Financial Management

Course content to be used by: BMS Sem 4

Faculty: Neha Gosain
E-mail: nehagosain@sscbs.ac.du.in
• Finance – art and science of managing money
• Financial management - Finance management is the strategic planning
and managing organization’s finances to better align their financial
status to their goals and objectives.

• Scope of financial management – acquisition and allocation of funds

• Three major questions :

• financial problems of a firm –
• investing,
• financing and
• dividend decision
Investment decision
• Selection of assets for the firm
• There are two types of assets – long-term and short-term
• Investment-related long-term assets – capital budgeting
• Benefits of such assets accrue over a long period of time
• Three aspects: choice amongst alternatives, level of risk, cost of capital or the
required rate of return
• Investment related to short-term assets – working capital management
• Short term assets that can be converted into cash easily without diminution in
value
• Trade-off between profitability and liquidity
Financing decision

• Choice of proportion of debt and equity

• Capital structure or leverage
• Reasonable proportion is to be determined also known as optimum
capital structure
Dividend decision

• Excess profits can either be distributed or retained

• DP ratio to be determined : proportion of profits to be paid out
Objectives of FM
Scope of FM
• Investment decision
• Financing decision
• Dividend decision
Finance and related disciplines
Profit maximisation vs wealth maximisation-
traditional and modern approach
 Time value of money
• Or the time preference of money means that value of a unit of money is
different in different time periods. MAIN REASON being reinvestment
opportunities
• Value of a sum of money received today is more than received in some
time
• Conversely, Value of rupee received later is less than a rupee received
today
 Compounding/discounting
• Compounding – interest is earned on a • Present value – current value of a future
given deposit/principal that has become amount. The amount to be invested today
part of the principal at end of a specified at a given interest rate over a specified
period
period to equal the future amount.
• Different time period compounding – • Discounting – determining the present
semi-
annually/quarterly/monthly/weekly/daily value of a future amount.
• Single amount (use present value interest
• Single amount (use future value interest factor)
factor)
• Mixed stream (use present value interest
• Mixed stream (use future value interest factor)
factor) • Annuity : a series of equal cash flows (use
• Annuity (use future value factor for present value factor for annuity)
annuity) • Perpetuity: annuity with an indefinite life,
• PV*FVF=FV making continuous annual payments
• FV*PVF=PV
CONCEPT OF RETURN
A return (also referred to as a financial return or investment return) is usually presented as a percentage
relative to the original investment over a given time period. There are two commonly used rates of return
in financial management.
Nominal rates of return that include inflation. Real rates of return that exclude inflation
An investment return can come in a wide range of forms, including capital gains, interest, dividends, or
rental income in the case of real estate.

1. HISTORICAL RETURN : The historical return of a financial asset, such as a bond, stock, security,
index, or fund, is its past rate of return and performance. The historical data is commonly used
in financial analysis to project future returns or determine what variables may impact future returns and
the extent to which the variables may influence returns. The data below provides the historical
performance of the S&P 500 index. December 31, 2016: 2,105 December 31, 2017: 2,540
Historical Return(s) = [(2,540 – 2,105) / 2,105] x 100 = 0.20665 x 100
Historical Return(s) = 20.7%
2. EXPECTED RETURN: An investor's expected return is the total amount of money they expect to gain or
lose on a particular investment or portfolio. Investors commonly use the expected return to help them make key
decisions on whether to invest in new vehicles or continue to hold on to their existing investments.The expected
return is generally based on historical returns.
Expected Portfolio Return = (Asset 1 Weight x Expected Return) + (Asset 2 Weight x Expected Return)...

3. ABSOLUTE RETURN : Absolute return is the return that an asset achieves over a specified period. This
measure looks at the appreciation or depreciation, expressed as a percentage, that an asset, such as a stock or a
mutual fund, achieves over a given period. Absolute return differs from relative return because it is concerned
with the return of a particular asset and does not compare it to any other measure or benchmark. As a historical
example, the Vanguard 500 Index ETF (VOO) delivered an absolute return of 150.15% over the 10-year period
ending Dec. 31, 2017. This differed from its 10-year annualized return of 8.37% over the same period.
4. HOLDING PERIOD RETURN : Holding period return is the total return received from holding an asset or portfolio of assets over a period of time,
known as the holding period. It is generally expressed as a percentage and is particularly useful for comparing returns on investments purchased at different
periods in time.
Holding Period Return=Income +(End Of Period Value − Initial Value)​​/Initial value
• What is the HPR for an investor who bought a stock a year ago at $50 and received $5 in dividends over the year if the stock is now trading at $60?
HPR=5+(60−50)50=30%

5. ANNULIZED RETURN : Annualized rate of return is a way of calculating investment returns on an annual basis.

6. ARITHMETIC RETURN : The arithmetic average corresponds to the sum of linear returns (linear scale) observed, dividing the result by the number of
observations. If we have 5 periods of returns, we add those returns and then divide the result by 5. This is the simplest way to calculate the average return on
a portfolio over multiple periods. Let's imagine that we have the following series of 4 annual returns: -50%, +35%, +21% and +10%. To find the annual
arithmetic average, just add the returns and divide by 4 = 4%

