Basics of Financial Management &

Time Value of Money

 Suggested Readings
1. Financial Management - [Link] – Vikas Publishing
2. Financial Management – Texts, Problem & Cases –Khan & Jain –
McGraw Hill
3. Financial Management –Prasanna Chanadra –McGraw Hill
4. Principles of Corporate Finance –Brealey, Myers, Allen & Mohanty- MC
Graw Hill Education
 Nature of Financial Management
• Basic Finance Functions:
• Financing or Capital Mix Decision - Capital Structure
• Investment or Long Term Asset Mix Decision - Capital Budgeting
• Liquidity or Short Term Asset Mix Decision - Working Capital
Management
• Profit Allocation Decision – Dividend Decision
Role of Finance Manager:
• Raising of Funds
• Allocation of Funds
• Profit Planning
• Understanding Capital Markets
 Financial Indicate any place or system that provides buyers
and sellers the means to trade financial instruments,
Markets
including bonds, equities, the various international
currencies, & derivatives

Futures Price is determined when the contract is signed &

the asset is exchanged on a pre-determined future
Market date
Value of the contract fluctuates until the expiration
date

Spot Market Price is determined at the time of trade, & the asset is
immediately transferred to the buyer - based on
current market conditions, & can change frequently
 Future Markets
Financial
Markets Spot Markets
Capital
Money Market
Market Securities like stocks and bonds are bought & sold
to raise LT funds for businesses & governments
• Organized exchange market where
participants can lend and borrow 1) New Issue/ Companies issue new issues of common
short-term, high-quality debt Primary Market & preferred stocks, notes, bills, &
securities with average maturities government bonds directly to the public
of one year or less 2) Secondary Already issued securities are traded
• Enables governments, banks, & Market
other large institutions to sell ST Trades securities not listed on major
securities to fund their ST cash OTC Market exchanges - dealers quote prices for
flow needs purchasing & selling a currency/ security/
other financial products, as market-
Foreign Exchange Market makers
 Equity shares - shareholder, as a fractional owner,
Capital Market Instruments
undertakes the maximum entrepreneurial risk
(Pure/Hybrid/Derivatives) associated with the company & has voting rights
Preference shares - shareholder is Debenture includes debenture stock, bonds & any
entitled to a fixed dividend or other securities of a company, whether constituting a
dividend calculated at a fixed rate charge on the assets of the company or not; having a
to be paid regularly before fixed coupon rate
dividend can be paid in respect of
equity shares
Sweat equity share is an instrument permitted to be issued by specified Indian companies,
under Section 2(88) of Companies Act, 2013 - a company issues to its employees or
directors at a discount or in exchange for something other than cash - Gateway Rail
Freight Limited
A Tracking stock is a specific type of stock issued by a parent company to represent the
performance of a certain business sector or subsidiary - do not provide ownership of the parent
company's assets - Daisy Corporation, a technology conglomerate, created it to represent the
performance of its technology division
Capital Market Instruments Derivatives are contracts which derive their values
from the value of an underlying asset
(Pure/Hybrid/Derivatives)
1) Forward: a tailored agreement between two parties to buy or sell an asset/product/
commodity at a defined price at a future date - traded on OTC exchanges - not standardized to
be controlled - effective for hedging & reducing risk

2) Option: is a contract or agreement between two parties to buy or sell any form of security
at a certain price in the future - parties do not have legal responsibility to keep their end of
the contract - can sell or buy the security at any time
3) Future: financial contracts that are basically identical to forwards, with the main
distinction being that features can be exchanged on exchanges, resulting in standardization
and regulation - frequently utilized in commodity speculation
4) Swaps: used to convert one type of cash flow into another - private agreements between
parties that are primarily exchanged over the counter and are not traded on stock exchanges
- Currency swaps and interest rate swaps are the two most popular types of swaps
What should be the objective of Financial management?
• Profit maximization (profit after tax - PAT)
• Maximizing Earnings per Share (EPS)
• Shareholders’ Wealth Maximization
 Profit Maximization
• Maximizing the Rupee Income of Firm
• Resources are efficiently utilized
• Appropriate measure of firm performance

