Financial Management Lacture notes, Commerce Department Shah Abdul Latif University, Khairpur, By Sir Anil Kumar

Financial Management Management Management Definition Definition: "Coordi "Coordinat nating ing work work activi activitie tiess so that that they they are compl complet eted ed effi effici cien entl tly y and and effe effect ctiv ivel ely y with with and and throu through gh othe otherr peopl people" e" (Robbins & Coulter, 2006) Functions: Basically five functions of management were proposed by a French industrialist named Henri Fayol but now condensed to four functions: namely: Planning, Organizing, Leading, Controlling. Financial Management Definition: “The process of procurement of funds and the efficient and wise allocation and use of the funds and resources". Nature of Financial Management relationship with the closely closely related related fields of The term nature refers to its relationship economics and accounting, its functions, scope and objectives. Relationship with the fields of Economics and Accounting Finance and Economics Macro Economics: Economics: Over Overal alll inst instit itut utio iona nall envi environ ronme ment nt in whic which h a firm firm operates. It looks at the economy as a whole. Fina Financ ncia iall mana manage gers rs shou should ld unde unders rsta tand nd the the econ econom omic ic envi enviro ronm nmen ent, t, specifically:  Recognize and understand how monetary policy affects the cost and availability of funds  Be versed in fiscal policy and its effects on the economy  Be aware of the various financial institutions and  Understand consequences of various levels of economic activity and changes in economic policy for their decision environment and so on. Micro Economics: Economic decisions of individuals and organizations. The concepts and theories relevant to financial management are:  Supply and demand relationships and profit maximization strategies.  Issues related to the mix of productive factors, optimal sales level and product pricing strategies.  Measurement of utility preference, risk and the determination of value  The rationale of depreciating assets.  Comparison of marginal revenue and marginal cost.

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Finance and Accounting Accounting provides basic financial input in shape of financial statements Financial Management analyses this input to determine past performance and future direction of a firm. Key Differences between finance and accounting are: 

Treatment of funds In accounting accrual system is followed. In Financial management Cash flows system is followed.



Decision Making An Accountant is primarily concerned with the collection and presentation of data A Financial manger is concerned with the financial planning, controlling and decision making. Thus finance begins where accounting ends Finance and other related disciplines Marketing, Production, Quantitative methods etc. Scope of Financial Management Approach to the scope is divided into 02 categories. 1. Tradi Traditi tion onal al Appro Approac ach h •

• •

This approach evolved during 1920’s and continued uptill the early fifties.

In initial stages it was known as corporate finance (CF) CF was concerned with procurement of funds externally from capital market institutions and through various financial instruments and did not consider proper allocation of capital.

Limitations of Traditional Approach Based on outsiders (e.g.: investors, bankers etc.) looking in approach and • insider looking in approach is ignored. Focus was on financing problems of a corporate enterprise and non – • corporate enterprise was outside its scope. More attention was given to episodic events e.g.: promotion, • incorporation, merger, consolidation, reorganization etc and day to day













2. Mode Modern rn App Appro roac ach h It views FM in broader sense and covers not only procurement of funds but efficient and wise allocation of funds as well. In modern sense it can be divided into three major decisions as functions of financial management 1. Inves Investm tmen entt Deci Decisi sion on It relates to the selection of assets in which funds will be invested by a firm. These assets fall into two categories. I. Lon Long g term term ass asset etss or Fix Fixed ed ass asset etss II. II. Short Short term term ass asset etss or Cur Curren rentt Asse Assets ts In this regard investment decisions fall into two categories: I. Capital Budgeting Long term investment decisions regarding the selection of fixed assets or an investment proposal whose benefits are likely to be received in future over the lifetime of a project. The main elements of capital budgeting decisions are: a) the long term assets and their composition (b) the business risk complexion of the firm (c) concept and measurement of the cost of capital II. Working Ca Capital Ma Management Maintaining the proper liquidity position of a firm by achieving trade-off between the profit and risk (liquidity). 2. Fina Financ ncin ing g deci decisi sion onss Decisions regarding the capital structure (Proportion of debt and equity financing) or leverage of a firm. A reasonable proportion of debt and equity capital is called the optimum capital structure. Financing decisions cover two interrelated aspects. Its one dimension called the capital structure theory is whether there is an optimum capital structure? And in what proportion should funds be raised to maximize the return to the shareholders? Its second dimension called the capital structure decision is to determine an appropriate capital structure, given the facts of a particular case. 3. Divide Dividend nd Policy Policy Decisi Decision on













Objective of Financial Management To ensure optimum financial decision through certain financial approaches referred to as decision criterion in respect of three areas namely: investment, financing, dividend is the objective of financial management. Two widely discussed approaches are: 1. Profit Maximizat Maximization ion Decision Decision Criterion Criterion Decisions that increase profit should be undertaken and decisions that decrease profit should be avoided. The term profit can be used in two senses: I.

