Section - 1Nature of Financial Management

Business ActivitiesKey functions in an organization are:ProductionHuman ResourcesMarketingFinanceFinancial Management is an integral part of Business ManagementIt deals with management of financial resources and related areas *

Finance FunctionsProcurement & effective utilization of fundsrisk, cost & control considerations are balancedIn the modern day business, since the size of business has grown enormously the finance function in separate & complex oneInvolves a number of important decisionsAn accountant is not concerned with management of funds*

Finance Functions/roleInvestment or Long Term Asset Mix Decision Evaluation of profitability of new investmentsCut off rate of new investmentsFinancing or Capital Mix DecisionWhen, where and how to acquire fundsCapital structure: debt-equity mixDividend or Profit Allocation DecisionDistribute-retain what proportionCash dividend, bonus sharesLiquidity or Short Term Asset Mix DecisionBalance firms illiquidity and profitability*

Financial GoalsProfit maximization (profit after tax)Maximizing Earnings per Share (EPS)Shareholders Wealth Maximization*

Profit MaximizationMaximizing the Rupee Income of Firm Resources are efficiently utilizedAppropriate measure of firm performanceServes interest of society also

E.g. Issue new shares and invest them in govt. securitiesProfit will increase but EPS decreases

*

Objections to Profit MaximizationIt is VagueIt Ignores the Timing of ReturnsIt Ignores RiskAssumes Perfect CompetitionIn new business environment profit maximization is regarded as UnrealisticDifficultInappropriate Immoral.*

Maximizing EPSIgnores timing and risk of the expected benefitMarket value is not a function of EPS. Hence maximizing EPS will not result in highest price for company's sharesMaximizing EPS implies that the firm should make no dividend payment so long as funds can be invested at positive rate of returnsuch a policy may not always work*

*Three Basic Factors Determine Market Value of share1) Amount of

2) Timing of

3) Risk ofExpected cash flows

Shareholders Wealth MaximizationMaximizes the net present value of a course of action to shareholders.Accounts for the timing and risk of the expected benefits.Determines that a good decision increases the price of the firms common stockIs an impersonal objectiveBenefits are measured in terms of cash flows.Fundamental objectivemaximize the market value of the firms shares.*

EVA Defined...EVA is a financial measurement tool that determines if a business is earning more than its true cost of capital.

EVA is the net operating profit minus an appropriate charge for the opportunity cost of all capital invested in an enterprise or project, or net income minus dollar cost of equity capital.

EVA is ...An estimate of true economic profit.A tool that focuses on maximizing shareholder wealth. A fundamental measure of Return on Capital.

Maximizing Shareholder Wealth and Market Value AddedMaximize shareholder wealth only if the companys managers are able to add value to the Total Equity Capital

This added value is what we call, Market Value Added, or MVA

Importance between Market Value and MVA: GM ExampleIn 1988, General Motors:

Market Value = $25 billion Total Equity Capital = $45 billion

MVAGM = $25 billion - $45 billion = - $20 billion

Importance between Market Value and MVA: Merck Example In 1988, Merck:

Market Value = $25 billionTotal Equity Capital = $5 billion MVAMERCK = $25 billion - $5 billion = + $20 billion

MVA: GM and Merck Same Market Values at the end of 1988.However, Merck created $20 billion while GM destroyed roughly the same amount.

MVAGM = - $20 billionMVAMERCK = + $20 billion

Calculating EVAEstimate based on revised reported earnings:

EVA = Sales Operating Expenses - Depreciation - Interest Expenses (includingTaxes) Equity Financing Expenses ( or, Cost of Equity x Total Equity Capital)

= Net Income - Cost of Equity x Total Equity Capital

EVA = Net Income Keq x Total Equity Capital = $3,533 million 12% x $7,700 million = $3,533 million $924 million = $2,609 million

The $2.6 billion is an estimate of the companys true economic profit for 1998.The Coca-Cola Company Example

Risk-return Trade-offRisk and expected return move in tandem; the greater the risk, the greater the expected return. Financial decisions of the firm are guided by the risk-return trade-off.The return and risk relationship: Return = Risk-free rate + Risk premiumRisk-free rate is a compensation for time and risk premium for risk. *

Managers Versus Shareholders GoalsA company has stakeholders such as employees, debt-holders, consumers, suppliers, government and society. 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 pursue their own personal goals at the cost of shareholders, or may play safe and create satisfactory wealth for shareholders than the maximum. 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.*

