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UNIT-1

Nature of Financial
Management
Meaning
We find that corporate finance is based on two
fields of study, Economics and Accounting.
Economics provides us much of the theory
that underlines our techniques, whereas
Accounting provides the data which helps us
in making decision. Financial Management
is the maintenance and creation of economic
value or wealth.
Illustration :
Consider two firms, Merck and General
Motors (G.M.) at the end of 2007, the total
market value of Merck, a large pharmaceutical
Co. was $ 103 billons. Over the life of the
business, Merck investor had invested about
$ 30 billions in the business. In other words
management created $ 73 billions in
additional wealth for the Shareholders G M on
the other hand, was valued at $ 30 billions at
the end of 2007; but over the year G M's
investors had actually invested $ 85 billions--
a loss in value of $ 55 billions. Therefore
Merck created wealth for its shareholder's,
while G M lost shareholder's wealth.
Financial Management is that branch of study
which deals with finance and its functions
which are-
• Raising of funds
• Allocations
• Controlling financial resources
The objective of all the above activities is to
maximize shareholder's wealth.
"Financial Management is the operational
activity of a business that is responsible for
obtaining and effectively utilising the funds
necessary for efficient operations."
Joseph & Massie
There are 3 A's of Financial Management.
• Anticipating Financial Needs
• Acquiring Financial Resources and
• Allocating Funds in Business
Since FM is concerned with the efficient use
of capital funds which is an important
economic resource.

Finance & Economics


Economics is concerned with the overall
institutional environment in which the firm
operates, which includes the internal and
external environment. It is effect with the
factors like.
• Growth rate of the economy
• Domestic saving rate
• The tax environment
• External economic relationship
• Demand and Supply relationship
• The rate of inflation
• The fiscal policy
• The terms on which the firm can raise

finance etc.
No financial manager can afford to ignore the
key development in the economic sphere and
the impact of the same on the firm. Since the
macro-economic environment defines the
setting within which a firm operates and
micro-economic theory provides the
conceptual underpinning(support) for the tools
of financial decision making.
Finance & Accounting
The finance and accounting functions are
closely related and almost invariably fall
within the domain of the chief financial
officer. We can understand the relation of
finance with account in the following three
heads.
• Score Keeping Vs Value Maximising

Accounting is concerned with score keeping,


whereas finance is aimed at value
maximizing.
“ The accountant role is to provide
consistently developed and easily interpreted
data about the firm’s past, present and
future operations. The financial manager
uses these data, either in raw form or after
certain adjustment and analyses, as an
important input to the decision- making
process.”
Gitman
• Accrual Method Vs. Cash Method
The accountant prepares the accounting
reports based on the accrual method which
recognizes revenues when the sale occurs and
matches expenses to sales. The focus of the
manager, however, is on cash flows. He is
concerned about the magnitude, timing and
risk of cash flows as these are the fundamental
determinants of value.
• Certainty Vs. Uncertainty
Accounting deals primarily with the past. It
records what has happened. Hence, it is
relatively more objective and certain. Finance
is concerned mainly with the future. It
involves decision making under imperfect
information and uncertainty.
Scope Of Financial Management

The firm secures whatever capital needs and


employs its activities which generates
returns on invested capital. Finance is
involved in all the activities of the firm such
as buying a new machine or replacing an old
machine for the purpose of increasing
production capacity effects the flow of
funds. Recruitment of employees in
production is clearly a responsibility of the
production department but it requires
payment of wages and salaries and other
benefits thus involves finance. Similarly
sales promotion activities comes within the
preview of marketing department but
advertisement and other marketing activities
involves the cash outflow hence finance is
involved therefore, it is understood that the
scope of financial management is not
restricted to finance department only but
also effects production and marketing
department as well. For better under
standing the scope of financial management
we can divide it into two approaches,
Traditional and Modern Approach.
Traditional Approach :- In early stage
the role of FM was restricted upto raising
and administrating of funds needed by the
corporate enterprises to meet their financial
needs such as;
• Arrangement of funds from financial
institutions.
• Arrangement of funds through financial
instruments like share, bonds etc.
• Looking after the legal and accounting
relationship between a corporation and
its sources of funds.
Thus, the finance manager has a limited role
to perform he was expected to keep accurate
financial records, prepare reports on the
corporation's status and performance and
manage cash in a way that the corporation
was in a position to pay its bills on time.
The term 'Corporate Finance' was used in
place of the present term 'Financial
Management'. The traditional approach
now has been discarded as it suffers from
certain limitation, the traditional approach
implied a very narrow scope for financial
management as it has not provided
analytical framework for financial decision
making.

