FINANCIAL MANAGEMENT 1

Prof. R Madhumathi
Department of Management Studies
 Module 1
Introduction
 Introduction
 Time Value of Money

Components of Time Value

Investment Opportunities

Capital Market Opportunities

 Time Value of Money

• Concept of time value

• Relevance to organizations
– economic
– Financial
An important principle in financial
management is that the value of money
depends on when the cash flow occurs -
Rs.100 now is worth more than Rs.100 at
some future time.
 TIME VALUE
• In organizations, flow of money occurs at various points of
time. In order to evaluate the worth of money the financial
managers need to look at it from a common platform, namely
one time duration. The common platform enables a
comparison of money over different time periods.
 The time-value of money: Money like any other
desirable commodity has a price. If you own money, you
can, 'rent' it to someone else, say a banker, who can use it
to earn income. This 'rent' is usually in the form of interest.
The investor's return, which reflects the time-value of
money, therefore indicates that there are investment
opportunities available in the market. The return indicates
that there is a
• risk-free rate of return rewarding investors for forgoing
immediate consumption
• compensation for risk and loss of purchasing power.
(b) Risk: An amount of Rs.100 now is certain, whereas
Rs.100 receivable next year is less certain. This
'uncertainty' principle affects many aspects of financial
management and is termed as risk value of money.

(c) Inflation: Under inflationary conditions, the value of

money, expressed in terms of its purchasing power over
goods and services, declines. Hence Rs.100 possessed
now is not equivalent to Rs.100 to be received in the
future.

(d) Personal consumption preference: Most of us have a

strong preference for immediate rather than delayed
consumption. As a result we tend to value the Rs.100 to
be received now more than Rs.100 to be received latter.
 There are three fundamental financial decisions facing
individuals and shareholders:

• Consumption decisions: How much of my available

resources should I spend on immediate consumption?

• Investment decisions: How much of the resources

available should I forgo now in the expectation of
increased resources at some time in the future? How
should such decisions be made?

• Financing decisions: How much cash should I borrow or

lend to enable me to carry out the above investment
and consumption decisions?

Note: Clearly, these decisions are interrelated and should not,

therefore, be viewed in isolation.
• Individuals are faced with the choice of how much of their wealth should be
consumed immediately, and how much should be invested for consumption
at a later date. This applies equally to young children with their pocket
money. Undergraduates with their grants, professionals with their capital,
and shareholders with their investment portfolios. All these cases involve a
trade-off between immediate and delayed consumption.

• We are primarily concerned with how managers should reach investment

decisions. Cash generated from business operations can be utilized in two
ways: it can be distributed to the shareholders in the form of a dividend, or
reinvested within the business. Periodically, the directors decide how much
of the shareholders' wealth to distribute in the form of dividends and how
much to withhold for investment purposes, such as building up stock levels
or purchasing new equipment. The shareholders will only be willing to forgo
a higher present level of consumption (in the form of dividends) if they
expect an even greater future level of consumption. It is this willingness to
give up consumption now with the aim of increasing future consumption
which characterizes investment financing decisions.
 Graphical example
• Deepak is the sole proprietor of Platt Enterprises, a
new business with just one asset of INR 4 million in
cash. He has a number of interesting investment
ideas (all lasting just a year) but before investing his
capital within the business, he asks the following
key questions:

• 1. What is the return I could earn by investing my

capital (or some part of it) in the capital market?
• 2. How much should I invest within the business?
• 3. What is the return from the business?
• Before addressing these issues, it is first necessary
to make certain simplifying assumptions that allow
us to portray in two-dimensional form the
essential features of the investment-consumption
decision model.
The basic assumptions are as follows:
• 1. Investors are wealth-maximizers.

