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I. FINANCIAL MANAGEMENT

Financial management is an academic discipline which is concerned with decision-making. This

decision is concerned with the size and composition of assets and the level and structure of financing. In

order to make right decision, it is necessary to have a clear understanding of the objectives. Such an

objective provides a framework for right kind of financial decision making. The objectives are concerned

with designing a method of operating the Internal Investment and financing of a firm. There are two widely

applied approaches, viz.

(a) Profit maximization and

(b) Wealth maximization.

The term ‘objective’ is used in the sense of an object, a goal or decision criterion. The three

decisions – Investment decision, financing decision and dividend policy decision are guided by the

objective. Therefore, what is relevant – is not the over-all objective but an operationally useful criterion: It

should also be noted that the term objective provides a normative framework. Therefore, a firm should try

to achieve and on policies which should be followed so that certain goals are to be achieved. It should be

noted that the firms do not necessarily follow them.

Profit Maximization as a Decision Criterion

Profit maximization is considered as the goal of financial management. In this approach, actions

that Increase profits should be undertaken and the actions that decrease the profits are avoided. Thus, the

Investment, financing and dividend also be noted that the term objective provides a normative framework

decisions should be oriented to the maximization of profits. The term ‘profit’ is used in two senses. In one

sense it is used as an owner-oriented.

In this concept it refers to the amount and share of national Income that is paid to the owners of

business. The second way is an operational concept i.e. profitability. This concept signifies economic

efficiency. It means profitability refers to a situation where output exceeds Input. It means, the value

created by the use of resources is greater that the Input resources. Thus in all the decisions, one test is used

I.e. select asset, projects and decisions that are profitable and reject those which are not profitable.

The profit maximization criterion is criticized on several grounds. Firstly, the reasons for the

opposition that are based on misapprehensions about the workability and fairness of the private enterprise

itself. Secondly, profit maximization suffers from the difficulty of applying this criterion in the actual real-

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world situations. The term ‘objective’ refers to an explicit operational guide for the internal investment and

financing of a firm and not the overall business operations. We shall now discuss the limitations of profit

maximization objective of financial management.

1) Ambiguity:

The term ‘profit maximization’ as a criterion for financial decision is vague and ambiguous

concept. It lacks precise connotation. The term ‘profit’ is amenable to different interpretations by different

people. For example, profit may be long-term or short-term. It may be total profit or rate of profit. It may

be net profit before tax or net profit after tax. It may be return on total capital employed or total assets or

shareholders equity and so on.

2) Timing of Benefits:

Another technical objection to the profit maximization criterion is that It Ignores the differences in

the time pattern of the benefits received from Investment proposals or courses of action. When the

profitability is worked out the bigger the better principle is adopted as the decision is based on the total

benefits received over the working life of the asset, Irrespective of when they were received. The following

table can be considered to explain this limitation.

3) Quality of Benefits

Another Important technical limitation of profit maximization criterion is that it ignores the quality

aspects of benefits which are associated with the financial course of action. The term ‘quality’ means the

degree of certainty associated with which benefits can be expected. Therefore, the more certain the

expected return, the higher the quality of benefits. As against this, the more uncertain or fluctuating the

expected benefits, the lower the quality of benefits.

The profit maximization criterion is not appropriate and suitable as an operational objective. It is

unsuitable and inappropriate as an operational objective of Investment financing and dividend decisions of

a firm. It is vague and ambiguous. It ignores important dimensions of financial analysis viz. risk and time

value of money.

An appropriate operational decision criterion for financial management should possess the following

quality.

1. It should be precise and exact.

2. It should be based on bigger the better principle.

3. It should consider both quantity and quality dimensions of benefits.

4. It should recognize time value of money.

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Wealth Maximization Decision Criterion

Wealth maximization decision criterion is also known as Value Maximization or Net Present-Worth

maximization. In the current academic literature value maximization is widely accepted as an appropriate

operational decision criterion for financial management decision. It removes the technical limitations of

the profit maximization criterion. It posses the three requirements of a suitable operational objective of

financial courses of action.

These are features are exactness, quality of benefits and the time value of money.

1. Exactness:

The value of an asset should be determined In terms of returns it can produce. Thus, the worth of a

course of action should be valued In terms of the returns less the cost of undertaking the particular course

of action. Important element in computing the value of a financial course of action is the exactness in

computing the benefits associated with the course of action. The wealth maximization criterion is based on

cash flows generated and not on accounting profit. The computation of cash inflows and cash outflows is

precise. As against this the computation of accounting is not exact.

