Financial management


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Importance of financial management
Overview of Financial Management
Time Value Of Money
Cost of capital
International Financial Management
Return and Risk
Valuation of financial instruments

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Financial management

  1. 1. 1The Importance of Financial Management Overview of Financial Management  Meaning Of Financial Management Financial management is concerned with raising financial resources and their effective utilization towards achieving the organizational goals. “Financial Management means planning, organizing, directing and controlling the financial activities such as procurement and utilization of funds of the enterprise. It means applying general management principles to financial resources of the enterprise. Financial Management is an essential part of the economic and non-economic activities which leads to decide the efficient procurement and utilization of finance with profitable manner. In the olden days the subject Financial Management was a part of accountancy with the traditional approaches. Now a days it has been enlarged with innovative and multi-dimensional functions in the field of business with the effect of industrialization, Financial Management has become a vital part of the business concern and they are concentrating more in the field of Financial Management. Scope/Elements 1. Investment decisions includes investment in fixed assets (called as capital budgeting). Investment in current assets are also a part of investment decisions called as working capital decisions. 2. Financial decisions - They relate to the raising of finance from various resources which will depend upon decision on type of source, period of financing, cost of financing and the returns thereby. 3. Dividend decision - The finance manager has to take decision with regards to the net profit distribution. Net profits are generally divided into two: a. Dividend for shareholders- Dividend and the rate of it has to be decided. b. Retained profits- Amount of retained profits has to be finalized which will depend upon expansion and diversification plans of the enterprise.
  2. 2. 2The Importance of Financial Management Objectives of Financial Management The financial management is generally concerned with procurement, allocation and control of financial resources of a concern. The objectives can be- 1. To ensure regular and adequate supply of funds to the concern. 2. To ensure adequate returns to the shareholders which will depend upon the earning capacity, market price of the share, expectations of the shareholders. 3. To ensure optimum funds utilization. Once the funds are procured, they should be utilized in maximum possible way at least cost. 4. To ensure safety on investment, funds should be invested in safe ventures so that adequate rate of return can be achieved. 5. To plan a sound capital structure-There should be sound and fair composition of capital so that a balance is maintained between debt and equity capital. Functions of Financial Management 1. Estimation of capital requirements: A finance manager has to make estimation with regards to capital requirements of the company. This will depend upon expected costs and profits and future programmers and policies of a concern. Estimations have to be made in an adequate manner which increases earning capacity of enterprise. 2. Determination of capital composition: Once the estimation have been made, the capital structure have to be decided. This involves short- term and long- term debt equity analysis. This will depend upon the proportion of equity capital a company is possessing and additional funds which have to be raised from outside parties. 3. Choice of sources of funds: For additional funds to be procured, a company has many choices like- a. Issue of shares and debentures b. Loans to be taken from banks and financial institutions c. Public deposits to be drawn like in form of bonds.
  3. 3. 3The Importance of Financial Management Choice of factor will depend on relative merits and demerits of each source and period of financing. 4. Investment of funds: The finance manager has to decide to allocate funds into profitable ventures so that there is safety on investment and regular returns is possible. 5. Disposal of surplus: The net profits decision have to be made by the finance manager. This can be done in two ways: a. Dividend declaration - It includes identifying the rate of dividends and other benefits like bonus. b. Retained profits - The volume has to be decided which will depend upon expansional, innovational, diversification plans of the company. 6. Management of cash: Finance manager has to make decisions with regards to cash management. Cash is required for many purposes like payment of wages and salaries, payment of electricity and water bills, payment to creditors, meeting current liabilities, maintainance of enough stock, purchase of raw materials, etc. 7. Financial controls: The finance manager has not only to plan, procure and utilize the funds but he also has to exercise control over finances. This can be done through many techniques like ratio analysis, financial forecasting, cost and profit control, etc.
  4. 4. 4The Importance of Financial Management  Major areas in Financial Management 1. Corporate finance = Business Finance 2. Investments  Work with financial assets such as stocks and bonds.  Value of financial assets, risk versus return, and asset allocation  Job opportunities o Stockbroker or financial advisor o Portfolio manager o Security analyst 3. Financial institutions  Companies that specialize in financial matters  Banks – commercial and investment, credit unions, savings and loal Insurance companies,Brokerage firms  Job opportunities 4. International finance  An area of specialization within each of the areas discussed so far  May allow you to work in other countries or at least travel on a regular basis  Need to be familiar with exchange rates and political risk  Need to understand the customs of other countries; speaking a foreign language fluently is also helpful
  5. 5. 5The Importance of Financial Management  Goals Of Financial Management All businesses aim to maximize their profits, minimize their expenses and maximize their market share. Here is a look at each of these goals. 1.Maximize Profits A company's most important goal is to make money and keep it. Profit-margin ratios are one way to measure how much money a company squeezes from its total revenue or total sales. 2.Minimize Costs Companies use cost controls to manage and/or reduce their business expenses. By identifying and evaluating all of the business's expenses, management can determine whether those costs are reasonable and affordable. Then, if necessary, they can look for ways to reduce costs through methods such as cutting back, moving to a less expensive plan or changing service providers. The cost-control process seeks to manage expenses ranging from phone, internet and utility bills to employee payroll and outside professional services. To be profitable, companies must not only earn revenues, but also control costs. If costs are too high, profit margins will be too low, making it difficult for a company to succeed against its competitors. In the case of a public company, if costs are too high, the company may find that its share price is depressed and that it is difficult to attract investors. When examining whether costs are reasonable or unreasonable, it's important to consider industry standards. Many firms examine their costs during the drafting of their annual budgets. 3.Maximize Market Share Market share is calculated by taking a company's sales over a given period and dividing it by the total sales of its industry over the same period. This metric provides a general idea of a company's size relative to its market and its competitors. Companies are always looking to expand their share of the market, in addition to trying to grow the size of the total market by appealing to larger demographics, lowering prices or through advertising. Market share increases can allow a company to achieve greater scale in its operations and improve profitability.
