Financial Management

Introduction
Financial Management (FM)
• Finance relates to Money.
• Broader scope of money includes anything that has monetary value.
• Financial Management is management of investments and financing
mix of a business in an optimal manner.
Financing Mix Investments
Liabilities & Owner’s Equity Assets
Current Liabilities Current Assets
Long term Debt Fixed Assets
Owner’s Equity
Functions of Financial Management
Inflow - - - - - - - - - - - - Outflow
Functions of Financial Management

-- -------------------
Inflow - - - - - - - - - - - - Outflow

Financing Investment Dividend Policy

Debt Current Assets Dividend Payment

Equity Fixed Assets Retained Earning
Functions of Financial Management
Inflow - - - - - - - - - - - - Outflow

Financing Investment Dividend Policy

Debt Current Assets Dividend Payment

Equity Fixed Assets Retained Earning

Interest

Profit 😀
or Loss 😒
Functions of Financial Management
Inflow - - - - - - - - - - - - Outflow

Financing Investment Dividend Policy

Debt Current Assets Dividend Payment

Equity Fixed Assets Retained Earning

Cash Building
AC Receivable Land
Inventory Machinery
Equipment
Etc etc
Functions of Financial Management
Inflow - - - - - - - - - - - - Outflow

Financing Investment Dividend Policy

Debt Current Assets Dividend Payment

Equity Fixed Assets Retained Earning

Portion of Profit Paid to Shareholder

Earnings that are retained for re-use

Considered as “Cash Asset”

 Functions of Financial Management
Inflow - - - - - - - - - - - - Outflow

Financing Investment Dividend Policy

Debt Current Assets Dividend Payment

Equity Fixed Assets Retained Earning

Interest Cash Building Portion of Profit Paid to Shareholder

Return is Must ….. No Risk AC Receivable Land
Profit 😀 Inventory Machinery Earnings that are retained for re-use
Return is Fixed …… Limited
or Loss 😒 Equipment
Etc etc Considered as “Cash Asset”
 Functions of Financial Management
Inflow - - - - - - - - - - - - Outflow

Financing Investment Dividend Policy

Debt Current Assets Dividend Payment

Equity Fixed Assets Retained Earning

Interest Cash Building Portion of Profit Paid to Shareholder

AC Receivable Land
Return is Uncertain Profit 😀 Inventory Machinery Earnings that are retained for re-use
or Loss 😒 Equipment
Return increases with Considered as “Cash Asset”
Etc etc
increased profits
 Functions of Financial Management
Inflow - - - - - - - - - - - - Outflow

Financing Investor’s Perspective Firm’s Perspective

Debt . . . . . . . . . . . . . Less Risk . . . . . . . . . . . . . . . . . . More Risk

Equity . . . . . . . . . . . . . More Risk . . . . . . . . . . . . . . . . . . Less Risk

Interest
Return is Uncertain Profit 😀
or Loss 😒
Return increases with
increased profits
Functions of Financial Management
Inflow - - - - - - - - - - - - Outflow

Financing Investment Dividend Policy

Debt Current Assets Dividend Payment

Equity Fixed Assets Retained Earning

Capital Structure
Financing
• How much of debt to be used.
• Mix of debt and equity is referred to as capital structure.
Source Risk for Return for Risk for firm Cost for Firm
Investor Investor
Debt Lower Lower Higher Lower
Equity Higher Higher Lower Higher

• Debt holder transfers (operational/ business) risk to firm, and expect lower return
• Firm transfers (operational/ business) risk to equity holders, who expect higher
returns for higher risks.
Functions of Financial Management
Inflow - - - - - - - - - - - - Outflow

Financing Investment Dividend Policy

Debt Current Assets Dividend Payment

Equity Fixed Assets Retained Earning

Less Investment Bigger Investment

Limited Return Huge Return

Capital Structure Working Capital Mngt. Capital Budgeting

Investment
• Where to invest?
• Fixed Assets – Capital Budgeting
• How much to invest in working capital.
• Current Assets – Working Capital Management

Investment Profits Risk

Fixed Assets Higher Higher
Current Assets Lower Lower
Dividend Policy
• How much to retain/ reinvest in business?
• How much to pay as dividend?

New
(External)
Equity
Retained
Additional
Earnings/
(External)
Internal
Debt
Equity

New
Investment/
Growth
(Financial) Goal of a Firm
• Profit Maximization ????????

