Financial management

1 The Importance of Financial Management

Overview of Financial Management

Meaning Of Financial ManagementFinancial management is concerned with raising financial resources and their

effective utilization towards achieving the organizational goals. “Financial

Management means planning, organizing, directing and controlling the financial

activities such as procurement and utilization of funds of the enterprise. It means

applying general management principles to financial resources of the enterprise.

Financial Management is an essential part of the economic and non-economic

activities which leads to decide the efficient procurement and utilization of finance

with profitable manner. In the olden days the subject Financial Management was a

part of accountancy with the traditional approaches. Now a days it has been enlarged

with innovative and multi-dimensional functions in the field of business with the

effect of industrialization,

Financial Management has become a vital part of the business concern and they are

concentrating more in the field of Financial Management.

Scope/Elements

1. Investment decisions includes investment in fixed assets (called as capital

budgeting). Investment in current assets are also a part of investment decisions

called as working capital decisions.

2. Financial decisions - They relate to the raising of finance from various

resources which will depend upon decision on type of source, period of

financing, cost of financing and the returns thereby.

3. Dividend decision - The finance manager has to take decision with regards to

the net profit distribution. Net profits are generally divided into two:

a. Dividend for shareholders- Dividend and the rate of it has to be

decided.

b. Retained profits- Amount of retained profits has to be finalized which

will depend upon expansion and diversification plans of the enterprise.


Objectives of Financial Management

The financial management is generally concerned with procurement, allocation and

control of financial resources of a concern. The objectives can be-

1. To ensure regular and adequate supply of funds to the concern.

2. To ensure adequate returns to the shareholders which will depend upon the

earning capacity, market price of the share, expectations of the shareholders.

3. To ensure optimum funds utilization. Once the funds are procured, they should

be utilized in maximum possible way at least cost.

4. To ensure safety on investment, funds should be invested in safe ventures so

that adequate rate of return can be achieved.

5. To plan a sound capital structure-There should be sound and fair composition

of capital so that a balance is maintained between debt and equity capital.

Functions of Financial Management

1. Estimation of capital requirements: A finance manager has to make

estimation with regards to capital requirements of the company. This will

depend upon expected costs and profits and future programmers and policies

of a concern. Estimations have to be made in an adequate manner which

increases earning capacity of enterprise.

2. Determination of capital composition: Once the estimation have been made,

the capital structure have to be decided. This involves short- term and long-

term debt equity analysis. This will depend upon the proportion of equity

capital a company is possessing and additional funds which have to be raised

from outside parties.

3. Choice of sources of funds: For additional funds to be procured, a company

has many choices like-

a. Issue of shares and debentures

b. Loans to be taken from banks and financial institutions

c. Public deposits to be drawn like in form of bonds.


Choice of factor will depend on relative merits and demerits of each source and period

of financing.

4. Investment of funds: The finance manager has to decide to allocate funds

into profitable ventures so that there is safety on investment and regular

returns is possible.

5. Disposal of surplus: The net profits decision have to be made by the finance

manager. This can be done in two ways:

a. Dividend declaration - It includes identifying the rate of dividends and

other benefits like bonus.

b. Retained profits - The volume has to be decided which will depend

upon expansional, innovational, diversification plans of the company.

6. Management of cash: Finance manager has to make decisions with regards to

cash management. Cash is required for many purposes like payment of wages

and salaries, payment of electricity and water bills, payment to creditors,

meeting current liabilities, maintainance of enough stock, purchase of raw

materials, etc.

7. Financial controls: The finance manager has not only to plan, procure and

utilize the funds but he also has to exercise control over finances. This can be

done through many techniques like ratio analysis, financial forecasting, cost

and profit control, etc.


Major areas in Financial Management

1. Corporate finance = Business Finance

2. Investments

Work with financial assets such as stocks and bonds.

Value of financial assets, risk versus return, and asset allocation

Job opportunities

o Stockbroker or financial advisor

o Portfolio manager

o Security analyst

3. Financial institutions

Companies that specialize in financial matters

Banks – commercial and investment, credit unions, savings and loal

Insurance companies,Brokerage firms

Job opportunities

4. International finance

An area of specialization within each of the areas discussed so far

May allow you to work in other countries or at least travel on a regular

basis

Need to be familiar with exchange rates and political risk

Need to understand the customs of other countries; speaking a foreign

language fluently is also helpful


Goals Of Financial ManagementAll businesses aim to maximize their profits, minimize their expenses and maximize

their market share. Here is a look at each of these goals.

1.Maximize Profits

A company's most important goal is to make money and keep it. Profit-margin ratios

are one way to measure how much money a company squeezes from its total revenue

or total sales.

2.Minimize Costs

Companies use cost controls to manage and/or reduce their business expenses. By

identifying and evaluating all of the business's expenses, management can determine

whether those costs are reasonable and affordable. Then, if necessary, they can look

for ways to reduce costs through methods such as cutting back, moving to a less

expensive plan or changing service providers. The cost-control process seeks to

manage expenses ranging from phone, internet and utility bills to employee payroll

and outside professional services.

To be profitable, companies must not only earn revenues, but also control costs. If

costs are too high, profit margins will be too low, making it difficult for a company to

succeed against its competitors. In the case of a public company, if costs are too high,

the company may find that its share price is depressed and that it is difficult to attract

investors.

When examining whether costs are reasonable or unreasonable, it's important to

consider industry standards. Many firms examine their costs during the drafting of

their annual budgets.

3.Maximize Market Share

Market share is calculated by taking a company's sales over a given period and

dividing it by the total sales of its industry over the same period. This metric provides

a general idea of a company's size relative to its market and its competitors.

Companies are always looking to expand their share of the market, in addition to

trying to grow the size of the total market by appealing to larger demographics,

lowering prices or through advertising. Market share increases can allow a company

to achieve greater scale in its operations and improve profitability.


The size of a market is always in flux, but the rate of change depends on whether the

market is growing or mature. Market share increases and decreases can be a sign of

the relative competitiveness of the company's products or services. As the total market

for a product or service grows, a company that is maintaining its market share is

growing revenues at the same rate as the total market. A company that is growing its

market share will be growing its revenues faster than its competitors. Technology

companies often operate in a growth market, while consumer goods companies

generally operate in a mature market.

