Unit - 1

FINANCIAL MANAGEMENT (Corporate Finance)

Need of Knowing Finance – A Managerial Perspective
Before we are learning the financial management there is a need to understand
what is the firm or corporation
The Firm (or) Corporation: Structural Set up
We will use firm generically to refer to any business, large or small,
manufacturing or service, private or public. Thus, a corner grocery store and Microsoft
are both firms. The firm’s investments are generically termed assets. While assets are
often categorized by accountants into fixed assets, which are long-lived, and current
assets, which are short-term, we prefer a different categorization. The assets that the firm
has already invested in are called assets-in-place, whereas those assets that the firm is
expected to invest in the future are called growth assets. While it may seem strange that
a firm can get value from investments it has not made yet, high-growth firms get the bulk
of their value from these yet-to-be-made investments. To finance these assets, the firm
can raise money from two sources. It can raise funds from investors or financial
institutions by promising investors a fixed claim (interest payments) on the cash flows
generated by the assets, with a limited or no role in the day-to-day running of the
business. We categorize this type of financing to be debt. Alternatively, it can offer a
residual claim on the cash flows (i.e., investors can get what is left over after the interest
payments have been made) and a much greater role in the operation of the business. We
term this equity. Note that these definitions are general enough to cover both private
firms, where debt may take the form of bank loans, and equity is the owner’s own money,
as well as publicly traded companies, where the firm may issue bonds (to raise debt) and
stock (to raise equity).
“If I have no intention of becoming a financial manger, why do I need to
understand financial applications / Analyse of Financial decision/ corporate finance?”
Every decision made in a business has financial implications, and any decision
that involves the use of money is a corporate financial decision, broadly every thing that a
business does fits under the rubric of corporate finance. It is, in fact, unfortunate that we
even call the subject corporate finance, since it suggests to many observers a focus on

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how large corporations make financial decisions, and seems to exclude small and private
businesses from its purview. Since the basic principles remain the same, whether one
looks at large, publicly traded firms or small privately run businesses. All businesses have
to invest their resources wisely, find the right kind and mix of financing to fund these
investments and return cash to the owners if there are not enough good investments. We
will lay the foundation by listing the three fundamental principles that underlie corporate
finance – the investment, financing and dividend principles – and the objective of firm
value maximization that is at the heart of corporate financial theory.
Some Fundamental Propositions about Corporate Finance (Financial Management)
There are several fundamental arguments we will make repeatedly throughout
1. Corporate finance has an internal consistency that flows from its choice of maximizing
firm value as the only objective function and its dependence upon a few bedrock
principles: risk has to be rewarded; cash flows matter more than accounting income;
markets are not easily fooled; every decision a firm makes has an effect on its value.
2. Corporate finance must be viewed as an integrated whole, rather than as a collection of
decisions. Investment decisions generally affect financing decisions, and vice versa;
financing decisions generally affect dividend decisions, and vice versa. While there are
circumstances under which these decisions may be independent of each other, this is
seldom the case in practice. Accordingly, it is unlikely that firms that deal with their
problems on a piecemeal basis will ever resolve these problems. For instance, a firm that
takes poor investments may soon find itself with a dividend problem (with insufficient
funds to pay dividends) and a financing problem (because the drop in earnings may make
it difficult for them to meet interest expenses).
3. Corporate finance matters to everybody. There is a corporate financial aspect to almost
every decision made by a business; while not everyone will find a use for all the
components of corporate finance, everyone will find a use for at least some part of it.
Marketing managers, corporate strategists, human resource managers and information
technology managers all make corporate finance decisions every day and often don’t
realize it. An understanding of corporate finance may help them make better decisions.
4. Corporate finance is fun. This may seem to be the tallest claim of all. After all, most
people associate corporate finance with numbers, accounting statements and hardheaded