Modern Approach :- Provides both


conceptual and analytical framework for
financial decision making. It means the
financial function covers both, acquisition
and allocating of funds the new approach is
an analytical way of viewing the financial
problems of a firm. the main contents of the
modern approach are as,
• What is the total valume of funds, an
enterprise should have ?
• What specific assets should an enterprise
acquire ?
• How are the funds required to be
financed ?

Objective of Financial Management

• Maintenance of Liquid Assets


• Maximization of profitability of the
firm
• Maximization of shareholder’s wealth
• Ensuring a fair return to shareholder’s
• Building up reserves for growth and
expansion
• Ensuring maximum operational
efficiency by efficient and effective
utilization of finance
• Ensuring financial discipline in the
management
Function of Financial Management

It is very difficult to separate the function


from production, marketing and other
function of the organization but the function
such as raising of funds, investing them in
assets and distributing return earned from
assets to shareholders can easily be
identified.
The function of financial management may
be classified on the basis of Liquidity,
Profitability and Management.

Liquidity : It is ascertained on the basis of


three important considerations.
• Forecasting cash flows, i.e., matching the

inflows against the cash outflow.


• Raising funds, i.e., financial manager

will have to ascertain the sources from


where the funds may be raised and the
time when these funds are needed.
• Managing the flow of internal funds.

Profitability : While ascertaining the


profitability we have to look after
• Cost control
• Pricing
• Forecasting future profits

Management : Asset management has


assumed an important role in financial
management. It includes both long and short
terms funds management.
Beside the above mentioned main function
there are some other functions also such as-
• Determining financial Need
• Determining sources of fund
• Profit allocation or dividend decision
• Financial analysis
• Optimal capital structure
• Cost volume profit analysis
• Profit planning and control
• Project planning and evaluation
• Working capital management
• Acquisition and mergers
• Corporate taxation

Role of Finance Manager :

Who is a finance manager ? What is his or


her role ? A financial manager is a person
who is responsible in a significant way to
carry out the financial function he occupies
the key position in the enterprises now a
days he is one of the member of the top
management. In today’s scenario, the job of
financial manager in India has become
important, complex and demanding, due to
certain changes such as.
• Industrial licensing framework has been
substantially relaxed, leading to
considerable expansion in the scope of
private sector investment.
• The Monopolies and Restrictive Trade
Practices (MRTP) has been virtually
abolished and the Foreign Exchange
Management Act (FEMA) has been
substantially liberalized.
• Freedom has been given to companies in
designing and pricing the securities
issued by them.
• The system of cash credit has been
replaced by a system of working capital
loan.
• The pace of mergers, acquisitions and
restructuring has intensified.
• The scope for direct investment has
expanded considerably and foreign
portfolio investment has assumed great
significance.
And also due to the wake of global
competition, economic uncertainty, tax
law changes, etc.
The key challenges of financial manager
may be as
• Investment planning
• Financial structure
• Mergers, acquisitions and restructuring
• Working capital management
• Performance Management
• Risk Management
• Investor relations
• Utilized the fund in the most efficient
manner.
• Financial Negotiation.
BOARDOFDIRECTORS

CHIEFEXECUTIVEOFFICER
(CEO)

VicePresident VicePresident
Marketing Production&Operation
Vice-President-Finance OR
ChiefFinancialOfficer(CFO)
Duties : OverseaFinancialPlanning
CorporateStrategic Planning
CentralCorporateCashFlow

Treasurer Controller

Duties :
Duties : Taxes
CashManagement FinancialStatements
CreditManagement CostAccounting
Capital Expenditure Dataprocessing
RaisingCapital
Financialplanning
ManagementofForeignCurrencies

In USA the function of the financial officer


are divided into two i.e., Tresureship and
Controller function. However these terms
are not used in India. In many corporations
of India financial managers are appointed to
perform the duties of the treasures and
controller.

