Distribution One

Financial Management

Ashish Pandey

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 What is the definition of Finance?

 Noun or Verb?
 Noun: “The science of the management of funds” (Merriam Webster)
 Verb: “To raise or provide funds or capital for …” (Merriam Webster)
 Plural noun form (Finances) has a different connotation: “Money or other liquid resources
of a government, business, group, or individual”

 Finance or Financial Decision Making is making “Investment, Financing, Control and

Payout” decisions.
 These decisions are relevant at different levels of unit of analysis.
 Household also invests, raises finance, keeps a budget and divests assets.
 So does a government.

 Our primary focus in this course will be firms (or corporates as commonly refer to them in
India)
 Course Objective: { What investment, financing , control and payout decisions a firm needs
to make? How a firm’s manager can make those decisions intelligently (relative term)? }

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 Decision Making Process

 What was the primary objective of the course?

 What investment, financing , control and payout decisions a firm needs to make? How a
firm’s manager can make those decisions intelligently?

 Operative word here is decision? What steps are involved in a decision making process?
 Simplistic decision making process
 List alternatives
 Estimate outcome for each alternative
 Rank those alternatives based on a defined metric
 Select the best feasible alternative

 What should be the overarching metric for you as a finance executive when making an
investment, a financing , a control or a payout decision?

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 Profit Maximization

 Is maximization of profit an accurately measurable goal?

 Denominator Issues. Absolute Profits?
 Frequency Issues. Quarterly , Annually?
 Time Value Issues. Lumpy, Continuous
 Quality of Earnings. Risky Cash Flow, Stable Cash Flow

 Maximize Shareholder Value i.e. Market Capitalization of the Firm

 Listing Status Issues: Unlisted Firms
 Definitional Issues: Enterprise Value or Market Capitalization
 Contribution Issues: What value you bring as a manager; isolate macroeconomic innovations

 For the purpose of this course, we will restrict to the normative definition of goal for a finance
executive:

“Create Value for Shareholders by doing something that they cannot do themselves”

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 How are firms structured?

 Sole Proprietorship: The simplest structure –one individual who owns and manages /operates the
enterprise
 Partnership: For business owned and operated by several individuals.
 Two varieties: general partnerships and limited partnerships. In a general partnership, the
partners manage the company and assume responsibility for the partnership's debts and
other obligations (jointly and severally).
 A limited partnership has both general partner (managing partner in India) and limited
partner. The general partners operate the business while the limited partners serve as
investors only. Partners owe debt only to the extent of their partnership contribution.

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 How are firms structured?

 Corporation: An independent legal entity, separate from its owners, with limited liability
protection. A corporation's debt is not considered that of its owners.
 Corporation is a separate legal entity - It can sue or be sued. It pays its own taxes.
 Shareholders elect a board of governors, board of governors appoint senior executives, and these
senior executives run the company. More on this – few minutes later.
 Characteristics of a corporation
 Private versus Public
 Both issue shares to raise equity capital
 Key Difference is in listing status and number of shareholder restrictions
 Other differences in compliance requirements, minimum capitalization etc.

 Limited Liability Company: An entity owned by members that offers liability protection. Liability
protection same as limited partnership but with some tax advantages (can elect to pay tax as
corporation). In default election, Profit and loss are passed through to the owners’ individual tax
returns. Not an Indian concept.

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 Claim on Assets

 A firm has some assets (tangible or intangible), or an expectation of future profit stream based
on some proprietary knowhow.
 A firm sells claim on these assets, or cash that will be generated by the assets to an external
party (bank for example)
 What is sells is a promise that I will pay you (lender or shareholder), a portion of cash-flow to
satisfy my obligation
 This promise to pay generates a notional asset called financial asset.
 Financial assets derive their value from a contractual claim on an underlying asset that may be
real or intangible. The underlying asset may exist today or may be expected to emerge in future.
 Financial asset can include loan, bonds, shares etc. – all of these are contractual claims to assets
or cash-flow of company (today or in future).

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 Simple and Compound Interest

 I invest INR 100,000 today in a bank and interest rate is 5% per annum. How much money
will I get after a year.
 100000*(1+5%) = 105,000
 I invest INR 100,000 today in a bank and interest rate is 5% per annum. How much money
will I get after two years.
 100000*(1+5%)2 = 110,250
 Why not 110000?
 I could have invested 100,000 in bank for 1 year at 5%. At end of year, bank would
have given me 105,000. I could have reinvested this 105,000 for another year.
 105000*(1+5%) = 100000*(1+5%)*(1+5%)
 This phenomenon of investing interest every period (for which interest is specified)
results in compounding and such interest is called compound interest.
 In general, Future Value = Present value (or Principal) * (1+r/m)mn
 In above example, interest of r percent per annum is paid m times in a year for n
years.
 How will the formula look if interest is paid only once a year?

