CHAPTER 1

OVERVIEW OF FINANCIAL
MANAGEMENT

Suggested reading(s)
Ross, Westerfield and Jordan, (2022). Fundamentals of Corporate Finance, 13th ed. McGraw-Hill Irwin.
Brealey, Myers, and Allen, (2020). Principles of Corporate Finance, 13th ed. McGraw Hill.
 2
Introduction
What is Finance?
▪ The science and art of managing money
▪ It includes the circulation of money, the granting of credit, the making of
investments, and the provision of banking facilities.
▪ It has many facets, which makes it difficult to provide one concise definition.
It is; 2

– Analytical tool for money and market.

– Concerned with resources acquisition, allocation and management
– The study of how to invest and raise money productively
▪ Finance uses accounting information as an input for decision-making.
 3
Basic Areas of finance
▪ Finance is generally divided into three areas:
1) Corporate finance
2) Investments
3) Financial institutions 3

4) International finance
5) Fintech
▪ But they are closely interconnected.

continued
 4
Basic areas of finance…
1.Corporate finance/Financial management/Business finance:
Management of financial decisions at corporate level relating to;
▪ How much and what types of assets to acquire?
▪ How to raise the capital needed to purchase assets, and
▪ How to run the firm so as to maximize its value?

continued
 5
Basic areas of finance…
2. Investments: Work with financial assets such as stocks and bonds. Some
of the important questions include:
– What determines the price of a financial asset, such as a share of
stock?
– What are the potential risks and rewards associated with investing in
financial assets?
– What is the best mixture of financial assets to hold?

continued
 6
Basic areas of finance…
3. Financial Institutions:
– Businesses that deal primarily in financial matters.
– Include Banks and Insurance companies
– Perform a variety of finance-related tasks.

continued
 7
Basic areas of finance…
4. International Finance:
– Finance across country lines
– It is not so much an area as it is a specialization within one of the main
areas we described earlier.
– In other words, careers in international finance generally involve
international aspects of either corporate finance, investments, or
financial institutions

continued
 8
Basic areas of finance…
5. Fintech:
– It is the combination of technology and finance
– It is a broad term for a company that uses the internet, mobile
phones, software, and/or cloud services to provide a financial service

continued
 9
Financial Management Decisions
▪ Imagine that you were to start your own business. No matter what type
you started, you would have to answer the following three questions in
some form or another:
1. What long-term investments should you take on? That is, what lines
of business will you be in and what sorts of buildings, machinery, and
equipment will you need? 9

2. Where will you get the long-term financing to pay for your
investment? Will you bring in other owners or will you borrow the
money?
3. How will you manage your everyday financial activities such as
collecting from customers and paying suppliers? continued
 10
Financial Management Decisions…
▪ Capital Budgeting: concerns the firm’s long-term investments-The
process of planning and managing a firm’s long-term investments.
▪ Capital Structure- Concerns ways in which the firm obtains and
manages the long-term financing it needs to support its long-term
investments.
– A firm’s capital structure (or financial structure) is the specific mixture
of long-term debt and equity the firm uses to finance its operations.
– The financial manager has two concerns in this area.
▪ First, what mixture of debt and equity is best?
▪ Second, what are the least expensive sources of funds for the firm?
 11
Financial Management Decisions…
▪ Working Capital Management-
– Refers to a firm’s short-term assets, such as cash, and its short-term
liabilities, such as money owed to suppliers.
– Managing working capital is a day-to-day activity that ensures that the
firm has sufficient resources to continue its operations and avoid
costly interruptions
 12
Financial Market and the corporation
 13
Principles That Form The Foundations of Financial Management
▪ Risk-Return Trade-off
– We won’t take on additional risk unless we expect to be compensated with
additional return.
– Investment alternatives have different amounts of risk and expected returns.
– The more risk an investment has, the higher will be its expected return.
13

▪ Time value of money

• A Birr received today is worth more than a Birr received in the future.
• A Birr received today is worth more than a Birr received a year from now. Because
we can earn interest on money received today, it is better to receive money earlier
rather than later. continued
 14
Principles …
▪ The agency problem
– Agency relationship is an arrangement in which an agent acts on the behalf of a
principal. For example, shareholders of a company (principals) elect management
(agents) to act on their behalf
– The separation of management and the ownership of the firm creates an agency
problem. 14

