Financial Managment

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					 Financial Management by
     Muhammad Arif
                     Books recommended
1.   Principles of corporate finance by Richard .A.Brealey
     and Stewart C Meyers.
2.   Advance corporate finance Ogden, Jen and Conner
3.   Intermediate Financial management by Troy, Brigham,
     Eugene F, Louis C and Gapenski
               Financial Management
Finance is the science of funds management. The general areas of finance are
    business (Corporate) finance, personal finance, and (Government) public finance.
    Finance includes saving money and often includes lending money. The field of
    finance deals with the concepts of time, money and risk and how they are
    interrelated. It also deals with how money is spent and budgeted.
Financial management means :-
• Managerial finance, the branch of finance that concerns itself with the managerial
    significance of finance techniques
• Corporate finance, an area of finance dealing with the corporate financial
Islamic financial management means:-
    Conventional financial management tagged with Shriah rulings is termed as Islamic
    financial management. Here data used whether historical or current and
    evaluation process for valuation of any asset remains the same, however
    investment strategy differs in some ways.
                    Financial Management
                                      Managerial finance

    It is the branch of finance that concerns itself with the managerial significance of finance
    techniques. It is focused on assessment rather than technique. Why because it is better to be
    approximately right rather than precisely wrong.
•   One concerned with management though would want to know what the figures mean.
•   They might compare the returns to other businesses in their industry and ask: are we
    performing better or worse than our peers? If so, what is the source of the problem? Do we
    have the same profit margins? If not why? Do we have the same expenses? Are we paying
    more for something than our peers?
•   They may look at changes in asset balances looking for red flags that indicate problems with
    bill collection or bad debt.
•   They will analyze working capital to anticipate future cash flow problems.
•   Managerial finance is an interdisciplinary approach that borrows from both managerial
    accounting and corporate finance
            Financial Management
                           Corporate finance

It is an area of finance dealing with the financial decisions corporations
make and the tools and analysis used to make these decisions. The
primary goal of corporate finance is to maximize corporate value. while
managing the firm's financial risks. Although it is in principle different
from managerial finance which studies the financial decisions of all
firms, rather than corporations alone, the main concepts in the study
of corporate finance are applicable to the financial problems of all
kinds of firms.
The discipline can be divided into long-term and short-term decisions
and techniques. Capital investment decisions are long-term choices
about which projects receive investment, whether to finance that
investment with equity or debt, and when or whether to pay dividends
to shareholders. On the other hand, the short term decisions can be
grouped under the heading "Working capital management“, the focus
here is on managing cash, inventories, and short-term borrowing and
lending (such as the terms on credit extended to customers).
                      Financial Management
                Main steps in carrying out Financial Management Decisions
1.   Capital investment decisions:- They are long-term corporate finance decisions relating to fixed assets and
     capital structure. Capital investment decisions thus comprise an investment decision, a financing
     decision, and a dividend decision.
2.   Project valuation:-each project's value is estimated using a discounted cash flow (DCF) valuation, and the
     opportunity with the highest value, as measured by the resultant net present value (NPV)
3.   Estimating the size and timing of all of the incremental cash flows resulting from the project and then
     discounting these cash flows to determine their present value.
4.   These present values are then summed, and this sum net of the initial investment outlay is the NPV.
5.   The NPV is greatly affected by the discount rate. Thus identifying the proper discount rate—the project
     "hurdle rate"—is critical to making the right decision. The hurdle rate is the minimum acceptable return
     on an investment—i.e. the project appropriate discount rate. The hurdle rate should reflect the riskiness
     of the investment, typically measured by volatility of cash flows, and must take into account the financing
     mix. Managers use models such as the CAPM or the APT to estimate a discount rate appropriate for a
     particular project, and use the weighted average cost of capital (WACC) to reflect the financing mix
6.   In conjunction with NPV, there are several other measures used as (secondary) selection criteria in
     corporate finance. These are visible from the DCF and include discounted payback period, IRR, Modified
     IRR (The internal rate of return (IRR) is a rate of return used in capital budgeting to measure and
     compare the profitability of investments, equivalent annuity, capital efficiency), and ROI In finance, (rate
     of return (ROR), also known as return on investment (ROI), rate of profit or sometimes just return, is the
     ratio of money gained or lost (whether realized or unrealized) on an investment relative to the amount of
     money invested);
                  Financial Management
                                  Present value (PV)

    PV is the value on a given date of a future payment or series of future payments,
    discounted to reflect the time value of money and other factors such as
    investment risk. Present value calculations are widely used in business and
    economics to provide a means to compare cash flows at different times on a
    meaningful "like to like" basis.
•   Formula :-present value= discount factor x (C1 i.e. expected cash flow at time t)
     Discount factor= 1/1+r
•   Example:- if you anticipate to receive Rs 100000/- at the end of year. Suppose the
    rate of interest is 10% than you would have to invest 100000/1.1=Rs 90909 This
    means that the present value today of Rs 100000/- onward one year is Rs 90909/-
                  Financial Management
                                Net present value (NPV)

  (NPV) or net present worth (NPW) is defined as the total present value (PV) of a time
   series of cash flows. It is a standard method for using the time value of money to
   appraise long-term projects. Used for capital budgeting, and widely throughout
   economics, it measures the excess or shortfall of cash flows, in present value terms,
   once financing charges are met.

