Introduction

Financial Management
• It is an important functional area of management and an integral part
of decision making of an organisation.
• Concerned with planning and controlling financial resources.
• In particular, the finance manager has to focus on;
• Procuring the required funds as and when necessary, at the lowest cost.
• Investing them in various assets in the most profitable way.
• Distributing them to investors in order to satisfy their expectations from the
firm.
Role of the Financial Manager
• Investment Decisions;
• Capital Budgeting decisions
• Working Capital decisions
• Financing Decisions
• Dividend Decisions
Objectives of Financial Management

Maximisation of Maximisation of
profits of the shareholder’s
firm wealth
Profit Maximisation
• Refers to maximising total accounting profit.
• Profit is regarded as the yardstick of efficiency of any firm.
• However, there are various problems with this concept;
• It ignores risk
• Ignores the financing aspect of that decision
• Ignores the timings of costs and returns (time value of money)
• It is a vague and ambiguous concept
• Not directly related to any measure of shareholders’ benefits
• It focuses on increase in profit of the current year or in near future. This is not
necessarily correct because many decisions have their costs and benefits
scattered over many years.
Shareholders’ Wealth Maximisation
• Refers to maximisation of value of share of a firm.
• The measure of wealth which is used in financial management is based on the concept of
economic value.
• Economic value is defined as the present value of future cash flows generated by a decision,
discounted at appropriate rate of discount which reflects the degree of associated risk. This
takes into consideration the timing of cash flows and the level of risk through the discounting
process.
• Shareholders’ wealth is represented by the present value of all future cash flows in the form of
dividends or other benefits expected from the firm. This is reflected in the market price of the
share.
• Maximisation of shareholders’ wealth considers that shareholders receive the highest
combination of dividend and increase in market price of the share.
• Thus, all financial decisions are evaluated in terms of their effect on firm’s future cash flows,
and hence on the market price of the share.
Time Value of Money (TVM)
• Money received today is different in its worth from money receivable at some
other time in future.
• The proverb ‘A bird in hand is worth two in the bush’ gives the correct
implications of the concept of TVM.
• Rupee received today has a higher value than the rupee receivable in future.
• Reasons for preference for current money;
• Future uncertainties
• Preference for current consumption
• Reinvestment opportunities
• In most of the financial decisions, a finance manager has to deal with cash inflows
and outflows at different time periods. Thus, there is a need to adjust the cash
flows for TVM.
Compounding Technique
• Used to find out the future value (FV) of present money.
• We will consider;
• FV of a single present cash flow
• FV of a series of cash flows (unequal or equal)
FV of a single present cash flow
FV = PV (1+r)n
Where,
FV = Future Value
PV = Present Value
r = % rate of interest
n = Time gap after which future value is to be ascertained
• FV = PV * FVIF (r,n)
• FVIF or CVIF(r,n) (pre calculated values for different combinations of r and n) = (1+r)n
Question: Find out the FV of ₹5,000 invested for 10 years at 5% rate of interest.
Solution: FV = 5,000 * FVIF (5%,10) = 5,000 * 1.629 = ₹8,145
FV of a series of equal cash
flows/Annuity
• Annuity is a finite series of equal cash flows made at regular intervals.
• Deposit of amount A is made at the end of each year for the next 4 years from today. This is
referred to as an annuity deposit of 4 years.
• F4 = A(1+r)3 + A(1+r)2 + A(1+r)1 + A
Where,
F4 = value at the end of year 4
A(1+r)3 = Deposit made at the end of year 1, compounded for 3 years
A(1+r)2 = Deposit made at the end of year 2, compounded for 2 years
A(1+r)1 = Deposit made at the end of year 3, compounded for 1 year
A = Deposit made at the end of year 4
• F4 = A* FVIFA(r%,4)
• FVIFA or CVIFA(r,n) (pre calculated values for different combinations of r and n) =
= A * [(1+r)n - 1]/r
FV of a series of equal cash
flows/Annuity
• Question 1: A deposit of ₹1,000 each year is to be made at the end of
each of the next 3 years from today. Find its value at the end of 3
years, assuming a 10% rate of interest compounded annually.
• Solution: 1,000 * FVIFA (10%,3) = 1,000 * 3.31 = ₹3,310