– Managers may make decisions that are not in line with the goal of maximization of
shareholder wealth
▪ Cash—Not Profits—is King
➢ Cash Flow, not accounting profit, is used to measure wealth.
➢ Cash flows, not profits, are actually received by the firm and can be reinvested.
continued
 15
Principles …
▪ Incremental Cash flow
• It is only what changes that counts;
• The incremental cash flow is the difference between the projected cash flows if
the project is accepted, versus what they will be, if the project is not accepted.
▪ Efficient capital market 15

– The values of all assets and securities at any instant in time fully reflect all available
information.
▪ The curse of competitive markets
– Why it is hard to find exceptionally profitable projects;

continued
 16
Principles …
▪ Taxes affect business decisions
– The cash flows we consider are the after-tax incremental cash flows to the firm as
a whole.

▪ All risks are not equal

– Some risk can be diversified away, and some cannot. 16

▪ Ethical Behavior;
– Ethics- Standards of conduct or moral judgment that apply to persons engaged in
commerce
• Ethical behavior is therefore viewed as necessary for achieving the firm’s goal of
owner wealth maximization
 17
Goal of Financial Management
▪ Possible financial goals
– Survive.
– Avoid financial distress and bankruptcy.
– Beat the competition.
– Maximize sales or market share.
– Minimize costs. Maximize profits. 17

– Maintain steady earnings growth

▪ The most cited goal is Profit maximization;
▪ Under the profit maximization decision criteria, actions that
increase profit of a firm should be undertaken; and actions that
decrease profit should be rejected. continued
 18
Profit Maximization- Limitations
1. Ambiguity: The term profit or income is vague and ambiguous concept.

▪ Different people understand profit in different several ways.

✓Does it mean an absolute figure expressed in dollar or a rate of
profitability?
✓Does it mean short-term or long-term profits?
18

✓Does it refer to profit after tax or before tax?

✓Net profit available to ordinary share holders?
Then, the question or the problem would be which profit is to be
maximized? continued
 19
Cont’d…
2. It could increase current profits while harming the firm future
survival .
▪ A business might increase short term profits at the expense of long-term
competitiveness and performance of a business.
▪ It could be done by reducing operating expenses:
– Cutting research and development expenditure 19

– Defer/postpone important maintenance costs

– Cutting staff training and development
– Buying lower quality materials
– Cutting quality control mechanisms
▪ These policies may all have a beneficial effect on short term profits but may
undermine the long term competitiveness and performance of a business.
continued
 20
Cont’d…

3. Ignore time value of money concept/Timing of Benefits:

✓ The profit maximization criterion ignores the differences in the time

pattern of benefits received from investment proposals.
20
▪ Profit Maximization criterion does not consider the distinction
between returns (benefits) received in different time periods and treats
all benefits as equally valuable irrespective of the time pattern differences
in benefits.
continued
 21
Cont’d…
▪ Example: ABC Company wants to choose between two projects: project 1
and project 2. both projects cost the same, are equally risky and are
expected to provide the following benefits over three years period.
BENEFITS (PROFITS)
YEAR PROJECT 1 PROJECT 2
21
1 ETB. 60,000 ETB. –0-
2 40,000 40,000
3 –0- 60,000
TOTAL ETB. 100,000 ETB. 100,000

continued
 22
Cont’d..
▪ The profit maximization criterion ranks both projects as being
equal. However,
– Project 1 provides higher benefits in earlier years and project 2
provides larger benefits in latter years.
– The higher benefits of project 1 in earlier years could be reinvested 22

to earn even higher profits for later years.

– Profit seeking organizations must consider the timing of cash
flows and profits because money received today has a higher value
than money received tomorrow. Cash flows in early years are valued
more highly than equivalent cash flows in later years.
continued
 23
Cont’d..
4. Does not consider Quality of Benefits (Risk of Benefits): Profit
maximization assumes that risk or uncertainty of future benefits is of no
concern to stockholders.
Risk is defined as the probability that actual benefit will differ from
the expected benefit.
23

▪ Financial decision making involves a risk-return trade-off. This means

that in exchange for taking greater risk, the firm expects a higher
return. The higher the risk, the higher the expected return.