2. Quality and Quantity and Benefit and Time Value of Money:

The second feature of wealth maximization criterion is that. It considers both the quality and

quantity dimensions of benefits. Moreover, it also incorporates the time value of money. As stated earlier

the quality of benefits refers to certainty with which benefits are received In future.

The more certain the expected cash inflows the better the quality of benefits and higher the value.

On the contrary the less certain the flows the lower the quality and hence, value of benefits. It should also

be noted that money has time value. It should also be noted that benefits received in earlier years should be

valued highly than benefits received later.

The operational implication of the uncertainty and timing dimensions of the benefits associated

with a financial decision is that adjustments need to be made in the cash flow pattern. It should be made to

incorporate risk and to make an allowance for differences in the timing of benefits. Net present value

maximization is superior to the profit maximization as an operational objective.

It involves a comparison of value of cost. The action that has a discounted value reflecting both

time and risk that exceeds cost is said to create value. Such actions are to be undertaken. Contrary to this

actions with less value than cost, reduce wealth should be rejected. It is for these reasons that the Net

Present Value Maximization is superior to the profit maximization as an operational objective.

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PROFIT MAXIMIZATION VS WEALTH MAXIMIZATION

PROFIT MAXIMISATION – It is one of the basic objectives of financial management. Profit

maximization aims at improving profitability, maintaining the stability and reducing losses and

inefficiencies.

Profit in this context can be seen in 2 senses.

1. Profit maximization for the owner.

2. Profit maximization is for others.

Normally profit is linked with efficiency and so it is the test of efficiency.

However this concept has certain limitations like ambiguity i.e. the term is not clear as it is nowhere

defined, it changes from person to person.

2. Quality of profit – normally profit is counted in terms of rupees. Normally amt earned is called as profit

but it ignores certain basic ideas like wastage, efficiency, employee skill, employee’s turnover, product

mix, manufacturing process, administrative setup.

3. Timing of benefit / time value of profit – in inflationary conditions the value of profit will decrease and

hence the profits may not be comparable over a longer period span.

4. Some economists argue that profit maximization is sometimes leads to unhealthy trends and is harmful

to the society and may result into exploitation, unhealthy competition and taking undue advantage of the

position.

WEALTH MAXIMISATION – One of the traditional

Approaches of financial management , by wealth maximization we mean the accumulation and creation

of wealth , property and assets over a period of time thus if profit maximization is aimed after taking care

, of its limitations it will lead to wealth maximization in real sense, it is a long term concept based on the

cash flows rather than profits an hence there can be a situation where a business makes losses every year

but there are cash profits because of heavy depreciation which indirectly suggests heavy investment in

fixed assets and that is the real wealth and it takes into account the time value of money and so is

universally accepted.

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II. FINANCIAL PLANNING

Definition

A comprehensive evaluation of an investor's current and future financial state by using currently

known variables to predict future cash flows, asset values and withdrawal plans. Most individuals work in

conjunction with an investment or tax professional and use current net worth, tax liabilities, asset

allocation, and future retirement and estate plans in developing the plan. These will be used along with

estimates of asset growth to determine if a person's financial goals can be met in the future, or what steps

need to be taken to ensure that they are.

Meaning

In general usage, a financial plan is a series of steps or goals used by an individual or business, the

progressive and cumulative attainment of which are designed to accomplish a financial goal or set of

circumstances, e.g. elimination of debt, retirement preparedness, etc. This often includes a budget which

organizes an individual's finances and sometimes includes a series of steps or specific goals for spending

and saving future income. This plan allocates future income to various types of expenses, such as rent or

utilities, and also reserves some income for short-term and long-term savings. A financial plan is

sometimes referred to as an investment plan, but in personal finance a financial plan can focus on other

specific areas such as risk management, estates, college, or retirement.

What is Financial Planning?

Financial Planning is the process of meeting your life goals through the proper management of your

finances. Life goals can include buying a house, saving for your child's higher education or planning for

retirement. The Financial Planning Process consists of six steps that help you take a 'big picture' look at

where you are currently. Using these six steps, you can work out where you are now, what you may need in

the future and what you must do to reach your goals. The process involves gathering relevant financial

information, setting life goals, examining your current financial status and coming up with a strategy or

plan for how you can meet your goals given your current situation and future plans.

Benefit’s of Financial Planning?

Financial Planning provides direction and meaning to your financial decisions. It allows you to

understand how each financial decision you make affects other areas of your finances. For example, buying

a particular investment product might help you pay off your mortgage faster or it might delay your

retirement significantly. By viewing each financial decision as part of the whole, you can consider its short

and long-term effects on your life goals. You can also adapt more easily to life changes and feel more

secure that your goals are on track.