New companies that are starting from scratch can experience fast gains in market

share. Once a company achieves a large market share, however, it will have a more

difficult time growing its sales because there aren't as many potential customers

available.

Important of financial management

The financial matters are one of the most important matters when it comes to your

business. Some people think that the business is all about marketing and selling the

product and they start a business on this assumption that this knowledge will be

sufficient for them in running the business. The ugly truth about starting a business is

that the financial matters should be solved at the first priority, if you want your

business to grow. At the start of the business, the financial managers and stakeholders

will face problems that will require financial decisions. The questions such as where

you should invest your money and from where the revenue should be generated are

the questions that need to solve quickly in order to get maximum profit out of the

business. To handle such matters, one should have extra knowledge in the field of

finance. The specific field of knowledge can be termed as financial management.

Financial management can be defined as taking financial decisions with the goal that

they should maximize the stockholder’s wealth. Finance management is very

important in the business and in the world of finance; financial management can be

called by many names such as corporate management and managerial finance.

Financial Managers ultimate goal is to maximize the stockholders profit but this goal

is aligned with smaller goals and they collectively increase the profitability of the

organization. Some other goals performed by the financial managers are increasing


the day to day profitability, managing the funds of short term loans and managing

daily finances. These goals can be managed by completing a lot of activities such as

financial accounting, managerial accounting, risk management and auditing.

These tasks are very difficult and a small businessman cannot spare time to perform

all these functions. So, if you have a small company then you should contact the

financial manager and seeks their help in managing the finance of the organization.

Alternatively, businessmen may avail themselves of the services of a financial

manager or seek the aid of companies providing financial management services. Some

firms also take help form the financial management software. By purchasing such

software, you will not have to contact the financial managers every time you face a

financial problem. This financial software is expensive so it is advised that you should

start with software which has basic features and then move on to the advanced one.

This financial software can help in preparing the bills and they can also be used for

making invoices and generating payrolls. You should look for these features in the

software because they will help you in daily work. Furthermore, if you are more

oriented toward visuals, choose programs that make use of graphs and charts, as these

probably will be easier for you to use.

Financial market

Market for the exchange of capital and credit in the economy. Money markets

concentrate on short-term debt instruments; capital markets trade in long-term

debt and equity instruments. Examples of financial markets: stock market, bond

market, commodities market, and foreign exchange market. Market for the exchange

of capital and credit in the economy. Examples of financial markets are stock markets,

bond markets, commodities markets, and foreign exchange markets.

See also money market. In economics, a financial market is a mechanism that allows

people to easily buy and sell financial securities, commodities, and other fungible

items of value at low transaction costs and at prices that reflect the efficient market

hypothesis.


Financial markets have evolved significantly over several hundred years and are

undergoing constant innovation to improve liquidity.Both general markets and

specialized markets exist. Markets work by placing many interested sellers in one

"place", thus making them easier to find for prospective buyers. An economy which

relies primarily on interactions between buyers and sellers to allocate resources is

known as a market economy in contrast either to a command economy or to a non-

market economy that is based, such as a gift economy.

Financial markets facilitate:

The raising of capital

The transfer of risk

International trade

They are used to match those who want capital to those who have it. Typically a

borrower issues a receipt to the lender promising to pay back the capital. These

receipts are securities which may be freely bought or sold. In return for lending

money to the borrower, the lender will expect some compensation in the form of

interest or dividends.

Financial markets could mean:

1. Organizations that facilitate the trade in financial products. Stock exchanges

facilitate the trade in stocks, bonds and warrants.

2. The coming together of buyers and sellers to trade financial products.stocks and

shares are traded between buyers and sellers in a number of ways including: the use of

stock exchanges; directly between buyers and sellers etc.

In academia, students of finance will use both meanings but students of economics

will only use the second meaning. Financial markets can be domestic or they can be

international.


Types of financial markets

The financial markets can be divided into different subtypes.

1.Capital markets which consist of:

* Stock markets, which provide financing through the issuance of shares or common

stock, and enable the subsequent trading thereof.

* Bond markets, which provide financing through the issuance of Bonds, and enable

the subsequent trading thereof.

2. Commodity markets, which facilitate the trading of commodities.

3. Money markets, which provide short term debt financing and investment.

4. Derivatives markets, which provide instruments for the management of financial

risk.

*Futures markets, which provide standardized forward contracts for trading products

at some future date; see also forward market.

5.Insurance markets, which facilitate the redistribution of various risks.

6. Forieng exchange markets, which facilitate the trading of foreign exchange.

Money market

Market for short-term (less than one year) debt securities. Examples of money

market securities include U.S. Treasury bills, federal agency securities, bankers'

acceptances, commercial paper, and negotiable certificates of deposit issued by

government, business, and financial institutions.

The importance of money market

Money Sources

The short-term funds available in the money market come from individuals who

deposit their cash in money market accounts. For individuals who keep their cash in

money market accounts, the benefits are similar to a checking account, with some

differences. Generally, the financial institution that holds your money market account

pays you a better interest rate than a traditional savings account, and in some cases

better than a certificate of deposit. In addition, you are allowed a limited number of

withdrawals every month and your deposits are insured by the federal government. In


return for a better interest rate and low risk of loss, your financial institution may

invest your deposits in short-term investments issued by other financial institutions,

banks, corporations or government agencies.

Federal Deficit

The federal government also borrows money from the money market.

This short-term borrowing is done through the U.S. Treasury, which issues shorter-

term securities called T-bills. Maturities for short-term T-bills vary from four, 13 and

26 weeks and are issued every week. Cash management T-bills are issued every

month and have a one-year maturity. These liquidity management instruments allow

the federal government to continue to finance the operations and services of the

federal government in cases of budget deficits and other cash shortages.

Government Agencies

Like the federal government, federal agencies may also issue short-term

securities to ensure the funding of a particular service or program. For instance,

federal mortgage guarantee programs like Ginnie Mae or Freddie Mac may require

short-term liquidity to cover specific claims or other financial obligations.

