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SYLLABUS
PAPER 3 : COST ACCOUNTING AND FINANCIAL MANAGEMENT
(One paper Three hours 100 Marks) Level of Knowledge: Working knowledge
structure, Constraints, Various capital structure theories (c) Business Risk and Financial Risk Operating and financial leverage, Trading on Equity. 5. Types of Financing (a) Different sources of finance (b) Project financing Intermediate and long term financing (c) Negotiating term loans with banks and financial institutions and appraisal thereof (d) Introduction to lease financing (e) Venture capital finance. 6. Investment Decisions (a) Purpose, Objective, Process (b) Understanding different types of projects (c) Techniques of Decision making: Non-discounted and Discounted Cash flow Approaches Payback Period method, Accounting Rate of Return, Net Present Value, Internal Rate of Return, Modified Internal Rate of Return, Discounted Payback Period and Profitability Index (d) Ranking of competing projects, Ranking of projects with unequal lives. 7. Management of Working Capital (a) Working capital policies (b) Funds flow analysis (c) Inventory management (d) Receivables management (e) Payables management (f) Management of cash and marketable securities (g) Financing of working capital.
CONTENTS
CHAPTER 1 SCOPE AND OBJECTIVES OF FINANCIAL MANAGEMENT 1. 2. 3. 4. 5. 6. 7. 8. 9. Introduction .........................................................................................................................1.1 Meaning of Financial Management .....................................................................................1.2 Evolution of Financial Management ....................................................................................1.5 Importance of Financial Management .................................................................................1.5 Scope of Financial Management .........................................................................................1.6 Objectives of Financial Management ...................................................................................1.7 Conflicts in Profit versus Value Maximisation Principle .....................................................1.11 Role of Chief Financial Officer (CFO) ...............................................................................1.13 Relationship of Financial Management with Related Disciplines .......................................1.14
CHAPTER 2 TIME VALUE OF MONEY 1. 2. 3. 4. 5. 6. 7. 8. Concept of Time Value of Money ........................................................................................2.1 Simple Interest ....................................................................................................................2.1 Compound Interest ..............................................................................................................2.2 Effective Rate of Interest .....................................................................................................2.7 Present Value ......................................................................................................................2.7 Annuity ...............................................................................................................................2.10 Perpetuity ..........................................................................................................................2.13 Sinking Fund ......................................................................................................................2.15 APPLICATION OF RATIO ANALYSIS FOR PERFORMANCE EVALUATION, FINANCIAL HEALTH AND DECISION MAKING
1.4 1.5 1.6 2.1 2.2 2.3 2.4 2.5 2.6 2.7 2.8 2.9
Application of Ratio Analysis in Financial Decision Making.. .............................................3.15 Limitations of Financial Ratios ..........................................................................................3.16 Summary of Ratios ...........................................................................................................3.17 Introduction .......................................................................................................................3.37 Utility of Cash Flow Analysis ............................................................................................3.37 Limitations of Cash Flow Analysis ....................................................................................3.38 AS 3 (Revised) and Cash Flow Statement ........................................................................3.38 Definitions .........................................................................................................................3.39 Cash and Cash Equivalents...............................................................................................3.39 Presentation of Cash Flow Statement................................................................................3.40 Procedure in Preparation of Cash Flow Statement ............................................................3.43 Funds Flow Analysis ..........................................................................................................3.55
CHAPTER 4 FINANCING DECISIONS UNIT I : 1.1 1.2 1.3 1.4 1.5 1.6 COST OF CAPITAL Introduction ..........................................................................................................................4.1 Definition of Cost of Capital..................................................................................................4.2 Measurement of Cost of Capital...........................................................................................4.3 Weighted Average Cost of Capital (WACC).......................................................................4.16 Marginal Cost of Capital.....................................................................................................4.20 Conclusion .........................................................................................................................4.25
UNIT II : CAPITAL STRUCTURE DECISIONS 2.1 2.2 2.3 2.4 2.5 2.6 Meaning of Capital Structure..............................................................................................4.26 Designing Capital Structure ...............................................................................................4.26 Key Concepts for Designing Optimal Structure..................................................................4.27 Optimal Capital Structure ...................................................................................................4.29 EBIT-EPS Analysis ............................................................................................................4.29 Cost of Capital, Capital Structure and Market Price of Share ............................................4.40
Capital Structure Theories .................................................................................................4.40 Capital Structure and Taxation...........................................................................................4.53 Over Capitalisation.............................................................................................................4.54
2.10 Under Capitalisation...........................................................................................................4.55 UNIT III : BUSINESS RISK AND FINANCIAL RISK 3.1 3.2 3.3 Introduction ........................................................................................................................4.57 Debt versus Equity Financing ............................................................................................4.58 Types of Leverage .............................................................................................................4.59
CHAPTER 5 TYPES OF FINANCING 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. Introduction ..........................................................................................................................5.1 Financial Needs and Sources of Finance of a Business ......................................................5.1 Long Term Sources of Finance............................................................................................5.4 Venture Capital Financing .................................................................................................5.10 Debt Securitisation.............................................................................................................5.13 Lease Financing.................................................................................................................5.14 Short Term Sources of Finance .........................................................................................5.16 Other Sources of Financing ...............................................................................................5.24 New Instruments ................................................................................................................5.25 International Financing.......................................................................................................5.27