Decision Making in Financial


Management :

Financial Management is indeed the key to


successful business operations, without
proper administration and effective
utilizations of finance, no business
enterprises can utilize its potentials for
growth and expansions. FM is concerned
with the acquisition, financing and
management of assets with some overall
goals in mind and for this purpose the
decisions making process of FM can be
broadly classified as
• Investment Decisions
• Financing Decisions
• Dividend Decisions

• Investment Decisions : It is most


important than the other two decisions. It
begins with the dertermination of total
amount of assets needed to be held by
the firm. How much of the fund it
needed to be invested in fixed and
current assets. Investment of funds in
fixed assets has long term implications as
funds are blocked for a long duration.
But immediate returns can be expected
from investment in current assets. Fixed
assets are termed as long term assets and
investment in it is popularly known as
“Capital Budegeting.” It may be
defined as the firm’s decision to invest
its current funds most efficiently in fixed
assets with an expected flow of benefits
over a series of year. Current assets are
termed as short term asset and
investment in it is known as "Working
Capital Management". The investment
in current asset can be converted into
cash within a financial year without
diminution(reduction) in value.
• Financial Decisions : Under this
process the financial manager is
concerned with make up of the left hand
side of the balance sheet. It is related to
the financing mix i.e., mix of debt and
equity which is known as the firm's
'Capital Structure'. The financing
manager must strike to obtain the best
financing mix of the optimum capital
structure for the firm. The capital
structure is considered as optimum when
the market value of shares is maximum.
the proper balance must be maintained
between return and risk. In the absence
of debt, the shareholder’s return is equal
to the firm’s return. The use of debt
affects the return and risk of
shareholders; it may increase the return
on equity funds, but it always increases
the risk as well. The change in the
shareholder’s return caused by the
change in the profits is called the
financial leverage(relationship between
the amount of money a company owes
and the value of its shares). A proper
balance will have to be struck between
return and risk. When the shareholder’s
return is maximized with given risk, the
market value per share will be
maximized with given risk, the market
value per share will be maximized and
the firm’s capital structure would be
considered optimum.Once the financial
manager is able to determine the best
combination of debt and equity, he or she
must raise the appropriate amount
through the best available sources.
• Dividend Decisions : This is the third
financial decision under this process the
financial manager has to decide whether
all profits be distributed or it should be
retained. This distribution of dividends
or retaining should be determined in
terms of its impact on the shrehloder’s
wealth. The financial manager should
determined optimum dividend policy.
This policy is one which maximizes the
market value of the firms shares. The
financial manager should consider the
questions of dividend stability, bonus
shares and cash dividend in practice.

Inter-Relation Among Financial


Decision :

• Inter-relation between “Investment


and Financing Decisions”: While
taking the investment decision, the
financial manger decides the type of
asset or project that should be selected.
The selection of a particular asset or
project helps to determine the amount of
funds required to finance the project or
asset. For example, suppose the
investment on fixed assets is Rs. 10 crore
and investment in current assets or
working capital is Rs. 4 crore. So the
total fund required to finance the total
assets is Rs. 14 crore.
Once the anticipation of funds required is
completed then the next decision is
financing decision. Financing decision
means raising the required funds by
various instruments.
There is a inter-relation between
investment decision and financing
decision, without knowing the amount of
funds required and types of fund (Short-
term and long-term) it is not possible to
raise fund. To put it in simple words,
investment decision and financing
decisions cannot be independent. They
are dependent on each other.
• Inter-relation between “Financing
Decisions and Dividend Decision”:
Financing decision influences and is
influenced by dividend decision, since
retention of profits for financing selected
assets or projects, reduces the profit
available to ordinary shareholder,
thereby reducing dividend payout ratio.
For example, to finance a certain project
amount required is Rs.14 crore. If the
financial manager plan to raise only Rs.7
crore from outside and the remaining by
way of retained earnings, and if the
dividend decision is 100% payout ratio,
then the financial manager has to depend
completely on outside sources to raise
the required funds. So dividend decision
influences the financing decision. Hence,
there is an inter-relation between
financing decision and dividend
decision.
• Inter-relation between “Dividend
Decisions and Investment
Decisions”: Dividend decision and
investment decision are inter-related
because retention of profits for financing
the selected assets depends on the rate of
return on proposed investment and the
opportunity cost of the retained profits.
Profits are retained when return on
investment is higher than the opportunity
cost of retained profits and vice-versa.
Hence, there is inter-relation between
investment decision and dividend
decision.