Financial Goals and Firms Mission and ObjectivesFirms primary objective is maximizing the welfare of owners, but, in operational terms, they focus on the satisfaction of its customers through the production of goods and services needed by themFirms state their vision, mission and values in broad termsWealth maximization is more appropriately a decision criterion, rather than an objective or a goal. Goals or objectives are missions or basic purposes of a firms existence*

Financial Goals and Firms Mission and ObjectivesThe shareholders wealth maximization is the second-level criterion ensuring that the decision meets the minimum standard of the economic performance. In the final decision-making, the judgement of management plays the crucial role. The wealth maximization criterion would simply indicate whether an action is economically viable or not.*

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 firmCentralisation of the finance functions can result in a number of economies to the firm.*

Status and Duties of Finance ExecutivesThe exact organisation structure for financial management will differ across firms. The financial officer may be known as the financial manager in some organisations, while in others as the vice-president of finance or the director of finance or the financial controller. *

Role of Treasurer and ControllerTwo more officersthe treasurer and the controllermay be appointed under the direct supervision of CFO to assist him or her.The treasurers function is to raise and manage company funds while the controller oversees whether funds are correctly applied.*

Section - 2Concepts of Value and Return

*ObjectivesUnderstand what gives money its time value.Explain the methods of calculating present and future values.Highlight the use of present value technique (discounting) in financial decisions.Introduce the concept of internal rate of return.

*Sounds like a good deal Is it? TOYOTA MOTOR CREDIT offered some securities for sale at $24,099 to the public on March 28, 2008. Under the terms of the deal, TMCC promised to repay the owner of one of these securities $100,000 on March 28, 2038, but investors would receive nothing until then.

Good deal? how to analyze this trade-off?plus side, you get back about $4 for every $1down side, you have to wait 30 years to get it

*Jill made a better investment... Isnt it? Jack decided not to go to college. He got a job at 18 and invested $4,000 each year. He stopped after 8years after investing a total of $32,000. His sister, Jill, went to MBA school + MS, started her career at age 26, at which point she began contributing $4,000. Jill did this for 40 years from 26 to 65. She invested a total of $160,000 and put her money into the same investment as her brother. Jill started investing the same year Jack stopped, and she saved for 40 years compared to just 8 years for her brother.

*Question?What is time value of money?

Cost to build titanic? $7mn in 1912Cost to build movie- $200mn in 1997

Inflation alone- worth 168mn today7mn invested at 4% in 1912 would yield 353mn in 2012Gj

*Time Preference for MoneyTime preference for money is an individuals preference for possession of a given amount of money now, rather than the same amount at some future time.Three reasons may be attributed to the individuals time preference for money:riskpreference for consumption -inflationinvestment opportunities- interest

*Required Rate of ReturnThe 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 investors required rate of return is: Risk-free rate + Risk premium.

Time Value AdjustmentTwo most common methods of adjusting cash flows for time value of money: Compoundingthe process of calculating future values of cash flows and Discountingthe process of calculating present values of cash flows.

Future ValueCompounding 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.

Future ValueThe general form of equation for calculating the future value of a lump sum after n periods may, therefore, be written as follows:

The term (1 + i)n is the compound value factor (CVF) of a lump sum of Re 1, and it always has a value greater than 1 for positive i, indicating that CVF increases as i and n increase.

ExampleIf you deposited Rs 55,650 in a bank, which was paying a 15 per cent rate of interest on a ten-year time deposit, how much would the deposit grow at the end of ten years?

We will first find out the compound value factor at 15 per cent for 10 years which is 4.046. Multiplying 4.046 by Rs 55,650, we get Rs 225,159.90 as the compound value:

*Future Value of an AnnuityAnnuity is a fixed payment (or receipt) each year for a specified number of years. If you rent a flat and promise to make a series of payments over an agreed period, you have created an annuity.

The term within brackets is the compound value factor for an annuity of Re 1, which we shall refer as CVFA.

*ExampleSuppose that a firm deposits Rs 5,000 at the end of each year for four years at 6 per cent rate of interest. How much would this annuity accumulate at the end of the fourth year? We first find CVFA which is 4.3746. If we multiply 4.375 by Rs 5,000, we obtain a compound value of Rs 21,875:

JJ case

Sinking FundSinking fund is a fund, which is created out of fixed payments each period to accumulate to a future sum after a specified period. For example, companies generally create sinking funds to retire bonds (debentures) on maturity.The factor used to calculate the annuity for a given future sum is called the sinking fund factor (SFF).

Present ValuePresent 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.

