Financial Management_MGT201

1st Week of Lectures

Important Notes

Lecture No 01:

29 Oct 2015_Saturday

Divided this course in 3 broad areas;

1_ Investment decision and capital budgeting

2_ Corporate financing

3_ misilanous subjects within the field of financial management

Review of Financial Management:

In lecture 01, we will cover

Major areas & concepts of FM, we will cover in this course

Analysis of financial statemento Balance sheet, profit n lose/Income statement, flow statement, shareholder equity

statement Investment decisions and Capital Budgeting

o Interest, time value, cash flows, NPV(net present value) Risk and Return (Its very important area)

o Uncertainty, Risk, Portfolio theory, Capital Asset Pricing Model(CAPM) Corporate Financing & Capital Structure (also important)

o Cost of capital, leverage, dividend policy Valuation

o Share, Bond, Corporate, Option Working capital & inventory management International Finance & foreign Exchange

Organizational Structure

1_ CEO(Chief Executive Officer):

Who manages the financing in an organization.Board of directors---share holders/Owners of the company

2_ CFO(Chief Financial Officer):It’s the MAIN internal entity which handle all the financial tasks in an organization.CFO is the man who handles financial management in a centralize way.

Below CFO there are two primary managers are known as Treasurer & Controller.

3_ TreasurerTreasurer who handles

Cash investment Capital budgeting Capital structure Inventory Corporate financing

4_ ControllerController is basically incharge of the finance accounts and audits.

So, we are talking about areas handled by TREASURER within corporation.

Business legal entities:

1_ Proprietorship (80% of total number of business worldwide)

Single owner is the company. The legal entity is the person who is the owner.

Disadvantages:

Unlimited liability. In case of bankruptcy, owner can lose the business and his personal belongings.

Difficult to get financing.

2_ Partnership:

Same as proprietorship except many owners Can be registered or unregistered

3_ Corporation (control 80% of global sales of products and services):

Limited liability and unlimited life(perpetual, going concern) Disadvantages:

Double-taxation (Corporate tax & dividend tax)Difficult to set up and costly to maintain.

Its called limited company registered by the state. its called the limited company because Its liability of shareholders is limited. It is limited to the amount of shareholding.

If a shareholder or a limited company goes bankrupt then the credit is cannot come after the personal assets of the owners of the shareholders. They can only sees the assets of the corporation.

Reminder: corporation is the separate legal entity.

4_ Hybrid (mixed) legal entity:

There are some types of hybrid legal entities,

o S-Type Corporation: Corporation without double taxation.o LLP: Limited Liability Partnership without double taxation.o PC: Professional Corporation i.e. doctors limited liabilities

Balance sheet:

BS is the snap shot of an assets and liabilities of a company at anytime.

Internal and External Business Environment:

Internal Business Environment:Internal environment of business normally consists of the following.i. Financeii. Marketingiii. Human Resourcesiv. Operations (Production, Manufacturing)v. Technologyvi. Other Functions (Logistics, Communications)

External Business Environment:The following business environment factors outside an organization have a profound effect onthe functions and operations of an organization.i. Customersii. Suppliersiii. Competitorsiv. Government/Legal Agencies & Regulationsv. Macro Economy/Markets:vi. Technological Revolution

SWOT Analysis:

An analysis which is used in a business is called SWOT Analysis. SWOT is an acronym whereS stands for StrengthsW stands for WeaknessesO stands for OpportunitiesT stands for Threats

Searching from lecture 01:

Proprietorship

Owner of a business or holder of a property.

Liability

Something for which one is liable; an obligation, responsibility, or debt.

 Liabilities The financial obligations entered in the balance sheet of a business enterprise.

Corporation:

A corporation is an legal entity created by state law. It has a distinct and separate existence from the individuals who created it, and those who control its operations. Corporations are commonly classified as profit or nonprofit, and public or nonpublic.

OR

A corporation is a legal body that has been established as a separate legal entity from its members and which has its own distinct rights and liabilities.

Balance sheet:

A balance sheet is a snapshot of a business's financial condition at a specific moment in time, usually at the close of an accounting period.

OR

A balance sheet is a financial statement that summarizes a company's assets, liabilities and shareholders' equity at a specific point in time. These three balance sheet segments give investors an idea as to what the company owns and owes, as well as the amount invested by shareholders.

Lecture No 02:

30 Oct 2015_Sunday_11:26am

We will study Investment capital budgeting and corporate financing.

Objective of Economics:

Profit maximization (for whom? Over what time period?) In economics, we can talk about profit maximization for an individual, the whole

society, or a particular class or group. We can also talk about profit maximization for the whole world in global terms.

Objective of Financial Management (FM):

Financial management is more focused.

Wealth maximization (for shareholders/owners, now) The objective of financial management, specifically, is to maximize the shareholders

wealth in the present terms.

Objective of Financial Accounting (FA):

Accurate, timely, consistent and generalized collection and reporting of financial data for FM.

The four different financial statements used for the purpose of reporting and analysis are1. Balance Sheet2. P/L or Income Statement3. Cash Flow Statement4. Statement of Retained Earnings (or Shareholders’ Equity Statement)

Market Value:We can say it is present value which is currently prevailing in market or the value which the sellers are ready to sale and buyers are ready to buy a particular asset.

