MBA - Sem - II

Financial Management
Unit – I

(Syllabus: Aims and Objectives of Financial Management, Du Pont Analysis,

Time Value of Money)

Introduction
What is Finance?
Finance is defined as the management of money and includes activities such as investing,
borrowing, lending, budgeting, saving, and forecasting.

There are three main types of finance: (1) personal, (2) corporate, and
(3) public/government.

What is Financial Management?

Meaning of Financial Management
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.

Scope/Elements

1. Investment decisions includes investment in fixed assets (called as capital budgeting). Investment
in current assets is 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.

Definitions

Howard and Uptron define financial management “as an application of general managerial
principles to the area of financial decision- making”.

Weston and Brighem define financial management “as an area of financial decision making,
harmonizing individual motives and enterprise goal”.

“Financial management is concerned with the efficient use of an important economic resource,
namely capital funds” - Solomon Ezra & J. John Pringle.

“Financial management is the operational activity of a business that is responsible for obtaining
and effectively utilizing the funds necessary for efficient business operations”- J.L. Massie.
“Financial Management is concerned with managerial decisions that result in the acquisition and
financing of long-term and short-term credits of the firm. As such it deals with the situations that
require selection of specific assets (or combination of assets), the selection of specific liability
(or combination of liabilities) as well as the problem of size and growth of an enterprise. The
analysis of these decisions is based on the expected inflows and outflows of funds and their
effects upon managerial objectives”. - Phillippatus.

Methods of Financial Management:

In the field of financing there are various methods to procure funds. Funds may be obtained from
long-term sources as well as from short-term sources. Long-term funds may be availed by
owners that are shareholders, lenders by issuing debentures, from financial institutions, banks
and public at large. Short-term funds may be availed from commercial banks, public deposits,
etc. Financial leverage or trading on equity is an important method by which a finance manager
may increase the return to common shareholders.

Functions of Financial Management

1. Estimation of capital requirements:
2. Determination of capital composition:
3. Choice of sources of funds: For additional funds to be procured, a company has many
choices like-
4. Investment of funds
5. Disposal of surplus
6. Management of cash
7. Financial controls

Financial Management Objectives

Efficient Financial management requires the existence of some objectives, which are as follows
1. Profit Maximization:

Objective of financial management is same as the objective of a company that is to earn

profit. But profit maximization cannot the sole objective of a company. It is a limited
objective. If profits are given undue Importance then problems may arise as discussed
below.
- The term profit is vague and it involves much more contradictions.
- Profit maximization has to be attempted with a realization of risks involved. A positive
relationship exists between risk and profits. So both risk and profit objectives should be
balanced.
- Profit Maximization does not take into account the time pattern of returns.
- Profit maximization fails to take into account the social considerations.

Concept-
Profit maximization is the main aim of any business and therefore it is also an objective
of financial management. Profit maximization, in financial management, represents the process
or the approach by which profits (EPS) of the business are increased. In simple words, all the
decisions whether investment, financing, or dividend etc are focused on maximizing the profits
to optimum levels.
Profit maximization is the traditional approach and the primary objective of financial
management. It implies that every decision relating to business is evaluated in the light of profits.
All the decision with respect to new projects, acquisition of assets, raising capital, distributing
dividends etc are studied for their impact on profits and profitability. If the result of a decision is
perceived to have a positive effect on the profits, the decision is taken further for
implementation.

Profit Maximization Theory / Model

The Rationale / Benefits :
Profit maximization theory of directing business decisions is encouraged because of following
advantages associated with it.

Economic Survival
Profit maximization theory is based on profits and profits are a must for survival of any business.
Measurement Standard
Profits are the true measurement of the viability of a business model. Without profits, the
business losses its primary objective and therefore has a direct risk to its survival.
Social and Economic Welfare
The profit maximization objective indirectly caters to social welfare. In a business, profits prove
efficient utilization and allocation of resources. Resource allocation and payments for land,
labor, capital, and organization takes care of social and economic welfare.