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Who is a Financial Planner?

A Financial Planner is someone who uses the Financial Planning process to help you figure out how

to meet your life goals. The Planner can take a 'big picture' view of your financial situation and make

Financial Planning recommendations that are suitable for you. The Planner can look at all your needs

including budgeting and saving, taxes, investments, insurance and retirement planning. Or, the Planner may

work with you on a single financial issue but within the context of your overall situation. This big picture

approach to your financial goals sets the Planner apart from other Financial Advisors, who may have been

trained to focus on a particular area of your financial life.

How to make financial planning work for you?

You are the focus of the Financial Planning process. As such, the results you get from working with

a Financial Planner are as much your responsibility as they are those of the Planner. To achieve the best

results from your Financial Planning engagement, you will need to be prepared to avoid some of the

common mistakes shown above by considering the following advice:

1. Set measurable goals

Set specific targets of what you want to achieve and when you want to achieve results. For

example, instead of saying you want to be 'comfortable' when you retire or that you want your children to

attend 'good' schools, you need to quantify what 'comfortable' and 'good' mean so that you'll know when

you've reached your goals.

2. Understand the effect of each financial decision

Each financial decision you make can affect several other areas of your life. For example, an

investment decision may have tax consequences that are harmful to your estate plans. Or a decision about

your child's education may affect when and how you meet your retirement goals. Remember that all of

your financial decisions are interrelated.

3. Re-evaluate your financial situation periodically

Financial Planning is a dynamic process. Your financial goals may change over the years due to

changes in your lifestyle or circumstances, such as an inheritance, marriage, birth, house purchase or

change of job status. Revisit and revise your Financial Plan as time goes by to reflect these changes so that

you stay on track with your long-term goals.

4. Start planning as soon as you can

Don't delay your Financial Planning. People, who save or invest small amounts of money early, and

often, tend to do better than those who wait until later in life. Similarly, by developing good Financial

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Planning habits such as saving, budgeting, investing and regularly reviewing your finances early in life,

you will be better prepared to meet life changes and handle emergencies.

5. Be realistic in your expectations

Financial Planning is a common sense disciplined approach to managing your finances to reach life

goals. It cannot change your situation overnight; it is a lifelong process. Remember that events beyond your

control such as inflation or changes in the stock market or interest rates will affect your Financial Planning

results.

6. Realize that you are in charge

If you're working with a Financial Planner, be sure you understand the Financial Planning process

and what the Planner should be doing. Provide the Planner with all of the relevant information about

financial status. Ask questions about the recommendations offered to you and play an active role in

decision-making.

Common Mistakes in Financial Planning Approach

1. Don't set measurable goals.

2. Make a financial decision without understanding its affect on other financial issues.

3. Confuse Financial Planning with investing.

4. Neglect to re-evaluate their Financial Plan periodically.

5. Think that Financial Planning is only for the wealthy.

6. Think that Financial Planning is for when they get older.

7. Think that Financial Planning is the same as retirement planning.

8. Wait until a money crisis to begin Financial Planning.

9. Expect unrealistic returns on investments.

10. Think that using a Financial Planner means losing control.

11. Believe that Financial Planning is primarily tax planning.

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There are three types of financial plans, viz.,

Short-term financial plan is prepared for maximum one year. This plan looks after the working capital

needs of the company.

Medium-term financial plan is prepared for a period of one to five years. This plan looks after replacement

and maintenance of assets, research and development, etc.

Long-term financial plan is prepared for a period of more than five years. It looks after the long-term

financial objectives of the company, its capital structure, expansion activities, etc.

Create a Sound Financial Plan

Step 1 Establish Goals

Step 2 Gather Data

Step 3 Analyze & Evaluate Your Financial Status

Step 4 Develop a Plan

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Step 5 Implement the Plan

Step 6 Monitor the Plan & Make Necessary Adjustments

Ten Principles of Sound Financial Management

1. Planning Policy

The planning system in the County will continue as a dynamic process, which is synchronized with

the capital improvement program, capital budget and operating budget. The County’s land use plans shall

not be allowed to become static. There will continue to be periodic reviews of the plans at least every five

years. Small area plans shall not be modified without consideration of contiguous plans. The Capital

Improvement Program will be structured to implement plans for new and expanded capital facilities as

contained in the County’s Comprehensive Plan and other facility plans. The Capital Improvement Program

will also include support for periodic reinvestment in aging capital and technology infrastructure sufficient

to ensure no loss of service and continued safety of operation.

