Financial management

Importance of financial management
Overview of Financial Management
Time Value Of Money
Cost of capital
International Financial Management
Return and Risk
Valuation of financial instruments

1. 1 The Importance of Financial Management
Overview of Financial Management
 Meaning Of Financial Management
Financial 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.

2. 2 The Importance of Financial Management
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.

3. 3 The Importance of Financial Management
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.

4. 4 The Importance of Financial Management
 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

5. 5 The Importance of Financial Management
 Goals Of Financial Management
All 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 professi onal 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.

6. 6 The Importance of Financial Management
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

7. 7 The Importance of Financial Management
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.

8. 8 The Importance of Financial Management
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.

9. 9 The Importance of Financial Management
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

10. 10 The Importance of Financial Management
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.

11. 11 The Importance of Financial Management
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.

12. 12 The Importance of Financial Management
 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.

13. 13 The Importance of Financial Management
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

14. 14 The Importance of Financial Management
 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,

15. 15 The Importance of Financial Management

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.

16. 16 The Importance of Financial Management
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
i = Interest Rate per Period
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,

17. 17 The Importance of Financial Management
Where:
FVoa = Future Value of an Ordinary Annuity
PMT = Amount of each payment
i = Interest Rate per Period
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.

18. 18 The Importance of Financial Management
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.

19. 19 The Importance of Financial Management
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.

20. 20 The Importance of Financial Management
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

21. 21 The Importance of Financial Management
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
MARKETPLACE
THE DEBT
TO EQUITY
MIX OF
THE FIRM
FINANCIAL
SOUNDNESS
OF THE FIRM

22. 22 The Importance of Financial Management
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.

23. 23 The Importance of Financial Management
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.

24. 24 The Importance of Financial Management
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.

25. 25 The Importance of Financial Management
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.

26. 26 The Importance of Financial Management
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 Appreciation
An 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.

27. 27 The Importance of Financial Management
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 0.1
10 0.2
11 0.4
12 0.2
13 0.1

28. 28 The Importance of Financial Management
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:
σ
2
= (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)]
2
P1 + [R2 – E(R)]
2
P2 + … + [Rn – E(R)]
2
Pn
which can be written as follows:
σ
2
=Σi[Rn – E(R)]
2
Pi

29. 29 The Importance of Financial Management
In this case the variance is 1.2 so the standard deviation is
σ=√1.2
=$.1095
Portfolio 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%

30. 30 The Importance of Financial Management

Solution:-



Portfolio Risk (Standard Deviation)

Portfolio Return Variance:-

Where Pij is the correlation coefficient between the returns on assets i and j
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


Definition of 'Capital Asset Pricing Model - CAPM'
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31. 31 The Importance of Financial Management
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%)).

32. 32 The Importance of Financial Management
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 Techniques
Valuation 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 valuation
Asset 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.

33. 33 The Importance of Financial Management
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 valuation
The 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.
Features
There 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.

34. 34 The Importance of Financial Management
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.

35. 35 The Importance of Financial Management
 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.

36. 36 The Importance of Financial Management
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.

37. 37 The Importance of Financial Management
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.

38. 38 The Importance of Financial Management
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.

39. 39 The Importance of Financial Management
 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.