 According to last slide today's worth of cash flow in future was Rs 90900/- but it is not
   necessary that you may have invested in some project Rs 90909/- today. It may be Rs
   75000/ therefore your net present value may be Rs15909 i.e. NPV=PV-required
   investment or NPV= Co+C1/1+r i.e. -75000+ (100000/1.1)=Rs 15909
What NPV Means
 If NPV > 0 the investment would add value to the firm the project may be accepted. NPV
   < 0 the investment would subtract value from the firm the project should be rejected.
   NPV = 0 the investment would neither gain nor lose value for the firm . However, NPV =
   0 does not mean that a project is only expected to break even, in the sense of
   undiscounted profit or loss (earnings) it can show net total positive cash flow and
   earnings over its life.
              Financial Management
                       Present values and rate of return

It is the return on the capital invested as proportion of initial outlay=
profit/investment = 100000-75000/75000= 33%.

These findings devise some decision rules for the capital investment i.e.

 (a) accept investments that have positive present value
(b) accept investments that offer rates of return in excess of their opportunity cost
of capital
                 Financial Management
                Trade off between investing in spot/future markets.

  Suppose you have some cash in hand and some cash to be received after one
  year. By investing on spot through cash or through borrowing you can increase
  your consumption today. On the contrary by using your future cash flows or
  through lending you can increase your consumption in tomorrow. This
  requires a trade off by using following assumptions.
• Net present value rule:- invest so as to maximize the net present value of the
  investment. This is the difference between the discounted, or present, value of
  the future income and the amount of the initial investment.
• Rate of return rule:- invest up to the point at which the marginal return on the
  investment is equal to the rate of return on the equal investments in the
  capital market. This is the point of tangency between the interest rate line and
  the investment opportunities line
             Financial Management
                           Example of tradeoff

Suppose you have Rs 100 and Rs 200 as cash to be received after one year.
In case you do not consume today than you would invest Rs 100 at 10%.
This would make your investment as Rs 110+200=Rs 310. On the contrary
if you borrow Rs 200 against your future cash flow. It would cost you as
200/1.1= Rs181 thus making total cash in hand as Rs281. if you again
invest this amount at 10% you would get Rs 310. However while investing
in real assets other than financial assets rule of diminishing return or
marginal returns come in to play making the payoff curve flat in the last. In
economics, diminishing returns (also called diminishing marginal returns)
refers to how the marginal contribution of a factor of production usually
decreases as more of the factor is used. According to this relationship, in a
production system with fixed and variable inputs (say factory size and
labor), beyond some point, each additional unit of the variable input
yields smaller and smaller increases in output. Conversely, producing one
more unit of output costs more and more in variable inputs.
This concept is also known as the law of diminishing marginal returns, the
law of increasing relative cost, or the law of increasing opportunity cost
Financial Management

Present value of Bonds and
                    Financial Management
                                      Terms to remember

•   A zero-coupon bond (also called a discount bond or deep discount bond) is a bond bought
    at a price lower than its face value, with the face value repaid at the time of maturity. It does
    not make periodic interest payments, or have so-called "coupons," hence the term zero-
    coupon bond.
•   A coupon bearing bond is a debt security, in which the authorized issuer owes the holders a
    debt and, depending on the terms of the bond, is obliged to pay interest (the coupon) and/or
    to repay the principal at a later date, termed maturity.
•   A perpetuity is an annuity that has no definite end, or a stream of cash payments that
    continues forever. There are few actual perpetuities in existence (although the British
    government has issued them in the past, and they are known and still trade. A number of
    types of investments are effectively perpetuities, such as real estate and preferred stock, and
    techniques for valuing a perpetuity can be applied to establish their prices. Perpetuities are
    but one of the time value of money methods for valuing financial assets
•   Annuity refers to any terminating stream of fixed payments over a specified period of time.
    This usage is most commonly seen in valuation of the stream of payments, taking into
    account time value of money concepts such as interest rate and future value. Examples of
    annuities are regular deposits to a savings account, monthly home mortgage payments and
    monthly insurance payments. Annuities are classified by payment dates.
                      Financial Management
                                         Terms to remember

