Unit I FM

FINANCIAL MANAGEMENT :
INTRODUCTION
CORPORATE FINANCE
An Introduction to the
Ten Basic Principles
1-3
Foundation of Finance
Finance fundamentals spring from 10
simple principles that don’t require
knowledge of finance to understand.
However, while it is not necessary to

understand finance in order to understand
these principles, it is necessary to
understand these principles in order to
understand finance.
1-4
PRINCIPLE 1
 The Risk-Return Trade-

Off
1-5
PRINCIPLE 2
 The Time Value of

Money
1-6
PRINCIPLE 3
 Cash – Not Profit – is

King.
1-7
PRINCIPLE 4
 Incremental Cash Flows

1-8
PRINCIPLE 5
 The Curse of Competitive

Markets
1-9
PRINCIPLE 6
 Efficient Capital Markets

1-10
PRINCIPLE 7
 The Agency Problem

1-11
PRINCIPLE 8
 Taxes Bias Business

Decisions.
1-12
PRINCIPLE 9
 All Risk is Not Equal

1-13
PRINCIPLE 10
 Ethical behaviour is
doing the right thing,
and ethical dilemmas are
everywhere in finance.
1-14
FINANCIAL MANAGEMENT
 “Financial Management is concerned with the acquisition,
financing and management of assets with some overall goal in
mind”
-J.C.VANHORNE
 "Financial Management is an area of financial

decision making, harmonizing individual motives
and enterprises goals”
-Weston and Brigham
Financial Management is that managerial activity

which is concerned with the planning and controlling
of the firm’s financial resources.
1-15
Financial Management: Defined

Management of funds is a critical aspect of
financial management. Management of funds act
as the foremost concern whether it is in a business
undertaking or in an educational institution.
Financial management, which is simply meant
dealing with management of money matters.
 This is the business management function that is

concerned with managing a business’ finances
 It refers to the application of financial management

tools and techniques to coordinate all the financial
functions in the business
Meaning of Financial 1-16
Management
 By Financial Management we mean efficient use of
economic resources namely capital funds. Financial
management is concerned with the managerial
decisions that result in the acquisition and financing of
short term and long term credits for the firm.
 Here it deals with the situations that require selection

of specific assets, or a combination of assets and the
selection of specific problem of size and growth of an
enterprise.
Scope of Financial 1-17
Management
 Sound financial management is essential in all types of
organizations whether it be profit or non-profit. Financial
management is essential in a planned Economy as well as in a
capitalist set-up as it involves efficient use of the resources.
 From time to time it is observed that many firms have been

liquidated not because their technology was obsolete or because
their products were not in demand or their labour was not skilled
and motivated, but that there was a mismanagement of financial
affairs. Even in a boom period, when a company make high
profits there is also a fear of liquidation because of bad financial
management.
1-18
Contd..
 Financial management optimizes the output from the given input of
funds. In a country like India where resources are scarce and the
demand for funds are many, the need of proper financial
management is required. In case of newly started companies with a
high growth rate it is more important to have sound financial
management since finance alone guarantees their survival.
 Financial management is very important in case of non-profit

organizations, which do not pay adequate attentions to financial
management.
 How ever a sound system of financial management has to be
cultivated among bureaucrats, administrators, engineers,
educationalists and public at a large.
Objectives of Financial 1-19
Management
Profit Maximization:
 The objective of financial management is the same as the objective of a
company which is to earn profit. But profit maximization alone cannot be
the sole objective of a company. It is a limited objective. If profits are
given undue importance then problems may arise, so profit maximization
objective is justified on the following grounds:
 Rationality
 Maximization of Social Benefit
 Efficient allocation and uses of resources
 Measurement of success of decisions
 Sources of incentive
1-20
Profit Maximization contd….

 Profit Maximization objective is considered to be a very limited objective,
because it has a number of drawbacks, which render this objective as an
ineffective decisional criterion. These drawbacks (limitations) are as under:
 Ambiguity / Loose expression of the term profit: The term profit is vague and
it involves much more contradictions.
 Profit Maximization objective ignores timing of benefit (time-value-money):
Profit Maximization fails to take into account the time pattern of returns. Profit
maximization does not take into account the social considerations
 Profit Maximization objective fails to recognize quality of benefits (risk
factor): Profit maximization must be attempted with a realization of risks
involved. A positive relationship exists between risk and profits. So both risk
and profit objectives should be balanced.
Objectives of Financial Management
1-21
contd..
Wealth Maximization:
“The value of a firm is represented by the market price of the company's

stock (equity share).” by Van Horne.
The market price of a firm's stock represents the assessment of all market
participants as to what the value of the particular firm is.
 It takes in to account present and prospective future earnings per share,
the timing and risk of these earning, the dividend policy of the firm and
many other factors that bear upon the market price of the stock. Market
price acts as the performance index or report card of the firm's progress
and potential.
 It is based on the concept of cash flows.
 It also signifies the net worth of the enterprise measured in terms of net
present value (NPV) i.e., the difference between Gross Present Value and
the Cost of Capital Investments required for achieving the benefits.
1-22
Wealth Maximization contd….