Limitations of Profit Maximization as an Objective of Financial

Management
Profit maximization is criticized for some of its limitations which are discussed below:

The Haziness of the Concept “Profit”

The term “Profit” is a vague term. It is because different mindset will have a different perception
of profit. For e.g. profits can be the net profit, gross profit, before tax profit, or the rate of profit
etc. There is no clearly defined profit maximization rule about the profits.

Ignores Time Value of Money

The profit maximization formula simply suggests “higher the profit better is the proposal”. In
essence, it is considering the naked profits without considering the timing of them. Another
important dictum of finance says “a dollar today is not equal to a dollar a year later”. So, the time
value of money is completely ignored.
Ignores the Risk
A decision solely based on profit maximization model would take a decision in favor of profits.
In the pursuit of profits, the risk involved is ignored which may prove unaffordable at times
simply because higher risks directly questions the survival of a business.

Ignores Quality
The most problematic aspect of profit maximization as an objective is that it ignores the
intangible benefits such as quality, image, technological advancements etc. The contribution of
intangible assets in generating value for a business is not worth ignoring. They indirectly create
assets for the organization.

Profit maximization ruled the traditional business mindset which has gone through drastic
changes. In the modern approach of business and financial management, much higher
importance is assigned to wealth maximization in comparison of Profit Maximization vs. Wealth
Maximization. The losing importance of profit maximization is not baseless and it is not only
because it ignores certain important areas such as risk, quality, and the time value of money but
also because of the superiority of wealth maximization as an objective of the business or
financial management.

Example of Profit maximization:

Profit Maximization seeks to find new methods to increase net revenue for a business, often
without relying on increased demand or changing sales prices – although these are also viable
strategies. As a result, many profit maximization strategies seek out new efficiencies or potential
savings on current operations.

1. Reducing Cost of Goods Sold

One of the most popular methods to maximize profit is to reduce the cost of goods sold while
maintaining the same sales prices. There are many different ways to do this, allowing businesses
to pick the easiest or the one with the most room for change. Examples of profit maximizations
like this include:
 Find cheaper raw materials than those currently used
 Find a supplier that offers better rates for inventory purchases
 Find product sources with lower shipping fees
 Reduce labor costs
An important profit formula for this process is Marginal Cost = Marginal Revenue. If
Marginal Cost equals Marginal Revenue, then the cost of producing one more unit is equal to the
revenue gained by selling one more unit. Thus companies know if they can adjust the Marginal
Cost so that it becomes less than Marginal Revenue, they can realize additional profit even
without increasing production, making this a common goal, according to the Intelligent
Economist.
This simple formula can also be used to analyze potential profit in other scenarios, such
as extending work hours or hiring additional sales personnel. In any examples of profit
maximization, the Marginal Cost of the change must be equal to or less than the Marginal
Revenue that will come from it.

2. Finding Ne w Production Efficiencies

Production facilities can also seek profit maximization through new efficiencies so that it costs
less to produce the same or more products, increasing profit margins.
Two standard methods work. The first method is to upgrade equipment and technology in a
factory so that materials are used more efficiently or the equipment doesn’t cost as much to run
and maintain.

The second method is to increase production numbers so that productio n volume scales up faster
than the costs of production. The factory can then produce more for less, thanks to economies of
scale. Many large factories with efficient, high- volume production choose this option. However,
it’s important to have confident predictions of demand so that the business knows these
additional products will have buyers.

While this applies primarily to production, other businesses can use the same approach to
examine their inventory management, picking and shipping costs.

3. Expanding Sales Windows

If a business already has surplus inventory on hand, a straightforward profit maximization

strategy is to increase sales opportunities. One option is to provide an online store where
customers can shop 24/7 without the need for a brick-and- mortar store to be open, maximizing
product availability. Companies can also choose to improve product availability through new
marketing, expanding into another region or selling overseas, although all these come with
associated costs.

