Lect one FM

8/13/2019 Lect one FM

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FINANCIAL MANAGEMENT

Fundamental Concepts


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Agenda

1. Introduction to Financial Management2. Time value of Mooney

3. Risk and Return4. Cost of capital


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1. Introduction to FinancialManagement

1. Finance Function2. Goals of financial management

3. Understand the conflicts of interest that canarise between owners and managers4. Ethical Behavior and Long Term Profitability

5. Case Study : Stakeholders Management inPower Sector


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Finance is the life-blood of business

It is required not only at the time of setting upbusiness but at every stage during existence ofbusiness.


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Management of Money

Systematic efforts of the managementto efficiently manage its finances

Application of general management principles toparticular financial operation

Financial Management


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Note There is difference BetweenFinance & Accounting

Accounting Accounting Profit Total Flow

Finance Cash Flow Incremental cash Flow Time value of Money


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Key Financial Decisions in a firm

Capital Budgeting

Working capital Management

Dividend Decision


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Purpose of Financial Management

Create Wealth


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Objectives of Financial Management

Goal of the Firm

ProfitMaximization

Shareholder WealthMaximization


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Agency Problem

Agency problem : The possibility of conflict ofinterest between stockholders andmanagement of a firm. Conflicts of interestamong stockholders, bondholders, andmanagers


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How to mitigate agency problem ?

Incentives - Managerial Compensation plans Direct Intervention by Shareholders

Threat of Sacking Threat of Takeover Corporate governance regulations


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Business Ethics & Social Responsibility

Ethical Behaviour Long term profitability _______________________________________


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2. Time value of Money


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What is Time Value of Money ?

The Time Value of Money (TMV) is based on the concept that a rupee today isworth more than it would be tomorrow.


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Two ways of looking at TVM

TVM

FV

PV


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What is Future Value?

FV = PV+ Interest (PV*r)= PV (1+r)

=PV ( 1 + r )n


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We can use FV concept for decisionmaking


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What is PV? Present Value is a value today of a sum of

money to be received at a future points oftime.

We know that FV=PV ( 1 + r ) n

So, PV = FVn / ( 1 + r) n

Finding the PV of a cash flow or series of cash flowswhen compound interest is applied is calleddiscounting (the reverse of compounding).


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Worth of a Firm

Conceptually, a firm should be worth thepresent value of the firms cash flows.

The tricky part is determining the size, timing ,and risk of those cash flows.


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Risk & Return


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What is return ?

Return is difference between an investment amount today andwhen initially invested

Invested Rs. 1000 one year ago Today that investment is worth Rs.1200 Return ? Return is Rs.200


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Expected Return

The symbol for expected return, r , is called r hat. r = Sum (all possible returns their probability)

Expected Return is based on probabilityDistribution

n

j

j j pr r 1

Expected Return is a weighted averageof the individual possible returns


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Risk

Risk refers to the potential variability ofreturns from a project or portfolio of projects


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Risk Premium

Risk Premium is the difference between

the expected return on the proposedinvestment and the risk free rate.


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Total risk of any investment

Total risk = Systematic risk + Unsystematic risk (market risk) (diversifiable)


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Risk & Beta

The systematic risk, or market risk, can affectall market investments. (A recession or a war,

for example, might impact all investments in a portfolio.)

We measure the systematic risk by the betacoefficient, or .


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Calculating Beta / Expected Return on aSecurity

For calculating the beta of a security, the following market model is employed:

(This Model is called the Capital Asset Pricing Model (CAPM ):

)( F M i F i R R R R

Expectedreturn ona security

=Risk-

free rate+

Beta of the

security

Market risk

premium

e j

e j => random error term


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General rule for

The general rule for is as follows:If = 1.0 then the investment has "normal"

market riskIf < 1.0 then the investment has below

normal market risk (for example U.S. securities'

= 0 or zero risk)If > 1.0 then the investment has a greaterthan normal market risk (higher risk)


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Cost of Capital


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Agenda

Cost of Debt and

Cost of Preference

Cost of Equity

Weighted Average Cost of Capital


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Note

Cost of capital is also called as hurdle rate, cut-off rate, target rate, minimum required rate of return, standard return

As an operational criterion it is related to the firmsobjective of wealth maximization.


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Cost of Debt

k d after taxes = k b (1 tax rate)where k

b is before tax cost of debt and k

d is

after tax cost of debt.


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Cost of Equity Capital

Cost of equity is determined by calculating the returnon equity.

Return on equity comes from two sources:

(a) Dividend(b) Capital gain


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Capital Asset Pricing Model (CAPM)

CAPM is the most widely used method to calculate thecost of equity.

According to the CAPM approach, there exists a linear

relationship between risk and expected return. CAPM calculates the cost of equity by considering the

risk-free rate prevalent in the economy and the risk-free premium desired by the investor.


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Cost of Retained Earnings

The cost of retained earnings (internal funds) is similarto the cost of equity.

Because shareholders forego their current incomewhen they allow the company to use the retainedearnings in profitable investments


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WACC is calculated by multiplying the cost of

each capital component by its proportionalweighting and then summing them.

Weighted Average Cost of Capital (WACC)


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Ends..

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