BA 5203 FINANCIAL MANAGEMENT

UNIT 1: FOUNDATIONS OF FINANCE

CONTENT – UNIT 1 FOUNDATION OF FINANCE
 Introduction to finance
 Financial management – nature, scope and functions of
finance
 organization of financial functions
 Objectives of financial management
 Major financial decisions
 Time value of money
 Features and valuation of shares and bonds
 Concept of risk and return
 Single asset and a portfolio 2
INTRODUCTION

 Finance life blood of the organization

Meaning of financial management:

- Management of flow of funds within the

organization

- Effective utilization for the attainment of

organizational objectives.

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DEFINITIONS OF FINANCIAL MANAGEMENT

 According to Solomon: “Financial management is

concerned with the efficient use of an important
economic resource namely, capital funds.”

 J.F Bradley : “ Financial management is the area of

the business management devoted to the judicious
use of capital in order to enable a business firm to
move in the direction of reaching its goal.”

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SCOPE OF FINANCIAL MANAGEMENT

1. Traditional approach – raising funds for corporates

(outside view)

2. Modern approach – optimum allocation inside the

organization (inside view)

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OBJECTIVES OF FINANCIAL MANAGEMENT

 Basic objectives - 1. Profit maximization 2. wealth

maximization

 Profit maximization – criticisms (ambiguity, time

value of money and risk factors

 Wealth maximization – maximizing the net present

worth means maximizing the market price of shares

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Contd…
OTHER OBJECTIVES

 Return maximization

 Provide support for decision making

 Manage risks

 Use resource effectively, efficiently and

economically

 Provide a supportive control environment

 Comply with authorities and safeguard assets

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ROLE OF FINANCE MANAGER
 Forecasting financial requirements
 Financing decisions
 Investment decisions – long term and short term
 Dividend decisions
 Deciding overall objectives
 Supply of funds to all parts of organization
 Evaluating financial performance
 Financial negotiation
 Stock exchange and share prices updates 8
LIQUIDITY VS. PROFITABILITY

 Liquidity – ability of the firm to pay its debt off

 Profitability – ability to make profit from the

investment

Both are contradictory to one another

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CONCEPT OF RISK AND RETURN
 Risk – variability of the expected return from the
investment made

 Return – gain or profit expected from the investment

 Risk associated return is given by:

Return = risk free return + risk premium

Risk – return trade off = optimization of risk and return

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FINANCIAL MANAGEMENT AND OTHER
FUNCTIONAL AREAS

 Financial management and production management

 Financial management and marketing management

 Financial management and personnel management

 Financial management and material management

 Financial management and accounting

 Financial management and statistics

 Financial management and economics

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SIGNIFICANCE OF FINANCIAL MANAGEMENT
 Effective and optimum utilization of funds

 Performance of organization finance

 Co-ordination with other departments

 Support decision making – minimizing the risk of profit

plan

 Also helps in profit planning, capital spending,

measuring cost and account receivable and so on…

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CONCEPT OF TIME VALUE OF MONEY

 A rupee worth today is more than a rupee available

at future date

Risk return trade off:

Higher the risk then higher the return, lower

the risk then lower the return

Time value of money – the value of time derived from

the use of money over the time as a result of
investment and re- investment 13
REASONS FOR TIME VALUE OF MONEY

 Risk

 Preference of present consumption

 Inflation

 Investment opportunity

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METHODS FOR TIME VALUE OF MONEY
CALCULATION

 Calculation of equivalent values from different

points of time is converted into values at particular
point of time (present or future)

 2 techniques :

1. Compounding

2. Discounting

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LIST OF COMPOUNDING TECHNIQUES
These techniques will ascertain the future value of the
present money
 Compounding of interest over ‘n’ years
 Multiple compounding periods
 Effective rate of interest
 Doubling period
 Compound value of a series of payments
 Compound value of an annuity 16
LIST OF DISCOUNTING TECHNIQUES
 Present value of lump sum
 Present value of series of cash flows
 Present value of annuity
 Present value of annuity due
 Present value of perpetuity
 Present value of growing perpetuity
 Present value of growing annuity
 Sinking fund 17
RISK AND RETURN OF SINGLE ASSET
 For single asset:

Rate of return = Annual income + (ending price – beginning price)

Beginning price

For example: price at beginning : $ 60.00

Price at end : $ 69.00
Dividend paid : $ 2.40

Rate of return = 2.4 + (69-60) / 60 = 0.19 = 19%

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Contd…
Formula may be refined as,

Rate of return = Annual income + End price – begin price

begin price begin price

Now rate of return = [2.4/60]+[(69-60)/60] = 0.4+0.15

= 0.19 = 19 %

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CALCULATION OF EXPECTED RATE OF RETURN
Economic Probability Rate of return
condition Pi Ri
Boom 0.3 16
Normal 0.5 11
Recession 0.2 6

Expected rate of return E(R) = ∑ Pi Ri

Economic Probability Rate of Pi Ri

condition Pi return Ri

Boom 0.3 16 4.8

Normal 0.5 11 5.5
Recession 0.2 6 1.2
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Contd…
 Expected rate of return E(R) = 11.5%