4. Cutting Overhead Costs

Overhead costs refer to the fixed expenses that a business pays to stay open, including everything
from leases and insurance to utilities, building maintenance, and accounting. Companies can
examine local lease opportunities to see if they can move into a building with a cheaper lease
without losing business or find ways to save on energy costs.

5. Profit Maximization Risks

No business exists in a vacuum, and profit maximization strategies carry their own risks. For
example, if a business tries to cut overhead costs by moving to a new area, they may find
demand at that location is lower and end up losing business. A company that switches to cheaper
raw materials may find they lose more money due to defective products and bad batches.

Wealth Maximization
2. Wealth Maximization:

- It is commonly agreed that the objective of a firm is to maximize value or wealth.

- Value of a firm is represented by the market price of the company's common stock. The
market price of a firm's stock represents the focal judgment of all market participants as
to what the value of the particular firm is. It takes in to account present and prospective
future earnings per share, the timing and risk of these earning, the dividend policy of the
 firm and many other factors that bear upon the market price of the stock. Market price
acts as the performance index or report card of the firm's progress.
- Prices in the share markets are largely affected by many factors like general econo mic
outlook, outlook of particular company, technical factors and even mass psychology.
Normally this value is a function of two factors as given below -
(a) The anticipated rate of earnings per share of the company
(b) The capitalization rate.
The likely rate of earnings per shares (EPS) depends upon the assessment as to how
profitably a company is growing to operate in the future.
- The capitalization rate reflects the liking of the investors for the company.
Wealth maximization is a modern approach to financial management. Maximization of profit
used to be the main aim of a business and financial management till the concept of wealth
maximization came into being. It is a superior goal compared to profit maximization as it takes
broader arena into consideration. Wealth or Value of a business is defined as the market price of
the capital invested by shareholders.

It simply means maximization of shareholder’s wealth. It is a combination of two words viz.

wealth and maximization. A wealth of a shareholder maximizes when the net worth of a
company maximizes. To be even more meticulous, a shareholder holds share in the
company/business and his wealth will improve if the share price in the market increases which in
turn is a function of net worth. This is because wealth maximization is also known as net worth
maximization.

Finance managers are the agents of shareholders and their job is to look after the interest of the
shareholders. The objective of any shareholder or investor would be a good return on their
capital and safety of their capital.

Both these objectives are well served by wealth maximization as a decision criterion for
business.

Source of Wealth Creation

Normally, two types of environment are faced by us – one is external and other is internal. If
both the conditions support an organization, it tastes the success. A most important external
factor which creates value is industry attractiveness and a similar internal factor is the
competitive advantage of the firm. Two main sources of wealth creation or value creations are
the industry attractiveness and competitive advantage of the firm. Let us discuss them in little
more details.

Industry Attractiveness
One of the most important factors for a firm to make profits is its industry attractiveness.
Explained by Michael Porter, there are five forces of industry attractiveness which are as
follows:

1. Barriers to Competitor’s Entry: Higher the entry barrier, higher is the chances for a firm
to sustain for a long term.
2. Substitutes: Lower the substitutes, lesser are the chances of consumers switching the
products.
3. Bargaining Power of Buyers: Lesser the bargaining power of buyers, the firm becomes in
a better position to dominate terms.
4. Bargaining Power of Suppliers: Lesser the bargaining power of suppliers and buyers, the
firm becomes in a better position to dominate terms.
5. Competition among Competitors: It emphasizes the degree of competition which exists
between the current competitors of the industry. Amicable conditions among the
competitors would make the firms enjoy the better position.

Example of Wealth Maximization:

Typical examples of wealth maximization can be the cases where the shareholders have
benefited from investing in a particular stock over some time. Because the company’s net worth
has grown, this has positively impacted the share values, too and thus increasing shareholders’
wealth. A very practical example can be an investment made in 1996 for a US-based company
called Havells. It is observed that any investor who has invested in Havells to a tune of $1500 in
this stock in 1996 and has retained the stock till now have seen a massive gain from a mere
$1500 to $ 4,000,000.