continued
 24
Cont’d..
Example: XY Company must choose between two projects. Both
projects cost the same. Project A has a 50% chance that its cash flows
would be actual over the next three years. And Project B has a 90%
probability that its cash flows for the next three years would be realized.
24

Expected Benefits
YEAR PROJECT A PROJECT B
1 ETB. 60,000 ETB. 45,000
2 65,000 50,000
3 95,000 85,000
TOTAL ETB. 220,000 ETB. 180,000 continued
 25
Cont’d..
▪ Under profit maximization, project A is more attractive because it adds
more to XY than project B. But if we consider the risk of the two
projects, the situation would be reversed.
• Expected benefit of project A = ETB. 220,000 x 50% = 110,000
• Expected benefit of project B = Br. 180,000 x 90% = 162,000
25

▪ The more certain the expected cash flow (return), the higher the
quality of benefits (i.e., low risk to investor). Conversely, the more
uncertain or fluctuating the expected benefits, the lower the quality of
benefits (i.e., high risk to investors).

continued
 26
Cont’d..
5. It doesn’t show cash flow available to shareholders

▪ Profit does not represent cash flow available to shareholders.

• Owners receive returns either through cash dividends or by

selling their shares for a better price. Higher Earning per Share 26

(EPS) doesn’t necessarily mean dividend payments will increase.

▪ Above all, accounting profit is affected by the accounting method

followed and is prone to manipulation by the management.
continued
 27
Shareholders Wealth Maximization
▪ The contemporary view of the goal of the firm is maximizing
shareholders value.
▪ Maximize the current value per share of the existing stock.
▪ It avoids the problems associated with the different goals.
▪ Share price today = Present value of all future expected dividends at the 27

required rate of return:


di
Max.Share. price. = max .
CF

i =1 (1 + k ) i
t

continued
 28
Cont’d..
▪ There are several reasons why wealth maximization decision criterion
is superior to Profit Maximization criteria.
– First, it has an exact measurement unlike profit maximization. It
depends on cash flows (inflows and outflows).
– Second, wealth maximization as a decision criterion consider the 28

quality as well as the time pattern of benefits.

– Third, it emphasizes on the long-term and sustainable
maximization of a firm’s common stock price in the financial
market.

continued
 29
Risk and Return
▪ Investment is the current commitment of resources for a period of time
in expectation of receiving future resources greater than the current
outlay.
– In order to part with resources committed
– The expected rate of inflation
– The uncertainty of the future payments 29

▪ The gain (or loss) from the investment is called return on investment .

continued
 30
Cont’d…
▪ Return on investment usually have two components.
– Periodic cash flows- the income component of return.
– Price change- Capital gain/loss.
▪ Thus, return is measured by taking the income plus the price change.
Rate of return = (Income + Capital gains)/Purchase price 30
 31
Risk and return on a stand-alone asset
▪ Risk: The chance that actual outcomes may differ from those expected.
▪ Stand-Alone Risk: The risk an investor would face if he or she
held only one asset.
▪ Expected Rate of Return: The rate of return expected to be realized
from an investment; the weighted average of the probability distribution
of possible results
✓Expected return is based on expected cash flows (not accounting
profits)
✓In an uncertain world future cash flows are not known with certainty
✓To calculate expected return, compute the weighted average of all
possible returns
 32
Risk and Rates of Return
▪ Possible returns
– Calculating Expected Return:

N
k=  k iP( k i )
i=1

where
ki = Return state i
P(ki) = Probability of ki occurring
N = Number of possible states

continued
 33
Risk and Rates of Return…
▪ Expected Return Calculation

Example
You are evaluating ABC Corporation’s common stock.You estimate the
following returns given different states of the economy

State of Economy Probability Return

Economic Downturn .10 –5%
Zero Growth .20 5%
Moderate Growth .40 10%
High Growth .30 20%
continued
 34
Risk and Rates of Return…

▪ Expected Return Calculation

Example
You are evaluating ABC Corporation’s common stock. You estimate the
following returns given different states of the economy

State of Economy Probability Return Expected (or

average) rate
Economic Downturn .10 x –5% = –0.5%
of return on
Zero Growth .20 x 5% = 1% stock is 10.5%
Moderate Growth .40 x 10% = 4%
High Growth .30 x 20% = 6%
N
k = 10.5%
k =  k iP(k i ) continued
i =1
 35
Risk and Rates of Return…
Example
Evaluate two investments: ABC Corporation’s common stock and assume a
one year Gov't Bond paying 6%. The return on the Gov't Bond does not
depend on the state of the economy--you are guaranteed a 6% return.

