year, twice a year, quarterly,

monthly, or daily

Continuous

compounding results when

there is an infinite number of
compounding periods

26

 Mathematical

adjustment for discrete

compounding:

FV PV (1 R / m) mt
R annual interest rate
m number of compounding periods per year
t time in years
27

 Mathematical

equation for continuous

compounding:

FV PVe Rt
e 2.71828

28

Example
Your bank pays you 3 percent per year on your
savings account. You just deposited $100.00 in
your savings account.
What is the future value of the $100.00 in one
year if interest is compounded quarterly? If
interest is compounded continuously?

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Example (contd)
Solution: For quarterly compounding:

FV PV (1 R / m) mt
$100.00(1 0.03 / 4)4
$103.03

30

Example (contd)
Solution (contd): For continuous compounding:

FV PVe

Rt

$100.00 e0.03
$103.05

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 The

stated rate of interest is the simple rate

or nominal rate

3.00% in the example

The

interest rate that relates present and

future values is the effective rate

$3.03/$100 = 3.03% for quarterly compounding

$3.05/$100 = 3.05% for continuous compounding

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 Definition
Growing

annuity
Growing perpetuity

33

growing stream is one in which each

successive cash flow is larger than the
previous one

A common problem is one in which the cash flows

grow by some fixed percentage

34

growing annuity is an annuity in which the

cash flows grow at a constant rate g:

C
C (1 g ) C (1 g ) 2
C (1 g ) n
PV

...
2
3
(1 R) (1 R)
(1 R)
(1 R) n 1
N

C1
1 g

1

R g 1 R

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growing perpetuity is an annuity where

the cash flows continue indefinitely:

C
C (1 g ) C (1 g ) 2
C (1 g )
PV

...
2
3
(1 R) (1 R)
(1 R)
(1 R)
Ct (1 g )t 1
C1

t
(1 R)
Rg
t 1

36