Financial management

Financial Management is the

application of the planning
and control functions to the
finance action

Functions of FM

Estimating financial needs

Identification of sources of finance
Developing an optimum capital structure
Capital budgeting
Working capital management
Dividend policy
M&A
Financial analysis
CVP analysis
Financial control

Time value of money

Same amount of cash, receivable during
different time periods has different values
Time preferences of money
Reason for time preferences for money:
Uncertainty
Preferences for consumption
Investment opportunities

Techniques of time value of

money
Techniques of time value of money

Compounding

Discounting

Compounding techniques

Compound value of lumpsum

Multiple compounding periods
Effective rate of interest
Doubling period
Compound value of a series of payments
Compound value of an annuity
Compound value of an annuity due

Compound value of a
lumpsum
Mr. Ram deposits Rs. 10000 for 3
years at 10%. What is the compound
value of his deposits?
Formula method:
FV = P(1+i)n

Multiple compounding
periods
Manohar deposits Rs. 20000 for 2
years at 10%. Calculate the maturity
value of the deposits if interest is
compounded half yearly.
Formula method:
FV = P(1+i/m)m*n

Effective rate of interest

When interest is compounded
annually, the nominal rate of interest
is the effective rate of interest
In case of multiple period
compounding, the effective rate of
interest will be higher than the given
nominal rate
ERI = (1+i/m)m-1

Doubling period
It refers to the time taken for
doubling the investment
Rule 72:
Doubling period = 72 /rate of interest

Rule 69:
Doubling period = 0.35 +69/interest rate

Compound value of series of

payments
Formula method:
FV = P1(1+i)n-1 + P2(1+i)n-2 + _ _ _ _ + P
Calculate the compound value of the
following payments:
year
1
2
3
Payment at the end
1000
2000
3000
Rate of interest = 12% p.a

Compound value of an
annuity
Annuity refers to a series of equal
annual payments made at the end of
each year for a particular period
Rajiv deposits Rs. 1000 at the end of
every year for five years. The rate of
interest is 12%. What is the maturity
value of the deposits?
FV = A( 1+i)n-1+ A(1+i)n-2+..
+A

Compound value of an annuity

due
Annuity due refers to equal, annual
payments made at the beginning
each year
Kamala deposits Rs. 5000 at the
beginning of each year for 3 years at
10%. What is the maturity value after
3 years?
FV = A(1+i)n + A(1+i)n-1 +.+
A(1+i)

Discounting techniques

Present
Present
Present
Present

value
value
value
value

of
of
of
of

a lumpsum
a series of payments
an annuity
an annuity due

Present value of a
lumpsum
Arun expects to receive Rs. 100000
after 5 years. Find the present value
of the future receipt, if his time
preference rate is 10%
PV = FV/(1+i)n

Present value of a series of

payments
PV = F1/(1+i)1 + F2/(1+i)2 +..
+Fn/(1+i)n
Calculate the present value of cashflows:
year
1
2
3
Expected cash flows
1000
2000
3000
Rate of interest = 10% p.a

Present value of an
annuity
Mr. Krishnan expects to receive an
annuity of Rs.5000 for three years.
His time preference rate is 10%.
Calculate the present value of
annuity.
PV = A/(1+i)1 + A/(1+i)2 ++
A/(1+i)n

Present value of annuity

due
Kalpana expects to receive Rs.6000
at the beginning of every year, for 4
years. Find out the present value of
the future receipt, if the rate of
interest is 10%
PV = A + A/(1+i)1 + A/(1+i)2 +..+
A/(1+i)n

Risk and Return

Risk refers to the degree of
variability of actual return from
expected return

Unique Risk
Unique risk which arises due to factors
specific to a company or security
Strike by workers of the company
Entry of a powerful competitors
Severe set back to the R&D efforts of the
company
Loss of big contract
Adverse verdict in a court case involving high
stakes
Dispute among the members of the promoters
family

Market Risk
Market risk which arises duo to
general economic wide factors
Political uncertainty
War and other calamities
Massive cut in government spending
Change in interest rate
Industrial recession

Relationship between
diversification and risk

Types of risk
Major two types of risk :
Systematic risk
Unsystematic risk

Other types:
Credit or default risk
Foreign exchange risk
country risk
Interest rate risk
Political risk
Liquidity risk

Risk and Return on a single

security

D1+(P1-P0)/P0
D1 = Dividend for the year
P0 = Price at the beginning of the
year
P1 = Price at the end of the year
P1-P0 = Capital gains

 Calculate the annual rate of return on

the stock of GTC Ltd.
Price at the beginning of the year P0=
Rs.60
Dividend at the end of the year D1=
Rs.3
Price at the end of the year P1= Rs.69

Variability of rate of
return

It defines the degree of deviation of individual rates

from the average rate of return
The following information relates to bright diamonds
Ltd.
Year Dividends(Rs.) Average market price(Rs.)
2001
2.00
40
2002
2.00
30
2003
2.00
40
2004
3.00
69
2005
3.50
100
2006
4.00
121
Calculate the annual rate of return on the share for the last five
years . How risky is the shares?