 Wealth maximization as a decision criterion is
used in the context of three important areas of
financial management:
 In case of investment decision, the value of firm is
maximized when projects with higher NPV are
accepted
 In case of financing decision, it may be stated that
when the return is maximized with the minimum risk,
market value per share will be maximized.
 In case of dividend decision, the optimum dividend
policy is one that maximizes the market value for share.
1-23
Functions of a Financial Manager

 Financial Forecasting: It requires the applications of various statistical,
mathematical & accounting techniques.
 Financial Planning: It is done under three distinct sub-activities
 Formulation of financial objectives
 Framing the financial policies
 Developing financial procedures
 Financial Decisions: It involves the determination of financial sources,

comparative study of their cost of capital, examining the impact on shareholder’s
equity, etc.
 Financial Negotiations
 Investment Decisions: It is function of financial management to determine the
volume of investments in fixed and current assets.
 Management of Cash Flows
Functions of a Financial Manager 1-24
contd…
 Management of Income: It comprises correct measurement of
income, distribution of income in correct proportion and
following the appropriate dividend policy.
 Appraisal of Financial Performance: This function analyze and
evaluate the financial performance of the business concern after
a definite interval and to communicate the results to top
management.
 Understanding Capital Market: Financial Manager should know
how risk is measured and how to cope with it in investment and
financing decisions.
 To make efforts for Increasing the Productivity of the Capital: It
is done by discovering the new opportunities of investments.
 To Advise the top Management: Financial Manager advise in
respect of proper diagnosis of the problem, alternative solutions
to the problem and selection of the best solutions.
Importance of Proper Financial
1-25
Management
1-26
Importance of FM Contd…
 Maximize use of financial resources
 FM allows you to identify and plan for the use

of your financial resources.
 It provides information for financial decision

making.
1-27
 Evaluate new business opportunities
 FM provides the key information and answer
questions of whether to exploit such
opportunities or not.
 That is, entrepreneurs can effectively analyze a

business opportunity and determine whether it
is worthwhile or not.
27
1-28
 Measuring business performance
 FM helps the investor to monitor the

progress of their business towards
achieving business goals and to take
corrective action where necessary.
1-29
 Making sound business decisions
 The financial information systems provides
a wide range of information that can be
used to make better decisions.
 This is done using financial ratios, break
even analysis etc.
1-30
MAJOR FINANCIAL MANAGEMNET
DECISIONS
 Investment decision
 Working capital decision
 Financing decision
 Earnings management decision

1-31
1. Investment decision
 This is also known as the Capital budgeting, and it

refers to the decision to invest in long term assets.
 The assets are expected to be used over a long

period of time e.g. when a firm acquires plant and
equipment or replaces an old equipment or when
you invest in research and development.
1-32
Importance of Capital Budgeting
 It determines the asset mix and hence

the business risk.
 It involves heavy initial outlays of the

business resources.
 Benefits accrue in future which future is

associated with risk and uncertainty.
1-33
2. Working capital decision
This is the decision concerned with the short term

assets/resources an organization uses to meet its day
to day obligations.
Such assets include:
 Cash reserves of the organisation
 Funds collected from debtors of the organization.
 Inventories
1-34
3. Financing decision
 This is the decision concerned with the sourcing of funds that are
utilized under the investment decision.
 Much management time and effort is devoted to trying to ensure
the adequacy of the company's profit flow.
 However, it is just as important that a company has an adequate
flow of funds if it is to remain in business and very much less
management time and effort is devoted to this need.
 As companies expand, they require growing amounts of cash to
finance acquisitions of fixed assets. They also require growing
amounts of cash to finance their growing working capital
requirements.
Some of this funding requirement will come from INTERNAL
sources, whilst some will need to come from EXTERNAL
sources.
1-35
4. Earnings Management Decision

The Financial Manager has to decide on what to
do with the earnings once they have been
realised. There are three options,
 To declare and pay all dividends to shareholders
 To retain all the earnings and hence declare and

pay no dividends
 To decide on what proportion to be paid and what

to be retained.
1-36
DECISIONS, RETURN, RISK,
AND MARKET VALUE
1-37
TIME VALUE OF MONEY

1-38
The Time Value of Money

Would you prefer to have Rs. 1
million now or Rs. 1 million 10
years from now?
Of course, we would all
prefer the money now!
This illustrates that there

is an inherent monetary
value attached to time.
What is The Time Value of 1-39
Money?
 A rupee received today is worth more than
a rupee received tomorrow
 This is because a rupee received today can be
invested to earn interest
 The amount of interest earned depends on the
rate of return that can be earned on the
investment
 Time value of money quantifies the value

of a rupee through time
1-40
Uses of Time Value of Money

 Time Value of Money, or TVM, is a concept that is
used in all aspects of finance including:
 Bond valuation
 Stock valuation
 Accept/reject decisions for project management
 Financial analysis of firms