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analyses. While corporate finance is quantitative in its focus, there is a significant
component of creative thinking involved in coming up with solutions to the financial
problems businesses doing encounter. It is no coincidence that financial markets remain
the breeding grounds for innovation and change.
5. The best way to learn corporate finance is by applying its models and theories to real
world problems. While the theory that has been developed over the last few decades is
impressive, the ultimate test of any theory is in applications.
The successful manager will need to be much more of a team player that has the
knowledge and ability to move not just vertically within an organization but horizontally
as well developing cross-functional capabilities will be the rule, not the exception. The
mastery of basic financial management skills is key ingredient that will be required in the
work place of yours not in too distant future.
Important focal points in the study of finance:
• Accounting and Finance often focus on different things
• Finance is more focused on market values rather than book values.
• Finance is more focused on cash flows rather than accounting income.
Why is market value more important than book value?
• Book values are often based on dated values. They consist of the original cost of the
asset from some past time, minus accumulated depreciation (which may not represent the
actual decline in the assets’ value).
• Maximization of market value of the stockholders’ shares is the goal of the firm.
Why is cash flow more important than accounting income?
• Cash flow to stockholders (in the form of dividends) is the only basis for valuation of
the common stock shares. Since the goal is to maximize stock price, cash flow is
more directly related than accounting income.
• Accounting methods recognize income at times other than when cash is actually
received or spent.
One more reason that cash flow is important:
When cash is actually received is important, because it determines when cash can be
invested to earn a return.

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Fields of Finance
Business finance: The term business and business finance is a very broad term. It covers
all the activities carried out with the intention of earning profits.
Corporation finance: It is a part of business finance and deals with the financial
practices, policies and problems of corporate enterprises or companies.
International finance: It is the study of flow of funds between individuals and
organisations beyond national boundaries and developing methods to handle these funds
more effectively.
Public finance: It deals with the financial matters of the government. It becomes a
crucial as the government deals with huge sums of money which can be raised through
sources like taxes or other methods and are required to be utilised within the statutory and
other limitations.
Three Areas of Finance
Financial Markets: Securities Trading, Financial Intermediaries, Derivative Securities &
Risk Management
Investments: Financial Analysis, Portfolio Management, Real Estate
Corporate Finance: Financial Management, Investment Banking, Venture Capital
What Is Finance?
Finance can be defined as the art and science of managing money. Virtually all
individuals and organizations earn or raise money and spend or invest money. Finance is
concerned with the process, institutions, markets, and instruments involved in the transfer
of money among individuals, businesses, and governments. Most adults will benefit from
an understanding of finance, which will enable them to make better personal financial
decisions. Those who work in financial jobs will benefit by being able to interface
effectively with the firm’s financial personnel, processes, and procedures.
Finance is the study of money (inflow and outflow) management, the acquiring of funds
(cash) and the directing of these funds to meet objective of financial management i.e.
wealth of the owner (share holders) this can be achieve by maximize returns and
minimizing risks.

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Finance is
 Capital is wealth that is used to generate more wealth.
 Finance is the discipline concerned with or the study of how to acquire and utilize
capital to the greatest benefit.
 In other words, finance deals with how value is created.
The Value Creation Process
Capital$ Financial Management Shareholder Wealth
Decisions
Finance is
 The finance function is the process of acquiring and utilising funds of a business.
o R.C. Osborn
 Financing consists of the raising, providing, managing of all the money, and
capital of funds of any kind to be used in connection with business.
o Bonneville and Dewey
Financial Management- “It is Concerns the acquisition, financing, and management of
assets with some overall goal in mind to maximaise the value of the firm”.
Financial management “it is concerned with efficient use of an important economic
resources namely capital funds” By Ezra Solomon
Managerial finance is concerned with the duties of the financial manager in the business
firm.
Financial managers actively manage the financial affairs of any type of businesses—
financial and non financial, private and public, large and small, profit-seeking and not-
for-profit. They perform such varied financial tasks as planning, extending credit to
customers, evaluating proposed large expenditures, and raising money to fund the firm’s
operations. In recent years, the changing economic and regulatory environments have
increased the importance and complexity of the financial manager’s duties. As a result,
many top executives have come from the finance area.
Approaches to the term Finance
 Traditional approach
 Modern approach