The Fundamental Principle of


Finance : The key question we asked
before making a business decision is will the
decision raise the market value of the firm ?
To answer this question, we have to look at
the fundamental principle of finance.
“ A business proposal- required of whether it is a new
investment or acquisition of another co. or a
restructuring initiative- raises the value of the firm only if
the present value of the future stream of net cash benefits
expected from the proposal is greater than the initial cash
outlay required to implement the proposal.”
The difference between the present value of
future cash benefits and the initial outlay
represent the net present value or NPV of
the proposal.
Net Present Value = Present Value of Future
Cash benefits – Initial Cash
Outlay
Risk Return Trade Off : At some points
we all saved some money. Why have we
done this ?..........
The answer is simple to expand our future
consumption opportunities. Before
investing, firstly, investor demand a min.
return for delaying consumption that must
be greater than the anticipated rate of
inflation (“a general and progressive increase in
prices; "in inflation everything gets more valuable
except money”). If they didn’t receive enough
to compensate for anticipated inflation
investors would purchase whatever goods
they desired ahead of time or invest in assets
that were subject to inflation and earn the
rate of inflation on those assets. There isn’t
much incentive to postpone consumption if
your saving are going to decline in terms of
purchasing power.
Financial decisions often involve alternative
cause of action. Should the firm set up a
plant which has capacity of one million tons
or two millions tons ? should the debt equity
ratio of the firm be 2:1 or 1:1 ? Should the
firm pursue a generous credit policy or
niggardly(miserly) credit policy ? should the
firm carry a large inventory or a small
inventory ?
The alternative course of action typically
have different risk-return implications. A
large plant may have a higher expected
return and higher risk exposure, whereas a
small plant may have lower expected return
and a lower exposure. A high debt equity
ratio compared to a lower debt-equity ratio,
may reduce the cost of capital but expose the
firm to greater risk. A ‘hot’stock, compared
to a defensive stock, may offer a higher
expected return but also a greater possibility
of loss. When investor choose to put his
money in risky investment side by side he
expected higher return. The more risk an
investment has the higher will be its
expected return. The relation between risk
and expected return is shown in the
following figure.
EXPECTED RETURN Expected return for
taking on added risk
or
Risk premium

Expected
Return for Risk Free Return
delaying
Consumption

RISK

The Risk-Return Relationship

Your decision to invest your money in


government bonds has less risk as interest
rate is known and the risk of default is very
less. On the other hand, you would incur
more risk if you decide to invest your money
in shares, as return is not certain. Financial
decisions of the firm are guided by the risk
return trade off. These decision are inter-
related and jointly affect the market value of
its shares by influencing return and risk of
the firm. The relationship between return
and risk can be simply expressed by the
following equation.

Return = Risk Free Rate + Risk Premium

Risk free rate is a rate obtainable from a


default-risk free govt. security. An investor
assuming risk from her investment require a
risk premium above the risk free rate. Risk
free rate is a compensation for time and risk
premium for risk. A proper balance between
return and risk should be maintained to
maximize the market value of a firm’s share.
Such balance is called risk return trade-off
and every financial decision involves this
trade off. We can also say that risk-return
trade off is the desire for the lowest possible
risk and highest possible return.
Profit Maximisation Versus Wealth
Maximisation

For long range planning and management


controls, a company establishes its overall
objective, which helps us in measuring
performance and control. Objective setting
is most important phase in the business
enterprises, since upon correct objective
setting the entire structure of the strategies,
polices and plans of a company rests. It is
generally agreed in theory that the financial
goal of the firm should be shareholder’s
wealth maximization (SWM), as reflected in
the market value of the firm share, the
behavioral assumption of profit
maximization has served economic theory as
well. Let see the concept of profit
maximization and wealth maximization.

Profit Maximisation : Profit as an


Objective has emerged from over a century
of economic theory. In this traditional
economic theory, the typical firm was small,
over managed and competing with a large
number of similar firms. In such a situation
• The profit of the firm become the income
of the owner
• The force of competition imposed profit
maximization upon the firm to survive in
business.
• Essential for growth and development of
business.
Profit is the difference between revenue
and costs, once revenue and costs are
identified the assumption of profit
maximization enables prediction to be
readily made about the consequence of any
environmental change.
The following factors have served to cast
doubt on the validity of the profit
maximization.
• In twenty first century, there has been

substaibtial changes in the owernership


and organization of business. The
typical large co is owned by a diffusion
of shareholders and managed by
salaried professionals with little or no
ownership interest, paid salaries often
unrelated to profit. Manager may then
view profits as only of a wide range of
performance indicators.
• The same period has seen the
concentration of markets dominated by
large corporation (often mulitnational)
so that competition may have been
severely weakened, such corporations
may well be able to survive at less than
maximum possible profits, simply by
virtue of their size.
It has traditionally been argued that the
objective of a company is to earn profit
hence the objective of financial management
is also maximization of profit and this very
objective has been criticized on the
following ground.
• The concept of profit maximization is
vague & narrow (It is not clear that it
means total operating profit or profit
occurring to shareholders ?)
• It ignores the risk factor as well as timing
of returns
• It emphasizes the short run profitability