1-41
Types of TVM Calculations

 There are many types of TVM
calculations
 The basic types will be covered are
include:
 Present & Future value of an investment
 Future value with compounding
 Future value with continuous compounding
 Present value of perpetuity
 Present value of growing perpetuity
 Present & Future value of annuities
1-42
Present Value of an Investment
 Present value calculations determine what the value

of a cash flow received in the future would be worth
today (time 0)
 The process of finding a present value is called

“discounting” (hint: it gets smaller)
 The interest rate used to discount cash flows is

generally called the discount rate
Formula used in PV of an 1-43
Investment
General Present Value Formula:

PV = CFt / (1+r)t
or PV = FVt / (1+r)t
or PV = FVt (PVIFr,t) -- See Table I
1-44
Valuation using Table I
PVIFr,t is found on Table I at the end of the book.
Period 6% 7% 8%
1 .943 .935 .926
2 .890 .873 .857
3 .840 .816 .794
4 .792 .763 .735
5 .747 .713 .681
1-45
Example of PV of an Investment
How much would Rs. 10,000 received five years from now be
worth today if the current interest rate is 10%?
1. Draw a timeline
r = 10%
? Rs. 10,000
PV 0 1 2 3 4 5
The arrow represents the flow of money and the numbers under
the timeline represent the time period.
Note that time period zero is today.

1-46
Example of PV of an Investment
 Calculation based on general formula:

PV = FVt / (1+r)t PV = 10,000 / (1+
0.10)5 = Rs. 6,209.21
 Calculation based on Table I:

PVt = 10,000 (PVIF10% , 5) = 10,000 (.621) =
Rs. 6,210.00 [Due to Rounding]
1-47
Future Value of an Investment

 You can think of future value as the
opposite of present value
 Future value determines the amount that a

sum of money invested today will grow to
in a given period of time
 The process of finding a future value is

called “compounding” (hint: it gets larger)
Formula used in FV of an 1-48
Investment
General Future Value Formula:

FV= CFt * (1+r)t
or FV = PVt * (1+r)t
or FV = PVt (FVIFr,t) -- See Table II
1-49
Valuation using Table II
FVIFr,t is found on Table II at the end of the book.
Period 6% 7% 8%
1 1.060 1.070 1.080
2 1.124 1.145 1.166
3 1.191 1.225 1.260
4 1.262 1.311 1.360
5 1.338 1.403 1.469
1-50
Example of FV of an Investment
How much money will you have in 5 years if you invest Rs.
10,000 today at a 10% rate of return?
1. Draw a timeline
r = 10%
Rs. 10,000 ?
0 1 2 3 4 5 FV
1-51
Example of FV of an Investment
 Calculation based on general formula:
FVn = CFt * (1+r)t
FV5 = 10,000 (1+ 0.10)5
= Rs. 16,105.10
 Calculation based on Table I:

FV5 = 10,000 (FVIF10%, 5)
= 10,000 (1.611)
= Rs. 16,110 [Due to Rounding]
1-52
Some Things to Note

 In both of the examples, note that if you were to
perform the opposite operation on the answers
(i.e., find the future value of Rs. 6210 or the
present value of Rs. 16105) you will end up with
your original investment of Rs. 10,000.
 This illustrates how present value and future value

concepts are intertwined. In fact, they are the
same equation . . .
 Take PV = FVt / (1+r)t and solve for FVt. You will get
FVt = PV * (1+r)t.
52
1-53
Compounding Periods
Compounding an investment m times a year for T

years provides for future value of wealth:
m×T
 r
FV = C0 × 1 + 
 m
For example, if you invest Rs. 50 for 3
years at 12% compounded semi-
annually, your investment will grow to
2×3
 .12 
FV = 50 × 1 +  = 50 × (1.06) 6 = Rs.70.93
 2 
Continuous Compounding 1-54
(Advanced)
 The general formula for the future value of an investment compounded

continuously over many periods can be written as:
FV = C0×erT
Where
C0 is cash flow at date 0,
r is the stated annual interest rate,

T is the number of periods over which the cash is
invested, and
e is a transcendental number approximately equal to
2.718. ex is a key on your calculator.
1-55
Perpetuity
A constant stream of cash flows that lasts forever.
C C C
…
0 1 2 3
C C C
PV = + + +
(1 + r ) (1 + r ) (1 + r )
2 3
The formula for the Present Value of a perpetuity

is: C
PV =
r
1-56
Perpetuity: Example
Q.What is the value of a British consol that promises to pay £15

each year, every year until the sun turns into a red giant and
burns the planet to a crisp?
The interest rate is 10-percent.
£15 £15 £15