This is what the company’s net worth has impacted the value of the stock and the wealth of the
shareholders. Wealth maximization not only happens in terms of stock value appreciation, but
there is one more way where one’s investment may make it grow significantly in terms of
companies providing dividends at successive intervals. The accumulation of these dividends and
stock value appreciation may also lead to gains for the shareholders.

Competitive Advantage

There are two elements of competitive advantage as per Michael Porter which are cost advantage
and differentiation advantage.

1. Cost advantage means the cost at which a firm producing the goods cannot be produced by
the competing firms at that cost. Due to this advantage, the firm can sell products at a lower
price than the competitors and still earn profit out of that. Customers are cost conscious and
therefore they are attracted towards the firm’s products. The firm enjoys good sales which
lead to more profits and better cash flows and therefore achieve wealth creation.
2. Differentiation advantage means the product offered by the firm can be easily differentiated
from other competitor’s products. The customers are convinced with a different p roduct
which is available only with the firm under concern. In such cases where the product is
unique, firms enjoy higher price and therefore this becomes the real source of value creation
for those firms.

Agency Problem
At times, wealth maximization may create conflict, known as agency problem. This describes
conflict between the owners and managers of firm. Owners appoints managers as their agents to
act on behalf of them. A strategic investor or the owner of the firm wo uld be majorly concerned
about the longer term performance of the business; that can lead to maximization of
shareholder’s wealth. Whereas, a manager might focus on taking such decisions that can bring
quick result, so that he/she can get credit for good performance. However, in course of fulfilling
the same, a manager might opt for risky decisions which can put the owner’s objectives at stake.
Hence, a manager should align his/her objective to broad objective of organization and achieve a
trade-off between risk and return while making a decision; keeping in mind the ultimate goal of
financial management i.e. to maximize the wealth of its current shareholders.

Difference between P rofit Maximization & Wealth Maximization

BASIS FOR WEALTH

PROFIT MAXIMIZATION
COMPARISON MAXIMIZATION

Concept The main objective of a concern The ultimate goal of the

is to earn a larger amount of concern is to improve the
profit. market value of its shares.

Emphasizes on Achieving short term Achieving long term

objectives. objectives.

Consideration of Risks No Yes

and Uncertainty

Advantage Acts as a yardstick for Gaining a large market

computing the operational share.
efficiency of the entity.

Recognition of Time No Yes

Pattern of Returns

Secondary 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, i.e, 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.

DuPont Analysis
What is DuPont Analysis?

DuPont Analysis is an extended examination of Return on Equity (ROE) of a company which

analyses Net Profit Margin, Asset Turnover, and Financial Leverage. This analysis was
developed by the DuPont Corporation in the year 1920.

In simple words, it breaks down the ROE to analyze how corporate can increase the return for
their shareholders.

Return on Equity = Net Profit Margin x Asset Turnover Ratio x Financial Leverage
= (Net Income / Sales) x (Sales / Total Assets) x (Total Assets / Total
Equity)

Individuals at all levels who would want to learn fundamental analysis and analysis beyond
valuations can register for Equity Research Analysis course certified by NSE Academy.

The company can increase its Return on Equity if it-

1. Generates a high Net Profit Margin.
2. Effectively uses its assets so as to generate more sales
3. Has a high Financial Leverage

What are the Components of DuPont Analysis?

DuPont analysis has 3 components to consider –
1. Profit Margin– This is a very basic profitability ratio. This is calculated by dividing the net
profit by total revenues. This resembles the profit generated after deducting all the expenses.
The primary factor remains to maintain healthy profit margins and derive ways to keep
growing it by reducing expenses, increasing prices etc, which impacts ROE.
For example; Company X has Annual net profits of Rs 1000 and Annual turnover of Rs
10000. Therefore the net profit margin is calculated as
Net Profit Margin= Net profit/ Total revenue= 1000/10000= 10%
2. Total Asset Turnover– This ratio depicts the efficiency of the company in using its assets.
This is calculated by dividing revenues by average assets. This ratio differs across industries
but is useful in comparing firms in the same industry. If the company’s asset turnover
increases, this positively impacts the ROE of the company.
For example; Company X has revenues of Rs 10000 and average assets of Rs 200. Hence the
asset turnover is as follows
Asset Turnover= Revenues/Average Assets = 1000/200 = 5
3. Financial Leverage- This refers to the debt usage to finance the assets. The companies
should strike a balance in the usage of debt. The debt should be used to finance the
operations and growth of the company. However usage of excess leverage to push up the
ROE can turn out to be detrimental for the health of the company.