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According to the Traditional approach, the term finance was interpreted to mean the
procurement of funds by corporate enterprises to meet their financing needs. The term
‘procurement’ was used in a broad sense to include the whole gamut of raising the funds
externally.
This approach was criticized on various grounds such as:
 It is too narrow and restrictive in nature. Procurement of the funds is only one of the
functions of finance and other functions are ignored.
 It considers the financial problems only of corporate enterprises. In that sense, it
ignores the financial problems of non-corporate entities like proprietary concerns,
partnership firms etc.
 It considers only the basic and non-recurring problems relating to the business. Day-to-
day financial problems of a normal company do not receive any attention
 It concentrates only on long term financing. It means that the working capital
management is out of the purview of the finance function.
The Modern approach, which is a more, balanced one and hence the acceptable one to
the modern scholars, interprets the term finance as being concerned with procurement of
funds and wise application of funds.
Scope of Finance Function
According to the modern approach, the function of finance is concerned with the
following three types of decisions:
 Financing Decisions
 Investment Decisions
 Dividend Policy Decisions
 Liquidity Decision
The Financing Decisions (Capital Structure)
Every business, no matter how large and complex it is, is ultimately funded with a
mix of borrowed money (debt) and owner’s funds (equity). With a publicly trade firm,
debt may take the form of bonds and equity is usually common stock. In a private
business, debt is more likely to be bank loans and an owner’s savings represent equity.
While we consider the existing mix of debt and equity and its implications for the
minimum acceptable hurdle rate as part of the investment principle, we throw open the

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question of whether the existing mix is the right one in the financing principle section.
While there might be regulatory and other real world constraints on the financing mix
that a business can use, there is ample room for flexibility within these constraints.
Financing decisions are the decisions regarding the process of raising funds. This
function of finance is concerned with providing the answers to various questions.
What is the best type of financing?
What is the best financing mix?
What is the best dividend policy?
How will the funds be physically acquired?
The Investment Decisions (Capital Budgeting)
Firms have scarce resources that must be allocated among competing needs. The first
and foremost function of corporate financial theory is to provide a framework for firms to
make this decision wisely. Accordingly, we define investment decisions to include not
only those that create revenues and profits (such as introducing a new product line or
expanding into a new market), but also those that save money (such as building a new
and more efficient distribution system). Further, we argue that decisions about how much
and what inventory to maintain and whether and how much credit to grant to customers
that are traditionally categorized as working capital decisions, are ultimately investment
decisions, as well. At the other end of the spectrum, broad strategic decisions regarding
which markets to enter and the acquisitions of other companies can also are considered
investment decisions. Corporate finance attempts to measure the return on a proposed
investment decision and compare it to a minimum acceptable hurdle rate (Hurdle Rate: A
hurdle rate is a minimum acceptable rate of return for investing resources in a project.) in
order to decide whether or not the project is acceptable or not. The hurdle rate has to be
set higher for riskier projects and has to reflect the financing mix used, i.e., the owner’s
funds (equity) or borrowed money (debt).
Investment decisions are the decisions regarding the application of funds raised by the
organisation. The investment decisions relate to the selection of assets in which the funds
should be invested.
What is the optimal firm size?
What specific assets should be acquired?

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 What assets (if any) should be reduced or eliminated?
Liquidity decision (Working Capital Management)
How do we manage existing assets efficiently?
Financial Manager has varying degrees of operating responsibility over assets greater
emphasis on current asset management than fixed asset management.
The Dividend Policy Decisions (Profit Allocation decision)
Most businesses would undoubtedly like to have unlimited investment
opportunities that yield returns exceeding their hurdle rates, but all businesses grow and
mature. As a consequence, every business that thrives reaches a stage in its life when the
cash flows generated by existing investments is greater than the funds needed to take on
good investments. At that point, this business has to figure out ways to return the excess
cash to owners. In private businesses, this may just involve the owner withdrawing a
portion of his or her funds from the business. In a publicly traded corporation, this will
involve either dividends or the buying back of stock.
Dividend policy decisions are strategic financial decisions and are concerned with the
answers to the questions like:
1. What are the forms in which the dividends can be paid to the shareholders?
2. What are the legal and procedural formalities to be completed while paying the
dividend in different forms?