…
0 1 2 3
£15
PV = = £150
.10
1-57
Growing Perpetuity
A growing stream of cash flows that lasts forever.
C C×(1+g) C ×(1+g)2
…
0 1 2 3
C C × (1 + g ) C × (1 + g ) 2
PV = + + +
(1 + r ) (1 + r ) 2
(1 + r ) 3
The formula for the Present Value of a growing perpetuity is:

C
PV =
r−g
1-58
Growing Perpetuity: Example
Q. The expected dividend next year is $1.30 and dividends are

expected to grow at 5% forever.
If the discount rate is 10%, what is the value of this promised
dividend stream?
$1.30 $1.30×(1.05)$1.30 ×(1.05)2

…
0 1 2 3
$1.30
PV = = $26.00
.10 − .05
1-59
Annuities
 An annuity is a cash flow stream in which
the cash flows are all equal and occur at
regular intervals.
 Note that annuities can be a fixed amount,

an amount that grows at a constant rate
over time, or an amount that grows at
various rates of growth over time. We
will focus on fixed amounts.
59
1-60
Types of Annuities
An Annuity represents a series of equal
payments (or receipts) occurring over a
specified number of equidistant periods.
Ordinary Annuity:
Annuity Payments or
receipts occur at the end of each period.
Annuity Due:Due Payments or receipts
occur at the beginning of each period.
1-61
Examples of Annuities
 Student Loan Payments

 Car Loan Payments
 Insurance Premiums
 Mortgage Payments
 Retirement Savings
1-62
PV of an Annuity
A constant stream of cash flows with a fixed maturity.
C C C C

0 1 2 3 T
 C C C C 
 PV = + + + T 
 (1 + r ) (1 + r ) 2
(1 + r ) 3
(1 + r ) 
The formula for the Present Value of an annuity is:
C  1 
PV = 1 − (1 + r )T 
r  
or
PV = C * PVIFA ( r , t )
1-63
Example of PV of an Annuity
Q. Assume that Mr. X owns an investment that will pay her
Rs. 100 each year for 20 years. The current interest rate
is 15%. What is the PV of this annuity?
1. Draw a timeline
100 100 100 100 100
0 1 2 3 …………………………. 19 20
?
r = 15%
1-64
Example of PV of an Annuity
2. Write out the formula using symbols:
PVA = C * {[1-(1+r)-t ]/r}
3. Substitute appropriate numbers:

PVA = 100 * {[1-(1+.15)-20 ]/.15}
4. Solve for the PV

PVA = 100 * 6.2593
PVA = Rs. 625.93
1-65
FV of an Annuity
A constant stream of cash flows with a fixed maturity.
The formula for the Future Value of an annuity is:
(1 + r ) T 1
FV = C  − 
 r r
or
FV = C * FVIFA (r , t )
1-66
Example of FV of an Annuity
Q. Assume that Mr. X owns an investment that will pay her
Rs. 100 each year for 20 years. The current interest rate
is 15%. What is the FV of this annuity?
1. Draw a timeline
100 100 100 100 100
0 1 2 3 …………………………. 19 20
?
r = 15%
1-67
Example of FV of an Annuity
2.Write out the formula using symbols:
FVAt = C* {[(1+r)t –1]/r}
3.Substitute the appropriate numbers:

FVA20 = 100 * {[(1+.15)20 –1]/.15
4.Solve for the FV:

FVA20 = 100 * 102.4436
FVA20 = Rs. 10,244.36
Formula for Ordinary Annuity & Annuity 1-68
Due
 For Present Value Calculation
 Formula for Ordinary Annuity
PVAt = CFt *(PVIFAr% ,t)
 Formula for Annuity Due
PVADt = CFt *(PVIFAr% ,t)(1+r)
 For Future Value Calculation

 Formula for Ordinary Annuity
FVAt = CFt *(FVIFAr% ,t)
 Formula for Annuity Due
FVADt = CFt *(FVIFAr% ,t)(1+r)
Where CFt = Cash Flow

1-69
RISK AND RETURN

ANALYSIS
1-70
Risk Defined
 There is no universally agreed-upon definition of risk.
 In the context of business and finance, risk is defined as

the chance of suffering a financial loss.
 Assets (real or financial) which have a greater chance of

loss are considered more risky than those with a lower
chance of loss.
 Risk may be used interchangeably with the term

uncertainty to refer to the variability of returns associated
with a given asset.
1-71
Return Defined
 Total Return represents the total gain or loss on an
investment over a given period of time
Income stream from the