• Objections to Profit Maximization

• It is Vague – No precise connotation
• Ignores the Timing of Returns
• Periods Alt. A(₹) Alt. B (₹)
I 50 -
II 100 100
III 50 100
• Ignores Risk & Assumes Perfect Competition
• In new business environment profit-maximization is regarded as Unrealistic /
Difficult/ Inappropriate / Immoral
 Maximizing EPS
• Ignores timing & risk of the expected benefit.

• Market value is not a function of EPS - hence maximizing EPS will not
result in highest price for company's shares

• Maximizing EPS implies that the firm should make no dividend

payment so long as funds can be invested at positive rate of return—
such a policy may not always work
 Shareholders’ Wealth Maximization

• Maximizes the net present value of a course of action to shareholders

• Accounts for the timing and risk of the expected benefits
• Benefits are measured in terms of cash flows
• Fundamental objective—maximize the market value of the firm’s
shares
Concept of Time Value of Money
 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:
• risk
• preference for consumption
• investment opportunities

Time Value of Money: Two most common methods of adjusting cash flows for time
value of money:
• Compounding —the process of calculating future values of cash flows &
• Discounting —the process of calculating present values of cash flows

Managers rely primarily on present value techniques as they are at Zero time (t=0)
when making decisions.
 FV of a Cash Flow Stream
• FVt = CF0 * (1+r)t
• If compounding is done more than once a year, the actual annualized rate of
interest would be higher than the nominal interest rate & it is called the
effective interest rate
𝑖 𝑛∗𝑚
• EIR = (1 + ) −1
𝑚
• Annuity is a fixed payment (or receipt) each year for a specified number of
years - if one rents a flat and promise to make a series of payments over an
agreed period, the customer has created an annuity

• Or FV = A * FVIFA ( Future Value Factor of an Annuity)

 Sinking Fund
• Allows businesses that have floated bonds to prevent a large lump-
sum payment at maturity - some bonds are issued with a sinking
fund feature attached to them
• A bond sinking fund is an Escrow Account (the third party account which
holds the asset until the conclusion of a specific event or time - an
independent trustee) into which a company places cash that it will
eventually use to retire a bond liability that it had previously issued

(1+𝑖)𝑛 −1 𝑖
• FV =A[ ] & A = FV [ 𝑛 ]
𝑖 (1+𝑖) −1
• The factor used to calculate the annuity for a given future sum is called the
sinking fund factor (SFF)
 Sinking Fund………
• RLB ltd. desires to create a BSF to retire a bond of ₹10 million
at the end of 5 years with an effective rate of interest of
12%pa. What will be the annuity for this BSF?

• FV of an annuity of ₹ 1 after 5 years = {(1/0.12) [(1+0.12)5 – 1]} =

8.3333 (1.7623 – 1) = 6.3525
• If the amount of annuity is ‘x’, then
• 6.3525x = 100,00,000
• or x = ₹15,74,183
 Present Value
• Present value of a future cash flow (inflow or outflow) is the
amount of current cash that is of equivalent value to the
decision-maker.
• Discounting is the process of determining present value of a
series of future cash flows.
• The interest rate used for discounting cash flows is also
called the discount rate.
 Present Value of an Annuity
• Computation of the PV of an Annuity can be written in the
following form:
1 1 (1+𝑖)𝑛 −1
•P=A[ − 𝑛 ] or A [ 𝑛 ]
𝑖 𝑖(1+𝑖) 𝑖(1+𝑖)
• The term within parentheses is the PV factor of an annuity of ₹1, which we
would call PVFA, and it is a sum of single-payment present value factors

• An executive is about to retire at the age of 60. His employer has offered
him two post-retirement options- (a) ₹20,00,000 lump sum, (b) ₹2,50,000 for
10 years. Assuming 5% rate of interest, which one is a better option?

