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Financial

Management

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MONEY:

it is one of the important vitamins


required for running any organisation, it is
just like blood, without which there is no
human being similarly without finance
there is no organisation.

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MONEY

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MONEY & FINANCE
A currency as long as you have with you it
is money only.

When lend it to others to buy or invest in


investment avenues (opportunities) it
becomes finance.

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MEANING OF FINANCIAL
MANAGEMENT
FM is concerned with the acquisition,
financing and management of assets to
achieve organizational goal.

ACQUISITION
OF ASSETS

MANAGEMEN FINANCING
T OF ASSETS THE ASSETS

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MEANING OF
FINANCIAL MANAGEMENT

Financial Management is concerned with 3


activities:
1. Anticipating (look forward to) financial
needs.
2. Acquiring financial resources.
3. Allocating funds in business.

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1. Anticipating financial needs: Estimation
of funds required for investment in fixed and
current assets.

2. Acquiring financial resources: Where and


how to obtain the funds to finance the
anticipated financial needs.

3. Allocating funds in business: Which


means allocation of available funds among
the best plans of assets, which are able to
maximise shareholders wealth.

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FINANCIAL DECISIONS
The financial management can be broken
down into 3 major decisions. (which are
important finance functions)
A firm takes these decisions simultaneously

and continuously in the normal course of


business.
Firm may not take these decisions in a

sequence, but decisions have to be taken


with the objective of maximizing
shareholders wealth.

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FINANCIAL
DECISIONS

INVESTMEN
FINANCING DIVIDEND
T
DECISION DECISION
DECISION

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Investment Decision
Decision which is related to the selection of
assets.
The required assets fall into 2 groups:

i) long-term assets: Ex: plant, Machine, land


& building. Investment in long-term assets is
popularly known as CAPITAL BUDGETING.
ii) Short-term Assets: Ex: raw materials,
work in process, finished goods, debtors,
cash, etc. which can be converted into cash
within a financial year.
Investment in currents assets is popularly
termed as WORKING CAPITAL
MANAGEMENT
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FINANCING DECISION
Determination of proportion of debt and
equity in capital structure.
Debt involves fixed cost (interest), which

may help in increasing the return on equity


but also increases risk.
Rising of funds by issue of equity shares is

one permanent source, but the shareholders


will expect higher rate of earnings.

It should be optimum finance mix, which


maximizes shareholders wealth.

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Dividend decision
Which relates to dividend policy. Dividend is

a part of profits, which are available for


distribution to equity shareholders.
It involves determination of portion of

Earning Per Share (EPS) to be declared as


dividend per share.
There are two options available in dealing

with net profits of a firm.


a. Distribution of profits as dividends
b. Retention of earnings in the firms itself if
they require for financing of any business
activity.

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FINANCIAL MANAGER SHOULD DETERMINE
OPTIMUM DIVIDEND POLICY, WHICH
MAXIMIZES MARKET VALUE OF THE SHARE
THERE BY MARKET VALUE OF THE FIRM.

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INTER-RELATION AMONG
FINANCIAL DECISIONS.
There is a interrelation between investment
decision and financing decision, without
knowing the amount of funds required and
types of funds (short-term & long-term) it is
not possible to raise funds.
These two are dependent on each other.

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Financing decisions influences and is
influenced by dividend decision, since
retention of profits for financing selected
projects reduces the profit available to
ordinary shareholders, there by reducing
dividend payout ratio.

Hence, there is an interrelation between


financing decision and dividend decision.

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Dividend decision and investment decisions
are interrelated because retention of profits
for financing the selected assets depends
on the rate of return of proposed
investment and the opportunity cost.

Profits are retained when return on


investment is higher than the opportunity
cost of retained profits and vice-versa.

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INTER-RELATION AMONG
FINANCIAL DECISIOINS
INVESTMENT
DECISION

FINANCING DIVIDEND
DECISION DECISION
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FEW INDIAN COMPAYNIES
BUY BACK OFFER

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Profit maximization
VS Wealth
maximization
Broadly, there are two alternative
objectives that a business firm can pursue

Profit Maximization

Wealth Maximization
Profit Maximization
It is a term which denotes the maximum profit to
be earned by an organization in a given period of
time.
The profit maximization goal implies that the
Investment, Financing and Dividend decisions of
the enterprise should be oriented to profit
maximization.
Merits of Profit
Maximization
Best Criterion on decision making.

Efficient allocation of resources.

