Financial management
Time value of money, Risk
and return, Valuation
Objectives of Financial
management
Profit maximisation/EPS
Ambiguity, quality of benefits/risk, timing of benefits
Wealth maximisation
Value, ie., worth to the owners
Capitalisation/discount rate that reflects risk and time preferences
Economic value added (EVA)
After tax operational profits of a firm less the cost of funds used to
finance investments
Focus on stakeholders
Employees, customers, suppliers, creditors, owners and others
who have direct link with the firm
Time value of money
I will gladly pay you Tuesday for a hamburger I
can eat today - Wimpie, from the Popeye cartoon
Learning Objectives
Explain the meaning of the time value of money and the
importance of the timing of cash flows in making financial
decisions
Calculate the future value and present value of cash flows for
one period and multiple periods
Solve for the interest rate implied by a given set of present
value and future value cash flows
Apply time value of money techniques to solve basic problems
facing financial managers
Use a calculator/excel sheet to solve time value of money
problems
Central concepts in finance
Risk-return tradeoff - Investors will take on additional
risk only if they anticipate higher return.
Time value of money value of a unit of money is
different in different time periods
A rupee available today is worth more than a rupee
available at a future date.
This is because a rupee today can be invested to earn a
return.
Techniques
Future value or Compounding
Compound interest is the interest earned on a
given deposit/principal that has become a part of
the principal at the end of a specified period
Principal refers to the amount of money on which
interest is received
Present value or Discounting
Present value is the current value of a future
amount
Discounting is determining the present value of a
future amount
RISK and RETURN
Risk and return of a single asset
Return actual income received plus any
change in the market price of an asset /
investment
Calculation of expected return single period
Risk variability of actual return from the
expected return associated with a given asset
Measurement of risk
Behavioural point of view
Sensitivity analysis
Probability distribution
Quantitative/statistical point of view
Standard deviation
Co-efficient of variation
Risk and return of a portfolio
Portfolio combination of two or more
securities/assets
Portfolio expected return
Portfolio risk
Correlation/covariance
Diversification
Risk return trade off
Risk return trade off
Systematic risk
Caused by factors that affect the overall market/all
securities
Non diversifiable/unavoidable
Unsystematic risk
Unique to particular company/industry/security
Diversifiable/ avoidable
CAPM
Provides a framework for basic risk return trade
Capital Asset Pricing model
Model that describes the relationship/tradeoff
between risk and expected/required rate of return
Explains the behaviour of security prices and
provides a mechanism to assess the impact of
proposed security investment on investors overall
portfolio risk and return
Provides a framework for basic risk return trade off in
portfolio management
Enables drawing certain implications about the risk
and size of risk premium necessary to compensate
for bearing risk
Efficiency of market
Assumptions
Investors well informed
Transaction costs are low
Negligible restrictions on investments
No investor is large enough to influence
Investors in general agreement about likely performance
Expectations are based on one year holding period
Investor preferences
Prefer to invest in securities with the highest return for a given
level of risk or lowest risk for a given level of return
Return a risk measured in terms of expected value and standard
deviation respectively
Measure of risk
Beta coefficient is an index of the degree of
responsiveness/comovement of security return with
market return
Risk free return
Expected return less risk free return = excess return
Beta coefficient represents the change in excess
return on the individual security over changes in
excess return on market portfolio
Beta of market portfolio is equal to 1
Index of systematic risk of individual security relative
to that of market portfolio
Beta of a security and CAPM
formula
The CAPM formula is: ra = rrf + Ba (rm-rrf)
Required Return = Risk free rate + (Market return Risk free rate) *
Beta
Portfolio Beta = (the sum of) {weight of security X Beta of security}
Valuation of long term securities
Valuation of bonds/debentures
Bond long term debt instrument used by
government, government agencies and
business enterprises to raise a large sum of
money
Par value value on the face of the bond
Coupon rate specified interest rate available
on security
Maturity period number of years after which
the par/specified value is payable to the
Illustration
A firm has issued a 10 percent coupon interest
rate, 10 year bond with a Rs. 1000 par value
that pays interest semi-annually. A bond
holder would have contractual right to
Annual interest of Rs 100 i.e., coupon interest rate
* par value (.10*1000) paid as Rs 50 at the end of
every 6 months
Par value at the end of 10th year - Rs. 1000
Basic bond valuation
Present value of contractual payments its issuer (corporate) is
obliged to make from the beginning till maturity
Appropriate discount rate would be the required return
commensurate risk and prevailing interest rate
When the required return is equal to the coupon rate, the
bond value equals the par value
Impact of required return on bond
values
Change in the basic cost of long term funds
Change in the basic risk of the firm
If RR>CR then bond value < par value: Discount (M-B)
If RR<CR then bond value > par value: Premium(B-M)
Impact of maturity on bond value
Time to maturity
RR
Bond value
Constant RR
Changing RR
Constant required returns
Changing required returns
The shorter the time to maturity, the smaller the
impact on bond value caused by a given change in
the required return
Yield to maturity
Rate of return investors earn if they buy a
bond at a specific price and hold it till maturity
Illustration
Valuation of preference shares
Expected return is the return that is expected
to be earned on a given security over an
infinite time horizon
Zero growth model
Constant growth/Gordon model
Variable growth model