Corporate

Corporations may borrow money from issuing short-term securities in the

money market. Generally, corporations have the option of borrowing money from the

bank or issuing a short-term security commonly called commercial paper.

Commercial paper is sometimes cheaper than borrowing from a bank and as a result,

commercial paper is a very common alternative. The purpose of short-term borrowing

in the money markets is similar to other institutions that borrow short-term funds. The

money raised in the money market may be used to fund operations, payroll or a

specific project.

Growth

The money circulating throughout the money market finances short-term

borrowing by large corporations and the government. This borrowing allows both

businesses and government agencies to continue to spend the money on programs and

expansion projects necessary to encourage economic growth.


Capital market

Trading center for long-term debt and corporate stocks. The New York Stock

Exchange (NYSE), which trades the stocks of many of the larger corporations, is a

prime example of a capital market. The amarican stock exchange and the regional

stock exchanges are also examples. In addition, securities are issued and traded

through the thousands of brokers and dealers on the over-the-counter (OTC)

market market.

One of the main functions of financial markets is to allocate capital. Capital markets

especially facilitate the raising of capital while money markets facilitate the transfer

of liquidity, in both cases matching those who have capital to those who need it.

Financial markets attract funds from investors and channel them to enterprises that

use that capital to finance their operations and achieve growth, from startup phases to

expansion--even much later in the firm’s life. Without financial markets, borrowers

would have difficulty finding lenders themselves. Intermediaries such as banks help in

this process. Bank deposits are a simple ways in which capital is allocated from a pool

of savers to businesses that want to deploy it. More complex transactions than a

simple bank deposit require markets where lenders and their agents can meet

borrowers and their agents, and where existing instruments can be resold. One

example being a stock exchanges.

A capital market is one in which individuals and institutions trade financial securities.

Organizations and institutions in the public and private sectors also often sell

securities on the capital markets in order to raise funds. Thus, this type of market is

composed of both the primary and secondary markets. Any government or

corporation requires capital (funds) to finance its operations and to engage in its own

long-term investments. To do this, a company raises money through the sale of

securities - stocks and bonds in the company's name. These are bought and sold in the

capital markets.


Stock market

Stock markets allow investors to buy and sell shares in publicly traded

companies. They are one of the most vital areas of a market economy as they

provide companies with access to capital and investors with a slice of

ownership in the company and the potential of gains based on the company's

future performance. This market can be split into two main sections: the

primary market and the secondary market. The primary market is where new

issues are first offered, with any subsequent trading going on in the secondary

market.

Bond Markets

A bond is a debt investment in which an investor loans money to an entity

which borrows the funds for a defined period of time at a fixed interest rate.

Bonds are used by companies, municipalities, states and U.S. and foreign

governments to finance a variety of projects and activities. Bonds can be

bought and sold by investors on credit markets around the world. This market

is alternatively referred to as the debt, credit or fixed income market. It is

much larger in nominal terms that the world's stock markets.

Financial Institution

An organization, which may be either for-profit or non-profit, that takes money from

clients and places it in any of a variety of investment vehicles for the benefit of both

the client and the organization. Common examples of financial institutions are retail

banks, which takedeposits into safekeeping and use them to make loans to other

customers, and insurance companies, which do not take deposits, but provide

guarantees of payment if a certain situation occurs in exchange for a premium. See

also: Depository institution, Non-depository institution.

Any institution that collects money and puts it into assets such as stocks, bonds, bank

deposits, or loans is considered a financial institution. There are two types of financial

institutions: depository institutions and non-depository institutions. Depository

institutions, such as banks and credit unions, pay you interest on your deposits and use

the deposits to make loans. Non depository institutions, such as insurance companies’.

brokerage firms, and mutual found companies, sell financial products. Many financial

institutions provide both depository and non depository services.


Time Value Of Money

Introduction

Time Value of Money (TVM) is an important concept in financial management. It can

be used to compare investment alternatives and to solve problems involving loans,

mortgages, leases, savings, and annuities. Time Value of Money is based on the

concept that a rupee that someone have today is worth more than the promise or

expectation that he or she will receive a dollar in the future.

The idea that money available at the present time is worth more than the same amount

in the future due to its potential earning capacity. This core principle of finance holds

that, provided money can earn interest, any amount of money is worth more the

sooner it is received. The time value of money or, discounted present value, is one of

the basic concepts of finance.

To fully understand time value of money one must first understand a few terms.

Present value and future value are totally different. They also have their disadvantages

and advantages; it just depends on how they are used.

Interest

Interest is a charge for borrowing money, usually stated as a percentage of the

amount borrowed over a specific period of time. Simple interest is computed only on

the original amount borrowed. It is the return on that principal for one time period. In

contrast, compound interest is calculated each period on the original amount borrowed

plus all unpaid interest accumulated to date.

Simple Interest

where:

p = principal (original amount borrowed or loaned)

i = interest rate for one period

n = number of periods


Present Value

Present Value of a Single Amount

Present Value is an amount today that is equivalent to a future payment, or series of

payments, that has been discounted by an appropriate interest rate. The difference

between the two depends on the number of compounding periods involved and the

interest (discount) rate.

Where:

PV = Present Value

FV = Future Value

i = Interest Rate per Period

n = Number of Compounding Periods

Present Value of Annuities

An annuity is a series of equal payments or receipts that occur at evenly spaced

intervals. Leases and rental payments are examples. The payments or receipts occur at

the end of each period for an ordinary annuity while they occur at the beginning of

each period for an annuity due.

Present Value of an Ordinary Annuity

The Present Value of an Ordinary Annuity is the value of a stream of expected or

promised future payments that have been discounted to a single equivalent value

today. It is extremely useful for comparing two separate cash flows that differ in some

way.