Present Value of a Single Cash FlowThe following general formula can be employed to calculate the present value of a lump sum to be received after some future periods:

The term in parentheses is the discount factor or present value factor (PVF), and it is always less than 1.0 for positive i, indicating that a future amount has a smaller present value.

*ExampleSuppose that an investor wants to find out the present value of Rs 50,000 to be received after 15 years. Her interest rate is 9 per cent. First, we will find out the present value factor, which is 0.275. Multiplying 0.275 by Rs 50,000, we obtain Rs 13,750 as the present value:

Present Value of an AnnuityThe computation of the present value of an annuity can be written in the following general form:

The term within parentheses is the present value factor of an annuity of Re 1, which we would call PVFA, and it is a sum of single-payment present value factors.

Capital Recovery and Loan AmortisationCapital recovery is the annuity of an investment made today for a specified period of time at a given rate of interest. Capital recovery factor helps in the preparation of a loan amortisation (loan repayment) schedule.

The reciprocal of the present value annuity factor is called the capital recovery factor (CRF).

*Present Value of PerpetuityPerpetuity is an annuity that occurs indefinitely. Perpetuities are not very common in financial decision-making:

Present Value of Growing AnnuitiesThe present value of a constantly growing annuity is given below:

Present value of a constantly growing perpetuity is given by a simple formula as follows:

Value of an Annuity DueAnnuity due is a series of fixed receipts or payments starting at the beginning of each period for a specified number of periods.

Future Value of an Annuity Due

Present Value of an Annuity Due

*Multi-Period CompoundingIf compounding is done more than once a year, the actual annualised rate of interest would be higher than the nominal interest rate and it is called the effective interest rate.

**EVA is defined as the net operating profit (NOPAT) minus an appropriate charge for the cost of capital. Alone, EVA is the an estimate of the true economic profit of a firm, or the amount by which earnings exceed the amount invested in the company.Only when earnings surpass all that was invested in the firm, is there a profit and shareholder wealth is created. NOPAT is the profits derived from a companys operations after taxes, but before financing costs and noncash-bookkepping entries. The capital charge is the product of the cost of capital times capital tied up in investment. In other words it is the cash flow required to compensate investors for the riskiness of the business given the amount of capital invested. Carlos will go into the details of calculating EVA in a moment. *Like I said earlier, EVA is an estimate of true economic profit. By looking at how profitable a company is through other financial measurement tools, a shareholder may be fooled by the companys true wealth because of accounting tricks (write offs, etc). EVA focuses on shareholder wealththe EVA formula takes into account a companys earnings and what a shareholders return should be. If a company has an EVA above 0, the shareholder is actually earning more than enough to compensate them for their invested capital. EVA is simply another measurement of a companys return on capital. *God explains the time value of moneyA man is trying to understand the nature of God and asked him: God, how long is a million years to you? God answered: A million years is like a minute. Then the man asked: God, how much is a million dollars to you? And God replied: A million dollars is like a penny. Finally the man asked: God, could you give me a penny? And God says: In a minute.

**The Story of Jack and JillDelaying making investments in order to launch your career can cost you dearly later on. Smaller investments made between the ages of 18-25 will yield much greater returns than larger investments made later on over a longer period from ages 26-65. Consider the classic parable taught in many basic economic courses:Jack decided not to go to college. He got a job at 18 and invested $4,000 each year into an IRA. He stopped after eight years after investing a total of $32,000. His sister, Jill, went to medical school, started her medical practice at age 26, at which point she began contributing $4,000 to her IRA. Jill did this for 40 years from 26 to 65. She invested a total of $160,000 and put her money into the same investment as her brother. Jill started investing the same year Jack stopped, and she saved for 40 years compared to just eight years for her brother.By age 65, whose IRA account do you thing was worth more money?Assuming both Jack and Jill earned a 10% annual return, Jill accumulated $1,327,778. But Jack had $1,552,739 $224,961 more than his sister!JackJill8 Investments ($4,000/yr) Ages 18-2540 Investments ($4,000/yr) Ages 26-65Ultimate value at age 65:$1,552,739Ultimate Value at age 65:$1,327,778Jacks account grows to a higher value because he started sooner!+$224,961Jack stopped investing at age 26 having invested only $32,000 to Jills $160,000. But Jacks money earned interest for eight years longer than his sister. It wasnt the money that made him successful it was the time value of money. Jack didnt put off investing when he first launched his career. By investing sooner than Jill, his account grew larger.The moral of this story is not to forego a college education and its promise of higher earning potential. No doubt, Jill earned more disposable income during her career. But Jacks investment head start was far superior, resulting in substantially greater savings.

*