Optimum utilization.
Drawbacks of Profit
Maximization
It ignores time value of money.
It is vague conceptually.
It ignores the risk factor.
It may tempt to make such decisions which
may in the long run prove disastrous.
Its emphasis is generally on Short run projects.
In the new business environment Profit
maximization is regarded as unrealistic,
difficult, inappropriate and immoral.
Wealth Maximization

Fundamental objective of wealth maximization is


to maximize the market value of the firms
shares.
Maximizes the net present value of a course of
action to the shareholders.
Benefits are measured in terms of cash flows.
Merits of Wealth
Maximization
The wealth maximization objective takes care of
the:
Shareholders interest
lenders or creditors interest
Workers or employees interest
It also ensures fair return to the shareholders,
building up reserves for growth and expansion,
ensuring financial discipline in the management.
Merits of Wealth
Maximization
It focuses on the long term.
It takes into account the time value of money.
It considers risk.
It maintains market price of the shares of the
organization.
It recognizes the value of regular dividend
payments.
Conflict:
Profit Maximization Wealth Maximization
Its main objective is to achieve
highest market value of
common stock.
Its main objective is to earn
It emphasizes long term
large amount of profits.
It considers time value of
It emphasizes short term money.
It ignores time value of It recognizes risk and
money. uncertainty.

It ignores risk and


It recognizes the timings of
return.
uncertainty.
It ignores timing of return
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Risk Return Trade of

What is Risk?

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RISK

It
is the variability of actual
return from the expected return
associated with a given asset.

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RETURN

It
is the actual income received
plus any change in market price
of an asset / investment

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Trade of

Trade of: A technique of reducing or


forgoing one or more desirable outcomes in
exchange for increasing or obtaining other
desirable outcomes in order to maximize
the total return or effectiveness under given
circumstances.

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Risk Return Trade of
What is Risk? Many investors view investment risk
as the possibility of losing part of your capital.
Think of risk as the potential for a negative return
on an investment -- the higher the probability of a
negative return, the greater the risk.

Additionally, the greater the range of possible


returns associated with an investment, the higher
the risk. Therefore, risk refers to the variability or
volatility of an investment's return. If an
investment's value fluctuates only slightly from
year to year, the investment has relatively low risk,
while wider value fluctuations reflect a relatively
high risk.
Riskis the chance that an investment's actual
return will be different than expected. 3/22/17 59
Roller Coaster

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If investment's returns have been going up
and down like a roller coaster ride and
keeping you up at night, then understanding
a fundamental investment principle called
Risk/Return Trade-off may help.
The concept is also known as the "ability-to-

sleep-at-night test".
A common misconception is that higher risk

equals greater return. The Risk/Return Trade-


off tells us that higher risk gives us the
possibility of higher returns. But there is no
guarantee.

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Deciding what amount of risk an investor can
take while remaining comfortable with
investments is very important.

In the investing world, the definition ofriskis the


chance that an investment's actual return will be
different than expected.

Technically, this is measured in statistics


bystandard deviation. Risk means having the
possibility of losing some, or even all, of the
original investment.

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Standard deviation

It is a rate at which the price of a security


increases or decreases for a given set of
returns.
Volatility is measured by calculating the

standard deviation of the annualized returns


over a given period of time. It shows the
range to which the price of a security may
increase or decrease.

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Low levels of uncertainty (low risk) are associated
with low potential returns. High levels of
uncertainty (high risk) are associated with high
potential returns.

Therisk/return tradeoffis the balance between the


desire for the lowest possible risk and the highest
possible return. This is demonstrated graphically in
the chart below. A higher standard deviation means
a higher risk and higher possible return.

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Risk/Return Tradeof

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A common misconception is that higher risk
equals greater return. The risk/return
tradeoff tells us that the higher risk gives us
thepossibilityof higher returns. There are
no guarantees. Just as risk means higher
potential returns, it also means higher
potential losses.

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Determining what risk level is most
appropriate for an investor isn't an easy
question to answer. Risk tolerance differs
from person to person.
Investor decision will depend on his goals,

income and personal situation, among other


factors.

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On the lower end of the scale, therisk-free
rate of returnis represented by the return
on Government Securities because their
chance ofdefaultis next to nothing. If the
risk-free rate is currently 6%, this means,
with virtually no risk, we can earn 6% per
year on deposited money.

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Definition:Higher risk is associated with greater
probability of higher return and lower risk with a greater
probability of smaller return. This trade off which an
investor faces between risk and return while considering
investment decisions is called the risk return trade off.

Description:For example, Mr.Anand faces a risk return


trade off while making his decision to invest. If he deposits
all his money in a saving bank account, he will earn a low
return i.e. the interest rate paid by the bank, but all his
money will be insured up to an amount of Rs 1 lakh
(currently the Deposit Insurance and Credit Guarantee
Corporation in India provides insurance up to Rs 1 lakh).

However, if he invests in equities, he faces the risk of


losing a major part of his capital along with a chance to
get a much higher return than compared to a saving
deposit in a bank.
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THE TIME VALUE OF
MONEY

ARUPEE THAT IS RECEIVABLE


TODAY IS MORE VALUABLE
THAN A RUPEE RECEIVABLE
IN FUTURE ?