Components investment
of the total
return Capital gain or loss due to
 Total return can be expressed either in rupee terms
changes in asset prices
or in percentage terms.
1-72
Rupee Returns
 The sum of the cash received and the change in
value of the asset, in rupees.
Dividends
Ending market
value
Time 0 1
Initial
investment
Rupee Return = Dividend + Change in Market Value

1-73
Percentage Return
 The sum of the cash received and the change in
value of the asset divided by the original
investment.
Rupee Return
Percentage Return =
Initial investment
Dividend + Change in Market Value

Percentage Return =
Initial investment
= Dividend Yield + Capital gain yield

1-74
Returns: Example
 Suppose you bought 100 shares of Infosys one year ago

today at Rs. 25. Over the last year, you received Rs. 20
in dividends (= 1 rupee per share × 100 shares). At the
end of the year, the stock sells for Rs. 30. How did you
do?
 Quite well. You invested 25 × 100 = Rs. 2,500. At the
end of the year, you have stock worth Rs. 3,000 and cash
dividends of Rs. 100. Your rupee gain was Rs.600 = 100
+ (3,000 – 2,500).
 Your percentage gain for the year is = 24.0 %
1-75
Average Rate of Return

 The average rate of return is the sum of the
various one-period rate of return divided by
the number of periods.
Average rate of return,
( R1 +  + RT )
R=
T
1-76
Holding-Period Returns
 The holding period return is the return that
an investor would get when holding an
investment over a period of n years, when
the return during year i is given as ri:
holding period return =

= (1 + r1 ) × (1 + r2 ) × × (1 + rn ) − 1
1-77
Holding Period Return: Example

 Suppose your investment provides the
following returns over a four-year period:
Year Return Your holding period return =

1 10% = (1 + r1 ) × (1 + r2 ) × (1 + r3 ) × (1 + r4 ) − 1
2 -5%
3 20% = (1.10) × (.95) × (1.20) × (1.15) − 1
4 15% = .4421 = 44.21%
1-78
Holding Period Return: Example
 An investor who held this investment would have

actually realized an annual return of 9.58%:
Geometric average return =
Year Return
(1 + rg ) 4 = (1 + r1 ) × (1 + r2 ) × (1 + r3 ) × (1 + r4 )
1 10%
2 -5% rg = 4 (1.10) × (.95) × (1.20) × (1.15) − 1
3 20% = .095844 = 9.58%
4 15%
So, our investor made 9.58% on his money for four
years, realizing a holding period return of 44.21%
1.4421 = (1.095844) 4
1-79
The Variability of Stock Returns
 Variance (σ 2) – a measure of volatility in units of percent

squared
N
∑ t
( R − R ) 2
Variance = σ 2 = t =1
 N −1
 Standard deviation (σ ) – a measure of volatility in percentage

terms
Standard deviation = Variance

Individual Securities or Single Financial
1-80
Assets
 The characteristics of individual

securities that are of interest are the:
 Expected Return
 Variance and Standard Deviation
 Covariance and Correlation

Single Financial Assets: Expected Return &
1-81
Risk
 Investors and analysts often look at historical returns as

a starting point for predicting the future.
 However, they are much more interested in what the
returns on their investments will be in the future.
 For this reason, we need a method for estimating future
returns.
 One way of doing this is to assign probabilities for
future states of nature and the returns that would be
realized if a particular state of nature would occur.
Return Measurement for a Single
1-82
Asset: Expected Return
 The most common statistical indicator of an asset’s risk is the

standard deviation, σ k, which measures the dispersion
around the expected value.
 The expected value of a return, k-bar, is the most likely
return of an asset.
Example : Expected Return, 1-83
Variance & Standard Deviation
Rate of Return
Scenario Probability Stock fund Bond fund
Recession 33.3% -7% 17%
Normal 33.3% 12% 7%
Boom 33.3% 28% -3%
Consider the following two risky asset world.

There is a 1/3 chance of each state of the
economy and the only assets are a stock fund and
a bond fund.
Stock fund Bond Fund

Rate of Squared Rate of Squared
Scenario Return Deviation Return Deviation
Recession -7% 3.24% 17% 1.00%
Normal 12% 0.01% 7% 0.00%
Boom 28% 2.89% -3% 1.00%
Expected return 11.00% 7.00%
Variance 0.0205 0.0067
Standard Deviation 14.3% 8.2%

Recession -7% 3.24% 17% 1.00%
Normal 12% 0.01% 7% 0.00%
Boom 28% 2.89% -3% 1.00%
Variance 0.0205 0.0067
E (rS ) = 1 × ( −7%) + 1 × (12%) + 1 × (28%)

3 3 3
E (rS ) = 11%

Recession -7% 3.24% 17% 1.00%
Normal 12% 0.01% 7% 0.00%
Boom 28% 2.89% -3% 1.00%
Variance 0.0205 0.0067
E (rB ) = 1 × (17%) + 1 × (7%) + 1 × ( −3%)