Probability T- Probability ABC

of Return Bill of Return Corp There is risk in
100% Owning ABC stock,
40% no risk in owning
30% the Treasury Bill
20%
10%
6% Return –5% 5% 10% 20% Return continued
 36
Risk and Rates of Return…
▪ Measuring Risk
– Standard Deviation (s) measure the dispersion of returns.
N
 =  (k i − k ) 2 P(k i )
i =1

Example
Compute the standard deviation on ABC common stock. the
mean (k) was previously computed as 10.5%
State of Economy Probability Return
Economic Downturn .10 –5%
Zero Growth .20 5%
Moderate Growth .40 10%
continued
High Growth .30 20%
 37
Risk and Rates of Return…

State of Economy Probability X (Return-Exp return)2=

Economic Downturn .10 x ( –5% – 10.5%)2 = 24.025%
Zero Growth .20 x ( 5% – 10.5%)2 = 6.05%
Moderate Growth .40 x (10% – 10.5%)2 = 0.10%
High Growth .30 x (20% – 10.5%)2 =27.075%
s2 = 57.25%
Higher standard s = 57.25%
deviation, higher risk s = 7.57%
NOTE: The standard
deviation of the T-Bill
is 0%
continued
 38
Coefficient of Variation
▪ If a choice has to be made between two investments that have the same
expected returns but different standard deviations, choose the one with
the lower standard deviation.
▪ Given a choice between two investments with the same risk but
different expected returns, investors generally prefer the investment
with the higher expected return.
38

▪ But, how do we choose between two investments if one has a higher

expected return and the other a lower standard deviation?

continued
 39
Cont’d…
▪ Use the coefficient of variation (CV) to measure the degree of risk,
CV = σ/ (k)
▪ The coefficient of variation shows the risk per unit of return, and it
provides a more meaningful basis for comparison than σ when the
expected returns on two alternatives are different. 39
 40
Measuring risk form historical data
▪ Measuring Risk
Standard Deviation (s) for historical data can be used to measure the
dispersion of historical returns.

N
1
= 
(n − 1) i =1
( ki − k ) 2
 41
DO IT!

41

Required: Calculate the expected return & Standard deviation.

 42
Cont’d…

42

ki ki
 43
Cont’d…

43
 44
Risk and return on Portfolio
▪ Portfolio is a collection of investment vehicles assembled to meet one or
more investment goals.
– Growth-Oriented Portfolio: primary objective is long-term price
appreciation
– Income-Oriented Portfolio: primary objective is current dividend
and interest income 44

– Capital preserving Portfolio: primary objective is getting marginal

income without depleting capital
▪ Return on Portfolio is the weighted average of returns on the individual
assets in the portfolio.

continued
 45
Cont’d…
rp = w1r1 + w2r2 + w3r3 + w4r4
n
rp =  w i  ki 
i =1
Where: rp = expected portfolio return
wi = portfolio weight in portfolio asset i
45
ki = expected return for portfolio asset i
▪ Assume that a security analyst estimated the upcoming year’s returns on the stocks
of four large companies. A client wishes to invest ETB 1 million, divided among the
stocks.

continued
 46
Cont’d…
▪ The investor invests 30% in Co. A (expected return of 15%), 10% in Co.
B (expected return of 12%), 20% in Co. C (expected return of 10%), and
40% in Co. D (expected return of 9%). The expected portfolio return is:
rp = w1r1 + w2r2 + w3r3 + w4r4
= 0.3(15%) + 0.1(12%) + 0.2(10%) + 0.4(9%) 46

=11.3%

continued
 47
Cont’d…
▪ Portfolio risk is the risk an investor would face if s/he held many assets.
▪ Standard Deviation (σ) of a portfolio return is calculated using all
individual assets in the portfolio.
▪ Unlike returns, the risk of a portfolio, σp, is generally not the weighted
average of the standard deviations of the individual assets in the
portfolio. 47

▪ σp will be smaller than the assets’ weighted σ , and it is theoretically

possible to combine stocks that are individually quite risky as measured
by their σ and form a portfolio that is completely riskless, with σp = 0.