Expected Return
The concept of chances of
occurrence are estimated
Possible outcome should be mutually
exclusive and collectively exhaustive
The sum of probability assigned to
various rates is one

Expected return = (R x P)

Calculation of expected
return
Mr. Jitendra gives you an estimate of
possible return from a security and
their probability. Calculate the
expected return.
Economic condition
Probability
Decline
-5
Stagnation
1
Expansion
12
Growth
20

rate of return(%)
0.25
0.25
0.25
0.25

Standard deviation of expected

return
Mr. Rajendra holds shares in Varun Ltd. He
estimates the possible return and their
probability as under. Calculate the expected
return and standard deviation of expected
return.

Possible Return(%) Probability

-20
0.10
-10
0.10
20
0.50
30
0.30

Choice of investment
Arun Ltd Varun Ltd
Expected return
22%
16%
Standard deviation 1.61% 16.25%
Advice Mr.Ganesh regarding the choice of
investment

Portfolio investment
The return of portfolio is the weighted
average of the return of the individual
securities

A portfolio consist of two securities A

and B. The expected return on these two
securities is 10% and 18% respectively.
The proportion of the securities in the
portfolio is 0.4 and 0.6. calculate the
expected return of portfolio.

 The possible outcomes of two securities under

different economic conditions are given below:
Economic condition
A
0.1
-10
B
0.2
12
C
0.4
9
D
0.2 7
18
E
0.1 -4
20
Calculate:

Probability x y
16
-5
7

I. The expected return on individual securities

II. The expected return on a portfolio of X and Y
a.
b.

If the proportion of X and Y is 50:50

If the proportion of X and Y is 20:80

 The following investment opportunities

are available to Mr. Shankar.

Economic condition probability

A
B
Good
0.5
40
Bad
0.5
0
40

Explain whether combining the securities in

the proportion of 50:50 should be advantage
to Mr. Shankar

Measuring portfolio risk

Find the expected return of each
security
Calculate the deviation of possible
return from the expected return ( d =
R-ER)
Find the product of each deviation of
the two securities and the respective
probability. (Pxd1xd2)
The sum of products is the
covariance

 The following information relates to

two securities A and B
State of the economy
probability
A
B
J
0.1
-10
16
K
0.2
12
-5
L
0.4
9
7
M
0.2
7
18
N
0.1
-4
20
Calculate the covariance of the return of securities
A and B. Also find the nature of correlation between
A and B.

Valuation of securities
Bond value

Liquidation value

Market value

Going concern value

Replacement value

Valuation of bonds or
debentures
Salient features:
Long term debt instruments
Coupon rate
Cash inflow consists of annual interest
and principal amount
No risk free

Bond with a maturity

period

Vd = I1/(1+kd)1 + I2/(1+kd)2 + .. + In/

(1+kd)n + MV/(1+kd)n

A bond whose par value is Rs. 1000

bears a coupon rate of 12% and has
a maturity period of 3 years. The
required rate of return on the bond is
10%. What is the value of the bond?

Bonds redeemable in
installments
Vd = CF1/(1+kd)1 + CF2/(1+kd)2 +.+
CFn/(1+kd)n
Air India has issued 5 years 8%% bonds of
Rs. 1000 each. The bond amount will be
amortized equally over its life. Ram, an
investor, requires a return of 7%. At what
price should he buy the bond?

Perpetual bonds
Vd = I/kd
Mr. Kannan has a perpetual bond of
Rs. 1000. He receives an interest of
Rs. 90 annually. What is the value of
the bond, if the required rate of
return is 10%?

Valuation of bond with

Half-yearly interest
Steps to valuate bond:
Annual interest is to be divided by 2
The maturity period is to be multiplied
by 2
Required rate of return is to be divided
by 2

Half yearly valuation

Vd = I/2/(1+kd/2)1 + I/2/(1+kd/2)2 + .. +
I/2/(1+kd/2)2n +
MV/(1+kd/2)2n

Mr. Mahesh holds bonds of the face value

of Rs. 1000 which carry a coupon rate of
10% p.a. Interest is payable half yearly.
The required rate of return is 12%p.a.
calculate the value of the bond if the
bonds are redeemable after 2 years.