Intrinsic value:Intrinsic value or the fair value is calculated by summing up the discounted future cash flows.

Real assets: Tangible assets (which we can touch) like land, car, house, equipment, wheat, fruits,

cotton and computers etc. It appears as long term or fixed assets. Also appears in current assets in form of

inventory or stock.

Securities:– Piece of paper representing a claim on an asset

• Direct Securities: Stocks and Bonds – Value depends on the cash flows generated by the underlying assets.

Use Discounted Cash Flow (DCF) techniques.• Indirect Securities: Derivatives, Futures, Options

– Value depends on the value (market price) of the underlying assets

Bonds: What is bonds?

• Internationally, the most common way for companies to raise financing and funds.

Companies demand wealth. So, paisay ko raise krnay k liay un k pas 2 hi rastay hotay hein ya issue bond ya stocks.

• A Bond is a long-term debt contract (on paper) issued by the Borrower (Issuer of the Bond ie. a company that needs money) to the Lenders (Bond Holder or Investors ie. Banks, financial institutions, and private investors).

Qarz denay wala hai woh bond purchase krta hai. Or jo qarz lenay wala hai woh bond ko issue krta hai.

• Bonds Issued represent Liabilities (on the Balance Sheet)A company issue bond jis k badlay mein usay paisa milta hai. Is form mein a bond is a liability.

• A Bond requires the Borrower to pay a pre-determined amount of interest regularly to the Lender. The interest may be Fixed or Floating.

Jis nay bond khareda hai usay aik fixed predetermined interest/ sood milay ga is bond pr.16:54….means Agr ap nay bond khareda hai to apnay us k badlay ksi ko paisa diya hai. Or woh jo qarz ap nay diya hai us k badlay apko sood wapis milay ga. And you will get this interest regular interval of time. Or ye interest/sood waqtan fawaqtan ik time of period tk milta rahay ga. Ye interest/sood ki sharah 10% ya 20 ya jitney bhi per month or per annual fix bhi ho sakta hai or FLOATING means market rate k hisab say market value k sath linked bhi ho sakta hai.

• Types of Bonds:– Debentures: Unsecured – no asset backing

For example jab qarz lia jaye to us k badlay mein koi cheez,asset ya land amanat k tor pr rkhwai jati hai. So, agr koi aesi cheez amanat k tor pr nahi rkhwai jar hi to us qarz pr interest rate/sood zyada hota hai. Ye unsecured way hai.

– Mortgage Bond: Secured by real property ie. Land, houseIs mein qarz k badlay koi zameen ya ghar etc amanat k tor pr rkhwaya jata hai tk tab jab tk k qarz ki raqam ada na kr di jaye.

– Others: Eurobond, Zeros, Junk, etc.

End 12:49pm__start 2:47pm

Stocks:• Most common source of raising funds under Islamic Shariah.• Stocks (or Shares) are paper certificates representing ownership in a business. Therefore, if a

company has issued 1 million shares and even if you own 1 share only, you are a part owner (or Shareholder) !

• Represents Equity (on the Balance Sheet)• The Stock certificate lasts as long as the company does. Note: Perpetual Concern• Shareholders have a Residual Claim on whatever Net Income (or Profit) and Assets are left over

after the Bond Holders have been paid off.

• Types of Stocks (or Shares):– Common Stock:

True owners. Shareholders receive Dividends or portion of the Net Income (which the management decides NOT to reinvest into the company in the form of Retained Earnings) in proportion to the number of shares they hold. The Dividend is uncertain. Common Stock holders have voting rights to elect a Board of Directors.

– Preferred Stock:A stock with a predetermined or fixed dividend. The Preferred Dividend is guaranteed and must be paid out before the Common Stock Dividend.

Difference between Bonds & Stock(share): Stocks(shares) are representative onweshipr of the company whereas Bonds are not

representative ownership of the company. Bonds have limited life but Shares are on going and perpetual. Shares represent as Equity whereas bonds represent as liability on balance sheet.

Analysis financial statements:There are 2 ways to analysis,

Share n bonds jo k company issue kr rhi hai..=========these types of securities will appear as ‘liabilities’.

Share or bonds jo company investment k tor pr purchase kr rhi hai..=========these types of securities will appear as ‘Assests’.

And they will appear under the current assets in the form of marketable security. Marketable securities Jo company nay market say bonds or shares ki surat khareday hein in order to generate extra revenue for them.

In against jo bonds or shares/stocks company nay issue kiay hon…sarmaya raise krnay k liay these types of bonds and shares consitute liabilities.Specificly agr ksi company nay bonds issue kiay hon paisa raise krnay k liay they will be appear as long term liability. Agr company ny aquity issue ki hon paisa raise krnay k liay then they will appear as common aquity on the liability side in balance sheet.

Values:• Book Value

– Value as shown on the Balance Sheet based on historical cost (or purchase price) and accumulated depreciation

Ksi bhi asset ya liability ki value jo k balance sheet pr appear ho rhi ho literary called book value. Historical cost means jab bhi hum nay us assest ko khareeda ho us time jo purchase price ada ki ho woh historical cost kehlati hai.

• Market Value– Value of asset as observed in the market. Depends on the Supply & Demand and

negotiations between Buyers & Sellers.Market mein khareed o farokht k liay jo price use ho rhi ho who market price kehlati hai.