NO
(Financial) Goal of a Firm – Cont.
• Profit Maximization
• Profits represent past performance.
• Accounting profits could be manipulated.
• Profits are made available after long intervals – Quarterly at best.
• So what?????
 2020 2021 2022 2023 2024 2025 2026 2027 2028 2029 2030

10 Lac 10 Lac 1 Lac

2020 2021 2022 2023 2024 2025 2026 2027 2028 2029 2030

10 Lac 9.1 Lac 1 Lac

9 Lac / 10 Years = 90,000

9 Lac / 20 Years = 45,000

(Financial) Goal of a Firm – Cont.
• Profit Maximization
• Profits represent past performance.
• Accounting profits could be manipulated.
• Profits are made available after long intervals – Quarterly at best.
• So what?????
(Financial) Goal of a Firm – Cont.
• Maximization of Shareholders Wealth
• Focused on Future Cash Flows
• Information available on daily basis – in Stock Markets.
• Reflects all available information – Efficient Market Hypothesis

Stock Princes are based on all available information.

Basic Principles of Finance
• Risk – Return Trade Off
• More Risk – More Return Expected Utility Theory

• Time Value of Money

• A Dollar received today has more value than a dollar received tomorrow.
• Cash flows are important – Not accounting income/ profits.
• Only consider cash inflows and cash outflows.
• Non Cash items like Depreciation do not have direct relevance to financial
management (Depreciation is only relevant because of its tax benefits).
• Incremental (Marginal/ Differential) cash flows are important for
financial decision making.
Basic Principles of Finance – Cont.
• The Agency Problem
• Principal (Investor) – Agent (Manager) conflict.
• Managers keep self interest ahead of investor’s interest.
• The Curse of Competitive Markets First Mover Competitive Advantage If Yes,
• No abnormal profits in the long run. - Can not be imitated We get SUSTAINABLE
- Continuously. COMP. ADVANTAGE
• Efficient Capital Markets
• Market Prices reflect all available information. Prices are always right and quickly
adjust to new information.
• Taxes
1. Weakare important
Form considerations.
Efficient Market Past Prices, Volume
• WeStrong
2. Semi Efficient
consider after taxMarket
cash flows. Past Prices, Volume, Public Info.
• Tax payments
3. Strong and TaxMarket.
Form Efficient benefits. Past Prices, Volume, Public Info., Insider Info
Basic Principles of Finance – Cont.
• All risk is not equal.
• Risk diversification
• Systematic (Market/ undiversifiable) vs. unsystematic (specific/ diversifiable)
risks
• Ethical behavior is doing the right thing.
• How would you feel if your action is published on front page of a main stream
news paper??
TIME VALUE OF MONEY
What the **** is Economics
 TIME VALUE OF MONEY
Economics
Allocation of Scarce Resource
which have alternative uses in a
way to Maximize Value
We can either
1. Consume the Money TODAY for something providing utility . . . . Or we can
2. Delay the Consumption, to Invest it, to make
3. More Money for More Consumption (More Utility)
4. in Future
 TIME VALUE OF MONEY
A dollar received today has greater value than a dollar received tomorrow
FVn = PV x ( 1 + i )n
FV = Future Value
PV = Present Value
i = Interest Rate
N = Future Time (No. of Years)
We can either
1. Consume the Money TODAY for something providing utility . . . . Or we can
2. Delay the Consumption, to Invest it, to make
3. More Money for More Consumption (More Utility)
4. in Future
 TIME VALUE OF MONEY
A dollar received today has greater value than a dollar received tomorrow
FVn = PV x ( 1 + i )n
FV = Future Value
PV = Present Value
i = Interest Rate
N = Future Time (No. of Years)

Periods 0 1 2 3
Interest Rate

Cash Value PV FV

Cash flows are positive initially for borrower, then gradually negative every year. Vice Versa for Lender
 TIME VALUE OF MONEY
A dollar received today has greater value than a dollar received tomorrow
FVn = PV x ( 1 + i )n

Find the FV of $100 compounded for 3 years at 5%

Periods 0 1 2 3
Interest Rate

Cash Value PV FV
 TIME VALUE OF MONEY
A dollar received today has greater value than a dollar received tomorrow
FVn = PV x ( 1 + i )n
Step by Step Approach
Formula Approach
Financial Calculator Approach
Spreadsheet Approach