and short-term projects


• Ignores social and moral obligations of
business.
A financial officer could easily increase
current profit by eliminating research and
development expenditures and cutting down
routine maintenance in the short run, this
might result in increased profits, but this is
clearly not in the best of long-run interests
of the firm.
Wealth Maximization :
Profit is the difference between revenue and
costs and profit maximization leads to
wealth maximization of the firm. The
separation of ownership from management,
the increase in the intensity of the
competition has lead to the redefinition of
profit maximization goal of a firm. As the
owners of the company are its shareholders
the primary financial objective of corporate
finance is usually stated to be maximization
of shareholder wealth. Since shareholders
receive their wealth through dividends and
capital gains, shareholders wealth will be
maximized by maximizing the value of
dividends and capital gains that shareholders
receive overtime. The shareholders wealth
maximization goal states that management
should seek to maximize the present value
of the expected future returns to the owners
of the firm.
The wealth maximization goal is advocated
on the following grounds:
• It takes into consideration long-run
survival and growth of the firm.
• It suggests the regular and consistent

dividend payment to the shareholder.


• The financial decisions are taken with a

view to improve the capital appreciation


of the share price
• It considers all future cash flows,
dividends and earning per share (EPS)
• Maximization of firm’s value is reflected
in the market price of share, since it
depends on shareholders expectations as
regards profitability, long-run prospects,
timing differences of returns, risk,
distribution of return etc. of the firm.
• Profit maximization partly enables the
firm in wealth maximization.
• The shareholders always prefer wealth
maximization rather than maximization
of inflow of profits.
• Maximizes the net present value of a

course of action to shareholders.


• Accounts for the timing and risk of the
expected benefits.
• Benefits are measured in terms of cash
flows.
• Fundamental objective—maximize the
market value of the firm’s shares.
Significance of Wealth- Maximization
The company although it cares more for the
economic welfare of the shareholders, it
cannot forget others who directly or
indirectly work for the overall development
of the company. Thus Wealth-
Maximization takes care of
 Lenders or creditors
 Workers or Employees
 Public or Society
 Management or Employer
 Other objective – Ensuring fair
return to shareholder, Building up
reserves for growth and expansion,
ensuring financial discipline in the
management

Time Value of Money

The value of money received today is


different from the value of money received
after some time in the future. The value of
money is time dependent which is based on
four reasons.
1. Inflation : Under inflationary
conditions the value of money,
expressed in terms of its purchasing
power over goods and services,
declines.
2. Risk : ‘A bird in hand is worth two in

the bush’. This statement implies that,


people consider a rupee today, worth
more than a rupee in the future, say after
a year. This is because uncertainty
connected with the future.
3. Personal Consumption Preference :
Individuals generally prefer current
consumption to future consumption. The
promise of a bowl of rice next week
counts for little to the starving man. He
prefers to consume today because of the
urgency of their present wants or
because of the risk of not being in a
position to enjoy future consumption
that may be caused by illness or death or
because of inflation.
4. Investment Opportunity : Money
like any other desirable commodity, has
a price, given the choice of Rs.100 now
or the same amount in one year’s time,
it is always preferable to take the Rs.100
now because it could be invested over
the next year at (say) 18% interest rate
to produce Rs.118 at the end of one
year. If 18% is the best risk free return
available, then your could be indifferent
to receiving Rs.100 now or Rs.118 in
one year’s time or it can be said that the
present value of Rs.118 receivable one
year hence is Rs.100.

Time Value of money or time preference of


money is one of the central ideas in finance.
It becomes important and is of vital
consideration in decision making.
The following notation will be used in our
discussion
PV = Present Value.
FVn = Future Value n year hence.
Ct = Cash Flow occurring at the end of year t
A = A stream of constant periodic cash flow
over a given time.
r = Interest rate or discount rate.
g = Expected growth rate in Cash Flows.
n = Number of periods over which the cash
flows occur.

Future Value of a Single Amount :


The process of investing money as well or
reinvesting the interest earned therein is
called compounding. The future value or
compounded value of an investment after n
year when the interest rate is r percent is

FVn = PV (1+r)n

In this equation (1+r)n is called the future


value interest factor or compound value
factor or simply future value factor.
Alternatively, we can consult a future value
interest factor (FVIF) table.