• PV of annuity= ₹2,50,000 X 7.722 =₹19,30,500 - since lump sum of

₹20,00,000 is more now, the executive should opt for it
 Capital Recovery and Loan Amortisation
• Capital recovery is the annuity of an investment made today for a
specified period of time at a given rate of interest - Capital recovery factor
helps in preparing a loan amortisation (loan repayment) schedule

𝑖(1+𝑖)𝑛
• A= P[ 𝑛 ]
(1+𝑖) −1

• Assume that you have borrowed ₹10 lakh from a financial institution in
the form of an educational loan at an interest of 14% p.a. The loan is to be
cleared in five equal installments. Prepare a loan amortization schedule.
• Annual Installment = ₹10,00,000 ÷ PVAF (5, 0.14);
• ₹10,00,000 ÷ 3.433 = ₹2,91,290
 Example……(Schedule)
• Year Loan Due Installment Interest Principal
component Component

1 10,00,000 2,91,290 1,40,000 1,51,290

2 8,48,710 2,91,290 1,18,820 1,72,470

3 6,76,240 2,91,290 94,674 1,96,616

4 4,79,624 2,91,290 67,148 2,24,142

5 2,55,480 2,91,290 35,767 2,55,523

(Rounding off Error) (Rounding off Error)
 PV of an Uneven Periodic Sum
• Investments made by of a firm do not frequently yield
constant periodic cash flows (annuity)
• In most instances the firm receives a stream of uneven cash
flows - thus the present value factors for an annuity cannot be
used
• The procedure is to calculate the present value of each cash
flow and aggregate all present values
 PV of Perpetuity
• Perpetuity is an annuity that occurs indefinitely - fixed coupon
payments on permanently invested (irredeemable) sums of
money - e.g. scholarships paid perpetually from an endowment -
not very common in financial decision-making:

• PV of a perpetuity = [Perpetuity / Interest rate]

• Present value of a perpetuity of ₹150,000 each year if the discount

rate is 14% should be = (150,000/0.14) = ₹10,71,428
 PV of Growing Annuities
• The present value of a constantly growing annuity is given below:
𝐴 1+𝑔 𝑛
•P= [1 − ( ) ]
𝑖 −𝑔 1+𝑖

• Present value of a constantly growing perpetuity is given by a simple

formula as follows:
𝐴
•P=
𝑖 −𝑔

• A company paid a dividend of ₹60 last year. The dividend stream

commencing one year is expected to grow at 10% p.a. for 15 years and
then ends. If the discount rate is 21%, what is the present value of the
expected series?

• ₹414.87
 Value of an Annuity Due
• Annuity due is a series of fixed receipts or payments starting at the beginning
of each period for a specified number of periods (e.g. Insurance premium
payable on a life insurance policy)

• The Future Value of an annuity due is calculated by moving each payment to

the end of the last payment interval & then adding up the future values - helps
in understanding how much the investment will be worth in the future

(1+𝑖)𝑛 −1
• Future Value of an Annuity Due = CF [ ] * (1+i)
𝑖
• If you deposit ₹ 15,000 at the beginning of each year for eight years at a 6%
interest rate, what will be the future value of the annuity due?
• ₹15,000* 9.8967* 1.06 = ₹1,57,358
 Value of an Annuity Due
• The Present Value of an annuity due tells us the current
value of a series of expected annuity payments - it indicates
what the future total to be paid is worth now
• For an annuity due, payments are made at the beginning of
the interval, and for an ordinary annuity, payments are made
at the end of a period
(1+𝑖)𝑛 −1
• Present Value of an Annuity Due = CF [ 𝑛 ] * (1+i)
𝑖(1+𝑖)
• You as a beneficiary are supposed to receive ₹ 15,000 at the
beginning of each year for eight years at a 6% interest rate,
what will be the present value of the annuity due?
• ₹15,000* 6.2095* 1.06 = ₹98,731