• 2. Only two periods are considered - the present

period (t0) and the next period (t1). This two-
period model implies that investments involve an
immediate cash outlay in order to receive a return
in terms of cash benefit in the following period, t1.
• It will be observed that the investment opportunities line is concave
to the origin rather than a straight line.
• This shape indicates the decreasing returns to scale of each
subsequent investment opportunity.
• As a wealth-maximizer, Deepak will first select those investment
projects offering the greatest return and work down towards those
offering the least return. Somewhere along the line (point 'I' in
Figure) the owner-manager will stop.
• Point 'I' represents the marginal project beyond which it ceases to be
worthwhile to invest.
• The marginal return from the next Rs.1 in investment would not be
sufficient to compensate for the sacrifice involved in giving up a
further Rs.1 in dividends.
• For Deepak, 'I' represents the point where the marginal return on
investment equals his marginal rate of time preference.
 Investment Opportunities
• Platt Enterprises has INR 4m available
• Assume that for investment there are only two possible
projects, each costing INR 2m and having a one-year life.
• Deepak could invest INR 4m, in both projects, producing a
INR 4m pay-off next year.
• He would probably prefer to invest only in project A,
costing INR 2m, that is giving a pay-off of INR 3m. Project B
is unprofitable, offering only INR lm from INR 2m
investment.
• If there are no opportunities to invest surplus cash
externally, say by putting it in a one-year deposit with a
bank or investing in short-term securities, Deepak would
have to pay a dividend to shareholders of the INR 2m
unused cash.
• In this example, the choice is fairly straightforward.
• But if Deepak had hundreds of potential projects it would be far harder
to know where the cut-off point for investment should be drawn.
• He needs a criterion for judging between cash today and cash receivable
next year.
• In effect, he requires a rate of exchange for the transfer of wealth across
time.
• Suppose he requires a minimum of Rs.115 receivable next year to
induce him to give up Rs.100 now,
• The rate of exchange would be Rs.115(t1):Rs.100(t0) or INR 1.15:INR 1.0.
This represents a premium for delayed consumption of one year of

(Rs.115 /Rs.100 )-1 = 0.15 or 15%

• This exchange rate between today's money and tomorrow's money

varies with the level of present consumption sacrificed.
 Marginal Rate of Time

• Deepak may be willing to forgo the first Rs.100 of potential dividend

in return for an additional 15 per cent next year, but to persuade
him to delay the consumption of a further Rs.100 will probably
require something in excess of 15 per cent.
• This variable exchange rate for the transfer of wealth across time at
various levels of investment is termed the marginal rate of time
preference, and will differ from individual to individual.
 Borrowing and Lending Opportunities
• Under our highly simplistic assumptions, our owner-
manager Deepak, is given only two decisions - consumption
and investment decisions.
• The more he invests, the less he can consume now, and
vice versa. T
• his ignores the third choice open to him, namely the
financing decision.
• Where capital markets exist, individuals and firms can buy
and sell not only real assets (i.e. fixed and current) but also
financial assets. When perfect capital markets are
introduced (i.e. no borrower can influence the interest rate,
all traders have equal and costless access to information,
no transaction costs or taxes), there will be a single market
rate of interest for both borrowing and lending.
• The existence of a capital market permits owners to transfer wealth
across time in a manner different from the investment - consumption
pattern of the firm. This is depicted in our example by the interest rate
line in the next Figure which represents the exchange rate between
current and future cash flows under perfect capital market conditions.
Its slope is (1+i), where i denotes the single period rate of interest. In
our example, the interest rate is found by relating present wealth to
next year's wealth at any point on the graph.
• The interest rate is found by relating present wealth to next
year's wealth at any point on the graph. At the extremes, this is
INR 6 million /INR 5 million = 1.20. The interest rate is therefore
20 per cent.
• With the introduction of financing opportunities through the
capital market, he can identify the appropriate level of corporate
investment.
• He should continue to invest in projects until where the interest
rate line is tangential to the investment opportunities line. At
this point, all investments offering a return at least as high as the
market rate of interest are accepted. They all offer positive net
present values.
• Investment as far as 'M' would mean a dividend of INR 3 million
today and an investment of INR 1 million (i.e. INR 4 million – INR
3 million).
• It is not worth investing further as the projects offer negative
returns.
• It would be more beneficial to withdraw the INR 3 million from
the business and to invest it in the capital market at 20 % p.a.
• From the investment opportunities curve, we find that the capital
outlay will produce cash flows of INR 2.4 million next year. Present
value of the INR 2.4 next year with an expectation of 20% will be 2.4 /
1.2 = INR 2 million. The one million spent now, is worth the present
value of INR 2 million, hence gives a net increase of INR 1 million from
the project activities.
• The new value of the business (considering the business returns)
becomes INR 5 million (starting capital of INR 4 million plus present
value of investment return INR 1m).
• The INR 3 million not invested by the firm could be paid out as a
dividend.
• An alternative would be for the firm to invest all or part of it on behalf
of the owners in the capital market until such time as investment
opportunities offering positive returns arise. Suppose Deepak is only
looking for a dividend of INR 1.5 million. The extra INR 1.5 million can
be invested in the capital market to earn INR 1.8 million next year (i.e.
INR 1.5m X 1.20). Deepak's cash flow next year will then be the INR
2.4m from capital investments plus the INR 1.8m from financial
investments.
 Ownership Opportunities
• Most firms are characterized by a large number of
shareholders (owners), few of whom are actively involved
in the management of the firm.
• It would obviously be an impossible task for managers to
evaluate investment decisions on the basis of the personal
investment - consumption preferences of all the
shareholders.
• The existence of capital markets renders any such attempt
unnecessary.
• Managers do not need to select an investment whose cash
flows exactly match shareholders' preferred time patterns
of consumption.
• The task of the manager is to maximize present value by
accepting all investment proposals offering a return at
least as good as the market rate of interest.
 Seperation Theorem