For example; Company X has average assets of Rs 1000 and equity of Rs 400. Hence the
leverage of the company is as
Financial Leverage = Average Assets/ Average Equity= 1000/400 = 2.5

DuPont Analysis Interpretation

DuPont Analysis gives a broader view of the Return on Equity of the company. It highlights the
company’s strengths and pinpoints the area where there is a scope for improvement. Say if the
shareholders are dissatisfied with lower ROE, the company with the help of DuPont Analysis
formula can assess whether the lower ROE is due to low-profit margin, low asset turnover or
poor leverage.
Once the management of the company has found the weak area, it may take steps to correct it.
The lower ROE may not always be a concern for the company as it may also happen due to
normal business operations. For instance, the ROE may come down due to accelerated
depreciation in the initial years.
The DuPont equation can be further decomposed to have an even deeper insight where the net
profit margin is broken down into EBIT Margin, Tax Burden, and Interest Burden.
Return on Equity = EBIT Margin x Interest Burden x Tax Burden x Asset Turnover Ratio x
Financial Leverage

ROE = (EBIT / Sales) x (EBT / EBIT) x (Net Income / EBT) x (Sales / Total Assets) x (Total
Assets / Total Equity)

How is DuPont ROE calculated?

There are a few changes in the calculation part when calculating ROE under the two approaches.
Let us understand the difference in calculation. Basically in the DuPont analysis, the three
components discussed above are taken into account for calculation.

The simple ROE helps in the understanding the return generated by the company on its equity.
But the reasons behind that (whether good or bad) is understood by the DuPont analysis.
In simple ROE, we calculate

ROE = Net Income/ Total equity

But while calculating DuPont ROE, we include a few more factors and calculate it as follows,

DuPont ROE = (Net Income/ Sales) * (Net Sales/Total Assets) * (TotalAssets/Total Equity)
Or
Profit Margin * Total Asset Turnover * Equity Multiplier

This helps in understanding which component is impacting ROE more.

Limitations/Drawbacks
Although DuPont has many advantages as stated above, but everything has its own
disadvantages also.

 The DuPont analysis uses accounting data from the financial statement in its analysis which
can be manipulated by the management to hide discrepancies.

 It is only useful for comparison between the companies under the same industry.

Can DuPont analysis be applied on a zero debt company?

After learning a new concept of DuPont analysis, we must be wondering

that whether this analysis is also done on a debt free company? Whether this
analysis will have the same usefulness for a debt free company or not?
DuPont Analysis is equally useful when analysing a debt free company. The above
formula remains the same, with just one exception- the financial leverage component is taken as
1 and the rest remains the same. Therefore the DuPont analysis can be performed on all kinds of
companies.

DuPont Analysis Example:

Let’s analyze the Return on Equity of Companies- A and B. Both the companies are into the
electronics industry and have the same ROE of 45%. The ratios of the two companies are as
follows-
Ratio Company A Company B
Profit Margin 30% 15%
Asset Turnover 0.5 6
Financial Leverage 3 0.5
Even though both companies have the same ROE, howe ver, the operations of the companies are
totally different.
 Company A is able to generate higher sales while maintaining a lower cost of goods
which can be seen from its high-profit margin.
On the other hand, company B is selling its products at a lower margin but having very
high Asset Turnover Ratio indicating that the company is making a large number of sales.
Moreover, company B seems less risky since its Financial Leverage is very low.
Thus DuPont Analysis helps compare similar companies with similar ratios. It will help
investors to measure the risk associated with the business model of each company.

