MBA234: Financial Management
Chapter 1: Introduction
Dr Suresha B
Associate Professor,
Department of Management Studies,
Christ Deemed to be University
Unit outline
● Introduction to Financial Management, Meaning of Finance, Economics and Accounting, Goal of
Financial Management & the three decisions - Investing, Financing & dividend, Corporate
Finance, Capital Markets and Investments, Business Ethics and Corporate Governance, Agency
problems - Managers v/s Stockholders, Agency problems - Stockholders v/s Bondholders.
● Time value of money - timelines, interest rate, number of periods, cash flows - Future values -
single cash flow, multiple cash flows, uneven cash flows - Present values - single cash flow,
multiple cash flows, uneven cash flows - Annuity, Annuity due
● Time value of money - Perpetuities, fractional time periods, quoted rate v/s effective rate, loan
amortisation schedule
● Time value of money - Applied problems
LEARNING OBJECTIVES
• Explain the nature of finance and its interaction with other management functions
• Review the changing role of the finance manager and his/her position in the
management hierarchy
• Focus on the Shareholders’ Wealth Maximization (SWM) principle as an operationally
desirable finance decision criterion
• Discuss agency problems arising from the relationship between shareholders and
managers
• Illustrate the organization of finance function
• Time Value of Money
Financial Management
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Important Business Activities
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Real And Financial Assets
• Real Assets: Can be Tangible or Intangible
• Tangible real assets are physical assets that include plant,
machinery, office, factory, furniture and building.
• Intangible real assets include technical know-how, technological
collaborations, patents and copyrights.
• Financial Assets are also called securities, are financial papers
or instruments such as shares and bonds or debentures.
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Equity and Borrowed Funds
• Shares represent ownership rights of their holders. Shareholders are
owners of the company. Shares can of two types:
• Equity Shares
• Preference Shares
• Loans, Bonds or Debts: represent liability of the firm towards
outsiders. Lenders are not owners of the company. These provide
interest tax shield.
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Equity and Preference Shares
• Equity Shares are also known as ordinary shares.
• Do not have fixed rate of dividend.
• There is no legal obligation to pay dividends to equity shareholders.
• Preference Shares have preference for dividend payment over
ordinary shareholders.
• They get fixed rate of dividends.
• They also have preference of repayment at the time of liquidation.
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Financial Decisions
Finance and Management Functions
• All business activities involve acquisition and use of funds.
• Finance function makes money available to meet the costs of
production and marketing operations.
• Financial policies are devised to fit production and marketing
decisions of a firm in practice.
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What activity is this?
MergerDomo has recently closed 2 startup funding deals in
superfoods and wellness companies, bringing its total to 5 deals
this year. Small and medium enterprise (SME)-focused neo-
On the consulting front they have closed over 19 deals to date banking platform Open on Tuesday said it has
and SME deal flow of ovaer USD 800 million on the platform. raised ₹735 crore (roughly $100 million) so far as part
of a Series C round led by Singapore-based Temasek.
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Finance Functions
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Aim of Finance Function
Finance Manager’s Role
• Raising of Funds
• Allocation of Funds
• Profit Planning
• Understanding Capital Markets
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Financial Procedures and Systems
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Financial Goals
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Objections to Profit Maximization
It is Vague
It Ignores the Timing of Returns
It Ignores Risk
Assumes Perfect Competition
In new business environment profit maximization is regarded as
• Unrealistic
• Difficult
• Inappropriate
• Immoral
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Maximizing Profit after Taxes or EPS
• Maximising PAT or EPS does not maximise the economic welfare of
the owners.
• Ignores timing and risk of the expected benefit
• Market value is not a function of EPS.
• Maximizing EPS implies that the firm should make no dividend
payment so long as funds can be invested at positive rate of return—
such a policy may not always work.
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Shareholders’ Wealth Maximization
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Risk-return Trade-off
• Financial decisions of the firm are guided by the risk-return trade-off.
• The return and risk relationship:
= Risk-free rate + Risk premium
• Risk-free rate is a compensation for time and risk premium for risk.
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Organisation of
Finance
Function
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Discussion Questions
Case 1
•Should stockholder wealth maximization be thought of as a
long-term or a short-term goal?
•If one action increases a firm’s stock price from a current level
of $20 to $25 in 6 months and then to $30 in 5 years but another
action keeps the stock at $20 for several years but then increases
it to $40 in 5 years, which action would be better?
•Think of some specific corporate actions that have these general
tendencies.
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Case 2
• Edmund Enterprises recently made a large investment to upgrade its
technology. While these improvements won’t have much effect on
performance in the short run, they are expected to reduce future
costs significantly.
• What effect will this investment have on Edmund Enterprises’
earnings per share this year?
• What effect might this investment have on the company’s intrinsic
value and stock price?