The Present Value of an Ordinary Annuity could be solved by calculating the present

value of each payment in the series using the present value formula and then summing

the results. A more direct formula is,

http://www.getobjects.com/Components/Finance/TVM/pv.html


Where:

PVoa = Present Value of an Ordinary Annuity

PMT = Amount of each payment

i = Discount Rate per Period

n = Number of Periods

Present Value of an Annuity Due

The Present Value of an Annuity Due is identical to an ordinary annuity except that

each payment occurs at the beginning of a period rather than at the end. Since each

payment occurs one period earlier, we can calculate the present value of an ordinary

annuity and then multiply the result by (1 + i).

Where:

PVad = Present Value of an Annuity Due

PVoa = Present Value of an Ordinary Annuity

i = Discount Rate per Period

Difference between an Ordinary Annuity and an Annuity-Due

Each payment of an ordinary annuity belongs to the payment period preceding its

date, while the payment of an annuity-due refers to a payment period following its

date.


A more simplistic way of expressing the distinction is to say that payments made

under an ordinary annuity occur at the end of the period while payments made under

an annuity due occur at the beginning of the period. Most annuities are ordinary

annuities. Installment loans and coupon bearing bonds are examples of ordinary

annuities. Rent payments, which are typically due on the day commencing with the

rental period, are an example of an annuity-due.

Future Value

Future Value of a Single Amount

Future Value is the amount of money that an investment made today (the present

value) will grow to by some future date. Since money has time value, we naturally

expect the future value to be greater than the present value. The difference between

the two depends on the number of compounding periods involved and the

going interest rate.

Where:

FV = Future Value

PV = Present Value


n = Number of Compounding Periods

Future Value of an Ordinary Annuity

The Future Value of an Ordinary Annuity (FVoa) is the value that a stream of

expected or promised future payments will grow to after a given number of periods at

a specific compounded interest.

The Future Value of an Ordinary Annuity could be solved by calculating the future

value of each individual payment in the series using the future value formula and then

summing the results. A more direct formula is,

http://www.getobjects.com/Components/Finance/TVM/iy.html

http://www.getobjects.com/Components/Finance/TVM/n.html

http://www.getobjects.com/Components/Finance/TVM/pv.html


Where:

FVoa = Future Value of an Ordinary Annuity

PMT = Amount of each payment


n = Number of Periods

Future Value of an Annuity Due

The Future Value of an Annuity Due is identical to an ordinary annuity except that

each payment occurs at the beginning of a period rather than at the end. Since each

payment occurs one period earlier, we can calculate the present value of an ordinary

annuity and then multiply the result by (1 + i).

Where:

FVad = Future Value of an Annuity Due

FVoa = Future Value of an Ordinary Annuity

i = Interest Rate Per Period

Importance of Time Value of Money

When a business chooses to invest money in a project -- such as an expansion, a

strategic acquisition or just the purchase of a new piece of equipment -- it may be

years before that project begins producing a positive cash flow. The business needs to

know whether those future cash flows are worth the upfront investment. That's why

the time value of money is so important to capital budgeting.

Time value of money is one of the most important concepts in the field of small

business financing. Small businesses rely on their cash flows. It is important for them

to know the accurate value of their cash flows. Understanding time value of money

and the calculation of various forms of time value of money can help businesses

accurately value their cash flows.


Capital Budgeting

The process in which a business determines whether projects such as building a new

plant or investing in a long term venture are worth pursuing. Oftentimes, a

prospective project’s lifetime cash inflows and outflows are assessed in order to

determine whether the returns generated meet a sufficient target benchmark. Ideally,

business should pursue all projects and opportunities that enhance shareholder value.

Popular methods of Capital Budgeting include Net Present Value (NPV), Internal rate

of Return (IRR), Discounted Cash Flow (DCF) and Payback Period.

Capital Budgeting is a tool for maximizing a company’s future profits since most

companies are able to manage only a limited number of large projects at any one type.

Capital Budgeting Techniques

Capital Budgeting is the process most companies use to authorize capital spending on

long term projects. Capital projects are individually evaluated using both quantitative

analysis and qualitative information. Most capital budgeting analysis uses cash

inflows and cash outflows.

Payback Period

The payback measures the length of time it takes a company to recover in cash its

initial investments.

This concept can also be explained as the length of time it takes the project to

generate cash equal to the investment and pay the company back. It is calculated by

dividing the capital investment by the net annual cash flow.

Net Present Value

Considering the time value of money is important when evaluating projects with

different costs and different cash flows. To use the Net Present Value method, it will

need to know the cash inflows, the cash outflows and the company’s required rate of

return on its investments. The required rate of return becomes the discount rate used

in the NPV calculation.


Internal Rate of Return

The internal return on an investment is the interest rate at which the net present value

of costs (negative cash flows) of investment equals the net present value of the

benefits (positive cash flows) of the investment.

Internal Rates of Return are commonly used to evaluate the desirability of

investments or projects. The higher a project’s internal rate of return, the more

desirable it is to undertake the project. Assuming all other factors are equal among the

various projects, the project with the highest IRR would probably be considered the

best and undertaken first.

Uses of IRR

IRR is an indicator of the efficiency, quality or yield of an investment because the

IRR is a rate quantity. This is in contrast with the net present value, which is an

indicator of the value or magnitude of an investment.

An investment is considered acceptable if its IRR is greater than an established

minimum acceptable rate of return or cost of capital. In a scenario where an

investment is considered by a firm that has equity holders, this minimum rate is the

cost of capital of the investment. (which may be determined by the risk adjusted cost

of capital of alternative investments)

Advantages and Disadvantages of the NPV and IRR methods

Advantages

With the NPV method, the advantage is that it is a direct measure of the rupees

contribution to the stakeholders.

With the IRR method, the advantage is that it shows the return on the original

money invested.

Disadvantages

With the NPV method, the disadvantage is that the project size is not

measured.


The importance of Capital Budgeting

Avoid forecast error

The future success of a business largely depends on the investment decisions

that corporate managers make today. Through making capital investments,

firm acquires the long lived fixed assets that generate the firm’s future cash

flows and determine its level of profitability. Thus this decision greatly

influences a firm’s ability to achieve its financial objectives.

Helps firm to plan its financing

Proper capital budgeting analysis is critical to a firm’s successful performance

because capital investment decisions can improve cash flows and lead to

higher stock prices. Yet, poor decisions can lead to financial distress and even

to bankruptcy.

