Section - 1

Nature of Financial
Management

Business Activities
Key

functions in an organization are:

Production
Human Resources
Marketing
Finance

Financial

Management is an integral
part of Business Management
It deals with management of
financial resources and related areas
2

Finance Functions
Procurement

& effective utilization of

funds
risk, cost & control considerations are balanced
In

the modern day business, since the size

of business has grown enormously the
finance function in separate & complex one
Involves a number of important decisions
An accountant is not concerned with
management of funds

Finance Functions/role
Investment

or Long Term Asset Mix Decision

Evaluation of profitability of new investments

Cut off rate of new investments
Financing

or Capital Mix Decision

When, where and how to acquire funds

Capital structure: debt-equity mix
Dividend

or Profit Allocation Decision

Distribute-retain what proportion

Cash dividend, bonus shares
Liquidity

or Short Term Asset Mix Decision

Balance firms illiquidity and profitability

Financial Goals
Profit

maximization (profit after

tax)
Maximizing Earnings per Share
(EPS)
Shareholders Wealth Maximization

Profit Maximization
Maximizing

the Rupee Income of

Firm
Resources are efficiently utilized
Appropriate measure of firm performance
Serves interest of society also
E.g.
Issue new shares and invest them in govt.
securities
Profit will increase but EPS decreases
6

Objections to Profit
Maximization
It is Vague
It Ignores the Timing of Returns
It Ignores Risk
Assumes Perfect Competition
In new business environment profit

maximization is regarded as
Unrealistic
Difficult
Inappropriate
Immoral.

Maximizing EPS
Ignores

timing and risk of the expected

benefit
Market value is not a function of EPS.
Hence maximizing EPS will not result in
highest price for company's shares
Maximizing EPS implies that the firm
should make no dividend payment so
long as funds can be invested at positive
rate of returnsuch a policy may not
always work
8

Three Basic Factors

Determine
Market Value of share
1)

Amount of

2)

Timing of

3)

Risk of

Expected
cash flows

Shareholders Wealth
Maximizes the net present value of a course
Maximization

of action to shareholders.
Accounts for the timing and risk of the
expected benefits.
Determines that a good decision increases
the price of the firms common stock
Is an impersonal objective
Benefits are measured in terms of cash flows.
Fundamental objectivemaximize the
market value of the firms shares.

10

EVA Defined...
EVA

is a financial measurement tool

that determines if a business is earning
more than its true cost of capital.

EVA

is the net operating profit minus

an appropriate charge for the
opportunity cost of all capital invested
in an enterprise or project, or net
income minus dollar cost of equity
capital.

EVA is ...
An

estimate of true economic

profit.
A tool that focuses on
maximizing shareholder wealth.
A fundamental measure of Return
on Capital.

Maximizing Shareholder
Wealth and Market Value
Added
Maximize

shareholder wealth only

if the companys managers are
able to add value to the Total
Equity Capital

This

added value is what we call,

Market Value Added, or MVA

Importance between Market

Value and MVA: GM Example
In

1988, General Motors:

Market Value = $25

billion
Total Equity Capital = $45 billion
MVAGM = $25 billion - $45 billion
= - $20 billion

Importance between Market

Value and MVA: Merck
Example
In

1988, Merck:
Market Value = $25

billion
Total Equity Capital = $5 billion
MVAMERCK = $25 billion - $5 billion
= + $20 billion

MVA: GM and Merck

Same

Market Values at the end of

1988.
However, Merck created $20
billion while GM destroyed
roughly the same amount.
MVAGM = - $20 billion
MVAMERCK = + $20 billion

Calculating EVA
Estimate

based on revised reported

earnings:
EVA = Sales Operating Expenses Depreciation - Interest Expenses
(includingTaxes) Equity
Financing Expenses
( or, Cost of
Equity x Total Equity Capital)
= Net Income - Cost of Equity x Total Equity
Capital

The Coca-Cola Company

Example
EVA

= Net Income Keq x Total Equity

Capital
= $3,533 million 12% x
$7,700
million
= $3,533 million $924 million
= $2,609 million

The

$2.6 billion is an estimate of the

companys true economic profit for
1998.