  6. 6. 6The Importance of Financial Management The size of a market is always in flux, but the rate of change depends on whether the market is growing or mature. Market share increases and decreases can be a sign of the relative competitiveness of the company's products or services. As the total market for a product or service grows, a company that is maintaining its market share is growing revenues at the same rate as the total market. A company that is growing its market share will be growing its revenues faster than its competitors. Technology companies often operate in a growth market, while consumer goods companies generally operate in a mature market. New companies that are starting from scratch can experience fast gains in market share. Once a company achieves a large market share, however, it will have a more difficult time growing its sales because there aren't as many potential customers available.  Important of financial management The financial matters are one of the most important matters when it comes to your business. Some people think that the business is all about marketing and selling the product and they start a business on this assumption that this knowledge will be sufficient for them in running the business. The ugly truth about starting a business is that the financial matters should be solved at the first priority, if you want your business to grow. At the start of the business, the financial managers and stakeholders will face problems that will require financial decisions. The questions such as where you should invest your money and from where the revenue should be generated are the questions that need to solve quickly in order to get maximum profit out of the business. To handle such matters, one should have extra knowledge in the field of finance. The specific field of knowledge can be termed as financial management. Financial management can be defined as taking financial decisions with the goal that they should maximize the stockholder’s wealth. Finance management is very important in the business and in the world of finance; financial management can be called by many names such as corporate management and managerial finance. Financial Managers ultimate goal is to maximize the stockholders profit but this goal is aligned with smaller goals and they collectively increase the profitability of the organization. Some other goals performed by the financial managers are increasing
  7. 7. 7The Importance of Financial Management the day to day profitability, managing the funds of short term loans and managing daily finances. These goals can be managed by completing a lot of activities such as financial accounting, managerial accounting, risk management and auditing. These tasks are very difficult and a small businessman cannot spare time to perform all these functions. So, if you have a small company then you should contact the financial manager and seeks their help in managing the finance of the organization. Alternatively, businessmen may avail themselves of the services of a financial manager or seek the aid of companies providing financial management services. Some firms also take help form the financial management software. By purchasing such software, you will not have to contact the financial managers every time you face a financial problem. This financial software is expensive so it is advised that you should start with software which has basic features and then move on to the advanced one. This financial software can help in preparing the bills and they can also be used for making invoices and generating payrolls. You should look for these features in the software because they will help you in daily work. Furthermore, if you are more oriented toward visuals, choose programs that make use of graphs and charts, as these probably will be easier for you to use. Financial market Market for the exchange of capital and credit in the economy. Money markets concentrate on short-term debt instruments; capital markets trade in long-term debt and equity instruments. Examples of financial markets: stock market, bond market, commodities market, and foreign exchange market. Market for the exchange of capital and credit in the economy. Examples of financial markets are stock markets, bond markets, commodities markets, and foreign exchange markets. See also money market. In economics, a financial market is a mechanism that allows people to easily buy and sell financial securities, commodities, and other fungible items of value at low transaction costs and at prices that reflect the efficient market hypothesis.
  8. 8. 8The Importance of Financial Management Financial markets have evolved significantly over several hundred years and are undergoing constant innovation to improve liquidity.Both general markets and specialized markets exist. Markets work by placing many interested sellers in one "place", thus making them easier to find for prospective buyers. An economy which relies primarily on interactions between buyers and sellers to allocate resources is known as a market economy in contrast either to a command economy or to a non- market economy that is based, such as a gift economy. Financial markets facilitate: The raising of capital The transfer of risk International trade They are used to match those who want capital to those who have it. Typically a borrower issues a receipt to the lender promising to pay back the capital. These receipts are securities which may be freely bought or sold. In return for lending money to the borrower, the lender will expect some compensation in the form of interest or dividends. Financial markets could mean: 1. Organizations that facilitate the trade in financial products. Stock exchanges facilitate the trade in stocks, bonds and warrants. 2. The coming together of buyers and sellers to trade financial products.stocks and shares are traded between buyers and sellers in a number of ways including: the use of stock exchanges; directly between buyers and sellers etc. In academia, students of finance will use both meanings but students of economics will only use the second meaning. Financial markets can be domestic or they can be international.
  9. 9. 9The Importance of Financial Management Types of financial markets The financial markets can be divided into different subtypes. 1.Capital markets which consist of: * Stock markets, which provide financing through the issuance of shares or common stock, and enable the subsequent trading thereof. * Bond markets, which provide financing through the issuance of Bonds, and enable the subsequent trading thereof. 2. Commodity markets, which facilitate the trading of commodities. 3. Money markets, which provide short term debt financing and investment. 4. Derivatives markets, which provide instruments for the management of financial risk. *Futures markets, which provide standardized forward contracts for trading products at some future date; see also forward market. 5.Insurance markets, which facilitate the redistribution of various risks. 6. Forieng exchange markets, which facilitate the trading of foreign exchange. Money market Market for short-term (less than one year) debt securities. Examples of money market securities include U.S. Treasury bills, federal agency securities, bankers' acceptances, commercial paper, and negotiable certificates of deposit issued by government, business, and financial institutions. The importance of money market  Money Sources The short-term funds available in the money market come from individuals who deposit their cash in money market accounts. For individuals who keep their cash in money market accounts, the benefits are similar to a checking account, with some differences. Generally, the financial institution that holds your money market account pays you a better interest rate than a traditional savings account, and in some cases better than a certificate of deposit. In addition, you are allowed a limited number of withdrawals every month and your deposits are insured by the federal government. In
  10. 10. 10The Importance of Financial Management return for a better interest rate and low risk of loss, your financial institution may invest your deposits in short-term investments issued by other financial institutions, banks, corporations or government agencies.  Federal Deficit The federal government also borrows money from the money market. This short-term borrowing is done through the U.S. Treasury, which issues shorter- term securities called T-bills. Maturities for short-term T-bills vary from four, 13 and 26 weeks and are issued every week. Cash management T-bills are issued every month and have a one-year maturity. These liquidity management instruments allow the federal government to continue to finance the operations and services of the federal government in cases of budget deficits and other cash shortages.  Government Agencies Like the federal government, federal agencies may also issue short-term securities to ensure the funding of a particular service or program. For instance, federal mortgage guarantee programs like Ginnie Mae or Freddie Mac may require short-term liquidity to cover specific claims or other financial obligations.  Corporate Corporations may borrow money from issuing short-term securities in the money market. Generally, corporations have the option of borrowing money from the bank or issuing a short-term security commonly called commercial paper. Commercial paper is sometimes cheaper than borrowing from a bank and as a result, commercial paper is a very common alternative. The purpose of short-term borrowing in the money markets is similar to other institutions that borrow short-term funds. The money raised in the money market may be used to fund operations, payroll or a specific project.  Growth The money circulating throughout the money market finances short-term borrowing by large corporations and the government. This borrowing allows both businesses and government agencies to continue to spend the money on programs and expansion projects necessary to encourage economic growth.