Develop and formulate long term strategic goals

The ability to set long term goals is essential to the growth and prosperity of

any business.

Seek out new investment projects

Estimate and forecast future cash flows

Facilitate the transfer of information

Monitoring and control of expenditures


Cost of capital

In previous classes, we discussed the important concept that the expected return on an

investment should be a function of the “market risk” embedded in that investment –

the risk-return trade off The firm must earn a minimum of rate of return to cover the

cost of generating funds to finance investments; otherwise, no one will be willing to

buy the firm’s bonds, preferred stock, and common stock. This point of reference, the

firm’s required rate of return, is called the cost of capital..

The cost of capital is the required rate of return that a firm must achieve in order to

cover the cost of generating funds in the marketplace. Based on their evaluations of

the riskiness of each firm, investors will supply new funds to a firm only if it pays

them the required rate of return to compensate them for taking the risk of investing in

the firm’s bonds and stocks. If, indeed, the cost of capital is the required rate of return

that the firm must pay to generate funds, it becomes a guideline for measuring the

profit abilities of different investments. When there are differences in the degree of

risk between the firm and its divisions, a risk-adjusted discount-rate approach should

be used to determine their profitability.

The overall percentage cost of the funds used to finance a firm's assets. Cost of capital

is a composite cost of the individual sources of funds including common stock, debt,

preferred stock, and retained earnings. The overall cost of capital depends on the cost

of each source and the proportion that source represents of all capital used by the firm.

The goal of an individual or business is to limit investment to assets that provide a

return that is higher than the cost of the capital that was used to finance those assets.

What impacts the cost of capital?

RISKINESS OF EARNINGS

INTEREST RATE

LEVELS IN THE

US/GLOBAL THE DEBT TO EQUITY MIX OF THE FIRM

FINANCIAL SOUNDNESS OF THE FIRM


The Cost of Capital becomes a guideline for measuring the profitability of different

investments. Another way to think of the cost of capital is as the opportunity cost of

funds, since this represents the opportunity cost for investing in assets with the same

risk as the firm. When investors are shopping for places in which to invest their

funds, they have an opportunity cost. The firm, given its riskiness, must strive to earn

the investor’s opportunity cost. If the firm does not achieve the return investors.

What is debt...

General Rule: Debt generally has the following characteristics:

• Commitment to make fixed payments in the future

• The fixed payments are tax deductible

• Failure to make the payments can lead to either default or loss of control of the firm

to the party to whom payments are due.

What would you include in debt?

Any interest-bearing liability, whether short term or long term.

Any lease obligation, whether operating or capital.

Converting Operating Leases to Debt

The “debt value” of operating leases is the present value of the lease.

payments, at a rate that reflects their risk.

In general, this rate will be close to or equal to the rate at which the company

can borrow.

Measuring Financial Leverage

Two variants of debt ratio.

Debt to Capital Ratio = Debt / (Debt + Equity).

Debt to Equity Ratio = Debt / Equity.

Ratios can be based only on long term debt or total debt.

Ratios can be based upon book value or market value.


Costs and Benefits of Debt

Benefits of Debt

Tax Benefits

Adds discipline to management

Costs of Debt

Bankruptcy Costs

Agency Costs

Loss of Future Flexibility

Tax Benefits of Debt

n a) Tax Benefits: Interest on debt is tax deductible whereas cashflows

on equity (like dividends) are not.

• Tax benefit each year = t r B

• After tax interest rate of debt = (1-t) r

n Proposition 1: Other things being equal, the higher the marginal tax

rate of a corporation, the more debt it will have in its capital structure

Financial stability

The Bank defines financial system stability to refer to the effort of the Bank aimed at

promoting the development of sound and well-managed banking and other financial

institutions as well as encouraging the development of efficient and well-functioning

financial markets.

Importance of financial stability

Financial stability is important as it reflects a sound financial system, which in turn is

important as it reinforces trust in the system and prevents phenomena such as a run on

banks, which can destabilize an economy. Additionally, a sound financial system

signals to the public that their money is handled in a way which will not unduly

jeopardise it. This is especially important for savings, including pension savings.


Elements of Financial Stability include an early warning system of monitoring

relevant indicators; as well as stimulating and making provisions for possible realistic

strains on the system by conducting stress testing. The above help regulators to

monitor the system and prepare for ways to avert potential or discovered stress on the

system.

Weighted Average Cost Of Capital(WACC)

The firm’s WACC is the cost of Capital for the firm’s mixture of debt and stock in their capital structure.

WACC = wd (cost of debt) + ws (cost of stock/RE) + wp (cost of pf. stock)

So now we need to calculate these to find the WACC.

wd = weight of debt

ws = weight of stock

wp = weight of prefered stock

Cost Of Debt (Kd)

We use the after tax cost of debt because interest payments are tax deductible for the firm.

Kd after taxes = Kd (1 – tax rate)

We use the effective annual rate of debt based on current market conditions. We do

not use historical rates.

Cost of Preferred Stock (Kp)

Preferred Stock has a higher return than bonds, but is less costly than common stock.

In case of default, preferred stockholders get paid before common stock holders.

However, in the case of bankruptcy, the holders of preferred stock get paid only after

short and long-term debt holder claims are satisfied.

Preferred stock holders receive a fixed dividend and usually cannot vote on the firm’s

affairs.


preferred stock dividend

Kp = market price of preferred stock

OR if issuing new preferred stock

preferred stock dividend

Kp = market price of preferred stock (1 – flotation cost)

Unlike the situation with bonds, no adjustment is made for taxes, because preferred

stock dividends are paid after a corporation pays income taxes. Consequently, a firm

assumes the full market cost of financing by issuing preferred stock. In other words,

the firm cannot deduct dividends paid as an expense, like they can for interest

expenses.

Cost of Equity ( Common Stock & Retained Earnings)

The cost of equity is the rate of return that investors require to make an equity

investment in a firm. Common stock does not generate a tax benefit as debt does

because dividends are paid after taxes.The cost of common stock is the highest.