2. Annual Budget Plans

Annual budgets shall continue to show fiscal restraint. Annual budgets will be balanced between projected

total funds available and total disbursements including established reserves.

1. A managed reserve shall be maintained in the General Fund at a level sufficient to provide for

temporary financing of critical unforeseen disbursements of a catastrophic emergency nature. The

reserve will be maintained at a level of not less than two percent of total Combined General Fund

disbursements in any given fiscal year.

2. A Revenue Stabilization Fund (RSF) shall be maintained in addition to the managed reserve at a

level sufficient to permit orderly adjustment to changes resulting from curtailment of revenue. The

ultimate target level for the RSF will be three percent of total General Fund Disbursements in any

given fiscal year. After an initial deposit, this level may be achieved by incremental additions over

many years. Use of the RSF should only occur in times of severe economic stress. Accordingly, a

withdrawal from the RSF will not be made unless the projected revenues reflect a decrease of more

than 1.5 percent from the current year estimate and any such withdrawal may not exceed one half of

the RSF fund balance in that year. Until the target level is reached, the Board of Supervisors will

allocate to the RSF a minimum of 40 percent of non-recurring balances identified at quarterly

reviews.

3. Budgetary adjustments which propose to use available general funds identified at quarterly reviews

should be minimized to address only critical issues. The use of non-recurring funds should only be

directed to capital expenditures to the extent possible.

4. The budget shall include funds for cyclic and scheduled replacement or rehabilitation of equipment

and other property in order to minimize disruption of budgetary planning from irregularly

scheduled monetary demands.

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3. Cash Balances

It is imperative that positive cash balances exist in the General Fund at the end of each fiscal year.

If an operating deficit appears to be forthcoming in the current fiscal year wherein total disbursements will

exceed the total funds available, the Board will take appropriate action to balance revenues and

expenditures as necessary so as to end each fiscal year with a positive cash balance.

4. Debt Ratios

The County’s debt ratios shall be maintained at the following levels:

1. Net debt as a percentage of estimated market value shall be less than 3 percent.

2. Debt service expenditures as a percentage of General Fund disbursements shall not exceed 10

percent. The County will continue to emphasize pay-as-you-go capital financing. Financing capital

projects from current revenues is indicative of the County’s intent to use purposeful restraint in

incurring long-term debt.

3. For planning purposes annual bond sales shall be structured such that the County’s debt burden

shall not exceed the 3 and 10 percent limits. To that end sales of general obligation bonds and

general obligation supported debt will be managed so as not to exceed a target of $200 million per

year, or $1 billion over 5 years, with a technical limit of $225 million in any given year. Excluded

from this cap are refunding bonds, revenue bonds or other non-General Fund supported debt.

4. For purposes of this principle, debt of the General Fund incurred subject to annual appropriation

shall be treated on a par with general obligation debt and included in the calculation of debt ratio

limits. Excluded from the cap are leases secured by equipment, operating leases, and capital leases

with no net impact to the General Fund.

5. For purposes of this principle, payments for equipment or other business property, except real

estate, purchased through long-term lease-purchase payment plans secured by the equipment will be

considered to be operating expenses of the County. Annual General Fund payments for such leases

shall not exceed 3 percent of annual General Fund disbursements, net of the School transfer.

Annual equipment lease-purchase payments by the Schools and other governmental entities of the

County should not exceed 3 percent of their respective disbursements.

5. Cash Management

The County’s cash management policies shall reflect a primary focus of ensuring the safety of

public assets while maintaining needed liquidity and achieving a favorable return on investment. These

policies have been certified by external professional review as fully conforming to the recognized best

practices in the industry. As an essential element of a sound and professional financial management

process, the policies and practices of this system shall receive the continued support of all County agencies

and component units.

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6. Internal Controls

A comprehensive system of financial internal controls shall be maintained in order to protect the

County’s assets and sustain the integrity of the County’s financial systems. Managers at all levels shall be

responsible for implementing sound controls and for regularly monitoring and measuring their

effectiveness.

7. Performance Measurement

To ensure Fairfax County remains a high performing organization all efforts shall be made to

improve the productivity of the County’s programs and its employees through performance measurement.

The County is committed to continuous improvement of productivity and service through analysis and

measurement of actual performance objectives and customer feedback.

8. Reducing Duplication

A continuing effort shall be made to reduce duplicative functions within the County government

and its autonomous and semi-autonomous agencies, particularly those that receive appropriations from the

General Fund. To that end, business process redesign and reorganization will be encouraged whenever

increased efficiency or effectiveness can be demonstrated.