3 3 3
E (rB ) = 7%

Recession -7% 3.24% 17% 1.00%
Normal 12% 0.01% 7% 0.00%
Boom 28% 2.89% -3% 1.00%
Variance 0.0205 0.0067
(11% 7%) = 3.24%

− − 2

Recession -7% 3.24% 17% 1.00%
Normal 12% 0.01% 7% 0.00%
Boom 28% 2.89% -3% 1.00%
Variance 0.0205 0.0067
(11% 12%) = .01%

− 2

Recession -7% 3.24% 17% 1.00%
Normal 12% 0.01% 7% 0.00%
Boom 28% 2.89% -3% 1.00%
Variance 0.0205 0.0067
(11% 28%) = 2.89%

− 2

Recession -7% 3.24% 17% 1.00%
Normal 12% 0.01% 7% 0.00%
Boom 28% 2.89% -3% 1.00%
Variance 0.0205 0.0067
1
2.05% = (3.24% + 0.01% + 2.89%)
3

Recession -7% 3.24% 17% 1.00%
Normal 12% 0.01% 7% 0.00%
Boom 28% 2.89% -3% 1.00%
Variance 0.0205 0.0067
14.3% = 0.0205
1-92
Portfolio Risk and Return

 An investment portfolio is any collection or combination of
financial assets.
 If we assume all investors are rational and therefore risk averse,

that investor will ALWAYS choose to invest in portfolios rather
than in single assets.
 Investors will hold portfolios because he or she will diversify

away a portion of the risk that is inherent in “putting all your eggs
in one basket.”
 If an investor holds a single asset, he or she will fully suffer the

consequences of poor performance.
 This is not the case for an investor who owns a diversified

portfolio of assets.
1-93
Risk of a Portfolio
 Diversification is enhanced depending upon the extent to
which the returns on assets “move” together.
 This movement is typically measured by a statistic known
as “correlation” as shown in the figure below.
1-94
Risk of a Portfolio (cont.)

 Even if two assets are not perfectly negatively
correlated, an investor can still realize diversification
benefits from combining them in a portfolio as shown in
the figure below.
The Return and Risk for 1-95
Portfolios
Recession -7% 3.24% 17% 1.00%
Normal 12% 0.01% 7% 0.00%
Boom 28% 2.89% -3% 1.00%
Variance 0.0205 0.0067
Note that stocks have a higher expected return than bonds and
higher risk. Let us turn now to the risk-return tradeoff of a portfolio
that is 50% invested in bonds and 50% invested in stocks.
Portfolios
Rate of Return
Scenario Stock fund Bond fund Portfolio squared deviation
Recession -7% 17% 5.0% 0.160%
Normal 12% 7% 9.5% 0.003%
Boom 28% -3% 12.5% 0.123%
Expected return 11.00% 7.00% 9.0%

Variance 0.0205 0.0067 0.0010
Standard Deviation 14.31% 8.16% 3.08%
The rate of return on the portfolio is a weighted average of the

returns on the stocks and bonds in the portfolio:
rP = wB rB + wS rS
5% = 50% × (−7%) + 50% × (17%)
Portfolios
Rate of Return
Recession -7% 17% 5.0% 0.160%
Normal 12% 7% 9.5% 0.003%
Boom 28% -3% 12.5% 0.123%

Variance 0.0205 0.0067 0.0010

rP = wB rB + wS rS
9.5% = 50% × (12%) + 50% × (7%)

Portfolios
Rate of Return
Recession -7% 17% 5.0% 0.160%
Normal 12% 7% 9.5% 0.003%
Boom 28% -3% 12.5% 0.123%

Variance 0.0205 0.0067 0.0010

rP = wB rB + wS rS
12.5% = 50% × (28%) + 50% × ( −3%)
Portfolios
Rate of Return
Recession -7% 17% 5.0% 0.160%
Normal 12% 7% 9.5% 0.003%
Boom 28% -3% 12.5% 0.123%

Variance 0.0205 0.0067 0.0010
The expected rate of return on the portfolio is a weighted average

of the expected returns on the securities in the portfolio.
E (rP ) = wB E (rB ) + wS E (rS )
9% = 50% × (11%) + 50% × (7%)
Portfolios
Rate of Return
Recession -7% 17% 5.0% 0.160%
Normal 12% 7% 9.5% 0.003%
Boom 28% -3% 12.5% 0.123%

Variance 0.0205 0.0067 0.0010
The variance of the rate of return on the two risky assets portfolio is
σ P = (wB σ B ) + (wS σS ) + 2(wB σ B )(wS σS )ρBS
2 2 2
where ρ BS is the correlation coefficient between the returns on the

stock and bond funds.
Portfolios
Rate of Return
Recession -7% 17% 5.0% 0.160%
Normal 12% 7% 9.5% 0.003%
Boom 28% -3% 12.5% 0.123%

Variance 0.0205 0.0067 0.0010
Observe the decrease in risk that diversification offers.