• Question 2: A 4 year annuity of ₹3,000 per year is deposited in a bank

account that pays 9% interest compounded yearly. The annuity
payments begin in year 12 from now. What is the FV of this annuity?
• Solution: 3,000 * FVIFA (9%,4) = 3,000 * 4.573 = ₹13,719
FV of a series of equal cash
flows/Annuity
• Question 3: A company offers to refund an amount of ₹44, 650 at the
end of 5 years for a deposit of ₹6,000 made annually. Find out the
implicit rate of interest offered by the company.
• Solution:
₹44,650 = ₹6,000 * FVIFA(r%,5)
FVIFA(r%,5) = 7.442
In the FVIFA tables, the value 7.442 corresponding to 5 years row is
found in 20% column. Thus, the implicit rate is 20%.
Discounting Technique
• Used to find out the Present Value (PV) of a future sum or a future
series.
• This is known as the reverse of compounding technique.
• We will consider;
• The PV of a future sum
• The PV of a future series
PV of a future sum
• PV of a future sum will be less than the future sum because of;
• Foregoing the opportunity to invest
• Foregoing the opportunity to earn interest during that period
• This interest foregone is the cost to investor
• The future expected money must be adjusted for this cost
• As the length of time for which one has to wait for the future money increases, the cost attached
to delay also increases reflecting the compounded value of lost opportunities.
• PV = FV/(1+r)n
• PV = FV * PVIF(r,n)
• PVIF(r,n) (pre calculated values for different combinations of r and n) = 1/(1+r) n
• Eg; ₹1,100 is receivable at the end of 1 year from now and the expected rate of interest which a
person can earn on his investment is 10% P.A., then PV = ₹1,000. Thus, ₹1,100 receivable after 1
year is equal in worth to ₹1,000 receivable today.
PV of a series of equal cash
flows/Annuity
• Receipt of amount A at the end of each year for the next 4 years from today.
• P0 = A/(1+r) + A/(1+r)2 + A/(1+r)3 + A/(1+r)4
Where,
P0 = Value today (value at the end of year 0)
A/(1+r) = Amount received at the end of year 1, discounted for 1 year
A/(1+r)2 = Amount received at the end of year 2, discounted for 2 years
A/(1+r)3 = Amount received at the end of year 3, discounted for 3 year
A/(1+r)4 = Amount received at the end of year 4, discounted for 4 years
• P0 = A * PVIFA (r%,4)
• PVIFA (r,n) (pre calculated values for different combinations of r and n) =
= A * [(1/r) – (1/r*{1+r}n]
PV of a series of equal cash
flows/Annuity
• Question 1: An investment scheme pays ₹900 at the end of each year
for the next 3 years from now. Find its present value if the investor’s
expected return is 10% P.A.
• Solution: ₹900*PVIFA (10%,3) = ₹2,238
Questions
1. An amount of ₹1,000 is deposited in an interest bearing account that pays 10% interest compounded
annually. The investor’s goal is to realise ₹1,500. How many years must the principal earn compound
interest before the desired amount is realised.
2. You are awarded a scholarship and 2 options are available:
A. Receive $1100 now
B. Receive $100 P.M. at the end of each next 12 months
Which option would you prefer if the interest rate in market is 12% P.A.
3. A deposit is made in year 0 in an account that will earn 8% compounded annually. It is desired to
withdraw $5000 three years from now and $7000 six years from now. What should be the size of the
deposit?
4. A company offers to refund an amount of Rs. 44,650 at the end of 5 years for a deposit of Rs. 6,000
made annually. Find the implicit rate of interest offered by the company.
5. An investor is considering the purchase of a bond that pays 8% P.A. on its face value of $1000. It will
mature in 20 years. What is the maximum purchase price that should be paid for this bond if the investor
requires 10% return?
Questions
6. The cost of a new automobile is ₹10,000. If the interest rate is 5%,
how much would you have to set aside now to provide this sum in 5
years?
7(A). You have to pay ₹12,000 a year in school fees at the end of each
of the next 6 years. If the interest rate is 8%, how much do you need to
set aside today to cover these bills?
7(B). You have invested ₹60,476 at 8% P.A. After paying the above
school fees, how much would remain at the end of 6 years?
Questions
8. After working on an office building for 3 years, you are about to sell it
for ₹4,20,000. But someone offers to rent it for 8 years for a fixed
annual rental of ₹8,000. At the end of this period, you would be able to
sell the building. Your real estate advisor estimates that prices of office
buildings will rise by 3% P.A. The discount rate is 5%. Would you sell it
right now or wait for 8 years? If you plan to wait for 8 years, will you
accept the offer of ₹8,000 rent P.A. or would you negotiate for a higher
amount?
Solutions
1. 1000*CVIF (n,10%) = ₹ 1500
CVIF (n,10%) = 1.5
Looking at the CVIF tables, n = 5
2. A: PV = $ 1100
B: PV = 100*PVIFA (12,1%) = 100*11.255 = $ 1125.5
Prefer Option B
3. PV = 5000 * PVIF (3,8%) + 7000 * PVIF (6,8%) = ₹ 8,380
4. 44,650 = 6,000 * CVIFA (5,r%)
CVIFA = 7.442
Looking at the CVIFA tables, r = 20%
5. PV = 80 * PVIFA (20,10%) + 1000 * PVIF (20,10%) = $830.12
Solutions
6. A * CVIF (5%,5) = 10,000
A = ₹7,812.5
7(a) 12,000 * PVAF (8%,6) = ₹55,476
7(b) (60,476-55,476) * CVIF (8%,6) = ₹7,934
Solutions
8. We will compare the present value of both the options;
Option A: Sell it today for ₹4,20,000
Option B: Rent it out for 8 years and sell after that
P8(Sale value after 8 years) = 4,20,000 * CVIF (3%,8) = ₹ 5,33,400
PV (P8) = 5,33,400 * PVIF (5%,8) = ₹3,61,111.8
PV (Rent) = 8,000 * PVIFA (5%,8) = ₹51,704