Calculation of standard deviation of return:

= root of [ ∑ Pi (Ri – E(R))^2 ]

Econo Proba Rate Pi Ri Ri – Ri – Pi(Ri –
mic bility of E(R) E(R)^2 E(R)^2
conditi Pi return )
on Ri
Boom 0.3 16 4.8 4.5 20.25 6.075
Normal 0.5 11 5.5 -0.5 0.25 0.125
Reces 0.2 6 1.2 -5.5 30.25 6.050
sion
21

Contd…
Answer is
standard deviation of rate of return - 3.5%

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PORTFOLIO OF ASSETS
 Portfolio means the combination of more than one
assets
Formula is E(Rp)= x1 E(R1) + x2 E(R2)
E(Rp) – expected rate of return of portfolio
X1 – Proportion of asset1 in portfolio
E(R1) – expected rate of return of asset1
X2 – proportion of asset2 in portfolio
E(R2) – expected rate of return of asset2 23
EXAMPLE FOR PORTFOLIO OF ASSETS
 Assume $1, 00,000 invested in two assets gold and
shares. Here 60% in gold and 40% in shares

Market condition Gold (Expected Shares

and probability rate of return) (Expected rate
of return)
Good 10% 5%
Bad 2% 1%

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Contd…
Market Gold Shares Gold Shares
condition (Expecte (Expecte proportio proportio
and d rate of d rate of n 60% n 40%
probabili return) return)
ty
Good 10% 5% 8% 4%
Bad 2% 1% 0.4% 0.2%

E(Rp) = 0.6 (8.4%) + 0.4(4.2%)

= 5.04+1.68

= 6.72%

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DIVERSIFICATION OF RISK IN PORTFOLIO
12%
If 100% in gold expected rate is 8.4%
10%
If 100% in shares expected rate is 4.2%
8%
If portfolio of gold and shares is 6.72%
Gold
6%
Shares
Portfolio
4%

2%

0% 26
Good Bad
FEATURES AND VALUATION OF EQUITY
SHARES AND BONDS

 Objective to maximize the market value of the firm’s

equity shares

 So we should know the value of bonds and shares

 Value of firm is the total sum of value of bonds and

shares

Basic discounted cash flow valuation model applied

to bonds and equity shares valuation.
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FEATURES OF EQUITY SHARES
1. They are permanent in nature
2. Equity shareholders are the actual owners of the company
and they bear the highest risk.
3. Equity shares are transferable, i.e. ownership of equity
shares can be transferred with or without consideration to
other person.
4. Dividend payable to equity shareholders is an appropriation
of profit.
5. Equity shareholders do not get fixed rate of dividend.
6. Equity shareholders have the right to control the affairs of
the company.
7. The liability of equity shareholders is limited to the extent of
their investment. 28
FEATURES OF BONDS
 Interest rate or coupon rate payable to bond
holders
 Bond holders get equal amount of payment in every
installment
 Bond holders don’t have control over the affairs of
company
 Debt instrument issued by government or any
business firm.
 They hold liability to the extent they purchased the
bonds
 It is not permanent and ends in certain maturity 29
period
BASIC VALUATION MODEL
 Value of asset = present value of cash flows expected from
the investment
Vo = c1 / (1+k)^1 + c2 / (1+k)^2 + c3 / (1+k)^3 + ….Cn/ (1+k)^n
Vo = value of asset at that time
Cn = cash flow
n = life of asset
PVIF = present value interest factor = 1 / (1+k)^t

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EXAMPLE PROBLEM
 An investor invested in a asset expected a cash
flow as below: required rate of return is 16%
Year Cash
flow
1 $20
2 $30
3 $220

Vo = PVIF(16,1) C1+ PVIF (16,2) C2 + PVIF (16,3)

C3
= (20*0.86) + (30*0.74) + (220*0.64)
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= 180.55
BOND VALUATION
 Par value : face value at which bonds issued
Rs.100 or Rs. 1000
 Coupon rate or interest rate : rate at which the bond
holders get paid
 Maturity period : corporate bonds 3- 10yrs ;
government bonds 20-25yrs
Formula, V = ∑ I PVIFA (Kd , n) + F PVIF (Kd,n)
V= value of bond; I= interest paid annually; F= Principal amount; n=
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maturity period
EXAMPLE PROBLEM

A person invested in bond par value = $100; required

rate of return = 13%; coupon rate = 12%; maturity
period = 8yrs

V = 12* PVIFA (14%,8) + 100 PVIF (14%,8)

= (12* 4.63) + (100* 0.35)

= 90.77
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Yield to maturity:

 The rate of return which an investors earns from the

bond, if holds the bond for maturity period.

 It is also called as required rate of return

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EQUITY VALUATION: DIVIDEND CAPITALIZATION
APPROACH

1. Single period valuation model

2. Multi period valuation model

Other approaches:

1. Earning capitalization approach

2. Book value approach

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3. Liquidation approach
THE END

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