9. Underlying Debt and Moral Obligations

The proliferation of debt related to but not directly supported by the County’s General Fund shall be

closely monitored and controlled to the extent possible, including revenue bonds of agencies supported by

the General Fund, the use of the County’s moral obligation and underlying debt.

1. A moral obligation exists when the Board of Supervisors has made a commitment to support the

debt of another jurisdiction to prevent a potential default, and the County is not otherwise

responsible or obligated to pay the annual debt service. The County’s moral obligation will be

authorized only under the most controlled circumstances and secured by extremely tight covenants

to protect the credit of the County. The County’s moral obligation shall only be used to enhance the

credit worthiness of an agency of the County or regional partnership for an essential project, and

only after the most stringent safeguards have been employed to reduce the risk and protect the

financial integrity of the County.

2. Underlying debt includes tax supported debt issued by towns or districts in the County, which debt

is not an obligation of the County, but nevertheless adds to the debt burden of the taxpayers within

those jurisdictions in the County. The issuance of underlying debt, insofar as it is under the control

of the Board of Supervisors, will be carefully analyzed for fiscal soundness, the additional burden

placed on taxpayers and the potential risk to the General Fund for any explicit or implicit moral

obligation.

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10. Diversified Economy

County must continue to diversify its economic base by encouraging commercial and, in particular,

industrial employment and associated revenues. Such business and industry must be in accord with the

plans and ordinances of the County.

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III. ACCORDING TO M.M. APPROACH DIVIDEND POLICY HAS NO EFFECT

ON SHARE PRICE OF A COMPANY

Introduction:

Dividend decision by any company is an important issue to be determined by the financial management.

The dividend policy of firm determines what proportion of earnings is paid to shareholders by way of

dividends and what proportion is ploughed back in the firm for reinvestment purpose that is retained

earnings. Payment of dividend is desirable because the shareholders invest in the capital of the company

with a view to earn higher return and to maximize their wealth. On the contrary, retained earnings are the

sources of internal finance for financing future requirement and expansion programmes of the company.

Thus, both growth and dividends are desirable. But they are in conflict; a higher dividend means less

provision of funds for growth and higher retained earnings means low dividends which majority of

shareholders dislike. As both decisions are complementary to each other and no decision can be taken

independent of the other, the finance manager has to formulate a guidable dividend policy in such a way as

to strike a comparison between dividend payment and retention.

Meaning of Dividend:

The word ‘dividend’ is derived from the Latin word “Dividendum” which means “that which is to be

divided”. This distribution is made out of the profits remained after deducting all expenses, providing for

taxation, and transferring reasonable amount to reserve from the total income of the company.

The term dividend refers to that part of the profits of a company, which is to be distributed amongst its

shareholders. It may, therefore, be defined as the return that shareholders get from the company, out of its

profits, on his shareholdings. According to the Institute of Chartered Accountants of India, dividend is, “a

distribution to shareholders out of profits or reserves available for this purpose.” A company cannot declare

dividend unless there is –

- Sufficient profits

- Board of Directors recommendation

- An acceptance of the shareholders in the annual general meeting.

Thus, the Board of Directors keeping in view the financial requirements of the company and the

quantum of reasonable return to shareholders decides how much dividend should be distributed. It is

declared in annual general meeting of the company and after approval it is known as ‘declared dividend’.

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Dividend Policy and Share prices:

Dividend decision is one of the three major decisions of financial management. The financial

management has to choose between distribution of earnings and retention of earnings. The choice would

depend on the effect of the decision on the shareholders wealth. That is, the payment of dividend should be

preferred, if it leads to the maximization of shareholders’ wealth. If it is not so, the firm should retain the

profit and should not distribute dividend. Financial experts have not been unanimous on this issue.

Since the principle objective of the firm is to maximize the share price, question arises, what is the

relationship between dividend policy and market share price? This is one of the most controversial and

unresolved questions, where the empirical evidence is often mixed.

However, there are opinions regarding the impact of dividends on the price of share or valuation of firm.

One school of thought believes that dividend is irrelevant and does not affect the price of shares. The other

school of thought believes that dividend is relevant and affects the prices of shares.

The following dividend model (Modigliani and Miller Hypothesis of Dividend Irrelevance) of

thoughts on the relationship between dividend policy and the price of shares have been discussed below:

Franco Modigliani and Merton H. Miller advocate that, the dividend policy of a firm is irrelevant, as it

does not affect the wealth of the shareholders. Thus, dividends are irrelevant i.e. the value of firm is

independent of its dividend policy. It depends on the firm’s earnings, which result from its investment

policy. When investment decision of a firm is given, the dividend decision is of no significance in

determining the value of firm.