continued
 48
Cont’d…
▪ The reason assets can be combined to form a riskless portfolio is that
their returns move counter-cyclically to each other when asset one returns fall,
those of other rise, and vice versa.
▪ The tendency of two variables to move together is called correlation,
and the correlation coefficient (ρ) measures this tendency.
48

continued
 49
Cont’d…
▪ In statistical terms, we say that the returns on Stocks A and B are;
– Perfectly negatively correlated, with ρ = −1.0.
– Perfectly positively correlated, with ρ = 1.0.
– Uncorrelated, with ρ = 0
▪ The ρ can range from +1.0, denoting that the two variables move up and 49

down in perfect synchronization, to –1.0, denoting that the variables

always move in exactly opposite directions.

continued
 50
Cont’d…
▪ Returns on two perfectly positively correlated stocks move up and down
together, and a portfolio consisting of two such stocks would be exactly
as risky as each individual stock.
▪ Thus, diversification does nothing to reduce risk if the portfolio
consists of stocks that are perfectly positively correlated.
▪ When stocks are perfectly negatively correlated, all risk can be diversified 50

away.

continued
 51
Cont’d…
▪ In reality, almost all stocks are positively correlated, but not perfectly so.
▪ Studies have estimated that on average, the correlation coefficient for the
monthly returns on two randomly selected stocks is in the range of 0.28
to 0.35.
▪ Under this condition, combining stocks into portfolios reduces but does
not completely eliminate risk.
51

Thus, diversification can reduce risk but not eliminate it.

▪ A portfolio that provides the highest return for a given level of risk is
called efficient portfolio.

continued
 52
Cont’d…
▪ As a rule, the risk of a portfolio declines as the number of stocks in the
portfolio increases.
▪ In general, there are higher correlations
– Between the returns on two companies in the same industry than for
two companies in different industries. 52

– Among similar “style” companies, such as large versus small, and

growth versus value.
▪ Thus, to minimize risk, portfolios should be diversified across industries and
styles.
continued
 53
Cont’d…
▪ Financial data shows,
– σ1 of a one-stock portfolio (or an average stock), is approximately 35% (in the
well developed financial market).
– However, a portfolio consisting of all stocks, which is called the market
portfolio, have a σM of 20%.
▪ Thus, almost half of the risk inherent in an average individual stock can 53

be eliminated if the stock is held in a reasonably well-diversified

portfolio.
▪ The risk that can be eliminated is called diversifiable risk, while the
part that cannot be eliminated is called market risk.

continued
 54
Cont’d…
▪ Diversifiable risk is caused by random events like lawsuits, strikes,
unsuccessful marketing programs, losing a major contract, and others
that are unique to a particular firm.
– Their effects on a portfolio can be eliminated by diversification; bad events in one
firm will be offset by good events in another.
▪ Market risk stems from factors that systematically affect most firms 54

and cannot be eliminated by diversification: war, inflation, recessions,

and high interest rates.
▪ Diversifiable risk is also known as company-specific, or unsystematic
risk.
▪ Market risk is also known as non-diversifiable, systematic; it is the
risk that remains after diversification. continued
 55
Cont’d…

55
 56
Market Risk
▪ Market risk of a stock is measured by beta coefficient.
– It measures a stock’s tendency to move up and down with the market.
bi = (σi/σM)ρiM
Where; bi - beta coefficient of Stock i
ρiM - correlation between Stock i’s R and the market R 56

σi - standard deviation of Stock i’s return

σM - standard deviation of the market’s return.

▪ The average beta for all stocks is 1.0.

continued
 57
Cont’d…
– If beta equals 1.0, the stock is as risky as the market, assuming it is
held in a diversified portfolio.
– If beta is less than 1.0 then the stock is less risky than the market;
– If beta is greater than 1.0, the stock is more risky than the market.
▪ Most stocks have betas in the range of 0.50 to 1.50. 57