  11. 11. 11The Importance of Financial Management Capital market Trading center for long-term debt and corporate stocks. The New York Stock Exchange (NYSE), which trades the stocks of many of the larger corporations, is a prime example of a capital market. The amarican stock exchange and the regional stock exchanges are also examples. In addition, securities are issued and traded through the thousands of brokers and dealers on the over-the-counter (OTC) market market. One of the main functions of financial markets is to allocate capital. Capital markets especially facilitate the raising of capital while money markets facilitate the transfer of liquidity, in both cases matching those who have capital to those who need it. Financial markets attract funds from investors and channel them to enterprises that use that capital to finance their operations and achieve growth, from startup phases to expansion--even much later in the firm’s life. Without financial markets, borrowers would have difficulty finding lenders themselves. Intermediaries such as banks help in this process. Bank deposits are a simple ways in which capital is allocated from a pool of savers to businesses that want to deploy it. More complex transactions than a simple bank deposit require markets where lenders and their agents can meet borrowers and their agents, and where existing instruments can be resold. One example being a stock exchanges. A capital market is one in which individuals and institutions trade financial securities. Organizations and institutions in the public and private sectors also often sell securities on the capital markets in order to raise funds. Thus, this type of market is composed of both the primary and secondary markets. Any government or corporation requires capital (funds) to finance its operations and to engage in its own long-term investments. To do this, a company raises money through the sale of securities - stocks and bonds in the company's name. These are bought and sold in the capital markets.
  12. 12. 12The Importance of Financial Management  Stock market Stock markets allow investors to buy and sell shares in publicly traded companies. They are one of the most vital areas of a market economy as they provide companies with access to capital and investors with a slice of ownership in the company and the potential of gains based on the company's future performance. This market can be split into two main sections: the primary market and the secondary market. The primary market is where new issues are first offered, with any subsequent trading going on in the secondary market.  Bond Markets A bond is a debt investment in which an investor loans money to an entity which borrows the funds for a defined period of time at a fixed interest rate. Bonds are used by companies, municipalities, states and U.S. and foreign governments to finance a variety of projects and activities. Bonds can be bought and sold by investors on credit markets around the world. This market is alternatively referred to as the debt, credit or fixed income market. It is much larger in nominal terms that the world's stock markets. Financial Institution An organization, which may be either for-profit or non-profit, that takes money from clients and places it in any of a variety of investment vehicles for the benefit of both the client and the organization. Common examples of financial institutions are retail banks, which takedeposits into safekeeping and use them to make loans to other customers, and insurance companies, which do not take deposits, but provide guarantees of payment if a certain situation occurs in exchange for a premium. See also: Depository institution, Non-depository institution. Any institution that collects money and puts it into assets such as stocks, bonds, bank deposits, or loans is considered a financial institution. There are two types of financial institutions: depository institutions and non-depository institutions. Depository institutions, such as banks and credit unions, pay you interest on your deposits and use the deposits to make loans. Non depository institutions, such as insurance companies’. brokerage firms, and mutual found companies, sell financial products. Many financial institutions provide both depository and non depository services.
  13. 13. 13The Importance of Financial Management Time Value Of Money Introduction Time Value of Money (TVM) is an important concept in financial management. It can be used to compare investment alternatives and to solve problems involving loans, mortgages, leases, savings, and annuities. Time Value of Money is based on the concept that a rupee that someone have today is worth more than the promise or expectation that he or she will receive a dollar in the future. The idea that money available at the present time is worth more than the same amount in the future due to its potential earning capacity. This core principle of finance holds that, provided money can earn interest, any amount of money is worth more the sooner it is received. The time value of money or, discounted present value, is one of the basic concepts of finance. To fully understand time value of money one must first understand a few terms. Present value and future value are totally different. They also have their disadvantages and advantages; it just depends on how they are used.  Interest Interest is a charge for borrowing money, usually stated as a percentage of the amount borrowed over a specific period of time. Simple interest is computed only on the original amount borrowed. It is the return on that principal for one time period. In contrast, compound interest is calculated each period on the original amount borrowed plus all unpaid interest accumulated to date. Simple Interest where: p = principal (original amount borrowed or loaned) i = interest rate for one period n = number of periods
  14. 14. 14The Importance of Financial Management  Present Value Present Value of a Single Amount Present Value is an amount today that is equivalent to a future payment, or series of payments, that has been discounted by an appropriate interest rate. The difference between the two depends on the number of compounding periods involved and the interest (discount) rate. Where: PV = Present Value FV = Future Value i = Interest Rate per Period n = Number of Compounding Periods Present Value of Annuities An annuity is a series of equal payments or receipts that occur at evenly spaced intervals. Leases and rental payments are examples. The payments or receipts occur at the end of each period for an ordinary annuity while they occur at the beginning of each period for an annuity due. Present Value of an Ordinary Annuity The Present Value of an Ordinary Annuity is the value of a stream of expected or promised future payments that have been discounted to a single equivalent value today. It is extremely useful for comparing two separate cash flows that differ in some way. The Present Value of an Ordinary Annuity could be solved by calculating the present value of each payment in the series using the present value formula and then summing the results. A more direct formula is,
  15. 15. 15The Importance of Financial Management Where: PVoa = Present Value of an Ordinary Annuity PMT = Amount of each payment i = Discount Rate per Period n = Number of Periods Present Value of an Annuity Due The Present Value of an Annuity Due is identical to an ordinary annuity except that each payment occurs at the beginning of a period rather than at the end. Since each payment occurs one period earlier, we can calculate the present value of an ordinary annuity and then multiply the result by (1 + i). Where: PVad = Present Value of an Annuity Due PVoa = Present Value of an Ordinary Annuity i = Discount Rate per Period Difference between an Ordinary Annuity and an Annuity-Due Each payment of an ordinary annuity belongs to the payment period preceding its date, while the payment of an annuity-due refers to a payment period following its date.