• Liquidation Value– Value if the company were closed down and its assets were sold individually.Agr ksi company ka dewalia ho gaya ho to us k assets individually sale hon. Aesi value liquidation value kehlati hai.

• Fair Value or Intrinsic Value (Most Important value)– Present Value of the working assets’ future cash flows. Use Discounted Cash Flow

(DCF) technique.– If the Intrinsic Value is less than the Market Value, then the asset is “undervalued” in

the mind of the investor

Paisay ka jo bohtat or bahao hai aenda anay walay salon mein us say hum asset ki value calculate karein gay. Or ye intrinsic ya fair value kehlati hai.

Financial markets:• Capital Markets

– Broadly speaking the capital market is a market for financial assets which have a long or indefinite maturity.

Stock Exchange – a place where shares in companies are bought and sold, or the organization of people

whose job is to do this buying or selling: Stock exchange (listed shares, unit trusts,TFC)Long Term Bonds

– Long term government & corporate bonds are also traded in capital markets.• Money Markets

– buying and selling of short term liquid debt instruments. (Short term means one year or less).Liquid means something which is easily en-cashable; an instrument that can be easily exchanged for cash.

Short term Bonds – Government of Pakistan: Federal Investment Bonds (FIB), Treasury-Bills (TBills) – Private Sector: Corporate Bonds, Debentures – Call Money, Inter-bank short-term and overnight lending & borrowing – Loans, Leases, Insurance policies, Certificate of Deposits (CD’s)– Badlah (money lending against shares), Road-side money lenders

• Real Assets or Physical Assets Market – It includes physical or tangible assets,

o Cotton Exchange, Gold Market, Kapra (Cloth) Marketo Property (land, house, apartment, warehouse)o Property (land, house, apartment, warehouse)o Computer hardware, Used Cars, Wheat, Sugar, Vegetables, etc.

Question raised:

i_how Bond system becomes ‘interest’ sood? Ii_How companies get benefit through bond system for raise their money?Iii_And what’s the advantage of a company to raise the money? Is it necessary in business??Iv_Can’t be a pretty business run without bond system?

In 2nd part, types of bonds,I_How it can be Fair loan, If we will have to provide any property for security? Ii_ And can someone willing to use that property till he get back his loan dues or not?

Also What types of Loans are restricted and what’s kind of allowed according to Islamic financing rules?

Lecture No 03:

31 Oct 2015_Monday_10:11pm

• Objective of Economics

– Profit maximization (for whom? over what time period?)

• Objective of Financial Accounting (FA)

– Accurate, timely, consistent, and generalized collection and reporting of financial data for FM

• Objective of Financial Management (FM)

– Wealth maximization (for shareholders / owners, now)

– Maximize stock price (one aspect)

– Find the best investments and financing in order to maximize shareholders’ wealth

4 Financial Statements:

Financial statement aesay hai jis trah ecg for human health. So, financial statement is historical recoat for financial health.

– Balance Sheet

– P/L(profit/lose) or Income Statement

– Cash Flow Statement

– Statement of Retained Earnings (or Shareholders’ Equity Statement)

Financial Accounting Review (FM 2-3):

– Assets + Expense = liabilities + shareholders’ equity + revenue (Note: Expense & Revenue are Temporary P/L accounts – the others are Permanent Balance Sheet Accounts)

– Left Hand Items increase when Debited. Right Hand items increase when credited.– For every journal entry, the Sum of Debits = the Sum of Credits

Financial Accounting Review (FM 2-4)Balance Sheet

• Assets (Left Hand Side)

– “Static snapshot” at one point in time (therefore vulnerable to inventory and cash swings)

– Balance Sheet Items or Accounts are “Permanent Accounts” that continue to accumulate from one cycle to the next.

– Historical cost basis (neglects increase in value of assets from increasing inflation)

– Assets are economic and business resources: tangible (inventory), intangible (patent, brand value, license), current (cash), fixed (machinery, land), long-term (property, loans given), contingent (legal claim pending, option), etc.

– Current Assets = Cash + Marketable Securities + Accounts Receivable + Pre-Paid Expenses + Inventory

– An Ageing Schedule is prepared to compute the value of recoverable Accounts Receivables.

– Inventory value (at any instant in time) is a very controversial figure which depends on Inventory Valuation Methodology (ie. FIFO, LIFO, Average Cost) and Depreciation Method (ie. Straight Line, Double Declining, Accelerated)

• Liabilities (Right Hand Side)

Balance sheet ka asool hai, total assets = total liabilities

Coz, Liabilities are sources. Their obligation and also sources which are then used to purchase to acquire economic resources.

– Liabilities are obligations of 2 types:

1) obligations to outside creditors 2) obligations to shareholders also known as equity.

– Liabilities can be current debts to others, long term loans taken, equity, retained earnings, contingent, unrealized gain on holding of marketable securities

– Current Liabilities = Account Payables + Short Term Loans + Accrued Expenses

– Net Working Capital = Current Assets – Current Liabilities

– Total Equity = Common Equity + Paid In Capital + Retained Earnings (Retained Earnings is NOT cash)

– Total Equity represents the residual excess value of Assets over Liabilities:

Assets – Liabilities = Equity = Net Worth

– Only Cash Account represents real Cash which can be used to pay your bills !!