The Time Value of Money Concept

What is Time Value of Money – Definition

There is no reason for any rational person to delay taking an amount owed to him or her. More
than financial principles, this is basic instinct. The money you have in hand at the moment is
worth more than the same amount you ‘may’ get in future. One reason for this is inflation and
another is possible earning capacity. The fundamental code of finance maintains that, given
money can generate interest, the value of a certain sum is more if you receive it sooner. This is
why it is called as the present value.

Basically, the time value of money validates that it is more beneficial to have cash now than
later. Say, if you invest a Rs. 100 today – the returns will be more compared to the same
investment made 2 months from now. Moreover, there is always a risk that the borrower might
delay even more or not pay at all in the future.

Why is that the case?

There are few main reasons backing this theory:

1. Opportunity Cost: If you have capital on hand currently, the funds could be used to invest
into other projects to achieve a higher return — i.e. the “opportunity cost” of the money.

2. Inflation: There are risks to consider such as inflation or the probability that the company in
question might go bankrupt in the future — i.e. future uncertainty should be costlier than the
lower risks identified on the present date.
3. Present Consumption

4. Uncertainty

The Terminology of Time Value

 Present Value - An amount of money today, or the current value of a future cash flow
 Future Value - An amount of money at some future time period
 Period - A length of time (often a year, but can be a month, week, day, hour, etc.)
 Inte rest Rate - The compensation paid to a lender (or saver) for the use of funds expressed
as a percentage for a period (normally expressed as an annual rate)

Opportunity Cost
 Opportunity cost = Alte rnative use
– The opportunity cost of money is the interest rate that would be earned by investing it.
– It is the underlying reason for the time value of money
– Any person with money today knows they can invest those funds to be some greater amount
in the future.
– Conversely, if you are promised a cash flow in the future, it’s present value today is less than
what is promised!

Choosing from Investment Alternatives

There are three choices:
1. Rs.20,000 received today
2. Rs.31,000 received in 5 years
3. Rs.3,000 per year indefinitely
4. To make a decision, you need to know what interest rate to use.
– This interest rate is known as your required rate of return or discount rate.

Time Value of Money (TVM) with an Example

The relevance of TVM depends on how much returns you can generate from the capital
available. Money has immense growth potential and the more you delay employing this
potential, the more you lose the chance to earn on it. For instance, if a friend or lender gives you
two options – to take Rs. 10,000 today or to take Rs, 10,500 next year.

Now, even if this promise is from someone or an entity you trust implicitly, chances are more
that the second option is a raw deal. With more and more schemes ranging from low-risk to high-
risk – tax-saving FDs, ELSS et. – there is a high chance that you can make at least 7% on this
sum, which is Rs. 10,700. But if the interest rate offered is less than 5%, then you may consider
taking the money next year. So, it depends on the possible returns as per the RBI guidelines or
the market.

Present Value and Future Value

Present Value is the same as Time Value as elaborated above. It is the money you have currently
that is equal to a future one-time disbursal or several part-payments – discounted by a suitable
rate of interest.

Future Value is the sum of money that any saving scheme with a compounded interest will build
to by a pre-decided future date. It applies to both lump sum as well as recurring investments like
SIP.

Basic TVM Formula

FV of Single Flow / Compounding (Computing Future Values)
Compound interest is interest that is earned on the principal amount invested and on any accrued
interest.
FV = PV ((1+ i)n
With Multiple Compounding
(When compounding is done more than once in a year)
Based on your financial circumstances at the time, the TVM formula can vary to some extent.
Example, in the case of annuity (income) or perpetuity (until death) pension payments, the
general formula can have more components. But as a whole, the basic TVM formula is as shown
in the image.