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 Present Value with time and discount rate

100
Present Value

r=10%

r=15%

Time (Years)

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 Time Value of Money

 A Rupee today as compared to a Rupee one year later

 I invest INR 100,000 today in a project and one year later I will receive INR 103,000 for sure.
Should I invest?
 I invest INR 100,000 today in a project and one year later I will receive INR 115,000 for sure.
Should I invest?
 I invest INR 100,000 today in a project and three years later I will receive INR 126,000 for sure.
Should I invest?

 One key concept in making investment decision is to compare investment and return at the
same period of time
 Hence, bring back future cash flows to the current time period (Present Value or discounting)

 Let us assume that equivalent investment alternative will yield me 8% per annum return.
 More on appropriate discount rate later.

 INR 103,000 1 year later is worth 103,000 / (1+8%) to me today. Or 103,000/1.08 = INR
95,370 today.
 Investing INR 100,000 to get INR 95,370 is never a good idea, in general (exceptions exist)

 The rate of return used for discounting (a rate of return offered by equivalent investment
alternative) is called discount rate, hurdle rate or opportunity cost of capital.
 The inverse of denominator [1/(1+r)n] or 1/1.08 = 0.926 in our case is called discount
factor.
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 Net Present Value (Simplistic Case)

 Difference between present value and net present value?

 I invested INR 100,000 today in a project and one year later I will receive INR 103,000 for
sure.
 We assumed that equivalent investment alternative will yield me 8% per annum return.
 The present value (PV) of INR 103,000 received 1 year later is worth 103,000/1.08 = INR
95,370 today.
 Net Present Value is nothing but sum of all cash flows from a project or investment on
today’s date.
 What will be NPV in our case?
 -100000 + 95370 = - 4,630

 Never invest in a negative NPV project

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 Net Present Value (Multiple Timings)

 I invest in a real estate project. Say a house. Project requires following investment:
 $50,000 today to buy land.
 $75,000 six months later to pay contractor for construction.(construction starts at month 6)
 The house can be sold immediately after construction and will be sold at $135,000 for sure.
Construction timeline is 6 months. Should I invest?
 Present value of investment outflow at 8% discount rate:
 50,000/1 + 75000/1.04 (??) = $122,115 (NO)
 50,000/1 + 75000/1.0392 = $122,168
 Present value of sales proceeds = 135000/1.08 = $125000
 NPV = Inflow – Outflow = 125000-122168 = $2,832
 I invest in another real estate project of house and shop. Project requires investment:
 $75,000 today to buy land, $100,000 six months later to pay for construction
 The house can be constructed in six months (after construction starts) and will be sold at
$135,000 after a year from today. The shop will be sold after 18 months for $50,000 from today.
Should I invest?
 Present value of investment at 8% discount rate: 75000/1 + 100000/(1.08)0.5 = $171,225
 Present value of sales proceeds = 135000/1.08 + 50000/(1.08)1.5 = $169,548
 NPV = Inflow – Outflow on today’s date = 169548-171225 = -$1,676
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 Present Value (Semiannual and Quarterly Payments)

 PV = Cn / (1+r/m)mn
 Cn is the cash flow at the end of year n, m is the number of times a year interest is
compounded, and r is the discount rate.
 The present value of $100 to be received at the end of year 3, discount rate being 8% and
compounded quarterly will be:
 PV = 100 / (1+0.08/4)4*3 = 78.85
 This is different from what the present value of $100 to be received at the end of year 3
will be, discount rate being 8% and compounded annually.
 Will it be higher or lower?
 PV = 100 / (1+0.08 /1)1*3 = 79.38
 You get more interest when compounded often or less?
 Hence your opportunity cost or hurdle rate increases when compounding is more frequent
 If hurdle rate is more, PV for the same amount of future cashflow at the same future
period will be less or more?

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 Present Value with time and discount rate

100
Present Value

r=10%, compounded annually

r=10%, Compounded semiannually

Time (Years)

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 Perpetuity

 Perpetuity are investments that pay a coupon every period (till infinity) but the principal is
not returnable.
 Example: I pay $100 today to buy a perpetual bond of Yes Bank that yields 10% per annum
in perpetuity. Yes Bank will pay me $10 every year starting next year (or to holder of bond
after my death).
 What is the value of this bond?
 PV of all future cashflows
 C/(1+r) + C/ (1+r)2 + C / (1+r)3 + ……+ C / (1+r)n where n tends to infinity
 If the payment is constant, the value of perpetuity is: C/r where C is cash payment every
period and r is discount rate per period.
 In above case, if my discount rate was 8%, the value of bond is 10/0.08 = $125
 For mathematically inclined friends, we will derive C/r
 What if perpetuity is growing every year, let’s say by g% every year.
 PV of perpetuity is C/(1+r) + C (1+g)/ (1+r)2 + C (1+g)2/ (1+r)3 ……
 The above expression will simplify to C /(r-g)
 Should we derive this again? It is easy ..same logic as earlier, just the common ratio now is
(1+g)/(1+r)