  16. 16. 16The Importance of Financial Management A more simplistic way of expressing the distinction is to say that payments made under an ordinary annuity occur at the end of the period while payments made under an annuity due occur at the beginning of the period. Most annuities are ordinary annuities. Installment loans and coupon bearing bonds are examples of ordinary annuities. Rent payments, which are typically due on the day commencing with the rental period, are an example of an annuity-due.  Future Value Future Value of a Single Amount Future Value is the amount of money that an investment made today (the present value) will grow to by some future date. Since money has time value, we naturally expect the future value to be greater than the present value. The difference between the two depends on the number of compounding periods involved and the going interest rate. Where: FV = Future Value PV = Present Value i = Interest Rate per Period n = Number of Compounding Periods Future Value of an Ordinary Annuity The Future Value of an Ordinary Annuity (FVoa) is the value that a stream of expected or promised future payments will grow to after a given number of periods at a specific compounded interest. The Future Value of an Ordinary Annuity could be solved by calculating the future value of each individual payment in the series using the future value formula and then summing the results. A more direct formula is,
  17. 17. 17The Importance of Financial Management Where: FVoa = Future Value of an Ordinary Annuity PMT = Amount of each payment i = Interest Rate per Period n = Number of Periods Future Value of an Annuity Due The Future Value of an Annuity Due is identical to an ordinary annuity except that each payment occurs at the beginning of a period rather than at the end. Since each payment occurs one period earlier, we can calculate the present value of an ordinary annuity and then multiply the result by (1 + i). Where: FVad = Future Value of an Annuity Due FVoa = Future Value of an Ordinary Annuity i = Interest Rate Per Period Importance of Time Value of Money When a business chooses to invest money in a project -- such as an expansion, a strategic acquisition or just the purchase of a new piece of equipment -- it may be years before that project begins producing a positive cash flow. The business needs to know whether those future cash flows are worth the upfront investment. That's why the time value of money is so important to capital budgeting. Time value of money is one of the most important concepts in the field of small business financing. Small businesses rely on their cash flows. It is important for them to know the accurate value of their cash flows. Understanding time value of money and the calculation of various forms of time value of money can help businesses accurately value their cash flows.
  18. 18. 18The Importance of Financial Management Capital Budgeting The process in which a business determines whether projects such as building a new plant or investing in a long term venture are worth pursuing. Oftentimes, a prospective project’s lifetime cash inflows and outflows are assessed in order to determine whether the returns generated meet a sufficient target benchmark. Ideally, business should pursue all projects and opportunities that enhance shareholder value. Popular methods of Capital Budgeting include Net Present Value (NPV), Internal rate of Return (IRR), Discounted Cash Flow (DCF) and Payback Period. Capital Budgeting is a tool for maximizing a company’s future profits since most companies are able to manage only a limited number of large projects at any one type. Capital Budgeting Techniques Capital Budgeting is the process most companies use to authorize capital spending on long term projects. Capital projects are individually evaluated using both quantitative analysis and qualitative information. Most capital budgeting analysis uses cash inflows and cash outflows. Payback Period The payback measures the length of time it takes a company to recover in cash its initial investments. This concept can also be explained as the length of time it takes the project to generate cash equal to the investment and pay the company back. It is calculated by dividing the capital investment by the net annual cash flow. Net Present Value Considering the time value of money is important when evaluating projects with different costs and different cash flows. To use the Net Present Value method, it will need to know the cash inflows, the cash outflows and the company’s required rate of return on its investments. The required rate of return becomes the discount rate used in the NPV calculation.
  19. 19. 19The Importance of Financial Management Internal Rate of Return The internal return on an investment is the interest rate at which the net present value of costs (negative cash flows) of investment equals the net present value of the benefits (positive cash flows) of the investment. Internal Rates of Return are commonly used to evaluate the desirability of investments or projects. The higher a project’s internal rate of return, the more desirable it is to undertake the project. Assuming all other factors are equal among the various projects, the project with the highest IRR would probably be considered the best and undertaken first.  Uses of IRR IRR is an indicator of the efficiency, quality or yield of an investment because the IRR is a rate quantity. This is in contrast with the net present value, which is an indicator of the value or magnitude of an investment. An investment is considered acceptable if its IRR is greater than an established minimum acceptable rate of return or cost of capital. In a scenario where an investment is considered by a firm that has equity holders, this minimum rate is the cost of capital of the investment. (which may be determined by the risk adjusted cost of capital of alternative investments) Advantages and Disadvantages of the NPV and IRR methods Advantages  With the NPV method, the advantage is that it is a direct measure of the rupees contribution to the stakeholders.  With the IRR method, the advantage is that it shows the return on the original money invested. Disadvantages  With the NPV method, the disadvantage is that the project size is not measured.