• This criterion maximizes the current wealth of the shareholders

who can then transform that wealth into whatever time pattern of
consumption they require. This they can do by lending or
borrowing on the capital market until their marginal rate of time
preference equals the capital market rate of interest. This
Separation Theorem, as it is usually termed, leads to the following
decision rules:

– Corporate management should invest in projects offering positive

present values when discounted at the capital market rate.
– Shareholders should borrow or lend on the capital market to
produce the wealth distribution which best meets their personal
time pattern of consumption requirements.
 Capital Market Opportunities
• When the two important assumptions i.e., the existence of
perfect capital markets and the absence of risk are relaxed,
the argument in favour of present value concept becomes
weaker. For one thing, there is no longer a unique rate of
interest in the capital market, but a range of interest rates
varying with the status of borrower, the amount required and
the perceived riskiness of the investment.
• There is no simple solution to the investment-consumption
decision when capital market imperfections prevail. In
advanced countries such as the United Kingdom, United
States, Japan and much of Western Europe, capital markets
are highly competitive and function fairly well so that
differences between lending and borrowing rate are
minimized, but significant differentials can be found in
emerging capital markets such as that in India.
• A major concern involves the particular capital market imperfections
where the borrowing rate is substantially higher than the lending rate.
• The steeper line represents the interest rate for the borrower and the
flatter line represents the lending rate. The existence of two different
interest rates gives rise to two different points on the investment
opportunities line 'CD'. Prospective borrowers, having to pay a higher
rate of interest for funds, would prefer the company to invest only ‘BD'
this year (i.e. up to project Y). However, prospective lenders will require
the company to discount at the lower lending rate leading to a much
greater investment of 'AD', with investment X being the marginal
project.
 Summary
Present value concept is relevant for managerial decisions because:

1. Managers are assumed to act in the best interest of the owners or

shareholders. This they can do by seeking to increase shareholders' wealth
in the form of maximizing cash flows through time. There is a market rate
of exchange between current and future wealth which is reflected in the
current rate of interest.

2. Managers should undertake all projects up to the point at which the

marginal return on the investment is equal to the rate of interest on
equivalent financial investments in the capital market. The result is an
increase in the market value of the firm and thus in the market value of the
shareholders' stake in the firm.

3. Management need not concern itself with shareholders' particular time

patterns of consumption or risk preferences. In well-functioning capital
markets, shareholders can borrow or lend funds to achieve their personal
consumption requirements. Furthermore, by carefully combining risky and
safe investments they can achieve the desired risk characteristics for those
consumption requirements.