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Goals/Objectives of Finance Function
Profit Maximization
According to this principle, all the functions of the business will have profit as
the main objective. Maximizing firms earnings after taxes.
Problems connected with this objective are:
1. The term profit is a ambiguous concept which isn't having precise connotation.
For example, profits can be long term or short term.
2. The profits always go hand in hand with risks.
3. Profit maximization as the goal of financial function ignores the time pattern of
returns.
4. Profit maximization as the objective doesn’t take into consideration the social
consideration as well as the obligations to various interests of workers,
consumers, society, etc…and ethical trade practices.
5. Could increase current profits while harming firm (e.g., defer maintenance, issue
common stock to buy T-bills, etc.).
6. Ignores changes in the risk level of the firm.
Earnings per Share Maximization

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Maximizing earnings after taxes divided by shares outstanding.
Problems connected with this objective are:
It does not specify timing and duration of expected returns.
It ignores changes in the risk level of the firm.
It calls for a zero payout dividend policy.
Shareholder Wealth Maximization
Value creation occurs when we maximize the share price for current shareholders.
Shortcomings of Alternative Perspectives
Wealth Maximization
• Due to limitations attached with profit maximization as an objective of the finance
function, it is no more accepted as the basic objective.
• The value of an asset is judged not in terms of its cost but in terms of the benefits
it produces.
• Thus, wealth maximization goal as a decision criteria suggests that , any financial
action which creates wealth or which has discounted stream of future benefits
exceeding its cost, is desirable and should be accepted and that which does not
satisfy this test should be rejected.
The goal of wealth maximization is supposed to be superior to the goal of profit
maximization due to the following reasons:
1. It uses the concept of future expected cash flows rather than the ambiguous
term of profits. As such, measurement of benefits in terms of cash flows
avoids ambiguity.
2. It considers time value of money. It recognises that the cash flows generated
earlier are more valuable than those generated later. That is why while
computing the value of total benefits, the cash flows are discounted at a
certain discounting rate.
3. Takes account of: current and future profits and EPS; the timing, duration,
and risk of profits and EPS; dividend policy; and all other relevant factors.
4. Thus, share price serves as a barometer for business performance.
The goal of the firm should be to maximize the stock price!
• This is equivalent to saying the goal is to maximize owners’ wealth.

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 • Note that the stock price is affected by management’s decisions affecting both
risk and profit.
• Stock price can be maintained or increased only when stockholders perceive that
they are receiving profits that fully compensate them for bearing the risk they
perceive.

FCF1 FCF2 FCF

Pr esentValue ( w)    .. .. 
(1  k ) 1
(1  k ) 2
(1  k ) 

Where:
W is present value or wealth of share holder
FCF is expected future Cash flows (income or earnings)
K is capitalization rate or cost of equity or WACC

The common stockholders are the owners of the corporation!

• Stockholders elect a board of directors who in turn hire managers to maximize the
stockholders’ well being.
• When stockholders perceive that management is not doing this, they might
attempt to remove and replace the management, but this can be very difficult in a
large corporation with many stockholders. More likely, when stockholders are
dissatisfied they will simply sell their stock shares.
• This action by stockholders will cause the market price of the company’s stock to
fall.
• When stock price falls relative to the rest of the market (or relative to the rest of
the industry)
• Management is failing in their job to increase the welfare (or wealth) of the
stockholders (the owners).
• Management is accomplishing their goal of increasing the welfare (or wealth) of
the stockholders (the owners).
The Role of the Financial Manager
The financial manager stands between the firm’s operations and the financial (or
capital) markets, where investors hold the financial assets issued by the firm. The