As an owne ownerr ori orien ente ted d con conce cept pt it refe refers rs to the the amou amount nt and and share of national income which is paid to the owners of business.

II.

As prof profit itab abil ilit ity y it it is is des descr crib ibed ed as an opera operati tiona onall con conce cept pt.. It refers to economic efficiency. A situation where output exceeds input.

OR Select assets, projects, and decisions which are profitable and reject those which are not. In the current financial literature profit maximization is used in the 2 nd sense. Criticism of Profit Maximization Decision Criterion The main flaws of this criterion are: I. Ambiguity of profit It is not clear which variant of profit to maximize. Variants may be: short term or long term profit, gross profit or net profit etc. II. Timing of Benefit It ignores the distinction between the benefits received today or tomorrow while value of a rupee today is worth more than tomorrow.













It avoids the degree of certainty with which benefit is received while a consistent benefit is always preferred by investors over ever fluctuating benefit. 2. Wealth Wealth Maximizati Maximization on Decision Decision Criterion Criterion It is also known as value maximization or net present worth maximization. Its operational features satisfy all the requirements lacking in the earlier approach and is considered as universally accepted decision criterion. It is based on Cash flow generated rather than accounting profit. The value of a stream of cash flows is calculated by discounting its elements back to the present at a capitalization rate (interest rate) that reflects both time and risk (quality). As a decision criterion it involves a comparison of value to cost. An action that has a discounted value that exceeds its cost can be said to create value and should be undertaken. OR The alternative with the greatest net present value should be selected The net present worth can be calculated as follows: W= A1/ (1+K) + A2/ (1+K) 2 + ……+ An/ (1+K)n – C Where A1, A2, … An represents streams of cash inflows over a period of time. K = Discount rate or interest rate. C = Initial outlay to acquire that asset.













Valuation Concepts Time Value of Money/ Discounted Cash Flow (DCF) Analysis Amount that is paid or received at two different points in time is different, and this difference is recognized and accounted for by discounted cash flow (DCF) analysis. OR The value of a unit of money is different in different time period. The value of a sum of money received today is worth more than tomorrow. Time Lines

Time:

0

1 10%

Cash Flows:

-1 -1000

2

3

4

?

?

?

20%

1100

Techniques of Time Value of Money Determination Compounding The process of determining the future value (FV) of a cash flow or a series of cash flows. Formula (Single Payment) for Numerical Solutions: FVn = PV (1+ i)n Where, PV = I or i = INT INT =

Pres Presen entt Valu Valuee or Begi Beginn nnin ing g Amou Amount nt Inte Intere rest st Rate Rate Amou Amount nt of Inte Intere rest st















Formula ( Single Payment ) for Tabular Solutions: FVn = PV (FVIFi, n) Spread sheet (Excel) FV (rate, nper, pmt, pv, type )

Discounting The process of finding the present value (PV) of of a future cash flow or a series of cash flows. It is reverse of compounding. Formula ( Single Payment ) for Numerical Solutions: FVn PVn = (1+ i)n Formula ( Single Payment ) for Tabular Solutions: PVn = FV ( PVIFi,n )













Annuity A series of equal periodic payments (PMT) made at fixed intervals for a specified number of periods An annuity has two categories. 1. Ordinary annuity An annuity whose payments occur at the end of each period is called an ordinary annuity 2. Annuity Due An annuity whose payments occur at the beginning of each period is called an annuity due. Future value of an annuity Sum of compounded payments Formula for determining future value of an Ordinary annuity for numerical solutions: FVAn = PMT (1+ i ) 0 + PMT (1+ i ) 1 + PMT (1+ i ) 2 + . . . . + PMT (1+ i ) n = PMT ∑ ( 1 + i) n-t t=1

n-1













Example of an annuity due: Suppose: If you deposit Rs.1000 at the beginning of each year for three years in a bank account @ 10% per annum interest rate, how much will you have at the end of three years. Present value of an annuity Sum of Discounted Payments Present value of an ordinary annuity Formula for determining Present value of an ordinary annuity for numerical solutions: PMT