Periods 0 1 2 3
Interest Rate

Cash Value PV FV
 TIME VALUE OF MONEY
A dollar received today has greater value than a dollar received tomorrow
FVn = PV x ( 1 + i )n
Step by Step Approach Find the FV of $100 compounded for 3 years at 5%
Formula Approach
Financial Calculator Approach
Spreadsheet Approach 115.76
Periods 0 1 2 3
Interest
5%Rate 5.25 5.51

Cash Value 100

PV 105 110.25 115.76
FV
 TIME VALUE OF MONEY
A dollar received today has greater value than a dollar received tomorrow
FVn = PV x ( 1 + i )n
Step by Step Approach Find the FV of $100 compounded for 3 years at 5%
Formula Approach FVn = 100 x ( 1 + 0.05 )3
Financial Calculator Approach
Spreadsheet Approach
FVn = 100 x 1.1576 = 115.76
Periods 0 1 2 3
5% 5.25 5.51

Cash Value 100 105 110.25 115.76

 TIME VALUE OF MONEY
A dollar received today has greater value than a dollar received tomorrow

Suppose you have some extra money and want to make an investment. A
broker offers to sell you a bond that will pay a guaranteed $115.76 in 3 years.
Banks are currently offering a guaranteed 5% interest on 3-year certificates of
deposit (CDs), and if you don’t buy the bond you will buy a CD. The 5% rate paid
on the CD is defined as your opportunity cost, or the rate of return you would
earn on an alternative investment of similar risk if you don’t invest in the
security under consideration. Given these conditions, what’s the most you
should pay for the bond?
 TIME VALUE OF MONEY
A dollar received today has greater value than a dollar received tomorrow

First, recall from the future value example in the last section that if you invested
$100 at 5% in a CD, it would grow to $115.76 in 3 years. You would also have
$115.76 after 3 years if you bought the bond.

Therefore, the most you should pay for the bond is $100—this is its “fair price,”
Which means, if you could buy the bond for less than $100, then you should
buy it rather than invest in the CD. Conversely, if its price were more than $100,
you should buy the CD. If the bond’s price were exactly $100, you should be
indifferent between the bond and the CD.
 TIME VALUE OF MONEY
A dollar received today has greater value than a dollar received tomorrow

Future Value Compounding FVn = PV x ( 1 + i )n

Present Value Discounting PVn = FVn

( 1 + i )n
VS
Simple Interest
Growth of $100 When Compounding
 TIME VALUE OF MONEY
Assume that 1 year from now you plan to deposit $1,000 in a savings
account that pays a nominal rate of 8%.

a. If the bank compounds interest annually, how much will you have in
your account 4 years from now?

b. What would your balance be 4 years from now if the bank used
quarterly com- pounding rather than annual compounding?
1. If you deposit $10,000 in a bank account that pays 10% interest
annually, how much will be in your account after 5 years?

2. What is the present value of a security that will pay $5,000 in 20

years if securities of equal risk pay 7% annually?

3. Your parents will retire in 18 years. They currently have $250,000,

and they think they will need $1 million at retirement. What annual
interest rate must they earn to reach their goal, assuming they don’t
save any additional funds?

4. If you deposit money today in an account that pays 6.5% annual

interest, how long will it take to double your money?
 ANNUITIES
If the payments are equal and are made at fixed intervals
then we Call it An Annuity

Ordinary Annuity
Payments are made at the end of each period Car Financing

Annuity Due
Payments are made at the start of each period Rent
 ANNUITIES
If the payments are equal and are made at fixed intervals
then we Call it An Annuity
Periods 0 1 2 3
5%
Ordinary Annuity
Payments -100 -100 -100

Periods 0 1 2 3
Annuity Due 5%

Payments -100 -100 -100

Annuities must have; 1. Constant Payments 2. Fixed Payments

 ANNUITIES
If the payments are equal and are made at fixed intervals
then we Call it An Annuity

Ordinary Annuity

Annuity Due
Annuity
You have $42,180.53 in a brokerage account, and you plan to deposit an
additional $5,000 at the end of every future year until your account
totals $250,000. You expect to earn 12% annually on the account. How
many years will it take to reach your goal?