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Agency Problems: Managers Versus
Shareholders’ Goals
• There is a Principal Agent relationship between managers and
shareholders.
• In theory, Managers should act in the best interests of shareholders.
• In practice, managers may maximise their own wealth (in the form of
high salaries and perks) at the cost of shareholders.
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Agency Problems: Managers Versus
Shareholders’ Goals
• Managers may perceive their role as reconciling conflicting objectives of
stakeholders.
• This stakeholders’ view of managers’ role may compromise with the
objective of SWM.
• Managers may avoid taking high investment and financing risks that may
otherwise be needed to maximize shareholders’ wealth. Such “satisfying”
behaviour of managers will frustrate the objective of SWM as a
normative guide.
• This conflict is known as Agency problem and it results into Agency costs.
Agency Costs
• Agency costs include the less than optimum share value for
shareholders and costs incurred by them to monitor the actions of
managers and control their behaviour.
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Organisation of the Finance Functions
• Reason for placing the finance functions in the hands of top
management
• Financial decisions are crucial for the survival of the firm.
• The financial actions determine solvency of the firm
• Centralisation of the finance functions can result in a number of economies to
the firm.
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Role of Treasurer and Controller
• Two officers—the treasurer and the controller—may be appointed
under the direct supervision of CFO to assist him or her.
• The treasurer’s function is to raise and manage company funds while
the controller oversees whether funds are correctly applied.
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Need for a Valuation Approach
• SWM requires a valuation model.
• The financial manager must know,
• How much should a particular share be worth?
• Upon what factor or factors should its value depend?
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Time VALUE AND RETURN
Required Rate of Return
• The time preference for money is generally expressed by an interest rate.
This rate will be positive even in the absence of any risk. It may be
therefore called the risk-free rate.
• An investor requires compensation for assuming risk, which is called risk
premium.
• The investor’s required rate of return is:
Risk-free rate + Risk premium.
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Required Rate of Return
• Would an investor want Rs. 100 today or after one year?
• Cash flows occurring in different time periods are not comparable.
• It is necessary to adjust cash flows for their differences in timing and
risk.
• Example : If preference rate =10 percent
• An investor can invest if Rs. 100 if he is offered Rs 110 after one year.
• Rs 110 is the future value of Rs 100 today at 10% interest rate.
• Also, Rs 100 today is the present value of Rs 110 after a year at 10%
interest rate.
• If the investor gets less than Rs. 110 then he will not invest. Anything
above Rs. 110 is favorable.
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Time Value Adjustment
• Two most common methods of adjusting cash flows for
time value of money:
• Compounding—the process of calculating future values of
cash flows and
• Discounting—the process of calculating present values of
cash flows.
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Future Value
• Compounding is the process of finding the future values of
cash flows by applying the concept of compound interest.
• Compound interest is the interest that is received on the
original amount (principal) as well as on any interest earned
but not withdrawn during earlier periods.
• Simple interest is the interest that is calculated only on the
original amount (principal), and thus, no compounding of
interest takes place.
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Future Value
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Future Value
• In Microsoft Excel: Use FV function.
FV(rate,nper,pmt,pv,type)
Where: rate= interest rate. nper= n periods, pmt= annuity
value, pv= present value, type= 1 for beginning of the period
and 0 for end for end of period.
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Future Value: Example
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Exercises
• A Debt scheme requires an annual contribution of Rs.6000 for 5 yrs.
The fund guarantees return of 7%. What will be the maturity value of
the fund?
Hint: 34,504
Effective yield or Return = (34504-30000)=4504/5=900.8/6000 = 15%.
Effective Yield or Return = (4504/30000)=15%
• What is the corpus created by a firm if it annually appropriates
Rs.50,000 of its profits to a fund for meeting its future obligation over
10 year period at an interest rate of 8%.
• Hint: 7,24,328
• Effective Yield or Return = (224328/500000)=44.86%
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Annuities
• These recurring or ongoing payments are technically referred to as
"annuities"
Types of Annuities
• Ordinary annuities: An ordinary annuity makes (or requires) payments at
the end of each period. For example, bonds generally pay interest at the
end of every six months.
• Annuities due: With an annuity due, by contrast, payments come at the
beginning of each period. Rent, which landlords typically require at the
beginning of each month, is a common example.
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Future Value of an Ordinary Annuity
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Future Value of an Annuity: Example
Assume you invested $1,000 in a bond for 5 yrs at 5% interest. What
would be its Maturity value?
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With Annuity tables
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Future Value of Annuities due:
• For example, if the $1,000 was invested on January 1 rather than December 31 it would
have an additional month to grow.
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Present Value of an Annuity
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Example
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Perpetuities
• A perpetuity is an annuity in which the periodic payments begin on a
fixed date and continue indefinitely. It is sometimes referred to as a
perpetual annuity.