PMT

PVAn =

+ 1

(1+i) =

PMT

+ ……. + 2

(1+i)

(1+i)n

PMT ∑ (1 + i)t t=1

Formula for Tabular Solutions: PVAn = PMT (PVIFAi, n) Example of an ordinary annuity Suppose you were offered a 3 – year annuity with payment of Rs. 100 @ 5% per annum. How large must the lump sum payment today be to make it equivalent to annuity? Present value of an annuity due Formula for Tabular Solutions: PVAn = PMT (PVIFAi, n) (1+i)n













Interest Rate

i

Uneven Cash Flow Streams A series of uneven (nonconstant) periodic payments made at fixed intervals for a specified number of periods

Present Value of An Uneven Cash Flow Stream Sum of the present values of the individual cash flows of the stream If cash flows stream represents an ordinary annuity along with other individual cash flows then these can be determined through the annuity formula. Formula:

1

2

1

PV = CF1

1

+ CF2 1+i 1+i

n 1

+. ... …+ CFn 1+i 1+i

1+i 1+i

t n ∑ CFt t=1

1 = 1+ i

n ∑ CFt (PVIF i, t) t=1

Future Value of An Uneven Cash Flow Stream Sum of the future values of the individual cash flows of the stream













∑ CFt t=1

1+i

=

∑ CFt (FVIF i, n- t) t=1

Different types of interest rates 1. Nomi Nomina nall or quote quoted d rate rate It is the interest rate normally quoted by the borrowers or lenders. It is also called annual percentage rate because it is usually interest per year. Suppose: 10% per annum or year. 2. Effect Effective ive annual annual rate rate (EAR) (EAR) When cash flows are compounded/ discounted frequently( more than once a year ), then to account for this effect, a new interest rate called effective annual rate is determined at which compounding/discounted takes place. Formula to calculate EAR: m i Nom

EAR =

1+

1 m

Where Here i = is the nominal, or quoted rate, while m = number of times compounding / discounting occurs per year Note: EAR process is not applied in case of annuities. 3. Perio Periodi dicc inter interes estt rate rate This is the interest rate actually charged by the lender or paid by the borrower each period. It can be annual percentage rate or effective interest rate. Semi annually, Quarterly, monthly, Daily and other















Weekly:

n x 52

AND

i / 52

Daily: n x 360 or 365 AND i / 360 or 365 OR effective annual rate is determined at which compounding/discounted takes place and then this new interest rate is used in the formulas of compounding and discounting for a lump sum amount. Or The following general formula can be used for more frequent compounding/ discounting. More frequent compounding: Formula:

mn i

FVn = PV

1+ m

More frequent discounting: FV PVn = (1 + i / m) mn













Suppose: A company borrows Rs. 1000 @ 6% interest rate and this load is to be repaid in 3 equal installments at the end of each of the 3 years. Loan Amortization Schedule Format Beginning Amount (1)

Payment

Interest

(2)

(3)

Repayment of principal (2) - (3)=(4)

Remaining balance (1) – (4)

Year 01 02 03 Total

Continuous Compounding and Discounting

We can keep compounding or discounting every hour, minute, second and so on continuously.













Example: Rs.611 is the value of an investment after 4 years. If this value is discounted continuously at an interest rate of 5 percent, then what would be the present value?

Valuation Models Securities

Pieces of paper that represent claims against assets such as land, Plants and equipment, commodities or other securities Types of securities 1. Direct claim securities Securities which have claims against the cash flows produced by real (tangible) assets Three primary classes of direct claim securities 1. Bo Bonds

2. Pr Preferred st stock 3. Co Common st stock

2. Indirect claim securities or Derivatives













t=1

( 1+ k t )t

BOND VALUATION Bond

A bond is a long-term debt contract issued by a business or governmental unit which receives the selling price of bond in exchange for promising to make interest payments and to repay the principal on a specified future date. Definition of terms frequently used in bond valuation