An equally weighted portfolio (50% in stocks and 50% in bonds)
has less risk than stocks or bonds held in isolation.
1-102

 A measure of the degree to which two variables “move together”
relative to their individual mean values over time
 The Covariance between the returns on two stocks can be

calculated as follows:
N
Cov(RA,RB) = σ A,B = Σ pi(RAi - E[RA])(RBi - E[RB])

i=1
 Where:
 σ Α,Β = the covariance between the returns on stocks A and B
 N = the number of states
 pi = the probability of state i
 RAi = the return on stock A in state i
 E[RA] = the expected return on stock A
 RBi = the return on stock B in state i
 E[RB] = the expected return on stock B
1-103

 The correlation coefficient is obtained by standardizing (dividing) the
covariance by the product of the individual standard deviations
 The Correlation Coefficient between the returns on two stocks can be

calculated as follows:
σ A,B Cov(RA,RB)
Corr(RA,RB) = ρ A,B = σ Aσ B = SD(RA)SD(RB)
Where:
 ρ A,B
=the correlation coefficient between the returns on stocks A and B
 σ A,B
=the covariance between the returns on stocks A and B,
 σ A=the standard deviation on stock A, and
 σ B=the standard deviation on stock B
1-104
Two-Security Portfolios with Various
Correlations
100%
ρ = -1.0
return
stocks
ρ = 1.0
100%
ρ = 0.2
bonds
σ
 Relationship depends on correlation coefficient
-1.0 < ρ < +1.0
 If ρ = +1.0, no risk reduction is possible
 If ρ = –1.0, complete risk reduction is possible
1-105
Portfolio Risk as a Function of the Number
of Stocks in the Portfolio
In a large portfolio the variance terms are effectively

σ diversified away, but the covariance terms are not.
Diversifiable Risk;
Nonsystematic Risk;
Firm Specific Risk;
Unique Risk
Portfolio risk
Nondiversifiable risk;
Systematic Risk;
Market Risk
n
Thus diversification can eliminate some, but not all of the risk of
individual securities.
Risk Diversification: Systematic & 1-106
Unsystematic Risk
 A systematic risk is any risk that affects a large number of assets,
each to a greater or lesser degree.
 It arises on account of economy wide uncertainties and the

tendency of individual securities to move together with changes
in the market. It is also known as Market risk.
 Examples of systematic risk include uncertainty about general

economic conditions, such as GNP, interest rates or inflation.
 This part of risk cannot be reduced through diversification.

Risk Diversification: Systematic &
1-107
Unsystematic Risk
 An unsystematic risk is a risk that specifically affects a single
asset or small group of assets.
 It arises from the unique uncertainties of individual securities. It

is also called unique risk.
 These uncertainties are diversifiable if a large number of

securities are combined to form well-diversified portfolios. Thus
unsystematic risk can be totally reduced through diversification.
 Announcements specific to a company, such as a gold mining

company striking gold, the government increases custom duty,
are examples of unsystematic risk.
Relationship between Risk and 1-108
Expected Return (CAPM)

Expected Return on the Market:
R M = RF + Market Risk Premium

Expected return on an individual security:
R i = RF + β i × ( R M − RF )
Market Risk Premium

This applies to individual securities held within well-
diversified portfolios.
Expected Return on an Individual 1-109
Security
 This formula is called the Capital Asset Pricing

Model (CAPM)
Ri = RF + βi × ( RM −RF )
Expected
Risk- Beta of the Market risk
return on = + ×
free rate security premium
a security
• Assume β i = 0, then the expected return is RF.

• Assume β i = 1, then Ri = RM
1-110
Capital Asset Pricing Model (CAPM):
Assumptions
 Market efficiency: The Capital Market efficiency implies that
share prices reflect all available information. Also, individual are
not able to effect the prices of securities. This means that there
are large number of investors holding small amount of wealth.
 Risk aversion and mean-variance optimization: Investors are

risk-averse. They evaluate a security’s return and risk in terms of
expected return and variance or standard deviation respectively.
They prefer the highest expected returns for a given level of
risks. This implies that investors are mean-variance and they
form efficient portfolios.
1-111
CAPM Assumptions contd….