Illustration : If you deposit Rs.1,000 today


in a bank that pays 10% interest
compounded annually, how much will the
deposit grow to after 8 years and 12 years ?

FV8 = Rs.1,000 (1.10)8


= Rs.1,000 (2.144)
= Rs.2,144
The Future Value, 12 year hence will be.
FV12 = Rs.1,000 (1.10)12
= Rs.1,000 (3.318)
= Rs.3,138
Graphic View :
GRAPHIC VIEW OF COMPOUNDING
FVIFr, n

5
12%
4

3 6%

2
1
0 percent

Periods
Compound and Simple Interest :
When money is invested at compound
interest which means that each interest
payment is reinvested to earn further
interest in future periods. By contrast, if no
interest is earned on interest the investment
earns only simple interest. In such a case the
invest grows, grows as follows.

Future Value = Present Value [ 1+ Number


of years X Interest rate]

Doubling Period :
How long would it take to double the
amount at a given rate of interest ? For this
we will look at the future value interest
factor we find when the interest rate is 12%
it takes about 6 years and when the interest
rate is 6% it takes about 12 years. To
simplify the calculation there is a rule of 72.
The doubling period is obtained by dividing
72 by the interest rate. For example if the
interest rate is 8 percent, the doubling period
is about 9 years (72/8).
To calculate the doubling period, a more
accurate rule is the rule of 69, according to
this rule, the doubling period is equal to

0.35 + 69/Interest rate

Illustrartion :

Interest Rate Doubling Period


10% 0.35 + 69/10
0.35 + 6.9
7.25 years.

Present Value of Single Amount :


Suppose someone promises to give you
Rs.1,000 three year hence what is the
present value of this amount if the interest
rate is 10% ? The present value can be
calculated by discounting Rs.1000, to the
present point of time as follows.
The process of discounting used for
calculating the present value is simply the
inverse of compounding. The present value
formula can be obtained by manipulating the
compounding formula.

FVn = PV (1+r)n ………………Equ. 1

Dividing Equ. 1 by (1+r)n we get

PV = FVn [ 1/(1+r)n ]

The Factor [ 1/(1+r)n ] is called the


discounting factor or the present value
interest factor (PVIFn)

Illustration : What is the present value of


Rs.1,000 receivable 16 years hence if the
discounting rate is 10%.
PV = FVn [ 1/(1+r)n ]
= 1,000[ 1/(1+.10)16 ]
= 1,000[ 1/(1.10)16 ]
= 1,000 [0.218]
= Rs.218

Graphic View : GRAPHIC VIEW OF DISCOUNTING


PVIFr, n

0 percent
100

75 6 percent

50 10 percent

25 14 percent

Periods

Present Value of an uneven Series :


In financial analysis we often come across
uneven cash flow streams. For example, the
cash flow stream associated with a capital
investment projected in typically uneven.
Likewise, the dividend stream associated
with an equity share is usually uneven and
perhaps growing.
The present value of a cash flow stream-
uneven or even- may be calculated with the
help of the following formula :
A1 A2 An At
PVn = + + =
(1+r) (1+r) 2
(1+r) n (1+r) t
t=1

PVn = present value of a cash flow stream.


At= cash flow occurring at the end of year t.
n = duration of the cash flow stream.

Future Value of Annuity : An annuity is


a stream of constant cash flow (payment or
receipt) occurring at regular intervals of
time. The premium payments of life
insurance policy, are an annuity. When the
cash flows at the end of each period, the
annuity is called an ordinary annuity or a
deferred annuity. When the cash flows
occur at the beginning of each period, the
annuity is called an annuity due.
Suppose you deposit Rs. 1,000 annually in a
bank for 5 years and your deposits earn a
compound interest of 10 %. What will be the
value of their series of deposit (an annuity)
at the end of 5 years ?

FVAn = Rs.1,000 (1.10)4 + Rs.1,000


(1.10)3 + Rs.1,000 (1.10)2 + Rs.1,000
(1.10) + Rs.1,000

= Rs. 1,000(1.464) + Rs.1,000


(1.331) + Rs.1,000 (1.21) + Rs.1,000
= Rs.6,105

Formula
The future value of an annuity.

FVAn = A [(1+r)n-1] r

Applications
Knowing what lies in store for you :

Suppose you have decided to deposit Rs.