Risk-return Trade-off
Risk

and expected return move in

tandem; the greater the risk, the
greater the expected return.
Financial decisions of the firm are
guided by the risk-return trade-of.
The return and risk relationship:
Return
= Risk-free rate + Risk premium
Risk-free rate is a compensation for
time and risk premium for risk.
19

Managers Versus
Shareholders Goals

A company has stakeholders such as employees,

debt-holders, consumers, suppliers, government
and society.
Managers may perceive their role as reconciling
conflicting
objectives
of
stakeholders.
This
stakeholders view of managers role may
compromise with the objective of SWM.
Managers may pursue their own personal goals at
the cost of shareholders, or may play safe and
create satisfactory wealth for shareholders than the
maximum.
Managers may avoid taking high investment and
financing risks that may otherwise be needed to
maximize shareholders wealth. Such satisfying
behaviour of managers will frustrate the objective
of SWM as a normative guide.

20

Financial Goals and Firms Mission

and Objectives
Firms

primary objective is maximizing the

welfare of owners, but, in operational terms,
they focus on the satisfaction of its customers
through the production of goods and services
needed by them
Firms state their vision, mission and values in
broad terms
Wealth maximization is more appropriately a
decision criterion, rather than an objective or a
goal.
Goals or objectives are missions or basic
purposes of a firms existence
21

Financial Goals and Firms Mission

and Objectives
The

shareholders wealth maximization

is the second-level criterion ensuring
that the decision meets the minimum
standard of the economic performance.
In
the final decision-making, the
judgement of management plays the
crucial role. The wealth maximization
criterion would simply indicate whether
an action is economically viable or not.

22

Organisation of the Finance

Functions
Reason

for placing the finance

functions in the hands of top
management
Financial decisions are crucial for the
survival of the firm.
The financial actions determine solvency of
the firm
Centralisation of the finance functions can
result in a number of economies to the firm.

23

Status and Duties of Finance

Executives
The

exact organisation structure

for financial management will differ
across firms.
The financial officer may be known
as the financial manager in some
organisations, while in others as
the vice-president of finance or the
director of finance or the financial
controller.
24

Role of Treasurer and

Controller
Two

more officersthe treasurer

and the controllermay be
appointed
under
the
direct
supervision of CFO to assist him or
her.
The treasurers function is to raise
and manage company funds while
the controller oversees whether
funds are correctly applied.
25

Section - 2
Concepts of Value
and Return

Objectives
Understand

what gives money its

time value.
Explain the methods of calculating
present and future values.
Highlight the use of present value
technique (discounting) in financial
decisions.
Introduce the concept of internal
rate of return.
27

Sounds like a good deal

Is
it? MOTOR CREDIT offered some
TOYOTA
securities for sale at $24,099 to the public on
March 28, 2008. Under the terms of the deal,
TMCC promised to repay the owner of one of
these securities $100,000 on March 28, 2038,
but investors would receive nothing until
then.
Good

deal? how to analyze this trade-off?

plus side, you get back about $4 for every $1
down side, you have to wait 30 years to get it

28

Jill made a better

investment...
Isnt
it? He got a job
Jack decided not to go
to college.
at 18 and invested $4,000 each year. He
stopped after 8years after investing a total of
$32,000. His sister, Jill, went to MBA school +
MS, started her career at age 26, at which
point she began contributing $4,000. Jill did
this for 40 years from 26 to 65. She invested a
total of $160,000 and put her money into the
same investment as her brother. Jill started
investing the same year Jack stopped, and she
saved for 40 years compared to just 8 years
for her brother.

29

Question?
What

is time value of money?

Cost

to build titanic? $7mn in 1912

Cost to build movie- $200mn in 1997
Inflation

alone- worth 168mn today

7mn invested at 4% in 1912 would
yield 353mn in 2012
Gj

30

Time Preference for Money

Time

preference for money is an

individuals 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 individuals time preference for
money:
risk
preference for consumption -inflation
investment opportunities- interest
31

Required Rate of
Return
The time preference for money is generally
expressed by an interest rate. This rate will
be positive even in the absence of any risk.
It may be therefore called the risk-free
rate.
An investor requires compensation for
assuming risk, which is called risk
premium.
The investors required rate of return is:
Risk-free rate + Risk premium.

32

Time Value
Adjustment
Two

most common methods of

adjusting cash flows for time value
of money:
Compoundingthe process of calculating
future values of cash flows and
Discountingthe process of calculating
present values of cash flows.

Future Value
Compounding

is the process of finding the

future values of cash flows by applying the
concept of compound interest.
Compound interest is the interest that is
received on the original amount (principal) as
well as on any interest earned but not
withdrawn during earlier periods.
Simple interest is the interest that is
calculated only on the original amount
(principal), and thus, no compounding of
interest takes place.