Retained earnings are considered to have the same cost of capital as new common

stock. Their cost is calculated in the same way, expect that no adjustment is made for

flotation costs.


International Financial Management

International financial management means doing business with making money

through the exchanging of foreign currency. It is including planning organizing

directing & controlling of money value in foreign exchange.

Currency AppreciationAn increase in the value of one currency with respect to another. This means that one

unit of the appreciating currency buys more units of the other currency than it did

previously.

Currency Depreciation

A decrease in the value of currency with respect to other currencies. This means that

the depreciated currency is worth fewer units of some other currency. While

depreciation means a reduction in value, it can be advantageous as it makes export in

the depreciated currency less expensive.

Importance of International financial management

Compared to national financial markets international markets have a different shape

and analytics. Proper management of international finances can help the organization

in achieving same efficiency and effectiveness in all markets, hence without IFM

sustaining in the market can be difficult.

International financial enables investor to asses and manage all the international risks

they might encounter in their f m process. The risks involved are political risk and

foreign exchange risk, transaction exposure and economic exposure.

International financial helps to multination companies get their financial decisionl,

when and how much to invest, , decision concerning the management working

capital among their different subsidiaries and management number of complexities.


Return and Risk

A financial decision typically involves risk. For example, a company that borrows

money faces the risk that interest rates may change, and a company that builds a new

factory faces the risk that product sales may be lower than expected. These and many

other decisions involve future cash flows that are risky. Investors generally dislike

risk, but they are also unable to avoid it. The valuation formulae for shares and debt

securities showed that the price of a risky asset depends on its expected future cash

flows, the time value of money, and risk. However, little attention was paid to the

causes of risk or to how risk should be defined and measured.

To make effective financial decisions, managers need to understand what causes

risk, how it should be measured and the effect of risk on the rate of return required by

investors.

The return on an investment and the risk of an investment are basic concepts in

finance. Return on an investment is the financial outcome for the investor. For

example, if someone invests $100 in an asset and subsequently sells that asset for

$111, the dollar return is $11. Usually an investment’s dollar return is converted to a

rate of return by calculating the proportion or percentage represented by the dollar

return. For example, a dollar return of $11 on an investment of $100 is a rate of return

of $11/$100, which is 0.11, or 11 per cent.

Risk is present whenever investors are not certain about the outcomes an investment

will produce. Suppose, however, that investors can attach a probability to each

possible dollar return that may occur. Investors can then draw up a probability

distribution for the dollar returns from the investment. A probability distribution is a

list of the possible dollar returns from the investment together with the probability of

each return. For example, assume that the probability distribution in table below is an

investor’s assessment of the dollar returns Ri that may be received from holding share

in a company for 1 year.

Dollar Return, Ri | ($)

Probability, Pi

9 0.110 0.211 0.412 0.213 0.1


Suppose the investor wishes to summarize this distribution by calculating two

measures, one to represent the size of the dollar returns and the other to represent the

risk involved. The size of the dollar returns may be measured by the expected value of

the distribution. The expected value E(R) of the dollar returns is given by the

weighted average of all the possible dollar returns, using the probabilities as weights

that is:

E(R) = ($9)(0.1) + ($10)(0.2) + ($11)(0.4) + ($12)(0.2) + ($13)(0.1) = $11

In general, the expected return on an investment can be calculated as:

E(R) = R1P1 + R2P2 + … + RnPn

which can be written as follows:

E(R)=ΣiRiPi

The choice of a measure for risk is less obvious. In this example, risk is present

because any one of five outcomes ($9, $10, $11, $12 or $13) might result from the

investment. If the investor had perfect foresight, then only one possible outcome

would be involved, and there would not be a probability distribution to be considered.

This suggests that risk is related to the dispersion of the distribution. The more

dispersed or widespread the distribution, the greater the risk involved. Statisticians

have developed a number of measures to represent dispersion. These measures

include the range, the mean absolute deviation and the variance. However, it is

generally accepted that in most instances the variance (or its square root, the standard

deviation, σ) is the most useful measure. Accordingly, this measure of dispersion is

the one we will use to represent the risk of a single investment. The variance of a

distribution of dollar returns is the weighted average of the square of each dollar

return’s deviation from the expected dollar return, again using the probabilities as the

weights. For the share considered opposite, the variance is:

σ2 = (9 – 11)2(0.1) + (10 – 11)2(0.2) + (11 – 11)2(0.4) + (12 – 11)2(0.2) + (13 – 11)2(0.1) = 1.2

In general the variance can be calculated as:

σ 2 = [R1 – E(R)]2P1 + [R2 – E(R)]2P2 + … + [Rn – E(R)]2Pn

which can be written as follows:

σ2=Σi[Rn – E(R)]2Pi


In this case the variance is 1.2 so the standard deviation isσ=√1.2=$.1095Portfolio Management, Return, Risk

What is Portfolio?

A Portfolio refers to a collection of investment tools such as stocks, shares, mutual

funds, bonds, and cash and so on depending on the investor’s income, budget and

convenient time frame.

Portfolio Management

Portfolio management is the art of selecting the right investment policy for the

individuals in terms of minimum risk and maximum return. It refers to managing an

individual’s investments in the form of bonds, shares, cash, mutual funds etc. so that

he earns the maximum profits within the stipulated time frame.

In plain terms, it is managing money of an individual under expert guidance of

portfolio managers.

Return of a Portfolio

The return of a portfolio is equal to the weighted average of the returns of individual

assets (or securities) in the portfolio with weights being equal to the proportion of

investment value in each asset.

Expected return:

Where RP is the return on the portfolio, Riis the return on asset i and Wi is the weighting of component asset (that is, the proportion of asset "i" in the portfolio).