▪ The beta of a portfolio is a weighted average of the individual securities’

betas.
bp = w1b1 + w2b2 +…+ wnbn
 58
Risk Return Relationship
▪ Have positive relationship between them.
▪ The model describes the relationship between a risk and required return
is CAPM.
▪ The market risk premium, RPM, is the premium that investors require for
bearing the risk of an average stock, and it depends on the degree of risk
aversion that investors on average have.
▪ The reward for bearing risk depends only on the systematic risk of
an investment since unsystematic risk can be diversified away.
RPM = RMkt − RRF
 59
Capital Asset Pricing Model (CAPM)
▪ It specifies the relationship between a risk and required rates of return
on well-diversified portfolios.
▪ CAPM was developed by Harry Markowitz in 1959.
▪ The assumptions underlying the CAPM’s development;
– All investors focus on a single holding period, and they seek to maximize the
expected utility. 59

– All investors can borrow or lend an unlimited amount at a given risk-free rate of
interest.
– All investors have identical estimates of the expected returns, variances, and
covariances among all assets

continued
 60
Cont’d…
▪ All assets are perfectly divisible and perfectly liquid.
▪ There are no transaction costs.
▪ There are no taxes.
▪ All investors are price takers (assume their own buying and selling
activity will not affect stock prices). 60

▪ The quantities of all assets are given and fixed.

continued
 61
Cont’d…
▪ The CML (capital market line) specifies the relationship between risk and
return for an efficient portfolio, but investors and managers are
more concerned about the relationship between risk and return of
individual assets.
▪ SML (security market line) specifies the relationship between risk and
return of individual assets. 61

ri = rRF + (rM – rRF)bi

= rRF + (RPM)bi
▪ SML is the representation of the CAPM. It displays the expected rate of
return of an individual security as a function of systematic risk.
continued
 62
Cont’d…

62

continued
 63
Cont’d…
▪ Unlike the CML for a well-diversified portfolio, the SML indicates that
the σi of an individual stock should not be used to measure its risk,
because some of the risk as reflected by σi can be eliminated by
diversification.
▪ Beta reflects risk after taking diversification benefits into account and
so beta, rather than σi, is used to measure individual stocks’ risks to
63

investors.

continued
 64
Cont’d…
▪ Suppose the risk-free rate is 4%, the market risk premium is 8.6%, and a
stock has a beta of 1.3. Based on the CAPM, what is the expected return
on this stock? What would the expected return be if the beta were to
double?
ri = rRF + bi(rM – rRF)
= 4% + 1.3*8.6%
64

= 15.18%
ri = rRF + bi(rM – rRF)
= 4% + 2.6*8.6%
= 26.36%
continued
 65
Arbitrage Pricing Theory (APT)
▪ CAPM is a single factor model that specifies risk as a function of only
one factor, the security’s beta.
▪ The risk–return relationship is more complex, with a stock’s required
return a function of more than one factor.
▪ Ross (1976) has developed APT that includes a number of risk factors, 65

so the required return be a function of two, three, four, or more

factors.

continued
 66
Cont’d…
APT model
ri = rRF + (r1 – rRF)bi1 + . . . + (rj – rRF)bij
ri = required rate of return on Stock i:
bi = sensitive only to economic Factor:
Example 66

▪ Assume that all stocks’ returns depend on inflation, industrial production,

and the aggregate degree of risk aversion (the cost of bearing risk, which
we assume is reflected in the spread between the yields on Treasury and
low-grade bonds).
continued
 67
Cont’d…
▪ The risk-free rate is 8.0%;
▪ The required rate of return is 13% on a portfolio with unit sensitivity to
inflation;
▪ The required return is 10% on a portfolio with unit sensitivity to
industrial production;
67

▪ The required return is 6% on a portfolio with unit sensitivity to the

degree of risk aversion.
▪ Assume that Stock i has factor sensitivities (betas) of 0.9 to inflation
portfolio, 1.2 to industrial production portfolio, and −0.7 to the risk-
bearing portfolio.
continued
 68
Cont’d…
▪ Stock i’s required rate of return, according to APT would be;
ri = 8% + (13% − 8%)0.9 + (10% − 8%)1.2 + (6% − 8%)(−0.7)
= 16.3%
▪ If the required rate of return on the market were 15.0% and if Stock i
had a CAPM beta of 1.1, then its required rate of return, according to
the SML, would be;
68

ri = 8% + (15% − 8%)1.1
= 15.7%
 69
Time Value of Money: An Introduction
▪ Time value of money refers to the fact that
– a birr in hand today is worth more than a birr promised at some time
in the future.
▪ Time allows one the opportunity to postpone consumption and earn
interest. 69

▪ The time value of money is used to determine whether future benefits

are sufficiently large to justify current outlays.
▪ Therefore, it is essential for financial managers to understand the time
value of money and its impact on financial asset prices.
 70
Time lines
▪ Show the timing of cash flows.
▪ Tick marks occur at the end of periods, so Time 0 is today; Time 1 is the
end of the first period (year, month, etc.) or the beginning of the second
period.

