Finance for Non-Finance professionals

Topic in focus:
1. Introduction, Finance basics, Time Value of money

Session starts at 10 AM

Session Prepared & handled by: Queries or need support?

Rahul R MBA- HEC Paris Contact psgct@faceacademy.in
PURPOSE OF THIS
COURSE
Expand more?

Is my business performing?

Should I borrow?

Why no profits?

Continue or quit?
Topics to be covered
Basics of Financial accounting

• What is money?
• Time value of money
• Risk and Return
• Future value and Present value
• NPV, Perpetuity, Annuity

Summary & Questions

 What is money?
•Money is any item or verifiable record that is generally accepted as payment
for goods and services and repayment of debts
•Function of money
•A medium of exchange,
•A unit of measure,
•A store of value
•A standard of deferred payment
•Evolution of money – Barter trade system to Fiat money
•Commodity money  Representative money  Fiat money
•Bretton Woods conference(1944),
•Supension of Dollar Gold convertibility (1971)
•Central banks – Modern Money theory.
What is finance?
• Finance is a management of money and
other valuables which can be easily
converted into cash

• Finance is concernedwith the

maintenance and creation of economic
value or wealth

• A science that describes the

management, creation and study of
money, banking, credit, investments,
assets and liabilities.
Main areas of Finance
• The three main areas of finance are
• Personal finance- Personal banking,
loans, investments, etc

• Corporate finance- companies financial

analysis, capital budgeting, financing etc
• Financial management
• Investment
• Financial markets

• Public finance- RBI, state budgets,

exchange rates, Policy making etc.
 Financial Accounting terminologies
• Capital - The financial resources that businesses can use to fund their operations like cash, machinery,
equipment and other resources. These are the assets that allow the business to produce a product or
service to sell to customers
• Capital gain - An increase in the value of an investment, calculated by the difference between the net
purchase price and the net sales price.
• Capital loss - The loss in the value of an investment, calculated by the difference between the purchase
price and the net sales price.
• Annual rate of return - The annual rate of gain or loss on an investment, expressed as a percentage.
• Interest - The fee charged by a lender to a borrower, usually expressed as an annual percentage of the
principal.
• Loan / Debt - A loan is a sum of money that one or more individuals or companies borrow from banks or
other financial institutions so as to financially manage planned or unplanned events.
• Bond - A debt security that represents money borrowed by a corporation, government, or other entity.
The borrower repays the amount of the loan, plus a percentage as interest. Income funds generally
invest in bonds.
 What is money?
•Money is any item or verifiable record that is generally accepted as payment
for goods and services and repayment of debts
•Function of money
•A medium of exchange,
•A unit of measure,
•A store of value
•A standard of deferred payment
•Evolution of money – Barter trade system to Fiat money
•Commodity money  Representative money  Fiat money
•Bretton Woods conference(1944),
•Supension of Dollar Gold convertibility (1971)
•Central banks – Modern Money theory.
 Time value of Money

• Time value of money (TVM) is the idea that money that is available at the
present time is worth more than the same amount in the future, due to its
potential earning capacity.
• Suppose, would you be interested, if you are asked to
• lend Rs.200 today and
• Receive same Rs.200 back after a month (Rs.200 = 1kg apple now)
• Hence one needs to be incentivised or compensated for waiting.
• May be a deal of Rs 220 after a month may ‘interest’ you.
• The time value needs to be appropriate too.
• Appropriate to WHAT?
What is Return?

• Return is a measure of how well a wealth/asset/Instrument

performs.
• It is the reward for
• Not purchasing something else (time value of money)
• Assuming the risk of the asset (“Risk premium”)
• For Example, Will you take the deal to buy a house and rent it, if
• Today the price is 10 lakhs
• And the rent is Rs 4000 per month.
• Maintenance, opportunity cost etc ??
• Let’s assume the price of the house has appreciated to 11 lakhs in a year.
• How much this deal has given returns (in one year)
What is Return?

• Solution
Initial Price= P0 = 10L
Price after 1 year = P1 = 11L
Rent paid = Dividend = D = 12*4000 = 48000

Compared to today, the price appreciated by

𝟏 𝟎

• So the return here is approximately 15%

 Rate of return

• We have just computed the net return of an asset. The net return of an
asset during the period from ‘t’ to ‘t+1’ is denoted by r𝒕+𝟏

r 𝒕 𝟏 𝒕 𝟏 𝒕

𝒕
where Pt is the price at t, Pt+1 is the price at t+1 and Dt+1 are the cash payments to
investor during the period.

• Gross return R 𝒕 𝟏 𝟏
1+r
𝒕
Returns in an Investment

• We often separate net returns into two components

r 𝒕 𝟏 𝒕 𝟏 𝒕 𝟏 𝒕 𝟏

𝒕 𝒕 𝒕

• Dt+1 / Pt is the income yield: Cash payouts received by investor

• Rent got from the house; Dividend for stocks; coupon payment from bonds
• (Pt+1 – Pt)/ Pt is the Capital gain/Loss: change in asset price
• Like that appreciation of the price of the house.
Risk – Return tradeoff

• Return: how large an asset’s payoffs are

• Risk: that uncertain the asset’s payoffs are

• There is always trade-off between risk and reward(expected return)

The higher the risk, the higher the reward

• Why is this true?