7. GEOMETRIC RETURN : The arithmetic average return assumes that the amount invested at the beginning of each year is the same. However, we
know that this is not the case, especially in an investment portfolio with financial assets. In a portfolio, even without reinforcements or withdrawals, the
truth is that the base value changes every year (if the period under analysis is annual). With the geometric mean, these results will be added to the amounts
invested at the beginning of the following year, creating the compound capitalization effect. The return of the geometric average thus provides a more
accurate assessment of the growth in the value of the portfolio in a given period of time. Taking into account the example above, ((1 - 50%) x (1 + 35%) x (1
+ 21%) x (1 + 10%)) ^ (1/4) – 1 = -2.6% .
CONCEPT OF RISK
• Risk: It is the discrepancy between what is expected and what has
happened. Variability in expected returns from estimated returns.
• Necessary to incorporate risk in capital budgeting decision since returns
occur over a long period of time. Level of risk will impact NPV, profitability,
share price, firm value.
• Cash flows are just estimates. Estimates are based on various assumptions
(for price, cost, competition) which are subject to variability.

RISK – outcomes can be assigned probabilities

UNCERTAINTY - outcomes cannot be assigned probabilities
CERTAINTY – Outcome are certain eg. Govt. securities
SOURCES OF RISK
• Systematic risk – overall market risk that effects all securities and cannot be diversified away
• SOURCES: Systematic risk arises from various factors that affect financial markets as a whole. These factors can
be broadly categorized into economic, political, and market factors.
• Each category comprises several specific sources of risk that investors should be aware of when assessing their
exposure to systematic risk.
1. Economic Factors
• Economic factors are a significant source of systematic risk, as they can impact the overall health and growth of
the economy, leading to widespread effects on financial markets.
• Interest Rates
• Interest rates significantly impact the cost of borrowing and the attractiveness of various investment options.
Changes in interest rates can affect the performance of stocks, bonds, and other investments, thereby impacting
the broader financial market.
• Inflation
• Inflation is the rate at which the general level of prices for goods and services is rising, eroding purchasing power
over time. High inflation can adversely affect financial markets by reducing the real return on investments and
influencing interest rate decisions by central banks.
• GDP Growth
• Gross Domestic Product (GDP) growth is a measure of economic expansion or contraction. Changes in GDP
growth can have widespread implications for financial markets, as they can affect corporate earnings, consumer
spending, and investment decisions.
2. Political Factors
• Political factors are another source of systematic risk, as they can influence financial markets through various channels, such as government policies,
regulatory changes, and political instability.
• Government Policies
• Government policies, such as fiscal and monetary policies, can significantly impact financial markets. Tax rates, government spending, and monetary
policy changes can influence market conditions and the performance of various investments.
• Regulatory Changes
• Changes in regulations can also impact financial markets by altering the business environment for various industries and sectors. Regulatory changes
can create uncertainties and additional costs for businesses, potentially affecting their profitability and investment attractiveness.
• Political Instability
• Political instability, such as social unrest, changes in leadership, or geopolitical conflicts, can create uncertainties in financial markets. These
uncertainties can lead to market volatility and negatively impact investment performance.
3. Market Factors
• Market factors are another source of systematic risk, encompassing aspects of the financial markets themselves that can impact investment
performance.
• Market Volatility
• Market volatility refers to fluctuations in asset prices and can be a significant source of systematic risk.
• Market Sentiment
• Market sentiment refers to the overall attitude of investors toward a particular market or asset class. It can be influenced by various factors, such as
economic data, news events, and investor psychology.

• Measure of systematic risk : Beta Coefficient

• The beta coefficient is a widely used measure of systematic risk that compares an individual security or portfolio's volatility to the broader market's
volatility.
• A beta greater than 1 indicates that the security or portfolio is more sensitive to market movements, while a beta less than 1 suggests lower
sensitivity.
• The beta coefficient can help investors gauge their exposure to market risk and make adjustments to their portfolios accordingly.
Unsystematic risk – firm specific and can be avoided by diversification
Sources
• Business Risk
Many external and internal issues can cause business risk. Banning of a particular product that a company
sells to legal authorities of a country is an example of external risk. Operational inefficiency and
miscommunication of important information constitutes internal risk.
• 2. Financial Risk
Financial risk deals with risk due to the debt equity ratio (or capital structure) of the company. An
inefficient capital structure may hinder growth and may increase chances of financial distress.
• 3. Strategic Risk
Strategic Risk occurs when a company lacks proper strategic planning before execution of important
events.
• 4. Operational Risk
Operational Risk occurs due to negligent or unforeseen events like a supply chain breakdown or negligence
of a critical process in the manufacturing process.
• 5. Legal Risk
These risks include lawsuits filed against the company, changes in government regulations having major
impact on a particular company etc.
How do you control Unsystematic Risk?
• Diversification is the one way used to reduce unsystematic risk of a portfolio. Having investments with
the right mix of safer and riskier securities in a variety of industries help in controlling the unsystematic.
Statistical techniques for measurement of risk

• Range
• Standard deviation
• Coefficient of variation
• Semi-variance
• Subjective probability distribution (non-statistical): using experience
and judgment to define a probability distribution