The MM hypothesis is based on the following assumptions:

There exist perfect capital market and investors are rational. Information is available to all free of

cost. There is no investor large enough to influence the market price of securities.

There is no transactional cost.

There is no floatation cost of raising new capital.

There exists no taxes or there is no difference in tax rates applicable to dividends and capital gains.

The investment policy of the firm is fixed and does not change. So the financing of investment

programmes through retained earnings does not change the business risk and there is no change in

required rate of return.

The matter of MM hypothesis may be stated as follows: If a company retains earnings instead of giving

it out as dividends, shareholders enjoy capital appreciation equal to the amount of earnings retained. If it

distributes earnings by way of dividends instead of retaining it, the shareholders enjoy dividends equal in

value to the amount by which his capital would have appreciated had the company chosen to retain its

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earnings. Lastly, because of operation of arbitrage, the dividend decision would be irrelevant even under

conditions of uncertainty. The market prices of the shares of two firms, with similar business risk

prospective future earnings and investment policies would be the same, irrespective of their pay-out ratios.

This is because of rational behaviour of shareholders. Hence, the division of earnings is irrelevant from the

viewpoint of the shareholders.

However, certain thinker affects the validity of this hypothesis. According to them, the MM hypothesis

is based on unrealistic assumptions. The approach is criticized on following grounds.

MM assumes that capital markets are perfect. This implies that there are no taxes, floatation costs

do not exist and there is absence of transaction costs. These assumptions are not valid in actual

conditions.

Apart from the market imperfection, the validity of the MM hypothesis, insofar as it argues that

dividends are irrelevant, is questionable under conditions of uncertainty. MM hold, it would be

recalled, that dividend policy is as irrelevant under conditions of uncertainty as it is when perfect

certainty is assumed. The MM hypothesis is, however, not valid as investors cannot be indifferent

between dividend and retained earnings under conditions of uncertainty. This can be seen in the fact

that the investors prefer near and certain dividend more rather than distant and uncertain dividend

or bonus stocks in future. Hence, they discount more the stock with distant dividend than the stock

with near dividend. Moreover, majority of shareholders being small investors they prefer current

income to meet their consumption requirements. Lastly, the payment of dividend conveys to the

shareholders information relating to the profitability of the firm. The significance of this aspect of

current dividend payments is expressed by Ezra Solomon in these words: “In an uncertain world in

which verbal statements can be ignored or misinterpreted, dividend action does provide a clear-cut

means of ‘making a statement’ that speaks louder than a thousand words”.

Modigliani and Miller ignores this facts but powerfully expressed by Gordon. Investors prefer dividend

to capital gains. So shares with higher current dividends, other things being equal, command higher price in

the market.

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IV. TERM STRUCTURE OF INTEREST RATES

Meaning:

The term structure of interest rates, also called the yield curve, is a graph that plots the yields of similar-

quality bonds against their maturities, from shortest to longest.

How It Works/Example:

The term structure of interest rates shows the various yields that are currently being offered on bonds of

different maturities. It enables investors to quickly compare the yields offered on short-term, medium-term

and long-term bonds.

Note that the chart does not plot coupon rates against a range of maturities -- that graph is called the

spot curve.

The term structure of interest rates takes three primary shapes. If short-term yields are lower than long-term

yields, the curve slopes upwards and the curve is called a positive (or "normal") curve. Below is an

example of a normal yield curve:

If short-term yields are higher than long-term yields, the curve slopes downwards and the curve is called a

negative (or "inverted") yield curve. Below is example of an inverted yield curve:

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Finally, a flat term structure of interest rates exists when there is little or no variation between short and

long-term yield rates. Below is an example of a flat yield curve:

It is important that only bonds of similar risk are plotted on the same yield curve. The most common type

of yield curve plots Treasury securities because they are considered risk-free and are thus a benchmark for

determining the yield on other types of debt.

The shape of the curve changes over time. Investors who are able to predict how term structure of interest

rates will change can invest accordingly and take advantage of the corresponding changes in bond prices.

Term structure of interest rates are calculated and published by The Wall Street Journal, the Federal

Reserve, and a variety of other financial institutions.

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Why It Matters:

In general, when the term structure of interest rates curve is positive, this indicates that investors desire a

higher rate of return for taking the increased risk of lending their money for a longer time period.

