INTRODUCTION TO FINANCE SECTION 1 INTRODUCTION TO FINANCIAL MANAGEMENT

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I. Meaning & Definitions

Financial Management is that specialized function of general management which is related to the procurement of finance and its effective utilization for the achievement of common goal of the organization. Financial Management is an area of financial decision making harmonizing individual motives and enterprise goals.- Weston and Brigam. Financial Management is the application of the planning and control functions to the finance function.- Howard and Upton. Financial Management is the operational activity of a business that is responsible for obtaining and effectively, utilizing the funds necessary for efficient operations.- Joseph and Massie. From the above definitions, it is clear that financial management is that specialized activity which is responsible for obtaining and affectively utilizing the funds for the efficient functioning of the business and, therefore, it includes financial planning, financial administration and financial control.

II. Objectives of Financial Management

The objectives or goals or financial management are as under: Profit Maximization - Maximization of profits is generally regarded as the main objective of a business enterprise. Each company collects its finance by way of issue of shares to the public. Investors in shares purchase these shares in the hope of getting medium profits from the company as dividend It is possible only when the company's goal is to earn maximum profits out of its available resources. If company fails to distribute higher dividend, the people will not be keen to invest their money in such firm and persons who have already invested will like to sell their stocks. Return Maximization - The second goal of financial management is to safeguard the economic interest of the persons who are directly or indirectly connected with the company, i.e. shareholders, creditors and employees. The all such interested parties must get the maximum return for their contributions. But this is possible only when the company earns higher profits or sufficient profits to discharge its obligations to them. Therefore, the goal of maximization of returns are inter-related.

Wealth Maximization - Frequently, Maximization of profits is regarded as the proper objective of the firm but it is not as inclusive a goal as that of maximizing it value to its shareholders. Value is represented by the market price of the ordinary share of the company over the long run which is certainly a reflection of company's investment and financing decisions. The performances of the company can well be evaluated by the value of its share. Wealth maximization has been accepted by the finance managers, because it overcomes the limitations of profit maximization. Wealth maximization means maximizing the net wealth of the companys share holders. Wealth maximization is possible only when the company pursues policies that would increase the market value of shares of the company. There are some arguments which are superior in wealth maximization: Wealth maximization is based on the concept of cash flows. Cash flows are a reality and not based on any subjective interpretation. On the other hand there are many subjective elements in the concept of profit maximization.

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It considers time value of money translates cash flows occurring of different periods into a comparable value of cash flows is considered critically in all decisions as it incorporates the risk associated with the cash flow stream.

III. Organization of Finance Function

Responsibilities of Financial Management are spread across the organization. For example Marketing Manager provides Demand Forecasts, Purchase Manager influences level of investment etc. However, the ultimate responsibility rests with the Top Management. Following is an example of Organization structure of a typical firm

IV. Time Value of Money Meaning

The time value of money is worth of money in present. Money available at the present time is worth more than the same amount in the future due to its potential earning capacity. This core principle of finance holds that, provided money can earn interest, any amount of money is worth more the sooner it is received. Everyone knows that money deposited in a savings account will earn interest. Because of this universal fact, we would prefer to receive money today rather than the same amount in the future. There are two concepts for Time Value of Money: Future Value Present Value

Future Value of Money

Lets say, you have won a cash prize! You have two payment options: A. Receive 10,000 now

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INTRODUCTION TO FINANCE
OR B. Receive 10,000 in three years Which option would you choose?

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If you're like most people, you would choose to receive the 10,000 now. Why would any rational person defer payment into the future when he or she could have the same amount of money now? For most of us, taking the money in the present is just plain instinctive. All things being equal, it is better to have money now rather than later. Back to our example: by receiving 10,000 today, you are poised to increase the future value of your money by investing and gaining interest over a period of time. For Option B, you don't have time on your side, and the payment received in three years would be your future value. To illustrate, we have provided a timeline:

If you are choosing Option A, your future value will be 10,000 plus any interest acquired over the three years. The future value for Option B, on the other hand, would only be 10,000. So how can you calculate exactly how much more Option A is worth, compared to Option B? Let's take a look.