Return of a Portfolio- Example

Portfolio value = Rs 2,00,000 + Rs 5,00,000 = Rs 7,00,000

rA = 14%, rB = 6%,

wA = weight of security A = Rs 2 lacs / Rs 7 lacs = 28.6%

wB = weight of security B = Rs 5 lacs / Rs 7 lacs=71.4%


Solution:-

Portfolio Risk (Standard Deviation)

Portfolio Return Variance:-

Standard Deviation of a Two-Asset Portfolio

The riskiness of a portfolio that is made of different risky assets is a function of three different factors:

1. the riskiness of the individual assets that make up the portfolio

2. the relative weights of the assets in the portfolio

3. the degree of co-movement of returns of the assets making up the portfolio

))()((2)()()()( ,2222

BABABBAAp COVwwww

Definition of 'Capital Asset Pricing Model - CAPM'

ER p=∑i=1

n

(w i×ER i)=( .286×14 % )+( .714×6 % )

=4 . 004 %+4 . 284 %=8 .288 %


A model that describes the relationship between risk and expected return and that is used in the pricing of risky securities.

Capital Asset Pricing Model (CAPM)

A model that describes the relationship between risk and expected return and that is

used in the pricing of risky securities.

The general idea behind CAPM is that investors need to be compensated in two ways:

time value of money and risk. The time value of money is represented by the risk-free

(rf) rate in the formula and compensates the investors for placing money in any

investment over a period of time. The other half of the formula represents risk and

calculates the amount of compensation the investor needs for taking on additional

risk. This is calculated by taking a risk measure (beta) that compares the returns of the

asset to the market over a period of time and to the market premium (Rm-rf).

The CAPM says that the expected return of a security or a portfolio equals the rate on

a risk-free security plus a risk premium. If this expected return does not meet or beat

the required return, then the investment should not be undertaken. The security market

line plots the results of the CAPM for all different risks (betas).

Using the CAPM model and the following assumptions,

we can compute the expected return of a stock in this CAPM example: if the risk-free

rate is 3%, the beta (risk measure) of the stock is 2 and the expected market return

over the period is 10%, the stock is expected to return 17% (3%+2(10%-3%)).


Valuation of financial instruments

What is Financial Instrument?A real or virtual document representing a legal agreement involving some sort of

monetary value. In today's financial marketplace, financial instruments can be

classified generally as equity based, representing ownership of the asset, or debt

based, representing a loan made by an investor to the owner of the asset. Foreign

exchange instruments comprise a third, unique type of instrument. Different

subcategories of each instrument type exist, such as preferred share equity and

common share equity, for example.

Valuation TechniquesValuation is The process of determining the current worth of an asset or company.

There are many techniques that can be used to determine value, some are subjective

and others are objective.

1. Net assets based valuationAsset valuation may consist of both subjective and objective measurements. For

example, in valuing a company, there is no number on the company's financial

statements that tells how much its brand name is worth; this aspect of asset valuation

must be subjective. On the other hand, net profit is an objective measurement based

on the company's income and expense figures. Common methods for determining an

asset's value include comparing it to similar assets and evaluating its cash flow

potential. Acquisition cost, replacement cost and deprival value are also methods of

asset valuation.

Net asset value is useful for shares valuation in sectors where the company value

come from the held assets rather than the stream of profit that was generated by the

company business. The examples are property companies and investment trusts. Both

are convenient ways wherein the investors can buy diversified bundles of the assets

they hold.


Important of net assets based valuation

Assets are the property individuals, groups and businesses own. The assets these

entities own can be tangible or intangible, valuable or invaluable. Tangible assets are

generally valuable, but sometimes, people and businesses hold onto sentimental items

that are of little or no value. Intangible assets, such as intellectual property, are often

highly valuable, especially to a business. A business must make itself aware of the

value of its assets, both tangible and intangible, for financial reporting, insurance

purposes, sale and reorganization.

Asset valuation is essential in financial reporting. A business's balance sheet

determines shareholder or owner's equity by subtracting assets from liabilities. To

accurately report equity, the business must first accurately value its assets.

Undervalued assets would result in an understated equity figure and overvalued assets

would result in an overstated equity figure.

2. Dividend based valuationThe dividend discount model is a method of valuing stock shares based fundamentals,

that is, based on facts and expectations about a company's business, future cash flows

and likely risks.

Function

Dividend valuation uses a formula to construct the fair value of a company's stock

based on its dividend yield. The process of using known factors to determine a price is

called "discounting," and dividend valuation is often called the dividend discount

model. The purpose, as with any valuation method, is to determine which stocks are

cheap, and should be bought, which are expensive, and should be sold, and which are

fairly valued and can be held.

FeaturesThere are four basic components to the dividend discount model: the dividend per

share, the appropriate rate of return, the beta value of the stock and the dividend

growth rate. In most cases, the appropriate rate of return is figured using Treasury

spreads, the difference between short-and long-term rates, or some similar market

premium rate.


There are many variations on the dividend discount model, many using different

methods to calculate the various inputs to the dividend valuation formula. Another

major type of valuation procedure is the two-stage or multi-stage models, that account

for the fact that the growth rate of a company changes over time. In most cases, a

company's early years can be characterized by 30 percent growth per year or more,

but mature companies tend to average a steady 6 percent over time, accounting for

inflation and GDP increases.

Important of dividend valuation

The dividend discount model tends to understate the value of a company with

intangible assets like reputation and brand recognition. On the other hand, it may

overvalue stocks out of favor with the market. No amount of careful calculation,

however, will necessarily predict the future movement of a stock, and assumptions

about future growth rates, interest rates, the price of risk and the stability of the

market make the model vulnerable to exaggerations.

Valuation involves estimating the intrinsic value of a stock, in either absolute or

relative terms, to determine whether the stock represents an attractive investment at

the current price. An undervalued stock, which trades below its intrinsic value, is

often seen as attractive because the discount provides a margin of safety and there is

potential for capital gain if market participants eventually reappraise the stock and

move its price closer to its intrinsic value. In contrast, an overvalued stock trades

above its intrinsic value, provides no margin of safety, and may offer limited capital

gains. Indeed, there could be greater potential for capital loss if market participants

reappraise the overvalued stock in a downward direction.

Thus, valuation plays an important role in determining capital gain or loss, which is a

key component of an investment's total return. However, you might wonder why

valuation is relevant for dividend growth investors, whose primary focus is on the

dividend component of total return. The purpose of this article is to demonstrate that

valuation is very relevant because it can have strong effects on the long-term growth

of dividend income.