30,000 per year in your public provident
fund A/c for 30 years. What will be the
accumulated amount in your public
provident fund A/c at the end of 30 years if
the interest rate is 11%

The accumulated sum will be


= Rs. 30,000 (FVIFA 11%, 30yrs)
= Rs. 30,000 [(1+.11)30-1] .11

= Rs. 30,000 [(1.11)30-1] .11


= Rs. 30,000 (199.02)
= Rs. 59,70,600.

How much should you save annually:


You want to buy a house after 5 years when
it is expected to cost Rs. 2 million. How
much should you save annually if your
savings earn a compound retrun of 12% ?

FVIFAn=5,r=12% = [(1+0.12)5-1] 0.12


= 6.353

The annual savings should be


Rs.20,00,000/6.353= Rs.3,14,812

Sinking Fund

It is a kind of reserve by which a provision


is made to reduce a liability,e.g., redemption
of debentures or repayment of a loan. A
sinking fund of specific reserve set aside for
the redemption of a long-term debt. The
main purpose of creating a sinking fund is to
have a certain sum of money to accumulated
for a future date by setting aside a certain
sum of money every year. It is a kind of
specific reserve. Every year a certain sum of
money is invested in such a way that will
compound interest, the exact amount to wipe
off the liability or replace the wasting asset
or to meet the loss, will be available. The
amount to be invested every year can be
known from the compound interest annuity
tables.
Finding the interest Rate
A finance company advertises that it will
pay a lump sum of Rs. 8,000 at the end of 6
years to investors who deposit annually
Rs,1,000 for 6 years. What interest rate is
implicit(suggested) in this offer ?

Find the FVIFAr,6


Rs.8,000 = Rs.1,000 X FVIFAr,6
FVIFAr,6 = Rs.8,000/Rs.1,000

Look at the FVIFAr,n table and read the row


corresponding to 6 years until you find a
value close to 8.000. Doing so, we find that
FVIA12%,6 is 8.115
So we conclude that the interest rate is
slightly below 12%.

How Long should you wait :


You want to take up a trip to the moon
which costs Rs 10,00,000 the cost is
expected to remain unchanged in nominal
terms. You can save annually Rs.50,000 to
fulfill your desire. How long will you have
to wait if your savings earn an interest of
12% ?

50,000 X FVIAn=?,12%, = 10,00,000


50,000 X {1.12n-1/0.12} =1,00,000
1.12n-1 = 2.4

1.12n = 2.4 +1= 3.4


n log 1.12 = log 3.4
n X 0.0492 = 0.5315
n = 0.5315/0.0492
n = 10.8 years
you will have to wait for about 11 years

Present Value of an Annuity :


Suppose you expect to receive
Rs.1,000 annually for 3 years, each receipt
occurring at the end of the year. What is the
present value or this stream of benefits if the
discount rate is 10% ? The present value of
this annuity is simply the sum of the present
values of all the inflow of this annuity :

Rs 1,000 (1/1.10) + Rs. 1,000 (1/1.10)2 + Rs.


1,000 (1/1.10)3
= Rs.1,000 X 0.9091 + Rs.1,000 X 0.8264 +
Rs.1,000 X 0.7513

= Rs.2,478.8

Formula

PVAn = A [{1-(1/1+r)n}/r]
A = Constant Periodic flow

Present Value interest factor for an


annuity is
1- 1
(1+r)n
PVIFr, n =
r

Applications
How much can you borrow for a car :
After reviewing your budget, you have
determined that you can afford to pay
Rs.12,000 per month for 3 years toward a
new car. You call a finance company and
learn that the going rate of interest on car
finance is 1.5% month for 36 months . How
much can you borrow ?

To determining the amount of borrowing,


we have to calculate the present value of
Rs.12,000 per month for 36 months at 1.5%
per month.
1- 1
(1+r)n
PVIFr, n =
r

= [{1-(1/1+r)36}/r]
= [{1-(1/1.015)36}/0.015]
= 27.70
Hence the present value of 36 payments of
Rs.12,000 each is :
Present value=Rs.12,000 x 27.70 = Rs.3,32,400

You can, therefore, borrow Rs.3,32,400 to buy


the car.

Period of loan Amortisation(the process of


paying back a debt by making a small regular payments over
:
a period of time)
You want to borrow Rs10,80,000 to buy a
flat. You approach a housing finance
company which charges 12.5% interest. You
can pay Rs. 1,80,000 per year toward loan
amortization. What should be the maturity
period of the loan ?

