Financial Management

Overview/ Financial Mathematics

Heshana Kuruppu

Overview
- External environment and Financial Manager
- Evolution of Finance
- Objective of the firm
Maximize shareholders wealth
Conflicts will arise that move organization away from above
objective
i. Competing interest between short term profit maximization Vs
long term wealth maximization
ii. Competing interest between management and shareholders.
iii. Social responsibility

Key Financial Management Decisions

i. Investment decisions
ii. Dividend decisions
iii. Financing decisions and Ownership Structure Decisions
The amount, timing and risk of cash flows generated by a
firm are largely depend on above financial decisions.

Financial Mathematics

Simple interest
Ex:
Investment value $ 100,000
Interest rate p.a. 12%
Interest for the year?
Interest for 6 months ?
Interest for 5 years ?
Total amount after 3 years?

I= P X r X t
I= Amount of Interest
P=Principal
r = interest rate per annum
t = number of years

Compound interest
Ex:
Investment value $ 100,000
Interest rate p.a. 12%
Interest for the year?
Interest for 6 months ?
Interest for 5 years ?
Total amount after 3 years
FV = P0 (1+i)
n

FVn= Compound value at the end of n period

P0=Principal at the start of first period
i = interest rate per period
n = number of periods
Other information same as above, Interest is compounded monthly/Quarterly /Semiannually.
What's your year end value under above three different time intervals?
Show interest earned under different scenarios.
What is your effective rate under different scenarios?

Effective Rate of Return

Nominal Rate
Quoted Annual Rate
Effective Rate
Rate which would produce same future value if annual compounds were
used

Effective Rate P.A.= (1+ j/m)

-1

j= Nominal interest rate per annum

m = frequency of compounding

Present Value
Given some future value (FV) what is equivalent value today
(PV)?
The equivalent present value depends upon the rate of
interest (return) that can be earned on investment during
the time period under consideration.

By rearranging nthe following formula:

FVn = PV0 (1+i)- same as compounding interest formula
We get PV:
n
PV0= FVn X [1/(1+i) ]

Present Value
Given some future value (FV) what is equivalent value today
(PV)?
The equivalent present value depends upon the rate of
interest (return) that can be earned on investment during
the time period under consideration.

By rearranging nthe following formula:

FVn = PV0 (1+i)- same as compounding interest formula
We get PV:
n
PV0= FVn X [1/(1+i) ]

Annuities
An annuity is the payment or receipt of equal cash flows for
a specified amount of time.
Two Types:
Ordinary Annuity:In which the equal cash payment or
receipt occur at the end of each period.
Annuity Due: In which the equal cash payment or receipt
occur at the beginning of each period.
The following table depicts four different calculation
scenarios under above two Annuity types
Ordinary Annuity

Annuity Due

FV of an OA

FV of an AD

PV of an OA

PV of an AD

Annuities
FV of an OA (FVAN):
Ms J receives a 3 yr ordinary annuity of $ 1,000 per year and
deposits money in a saving account at the end of each year.
Annual compounded interest rate is 6%.
Whats the value of her account at the end of 3 yrs?
Omega Co wishes to set aside an equal annual end of year
amount in a fund earning 10% p.a. over next 5 yrs. The firm
wants to have $ 5Mn at the end of 5 yrs in order to retire $ 5
Mn in outstanding bond. How much must be deposited in
the account at the end of each year?
Ordinary Annuity Formula
Please refer reading material for both PV and FV
calculation of annuity.

Annuities
FV of an AD (FVAND):
Ms J receives a 3 yr an annuity of $ 1,000 per year and
deposits money in a saving account at the beginning of
each year. Annual compounded interest rate is 6%.
Whats the value of her account at the end of 3 yrs?

Ordinary Annuity Formula

Please refer reading material for both PV and FV
calculation of annuity.

Annuities
PV of an OA (PVAN):
Find PV of an ordinary $ 1,000 annuity received at the end of each
year for 5 years discounted at a 6% rate.
Big Tool Co purchases a machine for $ 100,000. This machine is
expected to generate annual cash flow of $ 23,742 to the firm over
next 5 years. What is the expected rate of return from this
investment?
Suppose you borrowed USD 10,000 from CB. The loan is for a
period of 3 years at an interest rate of 10%. It requires that you
make three equal, end of year payments that include both
principal and interest on the outstanding balance. Calculate
annual payment required.

Annuities
PV of an AD (PVAND):
Find PV of an $ 1,000 annuity received at the beginning of
each year for 5 years discounted at a 6% rate.
Suppose you borrowed USD 10,000 from CB. The loan is for
a period of 3 years at an interest rate of 10%. It requires that
you make three equal, beginning of the year payments that
include both principal and interest on the outstanding
balance. Calculate annual payment required.

PV of Deferred Annuities (Pg 8)

An annuity begins more than one year in future.
EX:
You wish to provide for college education of your
daughter. She begins college 5 yrs from now. You wish
to have $ 15,000 available for her at the beginning of
each year in college. How much must be invested today
at a 12% annual rate in order to provide the 4-yrs, $
15,000 annuity for your daughter?

Perpetuities (Pg 8)
Stream of equal cash flows which are expected to
continue indefinitely.
PV=R/i

Continuous Compounding
This is an investment in which interest is added
continuously rather than at discrete points in time.
FV=Re
n

i n

PV of Uneven CF
Signal Co is evaluating an investment (USD 400,000) in
new equipment that will be used to manufacture a new
product. The equipment is expected to have a useful
life of 5 years and yield the following:
End of year

CF

100,000

150,000

-50,000

200,000

100,000

Required rate of return 10%. Decide whether to

purchase the equipment