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Financial management

Time value of money, Risk


and return, Valuation

Objectives of Financial
management

Profit maximisation/EPS

Ambiguity, quality of benefits/risk, timing of benefits

Wealth maximisation

Value, ie., worth to the owners

Capitalisation/discount rate that reflects risk and time preferences

Economic value added (EVA)

After tax operational profits of a firm less the cost of funds used to
finance investments

Focus on stakeholders

Employees, customers, suppliers, creditors, owners and others


who have direct link with the firm

Time value of money


I will gladly pay you Tuesday for a hamburger I
can eat today - Wimpie, from the Popeye cartoon

Learning Objectives
Explain the meaning of the time value of money and the
importance of the timing of cash flows in making financial
decisions
Calculate the future value and present value of cash flows for
one period and multiple periods
Solve for the interest rate implied by a given set of present
value and future value cash flows
Apply time value of money techniques to solve basic problems
facing financial managers
Use a calculator/excel sheet to solve time value of money
problems

Central concepts in finance


Risk-return tradeoff - Investors will take on additional
risk only if they anticipate higher return.
Time value of money value of a unit of money is
different in different time periods
A rupee available today is worth more than a rupee
available at a future date.
This is because a rupee today can be invested to earn a
return.

Techniques

Future value or Compounding

Compound interest is the interest earned on a


given deposit/principal that has become a part of
the principal at the end of a specified period

Principal refers to the amount of money on which


interest is received

Present value or Discounting

Present value is the current value of a future


amount

Discounting is determining the present value of a


future amount

RISK and RETURN

Risk and return of a single asset

Return actual income received plus any


change in the market price of an asset /
investment
Calculation of expected return single period
Risk variability of actual return from the
expected return associated with a given asset

Measurement of risk

Behavioural point of view

Sensitivity analysis

Probability distribution

Quantitative/statistical point of view

Standard deviation

Co-efficient of variation

Risk and return of a portfolio

Portfolio combination of two or more


securities/assets

Portfolio expected return

Portfolio risk

Correlation/covariance

Diversification

Risk return trade off

Risk return trade off

Systematic risk

Caused by factors that affect the overall market/all


securities

Non diversifiable/unavoidable

Unsystematic risk

Unique to particular company/industry/security

Diversifiable/ avoidable

CAPM

Provides a framework for basic risk return trade

Capital Asset Pricing model

Model that describes the relationship/tradeoff


between risk and expected/required rate of return
Explains the behaviour of security prices and
provides a mechanism to assess the impact of
proposed security investment on investors overall
portfolio risk and return
Provides a framework for basic risk return trade off in
portfolio management
Enables drawing certain implications about the risk
and size of risk premium necessary to compensate
for bearing risk

Efficiency of market

Assumptions

Investors well informed

Transaction costs are low

Negligible restrictions on investments

No investor is large enough to influence

Investors in general agreement about likely performance

Expectations are based on one year holding period

Investor preferences

Prefer to invest in securities with the highest return for a given


level of risk or lowest risk for a given level of return

Return a risk measured in terms of expected value and standard


deviation respectively

Measure of risk

Beta coefficient is an index of the degree of


responsiveness/comovement of security return with
market return

Risk free return

Expected return less risk free return = excess return

Beta coefficient represents the change in excess


return on the individual security over changes in
excess return on market portfolio
Beta of market portfolio is equal to 1
Index of systematic risk of individual security relative
to that of market portfolio

Beta of a security and CAPM


formula
The CAPM formula is: ra = rrf + Ba (rm-rrf)
Required Return = Risk free rate + (Market return Risk free rate) *
Beta
Portfolio Beta = (the sum of) {weight of security X Beta of security}

Valuation of long term securities

Valuation of bonds/debentures

Bond long term debt instrument used by


government, government agencies and
business enterprises to raise a large sum of
money
Par value value on the face of the bond
Coupon rate specified interest rate available
on security
Maturity period number of years after which
the par/specified value is payable to the

Illustration

A firm has issued a 10 percent coupon interest


rate, 10 year bond with a Rs. 1000 par value
that pays interest semi-annually. A bond
holder would have contractual right to

Annual interest of Rs 100 i.e., coupon interest rate


* par value (.10*1000) paid as Rs 50 at the end of
every 6 months

Par value at the end of 10th year - Rs. 1000

Basic bond valuation

Present value of contractual payments its issuer (corporate) is


obliged to make from the beginning till maturity
Appropriate discount rate would be the required return
commensurate risk and prevailing interest rate
When the required return is equal to the coupon rate, the
bond value equals the par value

Impact of required return on bond


values

Change in the basic cost of long term funds

Change in the basic risk of the firm

If RR>CR then bond value < par value: Discount (M-B)

If RR<CR then bond value > par value: Premium(B-M)

Impact of maturity on bond value

Time to maturity

RR

Bond value

Constant RR

Changing RR

Constant required returns

Changing required returns

The shorter the time to maturity, the smaller the


impact on bond value caused by a given change in
the required return

Yield to maturity

Rate of return investors earn if they buy a


bond at a specific price and hold it till maturity
Illustration

Valuation of preference shares

Expected return is the return that is expected


to be earned on a given security over an
infinite time horizon

Zero growth model

Constant growth/Gordon model

Variable growth model