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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 12 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 value of a lumpsum

Present value of a series of payments

Present value of an annuity

Present value of 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 12 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.

YearDividends(Rs.)Average market price(Rs.)

2001 2.0040

2002 2.0030

2003 2.0040

2004 3.0069

2005 3.50100

2006 4.00121

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 rate of return(%) Probability

Decline-50.25

Stagnation 10.25

Expansion120.25

Growth200.25

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 LtdVarun Ltd

Expected return22% 16%

Standard deviation1.61% 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 Probabilityxy

A 0.1 -10 16

B 0.2 12 -5

C 0.4 9 7

D 0.2 7 18

E 0.1-4 20

Calculate:

The expected return on individual securities

The expected return on a portfolio of X and Y

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 conditionprobability A B

Good 0.5 40 0

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

(Pxd1xd2)

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

Market value

Liquidation 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

The yield to an investor who had purchased the debentures at Rs. 1000;

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 = D0(1+g)

ke-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%.