P/L or Income Statement:

• P/L or Income Statement

– “Flow statement” over a period of time matching the operating cycle of the business. Generally: Revenue – Expense = Income

– Right Hand Side Receipts are Added. Left Hand Side Receipts are Subtracted.

– P/L Items or Accounts are “Temporary” Accounts that need to be closed at the end of the accounting cycle.

– Operating Revenue – Cost of Goods Sold = Gross Revenue

– Cost of Goods Sold is a very controversial figure that varies depending on Inventory Valuation Method (ie. FIFO, LIFO, Average Cost) and Depreciation Method (Straight Line, Double Declining, Accelerated). Depreciation is treated as an expense (although it is non-cash)

– Gross Revenue – Admin & Operating Expenses = Operating Revenue

– Operating Revenue – Other Expenses + Other Revenue = EBIT

– EBIT – Financial Charges & Interest = EBT Note: Leasing Treatment

– EBT – Tax = Net Income

– Net Income – Dividends = Retained Earnings

– Net Income is NOT cash (it can’t pay for bills)

• Cash Flow Statement ......yahan say again start krna hai...11:02_ 25.08 lecture 03

– Divided into 3 parts: Operations, Investment, Financing

– Operating Cash Flow Statement has 2 Approaches: 1) Direct and 2) Indirect. Can be derived from P/L or Income Statement

and two consecutive year Balance Sheets.

– Not Accrual Basis but rather Cash Basis: Cash Receipts and Cash Payments

– “Flow statement” over a period of time matching the operating cycle of the business. Generally: Revenue – Expense = Income

– Increases in Current Assets are Cash Payments (-). Increase in Current Liabilities are Cash Receipts (+). Right Hand Side Receipts are Added. Left Hand Side Receipts are Subtracted.

• Statement of Retained Earnings or Shareholders’ Equity Statement

– Total Equity = Common Par Stock Issued + Paid In Capital + Retained Earnings (Retained Earnings is the cumulative income that is not given out as Dividend – it is NOT cash)

SOME FINANCIAL RATIOS:

• LIQUIDITY & SOLVENCY RATIOS:Ye ratios ye idea detay hein company ki cash generation value kitni hai. Kitni asani say campany apnay assests bech k cash hasil kr sakti hai.

– Current Ratio:

Current assests / Current Liabilities

Rule of thumb 1.0 – 4.0 (?)

– Quick/Acid Test ratio:

(Current assests – inventory ) / current liabilities

Rule of thumb 0.3 – 1.5 (?)

– Average Collection Period:

Net sales/ average accounts recieveable

Rule of Thumb Credit Cycle +15 days.

• PROFITABILITY RATIOS:It gives the reader some idea of the level of profit that a company is able to generate.

– Profit Margin (on sales):

Its most common.

Net income / Sales

Rule of thumb 5 - 30% (?)

– Return on Assets (ROA):

Net income / Common equity

– Return on equity(ROE):

Net income / Common equity

Rule of thumb compare to interest cost

ASSET MANAGEMENT RATIOS These measures show how effectively the firm has been managing its assets.

– Inventory TurnOver:

Sales / Inventories

Rule of Thumb relative to Op. Cycle

– Total Asset TurnOver:

Sales / Total assets

DEBT (OR CAPITAL STRUCTURE) RATIOS:

o Debt Assets:

Total Debt / Total Equity

Rule of Thumb less than 0.66

o Debt Equity:

Most commonly used in pakistan this ratio

Total Debt / Total Equity

Rule of Thumb New projects: 60/40

o Times-Interest-earned:

EBIT / Interest charges

Rule of Thumb More than 4.0

Market Value Ratios:Most Important ratios.

o Price earning (P/E ratio):

Market Price per share / Earnings Per Share

Rule of Thumb Buy share if under 10(?)

o Market / Book (M/B Ratio): Market Price per share / Book Value per share

o Earning Per Share (EPS Ratio):Net Income / Average Number of Common share Outstanding.

Lecture No 04:

3 Nov 2015_ Thursday _ 2:55pm

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These concepts are very important while going to make any financial decision.

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FM Concepts:There are certain financial management concepts that should be kept in mind, while making an analysisof a financial decision. The one-liners given here would help you in committing these concepts to yourmemory.

• A rupee today is worth more than a rupee tomorrow. Time Value of Money & Interest

Ksi khas waqt, ksi khas zaroort k paish e nazar pr lia gaya loan ya raqam us raqam ya interest say behter hai jab us ki zaroort na rahay.

• A safe rupee is worth more than a risky rupee. - Risk and Return

• Don’t compare apples to oranges- Discounting & NPV (very imp concept for this course)

Compare Different investments at the same point of time.

• Don’t put all your eggs in one basket.- Portfolio Diversification

Means ksi investor ko apni tamam wealth ksi ik business mein hi invest nahi kr deni chahiye. coz, is trah loses ka chance bht zyada hojata hai. Agr us business mein lose ho jata hai to means investor apna sara sarmaya lay dobay ga. Is k barakas who apnay total sarmaye ko 10 different business mein invest karay ga to lose k chances bht kam ho gay.