  20. 20. 20The Importance of Financial Management The importance of Capital Budgeting  Avoid forecast error The future success of a business largely depends on the investment decisions that corporate managers make today. Through making capital investments, firm acquires the long lived fixed assets that generate the firm’s future cash flows and determine its level of profitability. Thus this decision greatly influences a firm’s ability to achieve its financial objectives.  Helps firm to plan its financing Proper capital budgeting analysis is critical to a firm’s successful performance because capital investment decisions can improve cash flows and lead to higher stock prices. Yet, poor decisions can lead to financial distress and even to bankruptcy.  Develop and formulate long term strategic goals The ability to set long term goals is essential to the growth and prosperity of any business.  Seek out new investment projects  Estimate and forecast future cash flows  Facilitate the transfer of information  Monitoring and control of expenditures
  21. 21. 21The Importance of Financial Management Cost of capital In previous classes, we discussed the important concept that the expected return on an investment should be a function of the “market risk” embedded in that investment – the risk-return trade off The firm must earn a minimum of rate of return to cover the cost of generating funds to finance investments; otherwise, no one will be willing to buy the firm’s bonds, preferred stock, and common stock. This point of reference, the firm’s required rate of return, is called the cost of capital.. The cost of capital is the required rate of return that a firm must achieve in order to cover the cost of generating funds in the marketplace. Based on their evaluations of the riskiness of each firm, investors will supply new funds to a firm only if it pays them the required rate of return to compensate them for taking the risk of investing in the firm’s bonds and stocks. If, indeed, the cost of capital is the required rate of return that the firm must pay to generate funds, it becomes a guideline for measuring the profit abilities of different investments. When there are differences in the degree of risk between the firm and its divisions, a risk-adjusted discount-rate approach should be used to determine their profitability. The overall percentage cost of the funds used to finance a firm's assets. Cost of capital is a composite cost of the individual sources of funds including common stock, debt, preferred stock, and retained earnings. The overall cost of capital depends on the cost of each source and the proportion that source represents of all capital used by the firm. The goal of an individual or business is to limit investment to assets that provide a return that is higher than the cost of the capital that was used to finance those assets. What impacts the cost of capital? RISKINESS OF EARNINGS INTEREST RATE LEVELS IN THE US/GLOBAL MARKETPLACE THE DEBT TO EQUITY MIX OF THE FIRM FINANCIAL SOUNDNESS OF THE FIRM
  22. 22. 22The Importance of Financial Management The Cost of Capital becomes a guideline for measuring the profitability of different investments. Another way to think of the cost of capital is as the opportunity cost of funds, since this represents the opportunity cost for investing in assets with the same risk as the firm. When investors are shopping for places in which to invest their funds, they have an opportunity cost. The firm, given its riskiness, must strive to earn the investor’s opportunity cost. If the firm does not achieve the return investors. What is debt... General Rule: Debt generally has the following characteristics: • Commitment to make fixed payments in the future • The fixed payments are tax deductible • Failure to make the payments can lead to either default or loss of control of the firm to the party to whom payments are due. What would you include in debt?  Any interest-bearing liability, whether short term or long term.  Any lease obligation, whether operating or capital. Converting Operating Leases to Debt  The “debt value” of operating leases is the present value of the lease.  payments, at a rate that reflects their risk.  In general, this rate will be close to or equal to the rate at which the company can borrow. Measuring Financial Leverage  Two variants of debt ratio.  Debt to Capital Ratio = Debt / (Debt + Equity).  Debt to Equity Ratio = Debt / Equity.  Ratios can be based only on long term debt or total debt.  Ratios can be based upon book value or market value.
  23. 23. 23The Importance of Financial Management Costs and Benefits of Debt  Benefits of Debt  Tax Benefits  Adds discipline to management  Costs of Debt  Bankruptcy Costs  Agency Costs  Loss of Future Flexibility Tax Benefits of Debt n a) Tax Benefits: Interest on debt is tax deductible whereas cashflows on equity (like dividends) are not. • Tax benefit each year = t r B • After tax interest rate of debt = (1-t) r n Proposition 1: Other things being equal, the higher the marginal tax rate of a corporation, the more debt it will have in its capital structure Financial stability The Bank defines financial system stability to refer to the effort of the Bank aimed at promoting the development of sound and well-managed banking and other financial institutions as well as encouraging the development of efficient and well-functioning financial markets. Importance of financial stability Financial stability is important as it reflects a sound financial system, which in turn is important as it reinforces trust in the system and prevents phenomena such as a run on banks, which can destabilize an economy. Additionally, a sound financial system signals to the public that their money is handled in a way which will not unduly jeopardise it. This is especially important for savings, including pension savings.
  24. 24. 24The Importance of Financial Management Elements of Financial Stability include an early warning system of monitoring relevant indicators; as well as stimulating and making provisions for possible realistic strains on the system by conducting stress testing. The above help regulators to monitor the system and prepare for ways to avert potential or discovered stress on the system. Weighted Average Cost Of Capital(WACC) The firm’s WACC is the cost of Capital for the firm’s mixture of debt and stock in their capital structure. WACC = wd (cost of debt) + ws (cost of stock/RE) + wp (cost of pf. stock) So now we need to calculate these to find the WACC. wd = weight of debt ws = weight of stock wp = weight of prefered stock Cost Of Debt (Kd) We use the after tax cost of debt because interest payments are tax deductible for the firm. Kd after taxes = Kd (1 – tax rate) We use the effective annual rate of debt based on current market conditions. We do not use historical rates. Cost of Preferred Stock (Kp) Preferred Stock has a higher return than bonds, but is less costly than common stock. In case of default, preferred stockholders get paid before common stock holders. However, in the case of bankruptcy, the holders of preferred stock get paid only after short and long-term debt holder claims are satisfied. Preferred stock holders receive a fixed dividend and usually cannot vote on the firm’s affairs.
  25. 25. 25The Importance of Financial Management preferred stock dividend Kp = market price of preferred stock OR if issuing new preferred stock preferred stock dividend Kp = market price of preferred stock (1 – flotation cost) Unlike the situation with bonds, no adjustment is made for taxes, because preferred stock dividends are paid after a corporation pays income taxes. Consequently, a firm assumes the full market cost of financing by issuing preferred stock. In other words, the firm cannot deduct dividends paid as an expense, like they can for interest expenses. Cost of Equity ( Common Stock & Retained Earnings) The cost of equity is the rate of return that investors require to make an equity investment in a firm. Common stock does not generate a tax benefit as debt does because dividends are paid after taxes.The cost of common stock is the highest. Retained earnings are considered to have the same cost of capital as new common stock. Their cost is calculated in the same way, expect that no adjustment is made for flotation costs.