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The finance manager must keep the Time
factor in mind to take the appropriate
decisions on financing, investment and
dividends.
Finance Manager must know the various

valuation concepts like Compound Value


Concept, Annuity Concept, Present Value
Concept etc.
All these concepts are basically based upon

the fact that, money has time value.

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Money has time Value means that the
value of money changes over a period of
time. The value of a rupee, today is
different from what it will be, say, after one
year.
Factors contributing to the Time Value

of Money:- Money has a time value


because of the following reasons:

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CURRENT
CONSUMPTION

POSSIBILITY
OF
UNCERTAINTY INVESTMENT
OPPORTUNITY

RATIONALE
(JUSTIFICATION)
OF THE TIME
PREFERENCE FOR
MONEY

Time value of money or time preference of money


is one of the central ideas in finance.
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Valuation Concepts/Techniques
The Time value of money implies:-
1. That a person will have to pay in future
more, for a rupee received today and

2. A person may accept less today, for a


rupee to be received in the future.

The above Two statements relate to TWO


DIFFERENT CONCEPTS.

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Compound value
concept
Valuation
Concepts
Discounting /
present value
concept

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COMPOUND VALUE CONCEPT
(INTEREST)

In this concept, the interest earned on the


initial principal amount becomes a part of
the principal at the end of the a
compounding period.
OR
The interest that is earned on a given
deposit and has become part of principal at
the end of a specified period.

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Ex:- Rs.1,000 invested at 10% is
compounded annually for three years,
calculate the compound value after 3 years.
Particulars Amount
Amount at the end of 1st year will be 1000 X 1,100
110/100
Amount at the end of 1st year will be 1100 X 1,210
110/10
Amount at the end of 1st year will be 1210 X 1,331
110/100
This compounding process will continue for an indefinite
time period. We can calculate the same by using an
equation also.

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CV = Po ( 1 + I ) n
CV = Compound Value
Po = Principal amount
( I ) = Interest rate per annum
n = Number of years for which compound is

done.
CV = 1,000 ( 1 + .10 ) 3

= 1,331.

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Ex. 1:- Mr. X who is deposited `10,00,000 in
a financial institute, which pay 8%
compound interest for a period of 5 years.
Calculate the amount to be received at the
end of 5 years.
CV P (1 I ) n
0

10,00,000 ( 1 + 0.08) 5
10,00,000 (1.469328)
14,69,328

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Computation by this formula can also
become very time consuming if the
number of years increase, say 10, 20 or
more. In such cases to save upon the
computational efforts, Compound Table
Value can be used. The table gives the
compound value of Rs.1, after n years
for a wide range of combination of I and
n.

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Ex. 2:- Mr. Shravan who is deposited `.
28,000 in a financial institute, which pay 6%
compound interest for a period of 7 years.
Calculate the amount to be received at the
end of 7 years.
CV = P0 ( 1 + I ) n

P0 = 28,000;
I=6%;
n=7

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Ex. 3:- Mr. X who is deposited `.1,00,000 in
a Bank, which pay 10% compound interest
for a period of 5 years. Calculate the
amount to be received at the end of 5
years.

CV P0 (1 I ) n

1,00,000 ( 1 +
0.10) 5
1,00,000 (1.610)
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VARIABLE COMPOUNDING PERIODS
Generally compounding is done once in a
year. In the above problem and we assumed
also that the compound is done annually.
If the investor promised to pay compound
interest for variable periods (semi annual,
quarter etc). This is calculated as follows:

CV n = P0 (1 + I/m) m x n
CV n = compound value at the end of year n

P0 = Principle amount at the year 0

I = Interest rate per annum; m= number of

times per year compounding is done ; n =


maturity period.
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Ex;- How much does a deposit of Rs.40,000 grow to at
the end of 10 year at the rate of 6% PA interest
compounding is done semi-annually. Determine the
amount at the end of 10 years.

CV n = P0 (1 + I/m) mxn

40,000 [ 1 + 0.06/2] 2 x 10

Or 40,000 [ *1.806] = 72,240


*see the compound sum of one rupee table (A-1) for 20 years @ 3% interest rate.
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Ex. 2:- Mr. Shravan who is deposited Rs.
28,000 in a financial institute, which pay 6%
compound interest half yearly for a period
of 5 years. Calculate the amount to be
received at the end of 5 years.

CV n = P0 (1 + I/m) mxn
P0 = ?
m = ?
m x n = ?