Future Value
The

general form of equation for

calculating the future value of a
lump sum after n periods may,
therefore, be written as follows:
Fn P (1 i ) n

The

term (1 + i)n is the compound

value factor (CVF) of a lump sum
of Re 1, and it always has a value
greater than 1 for positive i,
indicating that CVF increases as i
Fn =P CVFn,i
and n increase.

Example
If

you deposited Rs 55,650 in a bank,

which was paying a 15 per cent rate
of interest on a ten-year time
deposit, how much would the deposit
grow at the end of ten years?

We

will first find out the compound

value factor at 15 per cent for 10
years which is 4.046. Multiplying
4.046
by Rs 55,650,
we get Rs
FV 55,650 CVF
55,650 4.046 Rs 225,159.90
225,159.90 as the compound value:
10, 0.12

Future Value of an Annuity

Annuity

is a fixed payment (or receipt)

each year for a specified number of years.
If you rent a flat and promise to make a
series of payments over an agreed period,
you have created an annuity.

The

(1 i ) n 1
Fn A

term within brackets is the

compound value factor for an annuity
of Re 1, which we shall refer as CVFA.
Fn =A CVFA n, i
37

Example
Suppose

that a firm deposits Rs 5,000 at

the end of each year for four years at 6
per cent rate of interest. How much
would this annuity accumulate at the end
of the fourth year?
We first find CVFA which is 4.3746. If we
multiply 4.375 by Rs 5,000, we obtain a
compound value of Rs 21,875:
JJ

case

F4 5,000(CVFA 4, 0.06 ) 5,000 4.3746 Rs 21,873

38

Sinking Fund
Sinking

fund is a fund, which is

created out of fixed payments each
period to accumulate to a future sum
after a specified period. For example,
companies generally create sinking
funds to retire bonds (debentures) on
maturity.
The factor used to calculate the
annuity for a given future sum is
called the sinking
fund

factor (SFF).
i
A = Fn

(1

i
)

Present Value
Present

value of a future cash flow

(inflow or outflow) is the amount of
current cash that is of equivalent
value to the decision-maker.
Discounting is the process of
determining present value of a
series of future cash flows.
The interest rate used for
discounting cash flows is also called
the discount rate.

Present Value of a Single Cash

Flow
The

following general formula can be

employed to calculate the present value of a
lump sum to be received after some future
periods:
Fn
n

F
(1

i
)
n
n
(1 i )

The

term in parentheses is the discount

factor or present value factor (PVF), and it
is always less than 1.0 for positive i, indicating
that a future amount has a smaller present
PV Fn PVFn ,i
value.

Example
Suppose

that an investor wants to

find out the present value of Rs
50,000 to be received after 15 years.
Her interest rate is 9 per cent.
First, we will find out the present
value factor, which is 0.275.
Multiplying 0.275 by Rs 50,000, we
obtain Rs 13,750 as the present
value:
PV = 50,000 PVF15, 0.09 = 50,000 0.275 = Rs 13,750

42

Present Value of an
Annuity
The computation of the present

value of an annuity can be written

in the following general form:
1
1
P A

n
i i 1 i

The

term within parentheses is the

present value factor of an
annuity of Re 1, which we would
call PVFA, and it is a sum of singleP=A
PVAF
payment
present
value factors.
n, i

Capital Recovery and

Loan Amortisation
Capital

recovery is the annuity of an

investment made today for a specified
period of time at a given rate of interest.
Capital recovery factor helps in the
preparation of a loan amortisation
(loan repayment) schedule.

1
A= P

PVAF
n ,i

A = P CRFn,i

The reciprocal of the present value annuity

factor is called the capital recovery factor
(CRF).

Present Value of
Perpetuity

Perpetuity

is an annuity that
occurs indefinitely. Perpetuities are
not very common in financial
Perpetuity
decision-making:
Present
value of a perpetuity
Interest rate

45

Present Value of Growing

Annuities
The

present value of a constantly

growing annuity is given below:
A
1 g
P=
1

i g
1 i

Present

value of a constantly
growing perpetuity is given by a
simple formula as follows:
P=

A
ig

Value of an Annuity Due

Annuity

due is a series of fixed

receipts or payments starting at the
beginning of each period for a
specified number of periods.
Fn = A CVFA n , i (1 i)

Future

Value of an Annuity Due

P = A PVFA n, i (1 + i )

Present

Value of an Annuity Due

Multi-Period
Compounding
If

compounding is done more than

once a year, the actual annualised
rate of interest would be higher
than the nominal interest rate and
it is called the effective interest
rate.

EIR =

i
1
m

n m

48