Financial Management Full Notes @ Mba Finance

Finance

Module 1

Finance is the economics of allocating resources over time. Financial Markets -

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Participation is financial markets is driven in part by the desire to shift future resources to he present so as to increase personal consumption, and thus satisfaction. Or one may shift resources to the future by lending them, buying common stoc stock, k, etc. etc. In exch exchan ange ge,, they they get get an expec expecta tatition on of incre increas ased ed futu future re resources, in the form of interest, dividends, and/or capital gains. Where financial investments serve the purpose of reallocating the same resources over time, real asset investment  can actually create new future resources. The provision of funds for real asset investment is important, as is the allocative information that financial markets provide to those interested in making real asset investment. Financial markets can help tell the investor whether a proposed investment is worthwhile by comparing the returns from the investment with those available on competing uses. Financial market participants are risk-averse, they would choose the less risky of two otherwise identical investments. in vestments.

Market Interest Rate & Prices The market interest rate is the rate of exchange between present and future resources. Determined by the supply and demand de mand of resources to be borrowed and lent. At any given time there are numerous market  interest rats covering different lengths of time and investment riskiness. A Simple Financial Market

Shifting Resources in Time A financial exchange line is comprised comprised of any transaction transaction that a participant participant with an initial amount of money may take by borrowing or lending at the market rate of interest. The line appears on a graph with CF 1, the cash flow later on the vertical axis, and CF0, the now cash flow on the horizontal. $2640 $1540

CF1

0 $1000

$2400

CF0

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If a participant had $1000 at t 0 and wished to borrow whatever he could with a promise to repay $1540 at t 1, how much could he borrow? Assume a 10% interest rate. CF1 = CF0 (1+ i) CF1 $1540 CF0 = --------- or ------------------- = $1400 (1+ i) 1.10 The participant could borrow $1400 with a promise to repay $1540 at t 1. The  present  maximum amount the participant could consume at t 0 is thus $2400 ( present  wealth ). $1400 is the present value of $1540. Present value is defined as the amount of money you must invest or lend at the present time so as to end up with a particular amount of money in the future. Finding the present value of a future cash flow is often called discounting the cash flow. Present value is also an accurate representation of what the financial market does when it sets a price on a financial asset.

Investing -

Investing in real assets allows for an increase in wealth because it does not require finding someone to decrease their own. For wealth to increase the present value of the amount given up for real asset investment must be less than the present value of what is gained from the investment.

Net Present Value -

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The present value of the difference between an a n investments cash inflows and outflows discounted at the opportunity costs (i) of those flows. CF1 NPV = -------- – CF 0 (1+ i) It is generally true that NPV = Change in present wealth. It is also the present value of the future amount by which the returns from the investment exceed the opportunity costs of the investor.

Internal Rate of Return Calculates the average per period rate of return on the money invested. Once calculated, it is compared to the rate of return that could be earned on a comparable financial market opportunity of equal timing and risk. IRR is the discount rate that equates the present value of an investments cash inflows and outflows. This implies that it is the discount rate that causes an investments NPV to be equal to zero. CF0 NPV = 0 = – CF1 + ----------(1+ IRR)

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CF0 (1+IRR) = -------CF1 An IRR IRR grea greate terr than than the the fina financ ncia iall ma mark rket et rate rate impli implies es an acce accept ptab able le investment (and a + NPV), an IRR lower than it does not (and a –NPV). IRR and NPV usually usually give the same answer as to whether an investment investment is acceptable, but often give different answers as to which of two investments is better.

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Corporate Example -

The The sole sole task task of a comp compan anyy is to ma maxi ximi mise se the the pres present ent wealth wealth of its its shareholders. A comp company any woul wouldd acce accept pt inve invest stme ment ntss up to the the point point wher wheree the the next next investment would have a –NPV or an IRR less than its opportunity cost.

More Realistic Financial Markets

Multiple Period Finance Multiple period exchange rates (interest) are written as (1 + I n)n, where n is the number of periods. Compound Interest -

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Compounding means that the exchange rate between two time points is such that that inter interes estt is earn earned ed not not only only on the the init initia iall inves investm tmen ent, t, but but also also on previo previousl uslyy earned earned interest interest.. The amount amount of mo money ney you end up with with by investing CF0 at compounding interest is written CF 0 = [1 + (i/m)] m t, where m is the number of times per period that compounding takes place, and t is the number of periods the investment covers. The most frequent type of compounding is called continuous. Interest is calculated and added to begin calculating interest on itself without any passage of time between compoundings. This reduces the above formula to CF0(eit), where e is = 2.718…., the base of a natural logarithm.

Multiple Period Cash Flows To find the present value of a cash flow occurring at any one future time point the following formula is used; CFt PV = --------(1+ it)t The present value of a set (stream) of cash flows is the sum of the present values of each of the future cash flows associated with the asset, calculated; CF1 CF2 CF3 PV = --------- + --------- + -------(1+ i1)1 (1+ i2)2 (1+ i3)3 Multiple Period Investment Decisions Calculating NPV when the investment decision will affect several future cash flows flows must must includ includee all presen presentt and future future cash cash flows flows associa associated ted with with the investment. CF1 CF2 CF3 NPV = --------- + --------- + -------(1+ i1)1 (1+ i2)2 (1+ i3)3 Calculating Calculating the IRR of a set of cash flows involves finding finding the discount discount rate that causes NPV to equal zero; CF1 CF2 CF3 NPV = ----------- + ----------- + -----------(1+ IRR) (1+ IRR)2 (1+ IRR)3 The only way to solve for the IRR of a multiple period cash flow stream is with the trial and error technique. Calculating Techniques and Short Cuts in Multiple Period Analysis The instruction to calculate the PV of a stream of future cash flows is; i s; T CFt PV = Σ --------t=1 (1+ i t)t 4

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When discount rates are consistent across the future this changes to; T CFt PV = Σ -------t=1 (1+ i)t

Calculation Methods Start with the CF furthest from the present, discount it one period closer and add the CF from the closer time point, discount that sum one period nearer, etc. Continue Continue process process until all cash flows are included and discounted discounted back to t0. PREFERRED METHOD Use present value tables. Adding up the cash flows after discounting each one for its respective time period. -

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Tables are valuable when finding the present value of annuities. A constant annuity is a set of cash flows that are the same amount across future time points. A  perpetuity  is a cash flow stream assumed to continue forever. forever. Formula is simply a division of the constant per-period CF by the constant per-period discount rate, or PV = CF/i. A slight modification of the above allows for the assumption that the cash flows will continue forever, but will grow or decline at a constant percentage rate during each period (AKA growth perpetuity ), ), PV = CF/(i – g) where g is the constant per-period growth rate of the cash flow. This equation will not work when i1, and rejected is CBR is 1 would have a positive NPV, and a CBR