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financial manager’s role is illustrated in Figure 1.1, which traces the flow of cash from
investors to the firm and back to investors again. The flow starts when the firm sells
securities to raise cash (arrow 1 in the figure). The cash is used to purchase real assets
used in the firm’s operations (arrow 2). Later, if the firm does well, the real assets
generate cash inflows which more than repay the initial investment (arrow 3). Finally, the
cash is either reinvested (arrow 4a) or returned to the investors who purchased the
original security issue (arrow 4b). Of course, the choice between arrows 4a and 4b is not
completely free. For example, if a bank lends money at stage 1, the bank has to be repaid
the money plus interest at stage 4b. Our diagram takes us back to the financial manager’s
two basic questions. First, what real assets should the firm invest in? Second, how should
the cash for the investment be raised? The answer to the first question is the firm’s
investment, or capital budgeting, decision. The answer to the second is the firm’s
financing decision. Capital investment and financing decisions are typically separated,
that is, analyzed independently. When an investment opportunity or “project” is
identified, the financial manager first asks whether the project is worth more than the
capital required to undertake it. If the answer is yes, he or she then considers how the
project should be financed.
But the separation of investment and financing decisions does not mean that the financial
manager can forget about investors and financial markets when analyzing capital
investment projects. The dividend decision or returns distribution among the investors as
the basic financial objective of the firm is to maximize the value of the cash invested in
the firm by its stockholders. Look again at Figure 1.1. Stockholders are happy to
contribute cash at arrow 1 only if the decisions made at arrow 2 generate at least adequate
returns at arrow 3. “Adequate” means returns at least equal to the returns available to
investors outside the firm in financial markets. If your firm’s projects consistently
generate inadequate returns, your shareholders will want their money back.

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Flow of cash between financial markets and the firm’s operations.
Key: (1) Cash raised by selling financial assets to investors;
(2) cash invested in the firm’s operations and used to purchase real assets;
(3) cash generated by the firm’s operations;
(4a) cash reinvested; (4b) cash returned to investors.

Duties and Responsibilities of Finance manager

Classification of duties and responsibilities:
• Recurring Duties
• Non-recurring duties
Recurring duties
It comprises of:
• Deciding financial needs
• Raising funds required
• Allocation of funds
1. Fixed asset management
2. Working Capital management
• Allocation of income
• Control of funds
• Evaluation of performance
• Corporate taxation
• Other duties

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Non-recurring Duties: Involves preparation of financial plan at the time of company
promotion, financial readjustments in times liquidity crisis, valuation of the enterprise at
the time of acquisition and merger thereof etc.
Organization of the Financial Management Function
Their roles are summarized as the treasurer is responsible for looking after the
firm’s cash, raising new capital, and maintaining relationships with banks, stockholders,
and other investors who hold the firm’s securities.
For small firms, the treasurer is likely to be the only financial executive. Larger
corporations also have a controller, who prepares the financial statements, manages the
firm’s internal accounting, and looks after its tax obligations. You can see that the
treasurer and controller have different functions: The treasurer’s main responsibility is to
obtain and manage the firm’s capital, whereas the controller ensures that the money is
used efficiently.
Still larger firms usually appoint a chief financial officer (CFO) to oversee both the
treasurer’s and the controller’s work. The CFO is deeply involved in financial policy and
corporate planning. Often he or she will have general managerial responsibilities beyond
strictly financial issues and may also be a member of the board of directors. The
controller or CFO is responsible for organizing and supervising the capital budgeting
process. However, major capital investment projects are so closely tied to plans for
product development, production, and marketing that managers from these areas are
inevitably drawn into planning and analyzing the projects. If the firm has staff members
specializing in corporate planning, they too are naturally involved in capital budgeting.