• Get insurance because you will break some eggs.- Hedging & Risk Management

Hedging & risk management k mutabiq tamam eggs aik hi basket mein dalay jaein ya different boxes mein totnay ka koi na koi chance baherhal majood rehta hai. Tahum, insurance hasil krnay means ye method use krnay k bad apni ksi cheez k nuqsan k paishe nazar claim kia ja sakta hai. Jo k loses say avoid krnay ka best way hai.

The Basic Objective of the Financial Management is to maximize shareholder WEALTH.

Interest Theory:

Interest Factors: sood ki sharah..

– i = iRF + g + DR + MR + LP + SR– i is the nominal interest rate generally quoted in papers. The “real” interest rate = i – gHere i = market interest rateg = rate of inflationDR = Default risk premiumMR = Maturity risk premiumLP = Liquidity preferenceSR = Sovereign RiskThe explanation of these determinants of interest rates is given as under:As,

A nominal interest rate is the interest rate that does not take inflation into account.

A real interest rate is the interest rate that does take inflation into account.

Risk Free Interest Rate (RF):

There is no such thing which is risk free but Aesi government introduce such securities jis mein risk ko kam say hata ul imkan kam kia ja sakta hai. Usay Risk Free interest rate kaha jata hai.

Inflation(g):

is the rate at which the general level of prices for goods and services is rising and, consequently, the purchasing power of currency is falling.

Default Risk Premium (DR):

Default risk refers to the risk that the company might go bankrupt or close down & bonds, or shares issued by the company may collapse.

Maturity Risk Premium (MR):

Means agr hum nay federal gov ka 10 years bond khareda hai to it means we take a risk. Coz, 10 years mein inflation or interest rate ki kami beshi ki wjay say is bond ki value mein depreciation ho sakti hai value gir sakti hai.Long term securities and investments require a higher maturity risk premium.

Sovereign Risk Premium (SR):In very easy wording aesa risk jo k mulki halaat k paish e nazar ineterst ki value mein kami beshi ka bais banay. Sovereign Risk refers to the risk of government default on debt because of political or economicturmoil, war, prolonged budget and trade deficits. This risk is also linked to foreign exchange (F/x),depreciation, and devaluation.

Highest rate of return with limited risk. Every company or investor want this.

Liquidity Preference (LP):Means k kitna kharch krna hai or kesayOr kitna save krna hai or kesay kis surat mein? In cash or other way.

Yield Curve Theory:Interest rate means sood ki sharah mein Time ki wjay sy jo difference atay hain unhein yield curve k name sy jana jata hai. Term Structure and Yield Curve:

Interest rates for any security vary across time horizon. Agr ksi aik investment ya security ki bhi bat karein to uski short term or long term interest rate mein difference hoga.

Short Term: Short term means for the period of one year or less.Medium Term: For the period of anywhere between one year to five years.Long Term: Anywhere between 15 years to 20 years some people say that medium term is from 5 year to ten years and long term from 10 years to 20 years and plus.

The supply & demand for funds vary depending on how long the funds are required.

Supply and demand short term k liay different ho sakti hai or long term k liay different. Example jin logon ko aik week k liay loan chahiye un ki tadad un logon jin ko aik year k liay loan chahiye kam ya zyada ho sakti hai.

Normally, short term interest rates are lower than long term rates, which is known as the Normal (or upward sloping) Yield Curve.Mean many thinks inflation means mehngai barhay gi to us k sath interest rate bhi barh jaye ga.

Abnormal Yield Curve(Downward Sloping) It is the case where the short term rates are higher than long term interest rates.

Mixed or Humped Back Curve

Theories For shape of the Yield Curves:Expectations Theory:Investors normally expect inflation (and interest) to rise with time thereby giving rise to a normal shaped yield curve.Means mostly investors think inflation(mehngai) k barhnay say interest rate bhi increase hoga. Expectation.

Liquidity Preference Theory:Investors prefer easily encashable securities with short maturities. The only problem is that short term securities are easy to encash but at maturity there is no guarantee that you can renew it .so,you can find a security today which will give you 25 %or 30% per annum they are not always renewable – hence unpredictable.

Short term securities may can give 30 to 40% per annum but we can’t it renew. Means koi guarantee nahi hai agr 6 months bad b isay renew kia ja sakay. Or other security choose ki ja sakay.

Short term indeed easy to cash but not easy to renew.

Market Segmentation:Market segmentation is the most common reason to the abnormal yield curve. Means Short term interest rates higher than long term interest rates.

The demand/supply for Short Term securities is different from that of Long Term securities.This can easily give rise to an Abnormal Yield Curve.

Demand/supply of short term interest rate ki long term k demand/supply say DIFFERENT or INDEPENDENT hoti hai.

there three kinds of interest we will talk about1-simple interest2-discrete compound interest3-continuous compound interest

1. Simple Interest (or Straight Line):F V = PV + (PV x i x n)Here,FV= Future ValuePV= Present Value I = interest rateN = term of investment

2. Discrete Compound Interest:o Most commonly used in Financial Management (for discounting and NPV Calculations)o FV = PV x (1 + i) ^n …………… If annually (yearly) compounding o FV = PV (1+ (i/m))^mxn …… Here ‘m’ refers to the compounding intervals during the

term of the investment. In order to calculate monthly then m =12, if weekly then m =52, if daily then m = 365. however, for quarterly compounding calculation m would be equal to 4

3. Continuous compound interest:FV = PV x e^ixn

Symbols:FV = Furture ValuePV = Present Valuei=Interest rate (% per year)n = # of yearse= fixed constant derived value 2.718 Example:Suppose you deposit Rs 10 in a bank today. The bank offers you 10% per annum (or per year)interest. How much money will you have in the bank after 15 years?