1. Par Value The par value is the stated face value of the bond 2. Coupon interest rate It is the interest rate paid by the issuer of bond to the subscriber of bond every year uptill the maturity maturity of bond. To calculate calculate coupon interest rate the coupon payment (Amount of interest) is divided by the par value. 3. Maturity date The future date on which the par value is repaid to the subscriber of bond 4. Call Provisions













t=1

( 1+ k d )t

( 1+ k d ) N

Formula for tabular form

VB = INT ( PVIFA kd.N ) + M ( PVIFkd.N )

Changes in bond value over time

The following time line is used throughout this topic to analyze the changes in bond value over time. Time Line:

Time: 0

1

2

100

100

3

4

5

100

100

100 2000

5%

1. Whenever the going rate of interest, K d equal to the coupon rate, a bond will sell at its par value. So the value of bond will remain same after one year, two years of issue of bond or throughout the life of bond.















Suppose Mr.X purchased a bond of Rs. 2000 offering Rs. 100 per year coupon interest payment, o1 year after the issue of bond with remaining maturity period of 4 years at going interest rate of 3% per year. Solution: Now the value of bond 01 year after the issue of bond with 04 year remaining maturity period at an interest rate of 3% would be : 2148.71 Coupon interest payment 100 Interest, or current yield = = Current price of the bond 2148.71 Interest, or current yield = 0.0465 = 0.0465 x 100 = 4.653 %

Suppose Mr.Y purchased a bond of Rs. 2000 offering Rs. 100 per year coupon interest payment, from Mr. X with remaining maturity period of 3 years at going interest rate of 3% per year.













B) When the going rate of interest is greater than the coupon interest rate Suppose: Going rate of interest, K d is moved to 7 % The Price of bond with 04 years maturity period is: 1864.52 The price of bond with 03 years maturity period is: 1895.03 Now the total rate of return or yield is calculated as under:

Coupon interest payment

100













Finding the interest rates on a bond Yield to maturity (YTM) The expected rate of return earned on a bond held to maturity The following general bond valuation model can be applied to find the k d INT Bond’s

value

=V =

INT

+ (1+k d) 1

INT

M

+ ……… + +……. + (1+ k d) 2 (1+ k d) N (1+ k d) N













Bond Values with semiannual compounding/discounting Time line for annual compounding/discounting Time:

0

1

2

3

4

100

100

100 2000

3%

-2148.71

100

Now above Time line can be converted as under for semi-annual













Reinvestment Rate Risk Bonds with the short maturities have the risk that the cashflows (interest payments plus maturity value) will be reinvested at lower interest rates. Add figure 7.3, page no. 298 PREFERRED STOCK VALUATION Most preferred stocks entitle their owners to regular, fixed dividend payments. These payments usually last forever and if so these are called perpetuities. Value of preferred stocks is found as under: D ps V ps = K ps















Dt = Dividend the stockholders are expected to receive at the end of year t, where t = 1, 2, 3, ….n. D0 =Most recent dividend which has just been paid and known with certainty P0 = Actual market price of the stock today. ^

Pt = Expected price of the stock at the end of each year t













Expected capital gain = P1 – P0 = 1050 – 1000 = 50 and expected capital gain yield = 50 / 1000 = .05 and in percent .05 x 100 = 5 % ^ Expected total return = Ks = Expected dividend yield (D t / P0 ) plus expected ^ capital gain yield (P1 – P0 / P0 ). 10 % + 5 % = 15 % Common Stock Valuation Models













k s =

= P0

= 0.134 = 13.4 % 8.58

So expected rate of return can be same as the minimum required rate of return or it may differ.

Normal or Constant Growth Stocks Valuation













110 + 10 = 10% 10% + 10 % 1100 = 20 % Suppose above analysis has been conducted on January, 01, 2008 when P 0 = 1100 is the stock price. And D 1 = 110 is the dividend expected at the end of 2008. Now what is the expected stock price at the end of 2008 or beginning













^ 5. The expected total rate of return, k s,s, is equal to the expected dividend yield ^ plus the expected growth rate; k s = dividend yield + g. Non-Constant Growth Stock’s Valuation •

During early part of life a firm’s growth rate is much faster than that



















































Financial Management Lacture notes, Commerce Department Shah Abdul Latif University, Khairpur, By Sir Anil Kumar

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