  26. 26. 26The Importance of Financial Management International Financial Management International financial management means doing business with making money through the exchanging of foreign currency. It is including planning organizing directing & controlling of money value in foreign exchange. Currency Appreciation An increase in the value of one currency with respect to another. This means that one unit of the appreciating currency buys more units of the other currency than it did previously. Currency Depreciation A decrease in the value of currency with respect to other currencies. This means that the depreciated currency is worth fewer units of some other currency. While depreciation means a reduction in value, it can be advantageous as it makes export in the depreciated currency less expensive. Importance of International financial management Compared to national financial markets international markets have a different shape and analytics. Proper management of international finances can help the organization in achieving same efficiency and effectiveness in all markets, hence without IFM sustaining in the market can be difficult. International financial enables investor to asses and manage all the international risks they might encounter in their f m process. The risks involved are political risk and foreign exchange risk, transaction exposure and economic exposure. International financial helps to multination companies get their financial decisionl, when and how much to invest, , decision concerning the management working capital among their different subsidiaries and management number of complexities.
  27. 27. 27The Importance of Financial Management Return and Risk A financial decision typically involves risk. For example, a company that borrows money faces the risk that interest rates may change, and a company that builds a new factory faces the risk that product sales may be lower than expected. These and many other decisions involve future cash flows that are risky. Investors generally dislike risk, but they are also unable to avoid it. The valuation formulae for shares and debt securities showed that the price of a risky asset depends on its expected future cash flows, the time value of money, and risk. However, little attention was paid to the causes of risk or to how risk should be defined and measured. To make effective financial decisions, managers need to understand what causes risk, how it should be measured and the effect of risk on the rate of return required by investors. The return on an investment and the risk of an investment are basic concepts in finance. Return on an investment is the financial outcome for the investor. For example, if someone invests $100 in an asset and subsequently sells that asset for $111, the dollar return is $11. Usually an investment’s dollar return is converted to a rate of return by calculating the proportion or percentage represented by the dollar return. For example, a dollar return of $11 on an investment of $100 is a rate of return of $11/$100, which is 0.11, or 11 per cent. Risk is present whenever investors are not certain about the outcomes an investment will produce. Suppose, however, that investors can attach a probability to each possible dollar return that may occur. Investors can then draw up a probability distribution for the dollar returns from the investment. A probability distribution is a list of the possible dollar returns from the investment together with the probability of each return. For example, assume that the probability distribution in table below is an investor’s assessment of the dollar returns Ri that may be received from holding share in a company for 1 year. Dollar Return, Ri | ($) Probability, Pi 9 0.1 10 0.2 11 0.4 12 0.2 13 0.1
  28. 28. 28The Importance of Financial Management Suppose the investor wishes to summarize this distribution by calculating two measures, one to represent the size of the dollar returns and the other to represent the risk involved. The size of the dollar returns may be measured by the expected value of the distribution. The expected value E(R) of the dollar returns is given by the weighted average of all the possible dollar returns, using the probabilities as weights that is: E(R) = ($9)(0.1) + ($10)(0.2) + ($11)(0.4) + ($12)(0.2) + ($13)(0.1) = $11 In general, the expected return on an investment can be calculated as: E(R) = R1P1 + R2P2 + … + RnPn which can be written as follows: E(R)=ΣiRiPi The choice of a measure for risk is less obvious. In this example, risk is present because any one of five outcomes ($9, $10, $11, $12 or $13) might result from the investment. If the investor had perfect foresight, then only one possible outcome would be involved, and there would not be a probability distribution to be considered. This suggests that risk is related to the dispersion of the distribution. The more dispersed or widespread the distribution, the greater the risk involved. Statisticians have developed a number of measures to represent dispersion. These measures include the range, the mean absolute deviation and the variance. However, it is generally accepted that in most instances the variance (or its square root, the standard deviation, σ) is the most useful measure. Accordingly, this measure of dispersion is the one we will use to represent the risk of a single investment. The variance of a distribution of dollar returns is the weighted average of the square of each dollar return’s deviation from the expected dollar return, again using the probabilities as the weights. For the share considered opposite, the variance is: σ2 = (9 – 11)2 (0.1) + (10 – 11)2 (0.2) + (11 – 11)2 (0.4) + (12 – 11)2 (0.2) + (13 – 11)2 (0.1) = 1.2 In general the variance can be calculated as: σ 2 = [R1 – E(R)]2 P1 + [R2 – E(R)]2 P2 + … + [Rn – E(R)]2 Pn which can be written as follows: σ2=Σi[Rn – E(R)]2Pi
  29. 29. 29The Importance of Financial Management In this case the variance is 1.2 so the standard deviation is σ=√1.2 =$.1095 Portfolio Management, Return, Risk What is Portfolio? A Portfolio refers to a collection of investment tools such as stocks, shares, mutual funds, bonds, and cash and so on depending on the investor’s income, budget and convenient time frame. Portfolio Management Portfolio management is the art of selecting the right investment policy for the individuals in terms of minimum risk and maximum return. It refers to managing an individual’s investments in the form of bonds, shares, cash, mutual funds etc. so that he earns the maximum profits within the stipulated time frame. In plain terms, it is managing money of an individual under expert guidance of portfolio managers. Return of a Portfolio The return of a portfolio is equal to the weighted average of the returns of individual assets (or securities) in the portfolio with weights being equal to the proportion of investment value in each asset. Expected return: Where RP is the return on the portfolio, Riis the return on asset i and Wi is the weighting of component asset (that is, the proportion of asset "i" in the portfolio). Return of a Portfolio- Example Portfolio value = Rs 2,00,000 + Rs 5,00,000 = Rs 7,00,000 rA = 14%, rB = 6%, wA = weight of security A = Rs 2 lacs / Rs 7 lacs = 28.6% wB = weight of security B = Rs 5 lacs / Rs 7 lacs=71.4%
  30. 30. 30The Importance of Financial Management Solution:- Portfolio Risk (Standard Deviation) Portfolio Return Variance:- Where Pij is the correlation coefficient between the returns on assets i and j Standard Deviation of a Two-Asset Portfolio The riskiness of a portfolio that is made of different risky assets is a function of three different factors: 1. the riskiness of the individual assets that make up the portfolio 2. the relative weights of the assets in the portfolio 3. the degree of co-movement of returns of the assets making up the portfolio Definition of 'Capital Asset Pricing Model - CAPM' ))()((2)()()()( , 2222 BABABBAAp COVwwww   %288.8%284.4%004.4 )%6(.714)%14(.286)( n 1i    iip ERwER
  31. 31. 31The Importance of Financial Management A model that describes the relationship between risk and expected return and that is used in the pricing of risky securities. Capital Asset Pricing Model (CAPM) A model that describes the relationship between risk and expected return and that is used in the pricing of risky securities. The general idea behind CAPM is that investors need to be compensated in two ways: time value of money and risk. The time value of money is represented by the risk-free (rf) rate in the formula and compensates the investors for placing money in any investment over a period of time. The other half of the formula represents risk and calculates the amount of compensation the investor needs for taking on additional risk. This is calculated by taking a risk measure (beta) that compares the returns of the asset to the market over a period of time and to the market premium (Rm-rf). The CAPM says that the expected return of a security or a portfolio equals the rate on a risk-free security plus a risk premium. If this expected return does not meet or beat the required return, then the investment should not be undertaken. The security market line plots the results of the CAPM for all different risks (betas). Using the CAPM model and the following assumptions, we can compute the expected return of a stock in this CAPM example: if the risk-free rate is 3%, the beta (risk measure) of the stock is 2 and the expected market return over the period is 10%, the stock is expected to return 17% (3%+2(10%-3%)).