 Homogeneous Expectations: All investors have the
same expectations about the expected returns and
risk of securities.
 Single Time period: All investors’ decisions are

based on single time period.
 Risk-free rate: All investors can lend and borrow at

a risk-free rate of interest. They form portfolios
from publicly traded securities like shares and
bonds.
1-112
Capital Market Line

 The capital market (securities markets) is the market for securities
 The capital market includes the stock market and the bond market.
 CML is used to illustrate all of the efficient portfolio combinations

available to investors.
 The CML is derived by drawing a tangent line from the intercept

point on the efficient frontier to the point where the expected return
equals the risk-free rate of return.
1-113
Capital Market Line

The Capital Market Line
Capital
Market
Line
Expected Return on
the Portfolio
12%
8%
4%
Risk-free
rate
0%
0% 10% 20% 30% 40%
Standard Deviation of the

Portfolio
1-114
Capital Market Line

The Capital Market Line and Iso Utility Curves
Highly
A risk-
Risk
taker
Expected Return on Averse
the Portfolio
Investor
12%
Capital
8%
Market
Line
4%
Risk-free
rate
0%
0% 10% 20% 30% 40%
Standard Deviation of the

Portfolio
1-115
The Security Market Line
Consider a portfolio composed of the following two assets:

• An asset that pays a risk-free return Rf, , and
• A market portfolio that contains some of every risky asset in
the market.
Portfolio E(R) Beta

Risk-free asset Rf 0
Market portfolio E(Rm) 1
Security market line: the line connecting the risk-free

asset and the market portfolio
1-116
The Security Market Line shows how an investor can construct a

portfolio of T-bills and the market portfolio to achieve the
desired level of risk and return.
1-117
Plots relationship between expected return and betas.
 In equilibrium, all assets lie on this line.

 If individual stock or portfolio lies above the line:
 Expected return is too high – stock is undervalued.
 Investors bid up price until expected return falls.
 If individual stock or portfolio lies below SML:

 Expected return is too low – stock is overvalued.
 Investors sell stock driving down price until expected
return rises.
1-118
E(RP)
A - Undervalued SML
•
•
A
RM • B • Slope = (y2-y1) / (x2-x1)
• = [E(RM) – RF] / (βM-0)
= [E(RM) – RF] / (1-0)
= E(RM) – RF
RF
• B - Overvalued = Market Risk Premium
•
β M =1.0 β i
Capital Market Line v/s 1-119
Security Market Line

 The capital market line (CML) is a line used in the capital asset
pricing model to illustrate the rates of return for efficient while
the security market line (SML) is a line that graphs the
systematic, or market, risk versus return of the whole market at
a certain time and shows all risky marketable securities.
 The CML is derived by drawing a tangent line from the
intercept point on the efficient frontier to the point where the
expected return equals the risk-free rate of return while the
SML essentially graphs the results from the capital asset
pricing model (CAPM) formula. The x-axis represents the risk
(beta), and the y-axis represents the expected return. The
market risk premium is determined from the slope of the SML.
Capital Market Line v/s 1-120
Security Market Line

 What is plotted
 CML plots efficient portfolios, i.e. combinations
of the risky portfolio and the risk-free asset (it is
not valid for individual assets)
 SML plots individual assets and portfolios
 Measure of risk
 for CML – standard deviation (because well
diversified portfolios)
 for SML – beta (because individual assets)

Unit I FM

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FINANCIAL MANAGEMENT :

However, while it is not necessary to

 The Risk-Return Trade-

 The Time Value of

 Cash – Not Profit – is

 Incremental Cash Flows

 The Curse of Competitive

 Efficient Capital Markets

 The Agency Problem

 Taxes Bias Business

 All Risk is Not Equal

 "Financial Management is an area of financial

Financial Management is that managerial activity

Financial Management: Defined

 This is the business management function that is

 It refers to the application of financial management

 Here it deals with the situations that require selection

 From time to time it is observed that many firms have been

 Financial management is very important in case of non-profit

Profit Maximization contd….

“The value of a firm is represented by the market price of the company's

Wealth Maximization contd….

Functions of a Financial Manager

 Financial Decisions: It involves the determination of financial sources,

 FM allows you to identify and plan for the use

 It provides information for financial decision

 That is, entrepreneurs can effectively analyze a

 FM helps the investor to monitor the

 Working capital decision

 Earnings management decision

 This is also known as the Capital budgeting, and it

 The assets are expected to be used over a long

Importance of Capital Budgeting

 It determines the asset mix and hence

 It involves heavy initial outlays of the

 Benefits accrue in future which future is

2. Working capital decision

This is the decision concerned with the short term

 Cash reserves of the organisation

 Funds collected from debtors of the organization.

4. Earnings Management Decision

 To retain all the earnings and hence declare and

 To decide on what proportion to be paid and what

TIME VALUE OF MONEY

The Time Value of Money

This illustrates that there

 Time value of money quantifies the value

Uses of Time Value of Money

 Accept/reject decisions for project management

 Financial analysis of firms

Types of TVM Calculations

Present Value of an Investment

 Present value calculations determine what the value

 The process of finding a present value is called

 The interest rate used to discount cash flows is

General Present Value Formula:

Valuation using Table I

PVIFr,t is found on Table I at the end of the book.

Note that time period zero is today.

 Calculation based on general formula:

 Calculation based on Table I:

Future Value of an Investment