Financial Management byMuhammad Arif

Books recommended1.Principles of corporate finance by Richard .A.Brealey and Stewart C Meyers.2.Advance corporate finance Ogden, Jen and Conner3.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

decisionsIslamic 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 ManagementMain 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 selected.

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 ManagementPresent 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 ManagementTrade 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 ManagementExample 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 Equities

Financial ManagementTerms 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 ManagementTerms 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 follows:

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 ManagementTerms 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 ManagementTerms 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 ManagementValuing 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 ManagementValuing 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 851,400

Financial ManagementCompound 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 ManagementValuing 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 = 5,000/1.10/2+5000/(1.10/2)2+5,000/(1.10/2)3+5,000/(1.10/2)4+5,000/(1.10/2)5+105,000/(1.10/2)6

Financial ManagementValuing 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 P0=Div1+P1/1+r=5+110/1.15=100.

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 5-0/1.15+5.5+121/91.15)2=100

Financial ManagementValuing 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 ManagementValuing 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 ManagementValuing 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 100Payout ratio= Div1/EPS1= 5.0/8.33= .6This reflects that company is plowing back = 1-.6= .40Growth rate= g = plowback ratio x ROE = .4 x .25 = .10The 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 opportunitiesAnother 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