If an asset has high risk, risk averse investors stay away from it. Asset
price goes down or the payoff should go up to entice the investor to
take risk.
 Personal Finance – Risk & Return

RETURN • Investments RISK

• Stocks, commodities and derivatives
• Mutual Funds
• Equity, Debt & Balanced
• Private firms fixed deposits, Bonds
• Banks’ FDs
• Bonds
• Loans
• Home loan
• Vehicle loan
• Personal loan
Future value and Present value

• Suppose you invest Rs 100 today and you have safe return of 5% then
how much do you receive in one year?
100*(1+0.05) = Rs 105
• This is plain simple interest calculation.
• If at the end of 1st year you invest again the complete proceeds to another
year again at 5% then now you receive at the end of 2nd year,
105 * 1.05 = Rs 110.25 (or) Rs 100 * (1.05)2
• If continued for one more year, then
110.25 * 1.05 = Rs 115.7625 (or) Rs 100 * (1.05)3
• More generally, future value of cash ‘C’ in T years invested at rate ‘r’ is
FV(C) = C * (1+r)T
Future value and Present value

• Let us now flip the story how much is Rs 100 to be received in 3 years
worth to us today?
it is worth the amount we should invest now to get Rs 100 in 3 years
• i.e., the Present value of Rs 100 to be received in 3 years is
100 = C* (1+r)3  i.e., C =
• If interest r is 5 % then the present value PV of 100 to be received in 3
years from now is Rs100/(1.05)3 = Rs 86.4
• In general, the present value of ‘C’ amount to be received in ‘T’ years when
interest rate is ‘r’ , is

PV(C) =
Future value and Present value- Discounting

• Example: You have to choose between receiving

A. 10M in 5 years or
This process of finding
B. 15M in 15 years the present value of a
which is better if r = 5%? future cash flow is
• Solution: Compute the respective present values called as
‘DISCOUNTING’.
The rate used here is
called as ‘discount rate’.

• So the opportunity A is worth more than B.

Net Present Value

• The Net Present Value (NPV) of an opportunity is defined as the sum of

present value of all/every future cash flows minus the initial investment.
• The Discount rate, r, is the expected return rate on an another equivalent
investment opportunity. Also called as ‘opportunity cost of capital’.
• Example: Consider a company investing in a new project that will require an
initial investment of 1 Million today. This project will yield following sequence
of returns/ cash inflows.
year 1 ₹ 100,000
year 2, 3, 4 ₹ 300,000 each
year 5 ₹ 100,000
Lets say the opportunity cost is 5%.
Net Present Value

• Solution: NPV = PV1 + PV2 +PV3+ PV4+ PV5 – Investment

• NPV = - 1M

= 951662 -1000000 = -48338

• Though the sum of cash flows is ₹ 1.1M. The present value of the future cash
inflows is ₹ 0.95M.
=> means, the money is better used by investing in that other opportunity.
• So if NPV < 0, then the project is not worthwhile.
Perpetuity

• A perpetuity is a constant stream of identical cash flows, C, that occur every

unit period (say year) and continues forever (infinite amount of time).
Example: govt pensions, perpetual preferred stock, rental agreement

• Perpetuity =

• Example: You own a agriculture land and have an agreement to rent out the property each
year for Rs 10000(otherwise worthless). Now municipal offers to buy the land for 170,000.
should you accept the offer? (consider opportunity rate both 5% & 7% per annum).
• Ans: the value of continuing the agreement perpetually
PV(rental) = 10000 / 0.05 = 200,000
As the city is offering less, the offer should be rejected.
 Growing Perpetuity

• A growing perpetuity is a stream of perpetual cash flows but that grows at a

constant rate ‘g’ (per year) forever.
• The price of a growing perpetuity is given by

• PV(Grow per.) =

• If C is the dividend of a company, this is called the Gordon growth formula.

• Example: In the same above example if the rent grows 2% every year then
Ans: PV(rental) =
 Annuity

• An annuity is a constant stream of cash flows ‘C’ , that occur every year, with
maturity in T years

• PV can be computed as the PV of a perpetuity issued now, minus the PV

of another perpetuity being issued in T years from now

• PV(Ann.) = 𝒕

• Example: If you need Rs 10000 every year for next four years. How much you have
to deposit in bank now. (Bank is giving 7% interest)

Ans: PV(Ann) =
Summary

• Money – is an unit of stored value of labour.

– That value varies with time
• Today’s money worth more than tomorrow’s
• Storing the money intelligently makes it grow through returns
• Quantum of returns are always linked to its risk perception
• When evaluating cashflow instruments, always consider “Present value”
• Present value is obtained by discounting the future value with appropriate
opportunistic rate of return.
• Net present value is cumulative sum of discounted cash flows occurring from
start(Investment) to end in an investment opportunity.
Questions?