VP of Finance
Treasurer Controller
Capital Budgeting Cost Accounting
Cash Management Cost Management
Credit Management Data Processing
Dividend Disbursement General Ledger
Fin Analysis/Planning Government Reporting
Pension Management Internal Control
Insurance/Risk Mgt Preparing Fin Statements
Preparing Budgets
Tax Analysis/Planning

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Financial planning
Financial planning indicates a firm’s growth, performance, investments and
requirements of funds during a given period of time, usually three to five years.
Financial planning help a firm’s financial manager to regulate flows of funds which is his
primary concern.
Examine interactions – help management see the interactions between decisions
Explore options – give management a systematic framework for exploring its
opportunities
Avoid surprises – help management identify possible outcomes and plan
accordingly Ensure feasibility and internal consistency – help management determine if
goals can be accomplished and if the various stated (and unstated) goals of the firm are
consistent with one another.
Steps in Financial Planning
Past performance
Operating characteristics
Corporate strategy and investment needs
Cash flow from operations
Financing alternatives
Consequences of financial plans
Consistency
Elements of Financial Planning
• Investment in new assets – determined by capital budgeting decisions
• Degree of financial leverage – determined by capital structure decisions
• Cash paid to shareholders – determined by dividend policy decisions
• Liquidity requirements – determined by net working capital decisions
Financial Planning Model Ingredients
• Sales Forecast – many cash flows depend directly on the level of sales (often
estimated sales growth rate)
• Pro Forma Statements – setting up the plan as projected financial statements
allows for consistency and ease of interpretation

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 • Asset Requirements – the additional assets that will be required to meet sales
projections
• Financial Requirements – the amount of financing needed to pay for the required
assets
• Plug Variable – determined by management decisions about what type of
financing will be used (makes the balance sheet balance)
• Economic Assumptions – explicit assumptions about the coming economic
environment
Financial Planning Process
Planning Horizon - divide decisions into short-run decisions (usually next 12 months) and
long-run decisions (usually 2 – 5 years)
Aggregation - combine capital budgeting decisions into one big project
Evaluating the current financial condition of the firm.
Analysing the future growth prospects and options.
Appraising the investment options to achieve the stated growth objective.
Projecting the future growth and profitability.
Estimating funds requirement and considering alternative financing options.
Comparing and choosing from alternative growth plans and financing options.
Measuring actual performance with the planned performance.
Financial forecasting is an integral part of financial planning. It uses past data to estimate
the future financial requirements.
A financial planning model establishes the relationship between financial variables and
targets, and facilitates the financial forecasting and planning process.
A financial planning model has the following three components:

1. Inputs
2. Model
3. Output
Prepare pro forma financial statements
Based on the model inputs and assumptions, the planning team developed the model
equations for pro forma profit and loss statement, funds flow statement and balance sheet.

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 To prepare the next year’s pro forma profit and loss statement, balance sheet and
funds flow statement, the planning team through a consultative process in the company,
made several assumptions and models about the relationships between financial
variables.
In practice, long-term financial forecasts are prepared by relating the items of profit
and loss account and balance sheet to sales. This is called the percentage to sales method.
Sustainable Growth Model
Sustainable growth may be defined as the annual percentage growth in sales that is
consistent with the firm’s financial policies (assuming no issue of fresh equity). The
following model can be used to determine the sustainable growth (gs) in sales:
Sustainable Growth Model and Financial Policy Trade-off
A simple way of ascertaining the growth potential of a company, given its current
financial conditions, is to examine the interaction between four financial policy goals
expressed as ratios:
 Target sales growth
 Target return on investment (net assets)
 Target dividend payout and
 Target debt-equity (capital structure)

 Growth Potential of a Single-product Company.

 Sustainable Growth Model for a Multi-product Company.
 Growth Potential of a Single-product Company
 Sustainable growth may be defined as the annual percentage growth in sales that
is consistent with the firm’s financial policies (assuming no issue of fresh equity):

Net margin × Retention × Leverage

Sustainable Growth 
Assets Turnover – (Net Margin × Retention X Leverage)

Growth Potential of a Multi-product Company

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 Sustainable growth rate in the case of multi-product or multi-division company is
to calculate the sustainable growth rate at the corporate level in terms of growth in assets.

