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Financial

management
Module -I
Chapter-I
Nature of financial
management
Business Activities
Production
Marketing
Finance
Specific questions addressed by finance:
How should funds be acquired?

How should funds be spent?

How should short-term assets/liabilities be
managed?

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

Cont
Why study finance?

To manage your personal resources

To deal with the world of business

To pursue interesting and rewarding career opportunities

To make informed public choices as a citizen

For the intellectual challenge

Defining Finance
Finance is the study of how people allocate scarce
resources over time
o costs and benefits are distributed over time
o but the actual timing and size of future cash
flows are often known only probabilistically
Understanding finance helps you evaluate these
uncertain cash flows

When implementing decisions, people make use of
the Financial System which can be defined as the
set of markets and other institutions used for
financial contracting and exchange of assets and
risks

Defining Finance: a new
paradigm.


Finance is the process of transforming existing assets
into new, contractual forms, as well as the
analytical techniques needed to support this
process, for the purpose of wealth creation in
modern, capitalistic economies.

Defining Finance - Features
Finance is analytical.

Finance is based on economic principles.

Finance uses accounting information as an input for
decision-making.

Finance is international in perspective.

Finance is constantly changing.

Finance is the study of how to invest and raise money
productively

Defining Finance: the three
primary areas of finance

Financial management (Corporate finance) deals
with how firms raise and use funds to make short-
term and long-term investments.

Investment deals with how the securities markets
work and how to evaluate and manage
investments in stocks and bonds.

Financial Markets and Institutions includes the study
of the banking system and markets
Corporate Finance: the
financial function
Corporations face two broad financial questions:
- What investments should the firm make?
- How should it pay for those investments?

Financial managers are concerned with :

Investment Decisions (use of funds):
The buying, holding or selling of types of assets

Financing Decisions (acquisitions of funds)



The Financial objective:
value creation
Goal of management: maximize the economic
well-being, or wealth, of the owners (current
shareholders)
=> maximize the price of the stock

Share price today = Present value of all future
expected dividends at required return.



Finance Functions
Investment or Long Term Asset Mix Decision

Financing or Capital Mix Decision

Dividend or Profit Allocation Decision

Liquidity or Short Term Asset Mix Decision

Financial Managers Role
Raising of Funds

Allocation of Funds

Profit Planning

Understanding Capital Markets

Goals of the Financial
Manager
Finance in the least costly way.
Invest in assets that generate more value than they
cost.

In order for us, as financial managers, to achieve
these goals, we must understand how to determine
value: identify cash flows and their timing, and
consider risk.

Financial Goals
Profit maximization (profit after tax)

Maximizing Earnings per Share

Shareholders Wealth Maximization

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-off.

The return and risk relationship:
Return = Risk-free rate + Risk premium

Risk-free rate is a compensation for time and risk
premium for risk.

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 .

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.

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
Chapter - 4
Valuation of Bonds and Shares
Introduction
Assets can be real or financial; securities like shares
and bonds are called financial assets while physical
assets like plant and machinery are called real
assets.

The concepts of return and risk, as the determinants
of value, are as fundamental and valid to the
valuation of securities as to that of physical assets.

Concept of Value
Book Value

Replacement Value

Liquidation Value

Going Concern Value

Market Value

Features of a Bond
Face Value

Interest Ratefixed or floating

Maturity

Redemption value

Market Value

Bonds Values and Yields
Bonds with maturity

Pure discount bonds

Perpetual bonds

Bond with Maturity
Bond value = Present value of interest + Present
value of maturity value:

0
1
INT
(1 ) (1 )
n
t n
t n
t
d d
B
B
k k
=
= +
+ +

Yield to Maturity
The yield-to-maturity (YTM) is the measure of a
bonds rate of return that considers both the interest
income and any capital gain or loss. YTM is bonds
internal rate of return.

A perpetual bonds yield-to-maturity

0
1
INT INT
(1 )
n
t
t
d d
B
k k
=
=
= =
+

Current Yield
Current yield is the annual interest divided by the
bonds current value.

Example: The annual interest is Rs 60 on the current
investment of Rs 883.40. Therefore, the current rate
of return or the current yield is: 60/883.40 = 6.8 per
cent.

Current yield does not account for the capital gain
or loss.

Yield to Call
For calculating the yield to call, the call period
would be different from the maturity period and the
call (or redemption) value could be different from
the maturity value.
Example: Suppose the 10% 10-year Rs 1,000 bond is
redeemable (callable) in 5 years at a call price of
Rs 1,050. The bond is currently selling for Rs 950.The
bonds yield to call is 12.7%.


( ) ( )
5
5
1
100 1, 050
950
1 YTC 1 YTC
t
t =
= +
+ +

Bond Value and


Amortisation of Principal
A bond (debenture) may be amortised every year,
i.e., repayment of principal every year rather at
maturity.
The formula for determining the value of a bond or
debenture that is amortised every year, can be
written as follows:
Note that cash flow, CF, includes both the interest
and repayment of the principal.

0
1
(1 )
n
t
t
t
d
CF
B
k
=
=
+

Pure Discount Bonds


Pure discount bond do not carry an explicit rate of
interest. It provides for the payment of a lump sum
amount at a future date in exchange for the
current price of the bond. The difference between
the face value of the bond and its purchase price
gives the return or YTM to the investor.