Hum ik bank mein 10 rupee jama kr rahay hein or maloom krna chahtay hein Future value 15 years bad kitni hogi?

If the bank is offering simple interest:F V = PV + (PV x i x n) = 10+ (10x0.10x15) = Rs. 25If the bank is offering discrete compounding: (compound mein sood pr sood milta hai)F V = PV x (1+ i) n = 10 x (1+0.10)15 = Rs. 42 approx.Banks do not offer continuous compounding but if they did:F V = PV x e ixn = 10 x (2.718) 0.10x15 = Rs. 45 approx

The miracle of compounding – you earn interest oninterest & principal!

what does nominal and real interest rate mean? Kindly explain it with examples.

Where as I understand DR Default Risk Premium is by default risk like bankrupt & close down a company. But what does it mean;Default Risk Premium is charged by the investor, as compensation, against the risk that the company might goes bankrupt.In case of lose what happens with investors in DR?Kindly explain Liquidity Preference (LP). I couldn’t understand it clearly. As I have read anywhere that, “ The cash money is called liquidity and the liking of the people for cash money is called liquidity preference.” However, what will be its exactly suitable and easy to understand definition?

Lecture No 05:

4 Nov 2015_Friday_2:17pm 3:18 leave out _start again 4:23pm

What is Forecast?

A forecast is the prediction about a condition and situation at some future time.

Financial Forecast?

Financially business decisions according to predict the likely future values of financial variables such as revenues, expenses and cash balance.

Financial Forecasting and planning detail good link..

http://www.zenwealth.com/businessfinanceonline/FF/FinancialForecasting.html

Financial Planning & Forecasting:

• Objectives of Financial Forecasting

– Reduce cost of responding to emergencies

– Be prepared to take advantage of opportunities

– Prepare contingency and emergency plans

– Prepare to deal with possible outcomes

• Planning Documents

– Cash Budget

– Pro Forma Balance Sheet

– Pro Forma Income Statement

• Methods

– Percent of Sales: Simple

– Cash Budget: Detailed, more complicated

Financial ForecastingPercent of Sales:

• Step 1: Estimate year-by-year Sales Revenue and Expenses

Cash flow/maal ka bahao hum SALE REVENUE say estimate karein gay.Aeinda anay walay salon mein Sale Revenue kesay change hoga? Is k bad expenses ko estimate kia jaye ga k aeinda anay walay salon mein expenses kia hongay.

Expensing mein cost of good sold, administrative cost, marketing cost and other expenses and depreciation shamil hein but we will use CASH Basis NOT Accrual Basis.

• Step 2: Estimate Levels of Investment Needs (in Assets) required to Meet Estimated Sales (using Financial Ratios)

• Step 3: Estimate the Financing Needs (Liabilities)

Yahan ye andaza lagana hai k Firms ya companies ki jo asset or liabilities hein who sale revenue k sath kesay kesay change hongi.

Jab hum assets or liabilities ki changing ko forecast kr sakein to us say ye andaza lagaya ja sakta hai k Company k pas investment k liay kitna sarmaya hoga? Or company ki short fall cash k hwalay say kitni hogi. Lehaza us ko borrowing kitni karna paray gi.

Ye sab cheezein SALE REVENUE say linked hein.

Percent of Sales Forecasting:

1st we will know that Asset or liabilities k Firm ietms ka SALE Revenue say kia link hai?

• General Assumptions:

– Current Assets: Generally grow in proportion to Sales

Means land, cash etc. so, sale revenue k increase honay say current asset mein bhi izafa hoga.

– Fixed Assets: Do not always grow in proportion to Sales. Ask if you need to expand property, office or factory space, machinery in order to achieve your Sales target.

Means sale revenue k increase honay say fixed assest like office, factory space etc ko bahranay ki zaroort nahi.

– Current Liabilities: Also called Spontaneous Financing.

Generally grow in proportion to Sales

– Long Term Liabilities: Also called Discretionary Financing.

Do not grow in proportion to Sales

Percent of Sales ForecastingNumerical Example of Café:

• Suppose you expect the Sales Revenue from your Café (or Canteen) business to grow from Rs 200,000 to Rs 300,000 and your Expenses to grow from Rs 50,000 to Rs 70,000 after 1 year.

• This means that the Sales Revenue growth rate is:

Current Sale Revenue value – increasing S/R value / current S/R value = (I wrote this for my convienent, there is no exact forumula)

(300,000-200,000) / 200,000 = 0.5 = 50%

• Similarly, the Expenses growth rate is:

• (70,000-50,000) / 50,000 = 40%

• Now, how do we estimate the required change in Investments (Assets) and Financing (Liabilities)? First compute some Key Financial Ratios.