Relationship between required

rate of return and coupon rate
If Kd = I, value = Face value
If Kd I, value Face value
If Kd I, value Face value

 Face value of the bond Rs. 1000

Annual Interest rate(I): coupon rate =
10%
maturity period 5 years
Find out the value of the bond if the
required
rate of return is a)10% b)12% c)8%

Bond yield measures

Current Yield = annual interest
current market price
Snow Ltd issued 12% debentures of
Rs. 1000. The current market price of
the debentures is Rs. 750. calculate
a) The yield to an investor who had
purchased the debentures at Rs. 1000;
b) The current yield

Holding period return

Holding period return = (SP PP)
+I
PP
Rajesh purchased Rs. 100 par value
bond for Rs. 80. The coupon rate is
8%. One year later, he sold the bond
at Rs. 90. what is the rate of return
during the holding period?

Yield to maturity
YTM = Annual Return
Average Value

lion industries Ltd has issued bonds of

the face value of Rs. 500. the coupon
rate is 12% and the bonds are
redeemable after 5 years. Current
market price is Rs. 435. calculate the
approximate YTM.

YTM of perpetual bond

YTM = annual interest
current market price

The coupon rate of interest on a Rs. 1000

par value. A perpetual bond is 8% an dthe
price is Rs. 800. what is the YTM?

Valuation of preference
shares
Vp = P.D1 +
P.D2 ++ P.Dn
MVn
(1+kp)1
(1+kp)2
(1+kp)n
(1+kp)n

Mr. lakshman is considering the purchase of a 7% preference

share

of Rs. 1000 redeemable after 5 years, at

par. Required rate of return is 9%. Is it advisable
to buy the preference share at Rs. 900?

Value of perpetual preference

shares
Vp = P.D/k
Mr. peter holds 9%irredeemable
preference shares of Rs. 1000. the
required rate of return is 12%. What is the
value of the preference shares?

Valuation of equity
shares
Methods of valuation:
Dividend capitalization approach
Earnings capitalization approach

Dividend capitalization
approach
Single period valuation model:
P0 =

D1 + P1
1 + ke

jyothi Ltd is expected to declare a dividend of Rs. 4

per share and reach a price of Rs. 220 after one

year from now. Calculate value (P0)of the

share, if the required rate of return is 12%

Multi period valuation

P0 = D1/(1+ke)1 + D2/(1+ke)2 ++ Dn/
(1+ke)n + Pn/(1+ke)n

Mr. Vinod wants to buy an equity share and

sell it after 2 years. The expected dividends
at the end of the first year and second year
are Rs. 3 and 4. the expected sale price of
the share is Rs. 250. calculate the current
price of the share, taking the required rate
of return as 15%

 An investor is looking for a 4 years

investment. The share of green star are
selling at Rs. 75. they have plans to pay a
dividend of Rs.7.50 per share at the end of
the 1st and 2nd year and Rs. 9 and Rs. 15
per share respectively at the end of 3rd and
4th years. The investors capitalization is
12% and the share price at the end of 4th
year is Rs. 120.
Find the current value of the share (P0)?

Dividend valuation
model
P0 = D1/(1+ke)1 + D2/(1+ke)n +.
+ Dn/(1+ke)n
When the dividend is constant
When dividend is growing

No growth concept
P0 = D/ke
Mahindra Ltd is currently paying a
dividend of Rs. 6 per share. It is not
expected to change the dividend in future.
Calculate the value of the share if the
required rate of return is 12%

Growth in dividends
Normal growth:
P0 = D1
ke-g

= D0(1+g)
ke-g

When,
D0 = current dividend
D1 = expected dividend
ke = required rate of return
g = expected growth rate

 Jitendra Ltd is expected to pay a

dividend of Rs. 5 per share, next
year. The dividend is expected to
grow perpetually at the rate of 10%.
What is the value of the share if the
capitalization rate is 15%?

Super normal growth

P0 = D1/(1+ke)1 + D2/(1+ke)n +.
+ Dn/(1+ke)n
Estimate the expected dividend
Find out PV of expected dividend (A)
Find out the value of share at the end of
super normal growth
Estimate the PV of super normal growth
(B)
Value of the share = A+B

 Skyrocket Ltd is currently paying a

dividend of Rs. 3 per share. The
dividend is expected to grow at 25%
annually for 5 years and then at 7%
forever. What is the present value of
the share if the capitalization rate is
14%.