FV = PV x [ 1 + (I/ N) ] (N*T)
Where,
FV is Future value of money,
PV is Present value of money,
I is the interest rate,
N is the number of compounding periods annually and
T is the number of years in the tenure.
FV of Uneven Cash Flows
Where n is the total number of periods from time 0 to the reference date for future value, we can
use the following formula to calculate future value:

FV = PV0 x (1+ i) n + PV1 x (1+ i) n-1 + PV2 x (1+ i) n-2…….

Simple Interest
 Simple interest is interest paid or received on only the initial investment (or principal).
 At the end of the investment period, the principal plus interest is received.

Value (Time n) = P + (N*P*K)

(Where: P = principal invested N = numbe r of years K = interest rate)

FV of an Annuity

F = P * [(1 + I) ^N – 1]/I
OR
n+
F = PV0 x (1+ i) (1+ i) n-1 + (1+ i) n-2…… + 1
Where
P = The payment amount
I = Equal to the interest (discount) rate
N = The number of payments (the “^” means N is an exponent)
F = The future value of the annuity

Present Value

PV of Single Flow / Discounting (Computing Present Values)

FV 1
  FV 
n
PV 0 n
(1  k ) ( 1  k)
n n

PV of Uneven Cash Flows

 Very often an investment offers a stream of cash flows which are not either a lump sum or an
annuity
 We can find the present or future value of such a stream by using the principle of value
additively.

FV0 FV1 FV2 FV3

………….
PV = (1+ i)0 + (1+ i)1 + (1+ i)2 + (1+ i) 3 +

Example (1)
 Assume that an investment offers the following cash flows. If your required
return is 7%, what is the maximum price that you would pay for this
investment?

100 200 300

PV     513 . 04
1 . 07  1 . 07  1 . 07 
1 2 3

Example (2)
 FV  300 1 . 05   500 1 . 05 
2 1
 700  1 , 555 . 75

PV of an Annuity

P = PMT × 1−((1+r)n1 )
r
Where:
P = Present value of an annuity stream
PMT = Amount of each annuity payment
r = Interest rate (also known as discount rate)
n = Number of periods in which payments will be made

Effective Interest Rate

What Is an Effective Annual Interest Rate?

An effective annual interest rate is the real return on a savings account or any interest-paying
investment when the effects of compounding over time are taken into account. It also reflects the
real percentage rate owed in interest on a loan, a credit card, or any other debt.

Example 1. - Suppose, for instance, one person has two loans, and each has a stated interest
rate of 10%, in which one compounds annually and the other compounds twice per year. Even
though they both have a stated interest rate of 10%, the effective annual interest rate of the loan
that compounds twice per year will be higher.

Effective Annual Interest Rate Formula

The following formula is used to calculate the effective annual interest rate:1

﴾ ﴿
EIR = 1+i n−1
n
Where:
i=Nominal interest rate n=Number of periods

Example 2.
Conside r these two offers: Investment A pays 10% inte rest, compounded monthly.
Investment B pays 10.1% compounded semiannually. Which is the better offer?
In both cases, the advertised interest rate is the nominal interest rate. The effective annual
interest rate is calculated by adjusting the nominal interest rate for the number of compounding
periods the financial product will undergo in a period of time. In this case, that period is one
year. The formula and calculations are as follows:

 For investment A, this would be: 10.47% = (1 + (10% / 12)) ^ 12 – 1

 And for investment B, it would be: 10.36% = (1 + (10.1% / 2)) ^ 2 – 1

Interpretation - Investment B has a higher stated nominal interest rate, but the effective annual
interest rate is lower than the effective rate for investment A. This is because Investment B
compounds fewer times over the course of the year. If an investor were to put, say, $5 million
into one of these investments, the wrong decision would cost more than $5,800 per year.

Doubling Period
The Rule of 72

• If time value of money tables or a financial calculator are not accessible and calculation is to
be done for how long it takes for particular money to be doubled…use the rule of 72!
72
Number of years to double 
Annual compound interest rate

If you expect to earn a 4.5% rate on your money it w ill double in :

72
  16 years
4.5

The Rule of 69