  32. 32. 32The Importance of Financial Management Valuation of financial instruments  What is Financial Instrument? A real or virtual document representing a legal agreement involving some sort of monetary value. In today's financial marketplace, financial instruments can be classified generally as equity based, representing ownership of the asset, or debt based, representing a loan made by an investor to the owner of the asset. Foreign exchange instruments comprise a third, unique type of instrument. Different subcategories of each instrument type exist, such as preferred share equity and common share equity, for example.  Valuation Techniques Valuation is The process of determining the current worth of an asset or company. There are many techniques that can be used to determine value, some are subjective and others are objective. 1. Net assets based valuation Asset valuation may consist of both subjective and objective measurements. For example, in valuing a company, there is no number on the company's financial statements that tells how much its brand name is worth; this aspect of asset valuation must be subjective. On the other hand, net profit is an objective measurement based on the company's income and expense figures. Common methods for determining an asset's value include comparing it to similar assets and evaluating its cash flow potential. Acquisition cost, replacement cost and deprival value are also methods of asset valuation. Net asset value is useful for shares valuation in sectors where the company value come from the held assets rather than the stream of profit that was generated by the company business. The examples are property companies and investment trusts. Both are convenient ways wherein the investors can buy diversified bundles of the assets they hold.
  33. 33. 33The Importance of Financial Management Important of net assets based valuation Assets are the property individuals, groups and businesses own. The assets these entities own can be tangible or intangible, valuable or invaluable. Tangible assets are generally valuable, but sometimes, people and businesses hold onto sentimental items that are of little or no value. Intangible assets, such as intellectual property, are often highly valuable, especially to a business. A business must make itself aware of the value of its assets, both tangible and intangible, for financial reporting, insurance purposes, sale and reorganization. Asset valuation is essential in financial reporting. A business's balance sheet determines shareholder or owner's equity by subtracting assets from liabilities. To accurately report equity, the business must first accurately value its assets. Undervalued assets would result in an understated equity figure and overvalued assets would result in an overstated equity figure. 2. Dividend based valuation The dividend discount model is a method of valuing stock shares based fundamentals, that is, based on facts and expectations about a company's business, future cash flows and likely risks. Function Dividend valuation uses a formula to construct the fair value of a company's stock based on its dividend yield. The process of using known factors to determine a price is called "discounting," and dividend valuation is often called the dividend discount model. The purpose, as with any valuation method, is to determine which stocks are cheap, and should be bought, which are expensive, and should be sold, and which are fairly valued and can be held. Features There are four basic components to the dividend discount model: the dividend per share, the appropriate rate of return, the beta value of the stock and the dividend growth rate. In most cases, the appropriate rate of return is figured using Treasury spreads, the difference between short-and long-term rates, or some similar market premium rate.
  34. 34. 34The Importance of Financial Management There are many variations on the dividend discount model, many using different methods to calculate the various inputs to the dividend valuation formula. Another major type of valuation procedure is the two-stage or multi-stage models, that account for the fact that the growth rate of a company changes over time. In most cases, a company's early years can be characterized by 30 percent growth per year or more, but mature companies tend to average a steady 6 percent over time, accounting for inflation and GDP increases. Important of dividend valuation The dividend discount model tends to understate the value of a company with intangible assets like reputation and brand recognition. On the other hand, it may overvalue stocks out of favor with the market. No amount of careful calculation, however, will necessarily predict the future movement of a stock, and assumptions about future growth rates, interest rates, the price of risk and the stability of the market make the model vulnerable to exaggerations. Valuation involves estimating the intrinsic value of a stock, in either absolute or relative terms, to determine whether the stock represents an attractive investment at the current price. An undervalued stock, which trades below its intrinsic value, is often seen as attractive because the discount provides a margin of safety and there is potential for capital gain if market participants eventually reappraise the stock and move its price closer to its intrinsic value. In contrast, an overvalued stock trades above its intrinsic value, provides no margin of safety, and may offer limited capital gains. Indeed, there could be greater potential for capital loss if market participants reappraise the overvalued stock in a downward direction. Thus, valuation plays an important role in determining capital gain or loss, which is a key component of an investment's total return. However, you might wonder why valuation is relevant for dividend growth investors, whose primary focus is on the dividend component of total return. The purpose of this article is to demonstrate that valuation is very relevant because it can have strong effects on the long-term growth of dividend income.