The present value of annuity of Rs1,80,000


is set equal to Rs.10,80,000.

1,80,000 x PVIAn,r = 10,80,000

1,80,000 x PVIA n=? r=12.5%


, =
10,80,000
1,80,000x[{1-(1/1.125)n}/0.125] = 10,80,000

[{1-(1/1.125)n}/0.125] = 10,80,000/1,80,000

= [{1-(1/1.125)n}/0.125] = 6
1/(1.125)n = 0.25
1.125n = 4
n log 1.125 = log 4
n x 0.0512 = 0.6021
n =0.6021/0.0512 = 11.76 years

you can perhaps request for a maturity of


12 years.

Determining the periodic withdrawal:


If we make an investment today for a given
period of time at a specified rate of interest,
we may like to know the annual income.
Capital recovery is the annuity of an
investment made today for a specified
period of time at a given rate of interest. The
reciprocal of the present value annuity factor
is called the capital recovery factor
(CRF).

Your father deposits Rs.3,00,000 on


retirement in a bank which pays 10%
interest. How much can he withdraw
annually for a period of 10 years.

A = Rs.3,00,000 x 1/PVIFA10%,10

= Rs.3,00,000 x 1/6.145
= Rs.48,819

Present Value of a Growing


Annuity :

The cash flow that grows at a constant rate


for a specified period of time is a growing
annuity.
n
(1+g)
1-
(1+r) n
PV of a Growing Annuity = A(1+g)
r-g

The above formula can be used when the


growth rate is less than the discount rate
(g<r) as well as when the growth rate is
more than the discount rate (g>r). However,
it does not work when the growth rate is
equal to the discount rate (g = r) in this case,
the present value is simply equal to nA.

For example , Suppose you have the right to


harvest a teak(a kind of asian tree) plantation for
the next 20 years over which you expect to
get 1,00,000 cubic feet of teak per year. The
current price per cubic feet of teak is Rs.
500, but it is expected to increase at a rate of
8% per year. The discount rate is 15%. The
present value of the teak that you can
harvest from the teak forest can be
determined as follows:
20
1.08
1-
PV of teak = Rs. 500 x 100,000 (1.08) 1.15 20
0.15-0.08

= Rs. 551,736683

A Note on Annuities Due :

Ordinary Annuity is the annuity in which


cash flows occur at the end of each period.
But in which cash flow occurs at the
beginning of each period is called an
annuity due.

For example : When you enter into a lease


for an apartment, the lease payments are due
at the beginning of the month. The first lease
payment is made at the beginning of the
month. the second lease payment is due at
the beginning of the second month, so on
and so forth.
Since the cash flow of an annuity due occurs
one period earlier in comparison to the cash
flows on an ordinary annuity, the following
relationship holds :

Annuity Due Value = Ordinary annuity


value x (1+r)

Present Value of a perpetuity :

A Perpetuity is an annuity of infinite


duration. The present value of a perpetuity
may be expressed as follows

P = A x PVIFA r,infinite
A = constant annual payment
PVIFA r,infinite = present value interest factor for
a perpetuity (an annuity of infinite duration)
The value of PVIFA r,infinite equal to :
1 1
=
(1+r) t r
t=1

.
Intra-Year Compounding and
Discounting:

So far we assumed that compounding is


done annually. Now we consider the case
where compounding is done more
frequently. Suppose you deposit Rs.1,000
with a finance company which advertises
that it pays 12% interest semi-annually- this
means that the interest is paid every six
months.
The general formula for the future value of a
single cash flow after n years when
compounding is done m times a year is :

FVn = PV [1+(r/m)]mxn

Effective Versus Stated Rate :


Rs. 1,000 grows to Rs,1,123.6 at the end of a
year if the stated rate of interest is 12% and
compounding is done semi-annually.This
means that Rs.1,000 grows at the rate of
12.36% per annum. The figur12.36 % is
called the effective interest rate.

The relationship between the effective


interest rate and the stated annual interest
rate is as follows :

Effective interest rate = [1+ (Stated


annual interest rate/m)]m -1

Shorter Discounting periods :


Sometimes cash flows have to be discounted
more frequently than once a year- Semi
annually, quarterly, monthly, or daily. As in
the case of intra-year compounding , the
shorter discounting period implies that (i)
the number of periods in the analysis
increases and (ii) the discount rate
applicable per period decreases.
Formula

PV = FVn [1/1+(r/m)]mn