PV (option A) = ₹4,20,000
PV (option B) = ₹3,61,111.8 + ₹51,704 = ₹4,12,815.8
Thus, Option A is better
If you go with option B, one will negotiate for a higher amount.
₹4,20,000- ₹3,61,111.8 = ₹58,888.2
A * PVIFA (5%,8) = ₹58,888.2
Thus, A = ₹ 9,111.58
One should negotiate for an amount higher than ₹ 9,111.58
Other Specific Cash Flows
Perpetuity: Infinite series of equal cash flows occurring at regular
intervals.
PVP = Annuity cash flow/r
Growing Perpetuity: Infinite series of periodic cash flows which grow
at a constant rate per period (g).
PVP = Cash flow1/(r-g)
Annuity Due: The discussion on FV or PV of annuity was based on the
presumption that cash flows occur at the end of each period starting
from now. However, in practice cash flows may also occur in the
beginning of each period. Such a situation is known as annuity due.
Other Specific Cash Flows
Future Value of Annuity Due
• Deposit of amount A is made at the beginning of each year for 4 years.
• F4 = A(1+r)4 + A(1+r)3 + A(1+r)2 + A(1+r)
• F4 = A* FVIFA(r%,4) * (1+r)
Present Value of Annuity Due
• Receipt of amount A at the beginning of each year for 4 years.
• P0 = A + A/(1+r) + A/(1+r)2 + A/(1+r)3
• P0 = A * PVIFA (r%,4) * (1+r)
Questions
1. In May 2020, a retired couple gave $1 to buy a lottery ticket and won a
record amount of $194 million. However, this sum was to be paid in 25
equal instalments. If the first instalment was received immediately, and the
interest rate was 9%, how much was the prize worth?
2. A company is selling a debenture which will provide annual interest
payment of ₹1200 for indefinite number of years. Should the debenture be
purchased if its being quoted in the market for ₹10,500 and the required
return is 12%?
3. A borrower ‘X’ borrows an amount of ₹10,00,000 from a bank @12% P.A.
on 1/4/2014. As the per the agreement, repayment including interest is to
be made in 5 equal instalments. First instalment falls due on 31/3/2017.
What would be the amount of each instalment?
Solutions
1. Annual Inflow = $194 million/25 = $7.76 million
Worth of the prize = [7.76 million * PVIFA (9%,25) * (1.09)] - 1 =
$83,086,862.2
2. PV (Debenture) = 1200/0.12 = ₹10,000
Should not be purchased as it is overpriced.
3. Value of 10,00,000 as on 31/3/2016 = 10,00,000 * FVIF (12%,2) =
₹12,54,000
12,54,000 = A * PVIFA (12%,5)
A = ₹3,47,850
Multi-period /Non Annual
Compounding
Nominal Interest Rate: Interest rate is specified on annual basis
Effective Interest Rate: The actual annualised rate when compounding is done more than once a year
(1+re) = (1+r/m)m
Where;
r: nominal interest rate
re: effective interest rate
m: number of compounding periods in a year
Eg; Value of $100 compounded semi-annually at 10% P.A. is $110.25. Here re is 10.25% P.A. which is higher than r
Continuous Compounding: FV=PV(e)rn
Where;
e: mathematical constant that is the base of the natural logarithm (2.7183)
r: rate of interest
n: number of years
Questions
1. A deposit of $10,000 is made in a bank for 1 year. The bank offers 2 options;
A. Receive interest @ 12% P.A. compounded monthly
B. Receive interest @ 12.25% P.A. compounded half yearly
Which option should be preferred?
2. A company is borrowing $2,000,000 from a bank for expansion of its
business. The banks gives it two options:
C. Return the money in 5 equal annual instalments @ 10% P.A.
D. Return the money in equal half yearly instalments over a period of 5 years
@ 9.8% P.A.
Which option should be preferred?
Solution
1.
Case I: re= (1+0.12/12)^12 – 1 = 12.68% PA
Case II: re= (1+0.1225/2)^2 – 1 = 12.63% PA
Option I is better as it offers a higher effective rate of interest.
2.
Option I: re= 10% PA
Option II: re= (1+0.098/2)^2 – 1 = 10.04% PA
Option I is better as you are paying lower effective rate of interest.