  35. 35. 35The Importance of Financial Management  Valuation of equity Instruments Determining the total value of a company involves more than reviewing assets and revenue figures. An equity valuation takes several financial indicators into account; these include both tangible and intangible assets, and provide prospective investors, creditors or shareholders with an accurate perspective of the true value of a company at any given time. The dividend discount model is a specialized case of equity valuation, and the value of a stock is the present value of expected future dividend. Equity valuations are conducted to measure the value of a company given its current assets and position in the market. These data points are valuable for shareholders and prospective investors who want to find out if the company is performing well, and what to expect with their stocks or investments in the near future. Equity-valuation formulas include the Dividend Discount Model, the Dividend Growth Model and the Price-Earnings Ratio. Function Investors who are considering multiple investments or outlining an investment strategy may request equity valuations of a company, to make the most informed investment decision. Valuation methods based on the equity of a company typically include a thorough analysis of cash accounts, as well as a forecast or projection of future dividends, future earnings (revenue) and the distribution of dividends. Features The total equity of a company is the sum of both tangible assets and intangible qualities. Tangible assets include working capital, cash, inventory and shareholder equity. Intangible qualities, or intangible "assets," may include brand potential, trademarks and stock valuations. Performance indicators include the price/earnings ratio, dividend yield, and the Earnings Before Interest, this is calculated by combining the net debt per share with the price per share.
  36. 36. 36The Importance of Financial Management Important of equity instrument valuation A thorough analysis of tangible and intangible assets allows prospective investors, shareholders and financial managers of a company to obtain critical performance data about the company's business operations. The equity valuation method takes several types of data into account, and can be used as part of a prediction model to determine the economic future of the company. The valuation also provides some indication of the level of risk involved in investing in the company. Identifying the dollar value of intangible assets can be a complicated process, and is typically undertaken by the financial manager or financial accountant. These assets may fluctuate significantly because of market conditions, but they do play an important role in equity valuation. Even though several financial ratios and factors are involved with the equity-valuation process, the final figures can provide a relatively accurate assessment of a company's financial status and revenue prospect.  Valuation of Debt Instruments Debt A debt is an obligation owed by one party (the debtor) to a second party, the creditor; usually this refers to assets granted by the creditor to the debtor, but the term can also be used metaphorically to cover moral obligations and other interactions not based on economic value. 1. Bonds/Debentures A bond or a debenture is a long-term debt instrument or security. It is issued by business enterprises or government agencies to raise long-term capital. A bond usually carries a fixed rate of interest. It is called as coupon payment and the interest rate is called as the coupon rate. The coupon payment can be either annually or semi- annually. A bond can be irredeemable or redeemable. Redeemable bonds have a fixed maturity date and irredeemable bonds have perpetual life with only interest payments periodically.
  37. 37. 37The Importance of Financial Management Basically, the value of a bond is the present value of all the future interest payments and the maturity value, discounted at the required return on bond commensurate with the prevailing interest rate and risk. Bonds are long term debt instruments issued by big corporate clientele or government delegacies or agencies to promote large amount . Bonds brought out by government agencies are secured and those issued by private sector companies may be unsecured or secured. The rate of interest on bonds is determined and they are reformable after a particular period. Here are some significant terms in bond valuation, They are as follows: Face value is also referred as par value. It is the value declared on the face of the bond. It makes up the amount that the unit borrows which is to be re-compensated at the time of maturity, after a certain period of time. A bond is in general issued at values such as Rs. 100 or Rs. 800. Coupon rate is the assigned rate of interest in the bond. The interest payable at regular intervals is the product of the par value and the coupon rate crumbled to the given time horizon. Maturity period brings up to the number of years after which the par value becomes payable to the bond holder. In general, corporate bonds have a maturity period of 7-10 years and government bonds 20 to 25 years. Redemption value is the amount the bond holder develops on maturity. A bond may be delivered at par, at a premium bond holder acquires more than the par value of the bond or at a discount bond holder acquires less than the par value of the bond. Market value is the price in the stock exchange at which the bond is traded. Market price is the price at which the bonds can be sold or bought and this price may be different from par value and redemption value.
  38. 38. 38The Importance of Financial Management Valuation of Bond This will depend on expected cash flows consisting of annual interest plus the principal amount to be received at maturity. The appropriate rate of capitalisation or discount rate to be applied will depend upon the riskiness of the bond e.g. government bonds are less risky and will therefore call for lower discount rates than similar bonds issued by private companies which will call for high rate of discount 2. Valuation of Preference Shares Preference Shares are issued by corporations or companies with the primary aim of generating funds. A preference share usually carries a fixed stated rate of dividend. The dividend is payable only upon availability of profits. In case of cumulative preference shares, arrears of dividends can be accumulated and in the year of profits common stock holders can be paid dividend only upon settlement of all the arrears of cumulative preference dividends. Preference share holders have preference right over payment of dividend and settlement of principal amount upon liquidation, over common share holders. A preference share can be irredeemable or redeemable. Redeemable preference shares have a fixed maturity date and irredeemable preference shares have perpetual life with only dividend payments periodically upon profit availability. Preference shares can alsobe cumulative and non-cumulative. A company may issue two types of shares,  Preference shares.  Ordinary shares. Preference shares have preference over ordinary shares in terms of payment of dividend and repayment of capital. They may be issued with or without a maturity period.  Redeemable preference shares with maturity.  Irredeemable preference shares are shares without any maturity.
  39. 39. 39The Importance of Financial Management  Cumulative preference shares unpaid dividends accumulate and are payable in the future.  Not cumulative shares do not accumulate dividends. Features of Preference and Ordinary Shares Following are the features preference shares,  Preference shareholders have claim on assets and income prior to ordinary shares.  The dividend rate is fixed in case of Preference shares.  A company can issue convertible Preference shares.  Both redeemable and irredeemable Preference shares can be issued Valuation of Preference Shares Basically, the value of a redeemable preference share is the present value of all the future expected dividend payments and the maturity value, discounted at the required return on preference shares.