•    Market Capitalization rate (or "cap rate") is a measure of the ratio between the net operating
     income produced by an asset (usually real estate) and its capital cost (the original price paid to buy
     the asset) or alternatively its current market value. The rate is calculated in a simple fashion as
    For example, if a building is purchased for $1,000,000 sale price and it produces $100,000 in
     positive net operating income (the amount left over after fixed costs and variable costs are
     subtracted from gross lease income) during one year, then:
     $100,000 / $1,000,000 = 0.10 = 10%
     The asset's capitalization rate is ten percent.
•    The dividend yield or the dividend-price ratio on a company stock is the company's annual
     dividend payments divided by its market cap, or the dividend per share divided by the price per
     share. It is often expressed as a percentage. Its reciprocal is the Price/Dividend ratio.
•    Dividend payout ratio is the fraction of net income a firm pays to its stockholders in dividends:
     The part of the earnings not paid to investors is left for investment to provide for future earnings
     growth. Investors seeking high current income and limited capital growth prefer companies with
     high Dividend payout ratio. However investors seeking capital growth may prefer lower payout ratio
     because capital gains are taxed at a lower rate. High growth firms in early life generally have low or
     zero payout ratios. As they mature, they tend to return more of the earnings back to investors.
                    Financial Management
                                      Terms to remember

•   Plow back ratio, shows the proportion of earnings not paid out as dividends, which is
    plowed back into the business. The formula is: = (100 - Dividend Payout Ratio) or = (Retained
    Profit PS / EPS-basic) * 100. If a company had losses during the period under review,
    Plowback ratio is not defined.
•   Earnings per share (EPS) are the earnings returned on the initial investment amount. Diluted
    Earnings Per Share (diluted EPS) is a company's earnings per share (EPS) calculated using
    fully diluted shares outstanding (i.e. including the impact of stock option grants and
    convertible bonds).
•   Earnings growth rate is the Annual rate of growth of earnings from investments. Generally,
    the greater the earnings growth, the better. When the dividend payout ratio is the same, the
    dividend growth rate is equal to the earnings growth rate. Earnings growth rate is a key value
    that is needed when the DCF model is used for stock valuation.
•   Free cash flow (FCF) is cash flow available for distribution among all the securities holders of
    an organization. They include equity holders, debt holders, preferred stock holders,
    convertible security holders, and so on.

              Financial Management
                           Terms to remember

• The P/E ratio (price-to-earnings ratio) of a stock (also called its
  "P/E", "PER", "earnings multiple," or simply "multiple") is a measure
  of the price paid for a share relative to the annual net income or
  profit earned by the firm per share. It is a financial ratio used for
  valuation: a higher P/E ratio means that investors are paying more
  for each unit of net income, so the stock is more expensive
  compared to one with lower P/E ratio. The P/E ratio has units of
  years, which can be interpreted as "number of years of earnings to
  pay back purchase price", ignoring the time value of money. In
  other words, P/E ratio shows current investor demand for a
  company share. The reciprocal of the PE ratio is known as the
  earnings yield. The earnings yield is an estimate of expected return
  to be earned from holding the stock.
• Long:- An obligation to buy a financial instrument.
• Short:- An obligation to sell a financial instrument.
                  Financial Management
                       Valuing present value of long dated assets

•   Zero coupon instruments (Treasury Bills/Commercial papers)
    PV=DF x C= C/1+r Suppose on investment of Rs 100 the return is 10% per year
    than 100/1.1= Rs 90.90.
•   For extended period the formula would be PV=∑ Ct/(1+rt)t. For example at the end
    of first year Rs 100 would fetch Rs 110 at the same rate in the 2nd year. The sum of
    all corresponding years would get you the PV for the period under review.
•   Term structure of interest rate is an important element in the decision making
    under financial management which is the series of interest rate prevailing in a
    market subject to different time horizons. This develops yield curve in the market
    that can be flat, humped, inverted or steep.
               Financial Management
               Valuing present value of perpetuities and Annuities