• Fixed coupon payments on permanently invested (irredeemable)
sums of money are prime examples of perpetuities.
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Present Value of Perpetuity
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Present Value of a Perpetuity: Example
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Multi Period Perpetuity
Growing Perpetuity
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Exercise:
Ramesh wants to retire and receive Rs.3,000 a month. He wants to pass this
monthly payment to future generations after his death.
He can earn an interest of 8% compounded annually. How much will he
need to set aside to achieve his perpetuity goal?
Hint: 450,000
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Sinking Fund
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Example
Present Value
• Present value of a future cash flow (inflow or outflow) is the amount of
current cash that is of equivalent value to the decision-maker.
• Discounting is the process of determining present value of a series of
future cash flows.
• The interest rate used for discounting cash flows is also called the discount
rate.
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Present Value of a Single Cash Flow
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Example
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PV of Uneven Cash Flows:
Example
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Present Value of Growing Annuities
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Example
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Example
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Multi-Period Compounding
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Effective Interest Rate: Example
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Continuous Compounding
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Exercises
1. What is future value of Rs.20,000 invested now after 5 years in a Bond at 8% coupon?
2. A firm plans to replace a machine at the end of 5 yrs from now which requires a capex of
Rs.50,00,000. Suggest how much of funds provisioning to be made to meet this obligation
if required rate is 10%.
3. Mr. X deposits Rs.10,000 at the end of every year and the deposit earns a compound
interest of 8%pa. determine how much money he will have at the end of 5 years.
4. Mr.X deposits Rs.5000 at the beginning of every year for 5 years in a Recurring Deposit
Scheme at 8% compounded annually. What is its Maturity value?
5. X contributes at the end of the year to a Recurring deposit the following amounts which
gives him 5% interest. Determine the future value of above series of payments
1. 1st year Rs.100,000
2. 2nd year Rs.200,000
3. 3rd Year Rs.300,000
4. 4th year Rs.400,000
5. 5th year Rs.500,000
6. A company needs Rs.10,00,000 after 5 years from now for replacement of its fixed
assets. It has established a sinking fund for the purpose. The investments to be made at
the end of each year. What annual payment must be made to ensure the needed
Rs.10,00,000 after 5 years. Assume 10% interest per year on investments. ACF 6.105
•Hint: R = Vn
ACFI,n
Where,
R = Cash flow
Vn= Maturiy alue
ACF = Annuity compound factor.
Future value of an Investment: Case Study
Mr. Mehta invested in the following fixed income securities on 1st April 2018.
• Rs.75,000 in NSC which gives 8% pa semi-annual coupon for 6 years
• Rs.60,000 STFC quarterly compounding NCD with coupon of 9% for 3
years
• Rs.90,000 IIFL Tier –I bond with semi annual interest of 4.5%. For 3 years
• Rs.50,000 SBI tax gain deposit of scheme of 8.5% interest per annum for
5 years.
• Determine
• The value of the bonds yield per annum.
• The portfolio Net worth after one year
• The maturity value of the instruments
Exercises
• It is now January 1, 2009. Today you will deposit $1,000 into a savings account that
pays 8%.
1. If the bank compounds interest annually, how much will you have in your account
on January 1, 2012?
2. What will your January 1, 2012, balance be if the bank uses quarterly
compounding?
3. Suppose you deposit $1,000 in three payments of $333.333 each on January 1 of
2010, 2011, and 2012. How much will you have in your account on January 1,
2012, based on 8% annual compounding?
4. How much will be in your account if the three payments begin on January 1, 2009?
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How is the EMI calculated for instant loan?
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Example of EMI calculation
• Assume you get an instant loan of ₹10,000 at an annual interest rate
of 13.5% for a period of 3 months.
• The monthly interest rate becomes:
which means you need to ₹3,408.61 as EMI for a loan of ₹10,000 for 3 months if borrowed at
13.5% interest rate.
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Now, let’s look at the EMI and interest
breakdown with each installment:
As we can see, the amount outstanding at the end of 3 months becomes zero which means the entire loan
amount along with interest gets paid. We also observe that the interest component reduces after every month.
The total interest paid during the loan tenor is 112.5 + 75.42 + 37.92 = 225.84
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Exercises
• Find the EMI to be paid for a Housing Loan of Rs.25 Lacs for 15yrs at
the rate of 7.5%PA.
• Find the EMI to be paid for a Car Loan of Rs.8 Lacs for 5yrs at the rate
of 10%PA.
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Capital Recovery and Loan Amortisation
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Loan Amortization Schedule
End Payment Interest Principal Outstanding
of Year Repayment Balance
0 10,000
1 3,951 900 3,051 6,949
2 3,951 625 3,326 3,623
3 3,951 326 3,625* 0
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End of Module 1
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