Many economists also believe that a steep positive curve means that investors expect strong future

economic growth with higher future inflation (and thus higher interest rates), and that a sharply inverted

curve means that investors expect sluggish economic growth with lower future inflation (and thus lower

interest rates). A flat curve generally indicates that investors are unsure about future economic growth and

inflation.

There are three central theories that attempt to explain why yield curves are shaped the way they are.

1. The "expectations theory" says that expectations of increasing short-term interest rates are what create a

normal curve (and vice versa).

2. The "liquidity preference hypothesis" says that investors always prefer the higher liquidity of short-

term debt and therefore any deviance from a normal curve will only prove to be a temporary phenomenon.

3. The "segmented market hypothesis" says that different investors adhere to specific maturity segments.

This means that the term structure of interest rates is a reflection of prevailing investment policies.

Because the term structure of interest rates is generally indicative of future interest rates, which are

indicative of an economy's expansion or contraction, yield curves and changes in these curves can provide

a great deal of information. In the 1990s, Duke University professor Campbell Harvey found that inverted

yield curves have preceeded the last five U.S. recessions.

Changes in the shape of the term structure of interest rates can also have an impact on portfolio returns by

making some bonds relatively more or less valuable compared to other bonds. These concepts are part of

what motivate analysts and investors to study the term structure of interest rates carefully.

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BONDS - BOND VALUATION

The fundamental principle of bond valuation is that the bond's value is equal to the present value of its

expected (future) cash flows. The valuation process involves the following three steps:

1. Estimate the expected cash flows.

2. Determine the appropriate interest rate or interest rates that should be used to discount the cash flows.

3. Calculate the present value of the expected cash flows found in step one by using the interest rate or

interest rates determined in step two.

Determining Appropriate Interest Rates

The minimum interest rate that an investor should accept is the yield for a risk-free bond (a Treasury bond

for a U.S. investor). The Treasury security that is most often used is the on-the-run issue because it reflects

the latest yields and is the most liquid.

For non-Treasury bonds, such as corporate bonds, the rate or yield that would be required would be the on-

the-run government security rate plus a premium that accounts for the additional risks that come with non-

Treasury bonds.

As for the maturity, an investor could just use the final maturity date of the issue compared to the Treasury

security. However, because each cash flow is unique in its timing, it would be better to use the maturity

that matches each of the individual cash flows.

Computing a Bond's Value

First, we need to find the present value (PV) of the bond's future cash flows. The present value is the

amount that would have to be invested today to generate that future cash flow. PV is dependent on the

timing of the cash flow and the interest rate used to calculate the present value. To figure out the value, the

PV of each individual cash flow must be found. Then, just add the figures together to determine the bond's

price.

PV at time T = expected cash flows in period T / (1 + I) to the T power

After you calculate the expected cash flows, you will need to add the individual cash flows:

Value = present value @ T1 + present value @ T2 + present value @Tn

Let's throw some numbers around to further illustrate this concept.

Example: The Value of a Bond

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Bond GHJ matures in five years with a coupon rate of 7% and a maturity value of $1,000. For simplicity's

sake, let's assume that the bond pays annually and the discount rate is 5%.

The cash flow for each of the years is as follows:

Year One = $70

Year Two = $70

Year Three = $70

Year Four = $70

Year Five = $1,070

Thus, the PV of the cash flows is as follows:

Year One = $70 / (1.05) to the 1st power = $66.67

Year Two = $70 / (1.05) to the 2nd power = $ 63.49

Year Three = $70 / (1.05) to the 3rd power = $ 60.47

Year Four = $70 / (1.05) to the 4th power = $ 57.59

Year Five = $1,070 / (1.05) to the 5th power = $ 838.3

Now to find the value of the bond:

Value = $66.67 + $63.49 + $60.47 + $57.59 + $838.37

Value = $1,086.59

How Does the Value of a Bond Change?

As rates increase or decrease, the discount rate that is used also changes. Let's change the discount rate in

the above example to 10% to see how it affects the bond's value.

Example: The Value of a Bond when Discount Rates Change

PV of the cash flows is:

Year One = $70 / (1.10) to the 1st power = $ 63.63

Year Two = $70 / (1.10) to the 2nd power = $ 57.85

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Year Three = $70 / (1.10) to the 3rd power = $ 52.63

Year Four = $70 / (1.10) to the 4th power = $ 47.81

Year Five = $1,070 / (1.10) to the 5th power = $ 664.60

Value = 63.63 + 57.85 + 52.63 + 47.81 + 664.60 = $ 886.52

1. As we can see from the above examples, an important property of PV is that for a given

discount rate, the older a cash flow value is, the lower its present value.