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 Annuity

 Annuity are investments that pay a coupon every period for a specified period of time but
the principal is not returnable.
 What is the difference with perpetuity?
 PV of perpetuity providing cash C in each year beginning from year 1, and disc. rate is r:
 PV = C/r
 FV of perpetuity providing cash C in each year beginning from year t+1 at year t:
 PV = C/r
 PV of perpetuity providing cash C beginning from year t+1 at year 0: C/r (1+r)t
 Difference between two perpetuities is annuity of year t providing cash C every year.
 Value of Annuity today : C/r - C/r (1+r)t = C (1 /r – 1/ r(1+r)t )
 Difference between two perpetuities is annuity of year t providing cash C every year.

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 Amortizing Loans

 Amortizing Loan: A loan with reducing principal. Example is home loan. We pay equal
monthly instalment. Initially a large proportion of monthly payment goes towards interest
payment and small amount towards principal payment.
 How to calculate EMI? Suppose a 30 year loan of $100,000 with 1% monthly interest.
 For a lender in this case, your EMI make a 30 year annuity for him.
 And the present value of annuity is known, it has to be $100,000. Why will lender give you
anything more (and why will you take anything less).
 Value of Annuity today : C/r - C/r (1+r)t = C (1 /r – 1/(1+r)t ) = 100,000
 In above C will be your monthly payment (unknown), r will be monthly interest rate of 1%
and t will be 360 months.
 Only 1 unknown in a single equation, we can solve this if we plug in numbers.
 C(1/0.01 – 1/0.01 (1+0.01)360) = 100,000 or C = 1028.6

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 Bonds

 Bond is simply a long term debt taken by the Government or Company

 If the government is borrower, we call the debt as treasury bond
 If the company is borrower, we call the debt as corporate bond
 Difference between bond and loan: bonds are generally tradeable in the market while
loans are bipartite agreements that aren’t traded.
 Other differences in terms of public versus private monitoring, when to stop a project
etc. exist but those are beyond the scope of this course.
 Terminology related to bonds.
 Face Value: Principal amount due at maturity
 Coupon: Interest paid by the bond (generally semiannually or annually)
 Tenor: Time between issuance and maturity
 Zero Coupon Bond: Bond that pays zero coupon
 Par Bond: A bond which is trading at face value
 Premium Bond : A bond which is trading above face value
 Discount Bond: A bond which is trading below face value
 Yield to Maturity : IRR (discount rate that sets NPV to zero)

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 How to value a bond?

 Just calculate present value of interest payment and principal repayment.

 Suppose on 1st January 2021, you purchased an Indian government 10 year tenor, zero
coupon bond with face value of 100. YTM is 12% (investors want 12% return as a
comparable investment with same risk delivers 12%). How much will you pay for this bond?
 PVbond = 100 /(1.12)^10 = 32.20
 Premium bond or discount bond?
 What will happen to bond price if discount rate increases to 13%?
 PVbond = 100 /(1.13)^10 = 29.46
 If interest rates go up, in general, bond prices go down
 Let us now look at a coupon paying bond. On 1st January 2021, you purchased an
Indian government 10 year tenor, 8 percent coupon bond with face value of 100. YTM
is 12%
 How much will you pay for this bond? More than zero coupon bond above or less?
 = 8/(1.12)+ 8/(1.12)2 + 8/(1.12)3 + 8/(1.12)4 + 8/(1.12)5 + 8/(1.12)6 + 8/(1.12)7 + 8/(1.12)8
+ 8/(1.12)9 + 8/(1.12)10 + ?/(1.12)10 = 77.4
 What will happen to this bond price when interest rate go up?
 When can we expect that a bond will trade at a premium?

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 Different metrics to evaluate capital decisions: Internal Rate of Return

3. IRR: IRR of an investment project is the discount rate that equates the present value of cash
outflows to the present value of cash inflows. A rate ‘r’ such that:
Σ[(Ct/(1+r)t)] = 0 or
NPV = C0 + C1/(1+r)1 + C2/(1+r)2 +…. + Ct/(1+r)t = 0

IRR
NPV

Discount Rate

 We can calculate IRR manually by trial and error method. Use some arbitrary initial value and
calculate NPV. If NPV is positive, then increase IRR or vice versa. Calculate new NPV. Continue
this adjustment till NPV is zero.

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 Internal Rate of Return: Example

Project Year 0 Year 1 Year 2 Year 3 Year 4 IRR NPV@10%

A -23616 10000 10000 10000 10000 25% 8083

IRR 23616 29520 24400 18000 10000

NPV 31699 34869 27355 19091 10000

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