Estimating Changes in Investment & Financing:

• Predicting Current Assets:

= Estimated Sales x (Current Assets / Sales)

= 300,000 x (0.20) = Rs 60,000 (Balance Sheet value)

• Assume no changes (no increase) in Fixed Assets.

• Predicting Retained Earnings (RE)

Wo paisa ya profit ka hissa jisay business mein reinvest kia jaye. Usay bhi forecast krna paray ga. Jis say pehlay ye andaza lagaya ja sakay k cash ki short fall kitni ho rhi hai. However, us k mutabiq andaza lagaya ja sakay k external finance ya loan kitna lena paray ga.

= Estimated Sales x Profit Margin x Plowback Ratio

= 300,000 x (0.25) x (1 - Payout Ratio) = 75,000 x (1-0.5)

= Rs 37,500 (Balance Sheet value)

Plow back ratio=1-pay out ratioPay out ratio=dividend/net incomeProfit margin=net income/sales

• Predicting Discretionary/External Financing (Liabilities)

Means aeinda anay walay year mein hamein kitni borrowing krna paray gi.

= Estimated Total Assets - Estimated Total Liabilities - Estimated Equity

= 160,000 - 0 - 137,500 = Rs 12,500

A pro forma cash flow statement is just like an ordinary cash flowstatement; the only difference is that the figures in a pro forma cash flow statement are estimated figures rather than actual ones.Pro forma means forecasted.

Investment is the equity.

• Construct the Cash Flow Statement Forecast (or Pro Forma Cash Flows) based on the Predicted Sales Revenue, Expenses, Assets, Liabilities, and Retained Earnings.

• If the Business wants to maintain its present Financial Ratios constant and its owners (or shareholders) do not want to invest more equity, then at what sales growth rate (g) (also the growth rate of assets and liabilities) can the business grow sustainably?

Business or sale revenue k increase honay ki osst kitni honi chahiye.. Agr same financial ratios ko maintain/barqarar rkhna ho to or zaati sarmaya business mein na invest krna chahtay hon? Isko is trah calculate kia ja sakta hai jisay desire growth rate(g) kaha jata hai.

g = ROE x (1 - b)

G (Desired Growth Rate) = return on equity x (1- pay out ratio)

where b = Dividend/Net Income

ROE(Return on Equity) = Net Income / Equity

• Drawback of Percent of Sales Method:

Rough approximate because does not account for Economies of Scale, (Mean its not in detailed.)Fixed Inventories,(agr business mein forecasting period k duran fixed assest mein koi bht baric hangings hoti hai to will not yiel very accurate answer.)and Lumpy Assets.(aesay asset jin ki minimal inventory lavel hamesha barqarar rkhni hoti hai. Usko consider nahi krtay)

Agr hum forecasted ratios ko hi ainda anay walay years mein barqrar rkhna chahtay hein or mazeed koi zaati sarmaya add nahi krna chahtay in business then

Lecture No 06: Very Important Lecture

4 Nov 2015_Friday_7:20pm

Objective Of Present Value:

• Objective is to calculate what is the Present Value from Future Cash Flows.

• We choose the Present (Today) as the most convenient point in time where we compare all the Cash Flows taking place at various points in time.

• We must compare everything at the SAME point in time otherwise, we would neglect Time Value.

Compare Different investments at the same point of time.

Future k cash flows ko present k sath compare krna.

Agr aj k 10 rupee ko 10 years bad k 10 rupee say compare kia jaye to aj ki value zyada hogi.

Example:

Means SAME TIME 2 different VALUES ko compare krna.

VALUES (Apples) to same hein BUT time CHANGE hai. So, after 10 year 10 rupee ko Discount kr k PRESENT mein lana Present Value hai.

• For example, Rs 105 is more than Rs 100 BUT, Rs105 after 1 year is not necessarily more than Rs100 today ! We first have to first bring all cash flows to the Present, or Discount them, and then compare them.

Means 105 is more than 100 rupees BUT Rs105 after 1 year is not necessarily more than 100Rs TODAY.

Jo 105Rs future ki bat ki usay present mein lana hoga. So, jis technique k through lay k aein gy usay discounting kehtay hein.

Discounting is basically bringing a FUTURE cash flow back to the PRESENT.

Interest Rate is kind of Opportunity of cost. Interest rate ko opportunity cost bhi kehtay hein.

WHY the Interest Rate as an Opportunity Cost?

• COZ, When you deposit your money in the bank and get interest, you are Sacrificing by (1) not consuming the money to buy something for yourself and

(2) not investing your money somewhere where you can get a higher return than the bank interest.

• Almost everyone can deposit money in a bank savings account and get Bank Interest, so this is the minimum Opportunity Cost for anyone. Any business project, investment, or deal has to give a return better than the Bank Interest.

Interest Rates for Discounting Calculations:

• Nominal (or APR) Interest Rate = i nom…………are very common

– Annual Nominal Interest Rate (quoted for 1 year)

– Published in newspapers

– Advertised by Credit Cards and Leasing Companies because it understates the actual (or Effective) interest you have to pay.

• Periodic Interest Rate = i per

– Used in FM for Discounting and Present Value (PV) calculations

– i per = ( i nom) / m where m = # of times compounding takes place in 1 year ie. If semi-annual compounding then m = 2

• Effective Interest Rate = i eff

– Used to compare securities and investments with different compounding cycles but not used for Discounting and PV.