0 1 2 3
i%

CF0 CF1 CF2 CF3

 71
Types of interest
▪ Simple Interest
– Interest paid (earned) on only the original amount, or principal,
borrowed (lent).
– Interest is earned only on the original principal amount invested.
▪ Compound Interest 71

- Interest paid (earned) on any previous interest earned, as well as on

the principal borrowed (lent).
- Interest is earned on both the initial principal and the interest
reinvested from prior periods.
continued
 72
Future Value of a Single Amount
▪ Future value refers to the amount of money an investment will grow to
over some length of time at some given interest rate.
▪ To determine the future value of a single cash flows, we need:
FVn= PV0 × (1 + i)n
Where: FV= Future value; PV0=Present value; i=Interest rate; n=Time 72

▪ If you invested ETB 2,000 today in an account that pays 6% interest, with
interest compounded annually, how much will be in the account at the
end of two years if there are no withdrawals?
FV1 = PV (1+i)n
= 2,000 (1.06)2
= ETB 2,247.20
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Present Value of a Single Amount
▪ Value today of a future cash flow.
▪ Discounting is the process of translating a future value or a set of
future cash flows into a present value.
▪ Calculating present value is simply the inverse of calculating future
value (compounding).
FVn n
1
73

PV = = FVn
(1+i) n 1+i

n
1
▪ Where: 1+i is the PV of ETB 1 interest factor.
 74
Future Value and Present Value of an Annuity
▪ Annuity is a series of equal periodic payments (PMT) for a specified
number of periods.
▪ An annuity whose payments occur at the end of each period is called
an ordinary annuity.
– Payments on mortgages, car loans, and student loans are generally 74

made at the ends of the periods and thus are ordinary annuities.
▪ If the payments are made at the beginning of each period, it is called
an annuity due.
– Rental lease payments, life insurance premiums.
 75
Future Value of an Ordinary Annuity
▪ The future value of an ordinary annuity can be computed as:
 (1 + i ) n − 1 
FV = PMT  
 i 
▪ If you plan to invest ETB1,000 each year beginning next year for
three years at an 8% compound interest rate. What will be the 75

future value of the investment?

FVA3 = ETB1,000{[(1 +0.08)3 - 1]/0.08}
= 1,000[(1.2597 - 1)/0.08]
= 1,000(3.246)
= ETB 3,246
 76
Present Value of an Ordinary Annuity
▪ Single amount of money that should be invested now at a given interest rate
in order to provide for an annuity for a certain number of future periods.

PVAOrdinary =

76

▪ If you will receive ETB1,000 each year beginning next year for three years at
an 8% compound interest rate. What will be the present value of the
investment?
PVAn = PMT{[1 - (1/(1 + i)n)]/i}
PVA3 = 1,000{[1 - (1/(1.08)3)]/0.08} = ETB 2,577
 77
Future Value of an Annuity Due
▪ An annuity due is one in which payments are made at the beginning of
each time interval.
FVAdue = FVAordinary(1 + r)

Where 77

FVAdue=Future value of annuity due

FVAordinary= Future value of ordinary annuity
 78
Present Value of Annuities Due
▪ Because each payment for an annuity due occurs one period earlier, the
payments will all be discounted for one less period.
▪ The PV of an annuity due must be greater than that of a similar ordinary
annuity.
PVAdue = PVAordinary(1 + r) 78
 79
Perpetuities
▪ An important special case of an annuity arises when the level stream of
cash flows continues forever.
▪ Such an asset is called a perpetuity because the cash flows are
perpetual.
▪ A perpetuity has the same cash flow every year forever.
▪ The present value of a perpetuity is simply: 79

PV for a perpetuity = PMT/i

▪ For example, an investment offers a perpetual cash flow of ETB 600 every
year. The return you require on such an investment is 8%. What is the
value of this investment?
▪ The Perpetuity PV = 600/0.08 = ETB 7,500
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Chapter End
80