Retained earnings
Growth =
(1+Debt/equity ratio)
Net assets

age factor × Retention ratio × (1+D/E)

 turnover × Profit margin × Lever
Sg Asset

Assumptions and Scenarios

 Make realistic assumptions about important variables

 Run several scenarios where you vary the assumptions by reasonable amounts
 Determine at least a worst case, normal case and best case scenario
Time value of money

Suppose you are purchasing some goods worth Rs.100/- today. We all know that in a
year’s time, you would require more than Rs.100/- to purchase the same goods as you
have done today. This is due to the “rise in prices”. This phenomenon is observed
constantly in almost all the economies, though the degree of increase would depend upon
so many factors and hence it differs from time to time and country to country. This
“increase” in prices is due to the fact that at any given time, more money chases less
goods and services. This means that there exists a gap between “supply” and “demand”
of goods and services and the degree of price rise directly depends upon the extent of
gap. The more the gap the higher the price rise and vice-versa. This general increase in
prices of goods or services with the passage of time is called “inflation”.
What is “time value of money”?

That with the passage of time, the value of “present money” reduces due to “inflation” is
clear to us and this phenomenon is referred to in finance as “time value of money”.

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Interest is in fact primarily a compensation for the loss in value of money due to passage
of time.
Time Preference for Money
Time preference for money is an individual’s 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 individual’s time preference for money:
1. Risk
2. Preference for consumption
3. Investment opportunities
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.
Hence we should familiarise ourselves with terms associated with “time value of
money” such as “compounding and discounting”.

Time Value Adjustment

Compounding—the process of calculating future values of cash flows and
Discounting—the process of calculating present values of cash flows.

Future Value or Compounding

It is a process by which given a specific present value, at a fixed rate of interest and
depending upon the frequency of compounding, the future compounded value can be
determined for a specific period. The future values of cash flows by applying the concept
of compound interest. The general form of equation for calculating the future value of a
lump sum after n periods may, therefore, be written as follows:

Fn  P(1  i ) n

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The term (1 + i) or (1+r) 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.
F.V. = P.V. (1+ r /100) n raised to “n” times, “n” representing the period in number of
years. This presupposes that the periodicity of compounding is yearly. In case the
periodicity of compounding is half-yearly, then the formula would change as follows:

F.V. = P.V. (1+ r /200) raised to “2n” times.

Similarly, the formula could be amended for quarterly compounding or monthly
compounding. Instead of using calculator for working out the future value,
Future Value of $100 = FV

FV  $100  (1  r ) t
Example - FV
What is the future value of $ 400,000 if interest is compounded annually at a rate of 5%
for one year?
FV  $400,000  (1  .05)1  $420,000

Future Value of an Annuity

Annuity refers to “multiple stream” of cash flows but which are equal to each other
and occurring annually. The cash flows could either be in flows or out flows. This means
that the following alternatives are available to us when we are talking of “annuity”.

We invest in equal installments over a period of time and get one lump sum at the end of
the period. The cash outflows that are equal to each other are called “annuity”. Herein
we use what is known as Future Value Interest Factor Annuity (FVIFA) .We multiply
the Annuity by this factor and get the future value of the cash out flows in one shot.

Let us study the following examples to understand the concept of “annuity”.

We are able to invest every year Rs.1000/- for a period of 5 years. We expect a return of
10% p.a. What will be the value of this investment at the end of 5 years?
Let us represent this by way of a timeline

At T0 T1 T2 T3 T4 T5

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 Investment = zero 1,000/- 1,000/- 1,000/- 1,000/- 1,000/-

Can we use the future value formula, find out the future value of each stream of
Rs.1000/- and add them up? Thus T1 investment would earn interest for 4 years, the 2 nd
year investment would earn interest for 3 years, the 3 rd year investment would earn
interest for 2 years, the 4th year investment would earn interest for 1 year and the last year
investment would not earn any interest. Instead of doing such an elaborate exercise, we
use the alternative “FVIFA”.
Present Value or Discounted value:
Discounted value: This is converse to the process of “compounding”. Just as we know the
present value for compounding, we should know the future value for discounting. This
value, when discounted at a given rate of discount, which is usually the rate of return
expectation, by a promoter or an investor gives us the present value. This again depends
upon the period for which the discounting is done.