If you choose Option A and invest the total amount at a simple annual rate of 10%, the future value of your investment at the end of the first year is calculated as follows: Future value of investment at end of first year: = ( 10,000 x 0.10) + 10,000 = 11,000 or Final equation: 10,000 x (0.10 + 1) = 11,000

If the 11,000 left in your investment account at the end of the first year is left untouched and you invested it at 10% for another year, how much would you have? Future value of investment at end of second year: = 11,000 x (1+0.10) = 12,100

Think back to math class and the rule of exponents, which states that the multiplication of like terms is equivalent to adding their exponents. In the above equation, the two like terms are (1+0.10), and the exponent on each is equal to 1. Therefore, the equation can be represented as the following: Future value = 10,000 x (1+0.10) = 12,100
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We can see that the exponent is equal to the number of years for which the money is earning interest in an investment. So, the equation for calculating the three-year future value of the investment would look like this: Future value = 10,000 x (1+0.10) = 13,310
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This calculation shows us that we don't need to calculate the future value after the first year, then the second year, then the third year, and so on. If you know how many years you would like to hold a present amount of money in an investment, the future value of that amount is calculated by the following equation:

Present Value of Money

If you received 10,000 today, the present value would of course be 10,000 because present value is what your investment gives you now if you were to spend it today. If 10,000 were to be received in a year, the present value of the amount would not be 10,000 because you do not have it in your hand now, in the present. To find the present value of the 10,000 you will receive in the future, you need to pretend that the 10,000 is the total future value of an amount that you invested today. In other words, to find the present value of the future 10,000, we need to find out how much we would have to invest today in order to receive that 10,000 in the future.

Let's walk backwards from the 10,000 offered in Option B. Remember, the 10,000 to be received in three years is really the same as the future value of an investment. If today we were at the two-year mark, we would discount the payment back one year. At the two-year mark, the present value of the 10,000 to be received in one year is represented as the following: Present value of future payment of 10,000 at end of year one: = 10,000 x (1+0.10) = 9,091
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Note that if today we were at the one-year mark, the above 9,091 would be considered the future value of our investment one year from now. Continuing on, at the end of the first year we would be expecting to receive the payment of 10,000 in two years. At an interest rate of 10%, the calculation for the present value of a 10,000 payment expected in two years would be the following: Present value of 10,000 in two year:

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= 10,000 x (1+0.10) = 8,264
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Of course, because of the rule of exponents, we don't have to calculate the future value of the investment every year counting back from the 10,000 investment at the third year. We could put the equation more concisely and use the 10,000 as FV. So, here is how you can calculate today's present value of the 10,000 expected from a three-year investment earning 10%: Present value of 10,000 in two year: = 10,000 x (1+0.10)-3 = 7,513

So the present value of a future payment of 10,000 is worth 7,513 today if interest rates are 10% per year. In other words, choosing Option B is like taking 7,513 now and then investing it for three years. The equations above illustrate that Option A is better not only because it offers you money right now but because it offers you 2,487 ( 10,000 - 7,513) more in cash! Furthermore, if you invest the 10,000 that you receive from Option A, your choice gives you a future value that is 3,310 ( 13,310 - 10,000) greater than the future value of Option B.

Present Value of a Future Payment

What if the payment in three years is more than the amount you'd receive today? Say you could receive either 15,000 today or 18,000 in four years. Which would you choose? The decision is now more difficult. If you choose to receive 15,000 today and invest the entire amount, you may actually end up with an amount of cash in four years that is less than 18,000. You could find the future value of 15,000, but since we are always living in the present, let's find the present value of 18,000 if interest rates are currently 4%. Remember that the equation for present value is the following:

In the equation above, all we are doing is discounting the future value of an investment. Using the numbers above, the present value of an 18,000 payment in four years would be calculated as the following: Present Value

Conclusion These calculations demonstrate that time literally is money - the value of the money you have now is not the same as it will be in the future and vice versa. So, it is important to know how to calculate the time value of money so that you can distinguish between the worth of investments that offer you returns at different times.