Pure Discount Bonds
Example: A company may issue a pure discount
bond of Rs 1,000 face value for Rs 520 today for a
period of five years. The rate of interest can be
calculated as follows:


( )
( )
5
5
1/ 5
1, 000
520
1 YTM
1, 000
1 YTM 1.9231
520
1.9231 1 0.14 or 14% i
=
+
+ = =
= =
Pure Discount Bonds
Pure discount bonds are called deep-discount
bonds or zero-interest bonds or zero-coupon bonds.
The market interest rate, also called the market
yield, is used as the discount rate.

Value of a pure discount bond = PV of the amount
on maturity:

( )
0
1
n
n
d
M
B
k
=
+
Perpetual Bonds
Perpetual bonds, also called consols, has an
indefinite life and therefore, it has no maturity value.
Perpetual bonds or debentures are rarely found in
practice.

Perpetual Bonds
Suppose that a 10 per cent Rs 1,000 bond will pay
Rs 100 annual interest into perpetuity. What would
be its value of the bond if the market yield or
interest rate were 15 per cent?
The value of the bond is determined as follows:

0
INT 100
Rs 667
0.15
d
B
k
= = =
Bond Values and Changes in
Interest Rates
The value of the bond declines
as the market interest rate
(discount rate) increases.
The value of a 10-year,
12 per cent Rs 1,000
bond for the market
interest rates
ranging from 0 per cent
to 30 per cent.


0.0
200.0
400.0
600.0
800.0
1000.0
1200.0
0% 5% 10% 15% 20% 25% 30%
Interest Rate
B
o
n
d

V
a
l
u
e
Bond Duration and Interest
Rate Sensitivity
The longer the maturity of a bond, the higher will be
its sensitivity to the interest rate changes. Similarly,
the price of a bond with low coupon rate will be
more sensitive to the interest rate changes.

However, the bonds price sensitivity can be more
accurately estimated by its duration. A bonds
duration is measured as the weighted average of
times to each cash flow (interest payment or
repayment of principal).

Volatility
The volatility or the interest rate sensitivity of a bond
is given by its duration and YTM. A bonds volatility,
referred to as its modified duration, is given as
follows:


The volatilities of the 8.5 per cent and 11.5 per cent
bonds are as follows:



Duration
Volatility of a bond
(1 YTM)
=
+
4.252
Volatility of 8.5% bond 3.87
(1.100)
= =
4.086
Volatility of 11.5% bond 3.69
(1.106)
= =
Valuation of Shares
A company may issue two types of shares:
o ordinary shares and
o preference shares

Features of Preference and Ordinary Shares
o Claims
o Dividend
o Redemption
o Conversion

Valuation of Preference
Shares
The value of the preference share would be the
sum of the present values of dividends and the
redemption value.
A formula similar to the valuation of bond can be
used to value preference shares with a maturity
period:

1
0
1
PDIV
(1 ) (1 )
n
n
t n
t
p p
P
P
k k
=
= +
+ +

Valuation of Ordinary
Shares
The valuation of ordinary or equity shares is relatively
more difficult.
o The rate of dividend on equity shares is not
known; also, the payment of equity dividend is
discretionary.
o The earnings and dividends on equity shares are
generally expected to grow, unlike the interest
on bonds and preference dividend.

Dividend Capitalisation
The value of an ordinary share is determined by
capitalising the future dividend stream at the
opportunity cost of capital
Single Period Valuation:

If the share price is expected to grow at g per cent,
then P
1
:
We obtain a simple formula for the share valuation
as follows:


1 1
0
DIV
1
e
P
P
k
+
=
+
1 0
(1 ) P P g = +
1
0
DIV
e
P
k g
=

Multi-period Valuation
If the final period is n, we can write the general
formula for share value as follows:


Growth in Dividends :


Normal Growth :
Super-normal Growth :

0
1
DIV
(1 ) (1 )
n
t n
t n
t
e e
P
P
k k
=
= +
+ +

Growth = Retention ratio Return on equity


ROE g b

=
1
0
DIV
e
P
k g
=

Share value PV of dividends during finite super-normal growth period


PV of dividends during indefinite normal growth period
=
+
Earnings Capitalisation
Under two cases, the value of the share can be
determined by capitalising the expected earnings:

o When the firm pays out 100 per cent dividends;
that is, it does not retain any earnings.
o When the firms return on equity (ROE) is equal to
its opportunity cost of capital.

Equity Capitalisation Rate
For firms for which dividends are expected to grow
at a constant rate indefinitely and the current
market price is given


1
0
DIV
e
k g
P
= +
Caution in Using Constant-
Growth Formula
Estimation errors

Unsustainable high current growth

Errors in forecasting dividends

Valuing Growth
Opportunities
The value of a growth opportunity is given as
follows:

1
1
NPV
EPS (ROE )

( )
g
e
e
e e
V
k g
b k
k k g
=

Price-Earnings (P/E) Ratio:


How Significant?
P/E ratio is calculated as the price of a share
divided by earning per share.

Some people use P/E multiplier to value the shares
of companies.

Alternatively, you could find the share value by
dividing EPS by E/P ratio, which is the reciprocal of
P/E ratio.

Price-Earnings (P/E) Ratio:
How Significant?
The share price is also given by the following
formula:


The earnings price ratio can be derived as follows:

1
0
EPS
g
e
P V
k
= +
1
EPS
1
g
e
o o
V
k
P P
(
=
(

Chapter-3
Working capital mangement