Present value of a future rupee – Process of discounting

The Present value of a future sum. Suppose we want to have Rs.10, 000/- after say two
years (T2). We want to know how much we should save now (T 0). This situation is exactly

the opposite of the earlier future value situation. The investment at T 0 should increase to
the desired future value at a desired rate of interest. The process of determining the
present value from future value is known as “discounting”. “Discounting” is converse of
“compounding”.
We want to get Rs.108/- at the end of T 1. The desired rate of interest is 8% per annum.
What is the amount that we should invest at T0?
Can we use the “future value” formula here?
Yes – with necessary modification as under:
n
Future value = Present investment x (1 + r/100)
Future value at T1, Rs.108/- = PV at T0 (to be determined) x (1.08)
PV at T0 = Rs. 108/1.08 = Rs.100/-.
Thus the formula for present value is as under:
n n
Present value = Future value / (1 + r/100) = Future value x [1/(1 + r/100) ]

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The reciprocal of compounding factor is referred to as “discounting factor. We need to
multiply the future value by this discounting factor and not divide. In the above formula,
n
1/ (1+r/100) is referred to as “discounting factor”.

Discounting factor = 1/compounding factor; discounting factor x compounding

factor = 1. Discounting factor would always be less than 1.

We want to get Rs.10,000/- after two years. The desired rate of interest is 12% p.a. The
frequency of is yearly.
What is the present value of this future sum of Rs.10,000/-?
The two-step process in determining present value is:
Step 1 = determine the discounting factor = 1/[1 + 12/200]2*2 = 0.7924

Step 2 = multiply the future value by this factor to get the present value
Present value =10,000 * .7924
Present value = Rs. 7,924/-

We invest at the beginning one lump sum amount and get returns over a period of
time that are equal to each other. The cash in flows that are equal to each other are
called “annuity”. Herein we use what is known as Present Value Interest Factor
Annuity (PVIFA). We multiply the Annuity by this factor and get the present value of
the future cash flows in one shot. Then we compare this present value with our proposed
investment at T0 taking decision on investment. We invest provided the Present value of
future annuities is at least equal to our investment at T0.

Concept of perpetuity

Perpetuity is an annuity that occurs indefinitely.

Present value = FV/r
This is the concept applicable in the case of pension. Pension is taken to be perpetual.
Can we find out the lump sum amount in case the pension amount is given?

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Suppose the pension amount is Rs. 1000/-. The expected rate of return is 10% p.a. What
is the core amount out of which interest is paid? The annual payment is Rs.12,000/-.
Hence the lump sum amount is Annual payment/rate of interest expressed in decimals.
Accordingly the lump sum amount is Rs. 12,000/0.1 = Rs. 1,20,000/-.
Doubling period:
A frequent question asked by any investor is “How much time will it take for me to
double my investment?” The answer lies in “Rule 72”. As per this rule, the period of
doubling the investment would be obtained by dividing the number 72 by the rate of
interest. This is only an approximate method. For example the rate of interest is 12%
p.a. The period in which the initial investment would double is 72/12 = 6 years. A more
accurate method is known as “Rule 69”, according to which, the doubling period is =
0.35 + 69/interest rate.
In the above rate of interest, the doubling period would work out to be = 0.35+69/12 =
6.10 years instead of 6 years, which is the result as per the “Rule 72 method”.

Risk-return Trade-off
o Risk and expected return move in tandem; the greater the risk, the greater the
expected return.
o Financial decisions of the firm are guided by the risk-return trade-off.
o The return and risk relationship:

Return = Risk-free rate + Risk premium

o Risk-free rate is a compensation for time and risk premium for risk.
Role of Management
Management acts as an agent for the owners (shareholders) of the firm.
An agent is an individual authorized by another person, called the principal, to act in the
latter’s behalf.
Agency Theory
Jensen and Meckling developed a theory of the firm based on agency theory.

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Agency Theory is a branch of economics relating to the behavior of principals and their
agents.
Principals must provide incentives so that management acts in the principals’ best
interests and then monitor results.
Incentives include stock options, perquisites, and bonuses.

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