Present Value of Series of Cash Flows

So far we have considered PV of single receipt or payment at some future date. In many instances we may be interested in the PV of series of receipts/payments at different time periods. In order to determine the PV of series of uneven cash-flows, first we need to determine individual PV of each cash flow as if it was a single cash flow and then aggregate PV of all the cash flows. For example: If you were to receive following income over a period of 4 years @ 10%, you can calculate PV for each cash flow using the following formula:

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Year 1 2 3 4 PV

Cash-flows 10,000 20,000 30,000 40,000

PV 10000*(1/1.10)1 20000*(1/1.10)2 30000*(1/1.10)3 40000*(1/1.10)4

PV 9,091 16,529 22,539 27,321 75,480

Else you may use the following formula PV = FV*PV Factor In the above example, PV factor calculation is illustrated:

Year 1 2 3 4 Total PV
Symbolically: PV = C1 + (1+i)

Cashflows 10,000 20,000 30,000 40,000 (1/1.10)1 = (1/1.10)2 = (1/1.10)3 = (1/1.10)4 =

PV Factor 0.909091 = 0.909091 0.826446 0.751315 0.683013

PV 10,000 * 0.909090 = 20,000 * 0.826446 = 30,000 * 0.751315 = 40,000 * 0.683013 = 9,091 16,529 22,539 27,321 75,480

0.909091/1.1 = 0.826446/1.1 = 0.751315/1.1 =

C2 + C3 + (1+i)2 (1+i)3

C4 + . . . . . . . . (1+i)4

Cn (1+i)n

The process of calculating Present Value is also known as Discounting

Annuities
An annuity is a series of equal payments or receipts that occur at evenly spaced intervals. Leases and rental payments are examples. The payments or receipts occur at the end of each period for an ordinary annuity while they occur at the beginning of each period of an annuity due.

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Ordinary Annuity: Payments are required at the end of each period. For example, straight bonds usually pay coupon
payments at the end of every six months until the bond's maturity date.

Annuity Due: Payments are required at the beginning of each period. Rent is an example of annuity due. You are usually
required to pay rent when you first move in at the beginning of the month, and then on the first of each month thereafter.

Future Value of an Ordinary Annuity The Future Value of an Ordinary Annuity (FVoa) is the value that a stream of expected or promised future payments will grow to after a given number of periods at a specific compounded interest. The Future Value of an Ordinary Annuity could be solved by calculating the future value of each individual payment in the series using the future value formula and then summing the results. A more direct formula is: FVoa = PMT [((1 + i)n - 1) / i] Where: FVoa = Future Value of an Ordinary Annuity PMT = Amount of each payment i = Interest Rate Per Period n = Number of Periods Example: What amount will accumulate if we deposit $5,000 at the end of each year for the next 5 years? Assume an interest of 6% compounded annually. PV = 5,000 i = .06 n=5 FVoa = 5,000 [ (1.3382255776 - 1) /.06 ] = 5,000 (5.637092) = 28,185.46 An annuity is a series of equal payments or receipts that occur at evenly spaced intervals. Leases and rental payments are examples. The payments or receipts occur at the end of each period for an ordinary annuity while they occur at the beginning of each period or an annuity due. Present Value of an Ordinary Annuity The Present Value of an Ordinary Annuity (PVoa) is the value of a stream of expected or promised future payments that have been discounted to a single equivalent value today. It is extremely useful for comparing two separate cash flows that differ in some way. PV-oa can also be thought of as the amount you must invest today at a specific interest rate so that when you withdraw an equal amount each period, the original principal and all accumulated interest will be completely exhausted at the end of the annuity. The Present Value of an Ordinary Annuity could be solved by calculating the present value of each payment in the series using the present value formula and then summing the results. A more direct formula is:

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PVoa = PMT [(1 - (1 / (1 + i) )) / i]

Where: PVoa = Present Value of an Ordinary Annuity PMT = Amount of each payment i = Discount Rate Per Period n = Number of Periods Example 1: What amount must you invest today at 6% compounded annually so that you can withdraw $5,000 at the end of each year for the next 5 years? PMT = 5,000 i = .06 n=5

PVoa = 5,000 [(1 - (1/(1 + .06)5)) / .06] = 5,000 (4.212364) = 21,061.82

Practice Questions
1. If you invested 15,00,00 in Fixed Deposit which earns an interest of 5% per annum, what would be your future value of money after 4 years? (Ans 18,23,259) 2. Mr X, has been given an opportunity to receive Rs 1060 one year from now. He knows that he can earn 6% interest on his investments. Determine how many rupees must be invested today to have 1060 after one year. (Ans- Rs 1000) 3. Calculate PV & FV of following Cash flows if the prevailing rate of interest is 9%: Year 1 - 25,000 Year 2 - 41,000 Year 3 65,000 Year 4 70,000 (Ans PV = Rs 1,57,226, FV = Rs 2,58,950)

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