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Ex. 3:- Mr. Aditya who is deposited `
1,00,000 with an investment company,
which pay 10% interest with semi
annual compounding. How much the
deposit grows to 5 years. Calculate the
amount to be received at the end of 5
years.
CV n = Po (1 + I/M) mxn

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COMPOUND VALUE OF SERIES OF
CASH FLOWS:
Annuity means a series of cash flows
(inflow/outflow) of a fixed amount for
specified number of years. This can be
divided in to 2 types.
1. Uneven cash flows 2. Even cash flows

Uneven cash flows:


. CV n = P1 (1 + I) n-1 + P2 (1 + I) n-2 +.

Where..
. CV n = compound value at the end of year n
. P 1 = Payment at the end of year 1
. P 2 = Payment at the end of year 2
. I = Interest rate
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1. Uneven cash
flows
Mr. Raj kumar deposits Rs.5,000, Rs.10,000,
Rs.15,000 Rs.20,000, and Rs.25,000 in his
savings bank account in the of year 1,2,3,4
and 5 respectively. Interest rate is 6%. He
wants to know his future value of deposits at
the end of 5 years.
CV n = P1 (1 + I) n-1 + P2 (1 + I) n-2 +.

CV 5 = 5,000(1 + 0.06) 5-1 + 10,000(1 + 0.06)


5-2 + 15,000(1 + 0.06) 5-3 +20,000(1 + 0.06) 5-4

+ 25,000(1 + 0.06) 5-5

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= 5,000(1 .262) + 10,000(1.191) +
15,000(1.124) +20,000(1 .060) + 25,000(1 .00)

= 6,310 + 11,910 + 16,860 + 21,200 + 25,000


= 81,280

CV CAN ALSO BE CALCULATE IN THE


FOLLOWING WAY
*see the compound sum of one rupee table (A-1) for 4,3,2,1,0, years
@ 6% interest rate.

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No. of
Compound
Amount times Future
Year ing factor
paid compounde value
(6%)
d
1 2 3 4 5=2x4

1 5,000 4 1.262 6,310


10,00 11,91
2 3 1.191
0 0
15,00 16,86
3 2 1.124
0 0
20,00 21,20
4 1 1.060
0 0
25,00 0 1.000 25,00
5
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Mr. Chary deposits at the end of each year
Rs.2,000, Rs.3,000, Rs.4,000 Rs.5,000 and
Rs.6,000, for 1 to 5 respectively. He wants
to know his series of deposits value at the
end 5 years with 6% rate of compound
interest.

CV n = P1 (1 + I) n-1
+ P2 (1 + I) n-2
+..

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2. Even cash flows : Annuity is a series of
even cash flows for a specified duration. It
involves a regular cash outflow or inflow.
Ex:- payment of LIC premium, depositing in a
recurring deposit account.
Cash flows may happen either at the end of

year or beginning of the year.


If cash flows happen at the beginning of he

year, it is called as an annuity due, where


as when the cash flows happen at the end it
is called as a deferred annuity or regular.

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COMPOUND VALUE OF DEFERRED ANNUITY:
Use the above formula

i.e., CV n = P1 (1 + I) n-1 + P2 (1 + I) n-2 +.

Ex: Mr. Satyam deposits Rs.500 at the end of

every year for 6 years at 6% interest.


Determine Mr. Satyam's money value at the end
of 6 years
Ans: 3,487.5

Shortcut formula: CV n = P (1 + I) n 1
I
P = fixed periodic cash flow, I = interest rate,

n = duration CV n = 500 (1 +0.06) 6 1

0.06
= 500 { 6.975} = 3,487.5
Ref. pg.no.54 HP.
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No.of
Compoundi
Amount times Future
Year ng factor
paid compounde value
(6%)
d

1 500 5 1.338 669.00


2 500 4 1.262 631.00
3 500 3 1.191 595.50
4 500 2 1.124 562.00
5 500 1 1.060 530.00
6 500 0 1.00 500.00
3,487.5
TOTAL
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OR
Use A-2 table as short cut .

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COMPOUND VALUE OF ANNUITY DUE:
When the cash flows involves at the beginning

of the year compound value of annuity is


calculated with the following formula:
CV n = P1 (1 + I) n + P2 (1 + I) n-1 + P3 (1 + I) n-2

. Pn (1 + I) n
(OR)
CV n = P (1 + I) 1 n (1 + I)
I
Ex: if you deposit Rs.2,500 at the beginning of
every year for 6 years in a saving bank
account at 6% compound interest. What is
maturity value of your money at the end of 6
years.
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0
No.of times
Amount Compoundin Future
Year compounde
paid g factor (6%) value
d
1.419
1 2,500 6 3,547.50

2 2,500 5 1.338 3,345.00

3 2,500 4 1.262 3,155.00

4 2,500 3 1.191 2,977.50

5 2,500 2 1.124 2,810.00

6 2,500 1 1.060 2,650.00

TOTAL 18,485.00

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THANK YOU ..

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