Valuation of equity Instruments

Determining the total value of a company involves more than reviewing assets and

revenue figures. An equity valuation takes several financial indicators into account;

these include both tangible and intangible assets, and provide prospective investors,

creditors or shareholders with an accurate perspective of the true value of a company

at any given time.

The dividend discount model is a specialized case of equity valuation, and the value

of a stock is the present value of expected future dividend.

Equity valuations are conducted to measure the value of a company given its current

assets and position in the market. These data points are valuable for shareholders and

prospective investors who want to find out if the company is performing well, and

what to expect with their stocks or investments in the near future. Equity-valuation

formulas include the Dividend Discount Model, the Dividend Growth Model and the

Price-Earnings Ratio.

Function

Investors who are considering multiple investments or outlining an investment

strategy may request equity valuations of a company, to make the most informed

investment decision. Valuation methods based on the equity of a company typically

include a thorough analysis of cash accounts, as well as a forecast or projection of

future dividends, future earnings (revenue) and the distribution of dividends.

Features

The total equity of a company is the sum of both tangible assets and intangible

qualities. Tangible assets include working capital, cash, inventory and shareholder

equity. Intangible qualities, or intangible "assets," may include brand potential,

trademarks and stock valuations. Performance indicators include the price/earnings

ratio, dividend yield, and the Earnings Before Interest, this is calculated by combining

the net debt per share with the price per share.


Important of equity instrument valuation

A thorough analysis of tangible and intangible assets allows prospective investors,

shareholders and financial managers of a company to obtain critical performance data

about the company's business operations. The equity valuation method takes several

types of data into account, and can be used as part of a prediction model to determine

the economic future of the company. The valuation also provides some indication of

the level of risk involved in investing in the company.

Identifying the dollar value of intangible assets can be a complicated process, and is

typically undertaken by the financial manager or financial accountant. These assets

may fluctuate significantly because of market conditions, but they do play an

important role in equity valuation. Even though several financial ratios and factors are

involved with the equity-valuation process, the final figures can provide a relatively

accurate assessment of a company's financial status and revenue prospect.

Valuation of Debt Instruments

Debt

A debt is an obligation owed by one party (the debtor) to a second party, the creditor;

usually this refers to assets granted by the creditor to the debtor, but the term can also

be used metaphorically to cover moral obligations and other interactions not based on

economic value.

1. Bonds/Debentures

A bond or a debenture is a long-term debt instrument or security. It is issued by

business enterprises or government agencies to raise long-term capital. A bond

usually carries a fixed rate of interest. It is called as coupon payment and the interest

rate is called as the coupon rate. The coupon payment can be either annually or semi-

annually.

A bond can be irredeemable or redeemable. Redeemable bonds have a fixed maturity

date and irredeemable bonds have perpetual life with only interest payments

periodically.


Basically, the value of a bond is the present value of all the future interest payments

and the maturity value, discounted at the required return on bond commensurate with

the prevailing interest rate and risk.

Bonds are long term debt instruments issued by big corporate clientele or government

delegacies or agencies to promote large amount . Bonds brought out by government

agencies are secured and those issued by private sector companies may be unsecured

or secured. The rate of interest on bonds is determined and they are reformable after a

particular period. Here are some significant terms in bond valuation,

They are as follows:

Face value is also referred as par value. It is the value declared on the face of the

bond. It makes up the amount that the unit borrows which is to be re-compensated at

the time of maturity, after a certain period of time. A bond is in general issued at

values such as Rs. 100 or Rs. 800.

Coupon rate is the assigned rate of interest in the bond. The interest payable at

regular intervals is the product of the par value and the coupon rate crumbled to the

given time horizon.

Maturity period brings up to the number of years after which the par value

becomes payable to the bond holder. In general, corporate bonds have a maturity

period of 7-10 years and government bonds 20 to 25 years.

Redemption value is the amount the bond holder develops on maturity. A bond may

be delivered at par, at a premium bond holder acquires more than the par value of the

bond or at a discount bond holder acquires less than the par value of the bond.

Market value is the price in the stock exchange at which the bond is traded. Market

price is the price at which the bonds can be sold or bought and this price may be

different from par value and redemption value.


Valuation of Bond

This will depend on expected cash flows consisting of annual interest plus the

principal amount to be received at maturity. The appropriate rate of capitalisation or

discount rate to be applied will depend upon the riskiness of the bond e.g. government

bonds are less risky and will therefore call for lower discount rates than similar bonds

issued by private companies which will call for high rate of discount

2. Valuation of Preference Shares

Preference Shares are issued by corporations or companies with the primary aim of

generating funds. A preference share usually carries a fixed stated rate of dividend.

The dividend is payable only upon availability of profits. In case of cumulative

preference shares, arrears of dividends can be accumulated and in the year of profits

common stock holders can be paid dividend only upon settlement of all the arrears of

cumulative preference dividends.

Preference share holders have preference right over payment of dividend and

settlement of principal amount upon liquidation, over common share holders. A

preference share can be irredeemable or redeemable. Redeemable preference shares

have a fixed maturity date and irredeemable preference shares have perpetual life with

only dividend payments periodically upon profit availability. Preference shares can

alsobe cumulative and non-cumulative.

A company may issue two types of shares,

Preference shares.

Ordinary shares.

Preference shares have preference over ordinary shares in terms of payment of

dividend and repayment of capital.

They may be issued with or without a maturity period.

Redeemable preference shares with maturity.

Irredeemable preference shares are shares without any maturity.


Cumulative preference shares unpaid dividends accumulate and are payable in

the future.

Not cumulative shares do not accumulate dividends.

Features of Preference and Ordinary Shares

Following are the features preference shares,

Preference shareholders have claim on assets and income prior to ordinary shares.

The dividend rate is fixed in case of Preference shares.

A company can issue convertible Preference shares.

Both redeemable and irredeemable Preference shares can be issued

Valuation of Preference Shares

Basically, the value of a redeemable preference share is the present value of all the

future expected dividend payments and the maturity value, discounted at the required

return on preference shares.

Economy & Finance

Financial management