•   Perpetuities:- The formula is Return=Cash flow/present value or r=C/PV. Suppose
    a person wants to endow a fund with cash flow of Rs 100000/ per year than
    according to this formula he has to provide Rs 1,000,000/- with an interest rate of
    10 i.e. = present value of perpetuity = C/r = 100000/.10 = Rs 1,000,000. Suppose
    another benefactor wants to provide Rs 100,000/- in a year with a growth of 4%
    on yearly basis. i.e. in a fashion that in the first year Rs 100,000/- would be
    provided with 1.04 and so on. In this case the formula would be PV=C/r-g i.e.
    100000/.10-.04. So accordingly he has to spare Rs 1,666,667.
•   Annuities:- The PV of an annuity is the difference between the values of two
    perpetuities i.e. PV of perpetuity (first payment year ) is = C/r whereas PV of
    perpetuity ( first payment year t+1) is C/r (1+r)t, hence PV of annuity from year 1
    to year t = C (1/r-1/r(1+r)t). Suppose in case of our benefactor to endow Rs
    100,000/ for 20 years he would have to spare 100000 x (1/.10-1/.10(1.10)20)= Rs
              Financial Management
                            Compound interest Rate

The distinction between simple and compound interest rates is that when money
is invested in compound interest, each interest payment is reinvested to earn
more interest in subsequent periods. In contrast the opportunity to earn interest
on interest is not provided by an investment that pays only simple interest.

By looking in to the curve path of simple and compound interests it transpires that
path of compound interest payments travel in straight line whereas in case of
simple interest rate it flattens in the latter period. Accordingly discounting process
also travels in straight line so in fact discounting of any cash flow incorporates
compounding impact
              Financial Management
                       Valuing present value of Bonds

Bonds are normally more than of one year tenor and are subject to periodical
profit payments on annual, semiannual or on quarterly basis. Their profit
payments can be fixed or floating based on some credible benchmark. To know
about their PV one needs to discount the prospective stream of its cash flows. On
maturity the cash flow includes principal amount. The formula is PV= ∑ Ct/(1+r)t .
In case of 3 years PIBs worth Rs 100,000/- with 10% return the formula would be =
              Financial Management
                        Valuing present value of Stocks

Cash payoffs on stock are in two forms i.e. (1) cash dividend and (2) capital gain or
losses. The rate of return on share thus is = expected return or market
capitalization rate=r=Div1+P1 (expected price at the year end) - P0 (current
price)/P0 or 5+110-100/100=.15=15%. Correspondingly price can be calculated as

Assumption:-All securities in an equivalent risk class are priced to offer the same
expected return.

Going forward one can look in to future by using this formula:- P0=∑ Div1/(1+r)t +
PH/(1+r)H Suppose in above case the dividend for the next year is 5.5 and the
price is Rs121 than for two years forecast the today's price would be 5-
              Financial Management
                        Valuing present value of Stocks

Present price can also be known by using this formula P0=Div1/r-g. In this case g is
the anticipated growth rate for company's, dividends, however g should be lesser
than r. Why because if g approaches r than stock price would become infinite.
Alternatively the formula can be used to obtain an estimate of market
capitalization rate r from Div1,P0,and g. i.e. r=Div1/P0+g.

However hard part is to get g because it also depends on pay out and plow back
ratios. This impacts return on equity and book equity per share. ROE can be
calculated as EPS1/book equity per share.

Dividend growth rate=g=Plow back ratio x ROE
              Financial Management
                       Valuing present value of Stocks
                      case of growth and income stocks

Income stocks are like perpetual bonds so its price can be calculated as
P0=Div1/r=EPS1/r=10.0/.10=100. In this case NPV per share comes out as=-
10+1/.10=0. However since it is assumed that increase in value caused by the extra
dividends in later years would once again make the market capitalization rate
equals the earnings price ratio = r= EPS1/P0=10/100=.10 or 10%. In general one
can think of stock price as the capitalized value of average earnings under a no
growth policy plus present value of growth opportunities = P0 = EPS1/r + PVGO.
The EPR therefore =EPS1/P0= r (1- PVGO/P0). If PVGO is positive than r has been
underestimated and if PVGO is negative than r has been overestimated.
            Financial Management
                       Valuing present value of Stocks

Example:- Suppose a company is expected to pay Rs 5 as dividend and the
dividend has to increase by 10% a year indefinitely. The capitalization rate r is 15%.
Further suppose EPS is Rs 8.3. Ratio of earnings to book equity is i.e. ROE= .25.
Than first:-
P0=Div1/r-g= 5/.15-.10=Rs 100
Payout ratio= Div1/EPS1= 5.0/8.33= .6
This reflects that company is plowing back = 1-.6= .40
Growth rate= g = plowback ratio x ROE = .4 x .25 = .10
The capitalized value of company's EPS if it had no growth policy would be EPS1/r
= 8.33/.15 = Rs 55.56. However since share price is Rs 100 so Rs 44.44 is the
amount for growth opportunities
Another version of using DCF formula is to use free cash flows instead of Dividend
which is = revenue – cost – investment . Or P0 = ∑ ( Free cash flow per share) t/
(1+r) t