– i eff = (1 + ( i nom / m ))m – 1

Back to our original question: How can Rs 105 after 1 year be less than Rs 100 today?

Answer: If the Periodic Interest Rate is say 10% per annum (p.a.), then we can use our old Interest Rate Formulas to solve what the PV of the future Rs 105 would be today. This is called Discounting the Future cash flow to the Present.

– PV = FV / (1 + i )n = 105 / (1+0.10)1 = 95.45

• i=interest rate• N=no. of years if we plug in the values

Most USED formula in this course.

– Thus, the PV of Rs 105 (1 year from now) is Rs 95.45 which is less than Rs 100.

Time & Arrow Diagram 1 Year Discounting of Future Value:

Downward Pointing Arrows to show Cash Outflows (Expenses, Cash Payments & Investments)

Upward Pointing Arrows to show Cash Inflows (Cash Receipts, income, cash profit)

Outflows: means maal ka bahao bahir ki janib

Inflows: maal ka bahao ander ki janib in very simple wording...

1st step ye hai k

Paisay ka bahao jo ainda anay walay salon mein hoga… means future cash flows ko forecast karein

2nd step phir ye k un net cash flows ki values jo hr ainda anay walay years ki hai unko Discount karein bari bari back to the present.

Discounting Cash Flows Cafe Case Study

Lets take an example to Understanding Discounting and NPV Concept.

• Suppose you are thinking about starting a small café or canteen inside a university campus.

• You make a simple Feasibility Report showing the Estimated Initial Investment and the Forecasted Cash Flows for the first Year (based on expected Cash Receipts from sales and Cash Payments for expenses).

1_Is business ko start krnay k liay jo sarmaya chahiye hoga usay Initial Investment kehtay hein.2_ then aik feasibility report prepare ki jaye gi k iski Expected Income(amdani) and Expenses(Akhrajaat) kitnay hongay.3_ then hum aik forcasted/pro forma cash flow banein gy.in steps k bad hamaray pas kuch key financial Data aa jaye ga. Lets it is

• The Key Financial Data is as follows:

– Initial Investment = Rs 100,000

– Forecasted Cash Receipts/Revenue (end Year 1) = Rs 200,000

This is a cash inflow for the business and is represented by an upward arrowMean end of the year INCOME/Profits/Returns.

– Forecasted Cash Payments (end Year 1) = Rs 50,000

This is a cash Outflow for the business and is represented by an downward arrowMean end of the year EXPENSES.

– Forecasted Future Investment (end Year 1)=Rs30,000

Means to increase sales needs to invest more money. investment in physical assets like, place for canteen, kitchen equipment or machinery or investment small physical assets. It is increased in assets as investments.

– Periodic Interest Rate (Opportunity Cost) = 10% p.a.

Saving account hasil kr k bank k bina ksi effort k 10% interest mil jata hai.

So, Tamam FUTURE cash Flows chahay wo Upward means Inflow hon ya Downward mean Outflow ko combine kr dia jaye ga.

Means FUTURE cash flows ko combine kr k NET PRESENT value mein convert kr diya jaye ga.

Simplified Cash Flow Diagram Café ExampleNet Cash Receipts = CF1 = FV1=200,000–50,000–30,000 = Rs 120,000

Now, What will be PRESENT VALUE of Rs 120,000 with 10% interest rate after 1 year?

REMEMBER:

Outflows will be sign as – negative.

Inflows will be sign as + positive.

• Present Value of Net Cash Flow from Year 1 =

PV(CF1)= CF1 / (1+ i )n = 120000 / (1+0.1)1 = + Rs 109,000

• Now to calculate the NET Present Value:

NPV = - Io + PV(CF1) = - 100,000 + 109,000 = + Rs 9,000

• The NPV of our Business after 1 Year is Positive Rs 9,000 which is a good sign.

• NPV = NET Present Value (taking Investment outflows into account)

NPV = - Initial Investment + Sum of Net Cash Flows from Each Future Year.

NPV = - Io +PV(CF1)+ PV(CF2) + PV(CF3)+ PV(CF4)+ ...

• Note that PV(CF1) means the Present Value of Future Net Cash Flow (CF) taking place at the end of Year 1. CF is like the FV in our Interest Formulas. Our compounding cycle is 1 year so the Periodic Interest Rate is 10%

Questions raised:

What does compounding means?

Compounding is the process where the value of an investment increases because the earnings on an investment, both capital gains and interest, earn interest as time passes. It is the ability of an asset to generate earnings, which are then reinvested in order to generate their own earnings. The exponential growth occurs because the total growth of an investment along with its principal earns money in the next period.

Accounting Vocabulary:

Accural Basis means: bajaye is k keh hum income or expenses us time pr record karein jab cash hum nay receive ya pay kia hai us ki bajaye expenses or income accrual basis k tehat tab record karein gay jab product ya service deliver ya avail kr lia hai. Accrual ka creteria ye hai k ap nay product ya service ko use ya provide kia ho ksi or k liay that is the basis of accrual basis.

Searching terms..Historical Cost

Depreciation methodInventory EBITLiQuidity PreferenceNet Present ValueDiscountingCompounding

Hamad teri rehmat da darya ilahi hr dam wagda jaye…