2. We can also compute the change in value from an increase in the discount rate used in our

example. The change = $1,086.59 - $886.52 = $200.07.

3. Another property of PV is that the higher the discount rate, the lower the value of a bond; the

lower the discount rate, the higher the value of the bond.

If the discount rate is higher than the coupon rate the PV will be less than par. If the discount rate is lower

than the coupon rate, the PV will be higher than par value.

How Does a Bond's Price Change as it Approaches its Maturity Date?

As a bond moves closer to its maturity date, its price will move closer to par. There are three possible

scenarios:

1. If a bond is at a premium, the price will decline over time toward its par value.

2. If a bond is at a discount, the price will increase over time toward its par value.

3. If a bond is at par, its price will remain the same.

To show how this works, let's use our original example of the 7% bond, but now let's assume that a year

has passed and the discount rate remains the same at 5%.

Example: Price Changes over Time

Let's compute the new value to see how the price moves closer to par. You should also be able to see how

the amount by which the bond price changes is attributed to it being closer to its maturity date.

PV of the cash flows is:

Year One = $70 / (1.05) to the 1st power = $66.67

Year Two = $70 / (1.05) to the 2nd power = $ 63.49

Year Three = $70 / (1.05) to the 3rd power = $ 60.47

Year Four = $1,070 / (1.05) to the 4th power = $880.29

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Value = $66.67 + $63.49 + $60.47 + $880.29 = $1,070.92

As the price of the bond decreases, it moves closer to its par value. The amount of change attributed to the

year's difference is $15.67.

An individual can also decompose the change that results when a bond approaches its maturity date and the

discount rate changes. This is accomplished by first taking the net change in the price that reflects the

change in maturity, then adding it to the change in the discount rate. The two figures should equal the

overall change in the bond's price.

Computing the Value of a Zero-coupon Bond

A zero-coupon bond may be the easiest of securities to value because there is only one cash flow - the

maturity value.

The formula to calculate the value of a zero coupon bond that matures N years from now is as follows:

Maturity value / (1 + I) to the power of the number of years * 2

Where I is the semi-annual discount rate.

Example: The Value of a Zero-Coupon Bond

For illustration purposes, let's look at a zero coupon with a maturity of three years and a maturity value of

$1,000 discounted at 7%.

I = 0.035 (.07 / 2)

N = 3

Value of a Zero-Coupon Bond

= $1,000 / (1.035) to the 6th power (3*2)

= $1,000 / 1.229255

= $813.50

Arbitrage-free Valuation Approach

Under a traditional approach to valuing a bond, it is typical to view the security as a single package

of cash flows, discounting the entire issue with one discount rate. Under the arbitrage-free valuation

approach, the issue is instead viewed as various zero-coupon bonds that should be valued individually and

added together to determine value. The reason this is the correct way to value a bond is that it does not

allow a risk-free profit to be generated by "stripping" the security and selling the parts at a higher price than

purchasing the security in the market.

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As an example, a five-year bond that pays semi-annual interest would have 11 separate cash flows

and would be valued using the appropriate yield on the curve that matches its maturity. So the markets

implement this approach by determining the theoretical rate the U.S. Treasury would have to pay on a zero-

coupon treasury for each maturity. The investor then determines the value of all the different payments

using the theoretical rate and adds them together. This zero-coupon rate is the Treasury spot rate.

The value of the bond based on the spot rates is the arbitrage-free value.

Determining Whether a Bond Is Under or Over Valued

What you need to be able to do is value a bond like we have done before using the more traditional

method of applying one discount rate to the security. The twist here, however, is that instead of using one

rate, you will use whatever rate the spot curve has that coordinates with the proper maturity. You will then

add the values up as you did previously to get the value of the bond.

You will then be given a market price to compare to the value that you derived from your work. If

the market price is above your figure, then the bond is undervalued and you should buy the issue. If the

market price is below your price, then the bond is overvalued and you should sell the issue.

How Bond Coupon Rates and Market Rates Affect Bond Price

If a bond's coupon rate is above the yield required by the market, the bond will trade above its par value

or at a premium. This will occur because investors will be willing to pay a higher price to achieve the

additional yield. As investors continue to buy the bond, the yield will decrease until it reaches market

equilibrium. Remember that as yields decrease, bond prices rise.

If a bond's coupon rate is below the yield required by the market, the bond will trade below its par

value or at a discount. This happens because investors will not buy this bond at par when other

issues are offering higher coupon rates, so yields will have to increase, which means the bond price

will drop to induce investors to purchase these bonds. Remember that as yields increase, bond

prices fall.