CHAPTER 6 INVESTMENT DECISIONS 1. 2. 3. 4. 5. 6. 7. Capital Budgeting Definition.................................................................................................6.1 Purpose of Capital Budgeting ..............................................................................................6.2 Capital Budgeting Process...................................................................................................6.2 Types of Capital Investment Decisions ................................................................................6.3 Project Cash flows ...............................................................................................................6.4 Basic Principles for Measuring Project Cash Flows .............................................................6.5 Capital Budgeting Techniques .............................................................................................6.9
CHAPTER 7 MANAGEMENT OF WORKING CAPITAL UNIT I : 1.1 1.2 1.3 1.4 1.5 1.6 MEANING, CONCEPT AND POLICIES OF WORKING CAPITAL
Introduction ..........................................................................................................................7.1 Meaning and Concept of Working Capital............................................................................7.1 Determinants of Working Capital .........................................................................................7.4 Issues in Working Capital Management...............................................................................7.5 Estimating Working Capital Needs.......................................................................................7.8 Operating or Working Capital Cycle.....................................................................................7.8
UNIT II : TREASURY AND CASH MANAGEMENT 2.1 2.2 2.3 2.4 2.5 2.6 2.7 Treasury Management: Meaning .......................................................................................7.40 Functions of Treasury Department.....................................................................................7.40 Management of Cash.........................................................................................................7.41 Methods of Cash Flow Budgeting ......................................................................................7.43 Cash Management Models ................................................................................................7.62 Recent Developments in Cash Management.....................................................................7.65 Management of Marketable Securities...............................................................................7.68
UNIT IV : MANAGEMENT OF RECEIVABLES 4.1 4.2 4.3 4.4 4.5 4.6 4.7 Introduction ........................................................................................................................7.73 Aspects of Management of Debtors...................................................................................7.73 Factors Determining Credit Policy......................................................................................7.74 Factors under the Control of the Finance Manager............................................................7.74 Financing Receivables.......................................................................................................7.81 Innovations in Receivable Management ............................................................................7.83 Monitoring of Receivables..................................................................................................7.87
UNIT V : MANAGEMENT OF PAYABLES (CREDITORS) 5.1 5.2 5.3 Introduction ........................................................................................................................7.92 Cost and Benefits of Trade Credit......................................................................................7.92 Computation of Cost of Payables.......................................................................................7.93
UNIT VI : FINANCING OF WORKING CAPITAL 6.1 6.2 6.3 6.4 Introduction ........................................................................................................................7.95 Sources of Finance ............................................................................................................7.95 Working Capital Finance from Banks.................................................................................7.98 Form of Bank Credit...........................................................................................................7.98
Appendix .................................................................................................................................... 1 - 8
1
Scope and Objectives of Financial Management
Learning Objectives
After studying this chapter you will be able to: Define Financial Management. Know the objectives, scope and how it has evolved over a period of time. Focus on Profit Maximization vis--vis Wealth Maximization. Outline the role of Chief Financial Officer in light of growing needs of a modern organization. Emphasis on relationship between Financial Management with accounting and other related fields.
1.
Introduction
We will like to explain Financial Management by giving a very simple scenario. For the purpose of starting any new business/venture, an entrepreneur goes through the following stages of decision making:Stage 1 Decide which assets (premises, machinery, equipment etc) to buy. Stage 2 Determining what is total investment (since assets cost money) required for buying assets. Stage 3 Apart from buying assets the entrepreneur would also need to determine how much cash he would need to run the daily operations (payment for raw material, salaries, wages etc.). In other words this is also defined as Working Capital requirement. Stage 4 The next stage is to decide what all sources, does the entrepreneur need to tap to finance the total investment (assets and working capital). The sources could be Share Capital (Including Entrepreneurs own funds) or Borrowing from Banks or Investment from Financial Institutions etc.
While deciding how much to take from each source, the entrepreneur would keep in mind the cost of capital for each source (Interest/Dividend etc.). As an entrepreneur he would like to
1.2
Financial Management
keep the cost of capital low. Thus, financial management is concerned with efficient acquisition (financing) and allocation (investment in assets, working capital etc) of funds with an objective to make profit (dividend) for owners. In other words, focus of financial management is to address three major financial decision areas namely, investment, financing and dividend decisions.
2.
Financial management is that managerial activity which is concerned with planning and controlling of the firms financial resources. In other words it is concerned with acquiring, financing and managing assets to accomplish the overall goal of a business enterprise (mainly to maximise the shareholders wealth). In todays world where positive cash flow is more important than book profit, Financial Management can also be defined as planning for the future of a business enterprise to ensure a positive cash flow. Some experts also refer to financial management as the science of money management. Financial management comprises the forecasting, planning, organizing, directing, coordinating and controlling of all activities relating to acquisition and application of the financial resources of an undertaking in keeping with its financial objective. Raymond Chambers Another very elaborate definition given by Phillippatus is Financial Management is concerned with the managerial decisions that result in the acquisition and financing of short term and long term credits for the firm. As such it deals with the situations that require selection of specific assets (or combination of assets), the selection of specific problem of size and growth of an enterprise. The analysis of these decisions is based on the expected inflows and outflows of funds and their effect on managerial objectives. There are two basic aspects of financial management viz., procurement of funds and an effective use of these funds to achieve business objectives.
Procurement Of Funds
Utilization Of Fund
1.3
2.1
Procurement of Funds
Since funds can be obtained from different sources therefore their procurement is always considered as a complex problem by business concerns. Some of the sources for funds for a business enterprise are:Debentures and Bonds
Owners Funds
Commercial Banks Angel Financing (Short, Medium & Long) Venture Capital
In a global competitive scenario it is not enough to depend on the available ways of raising finance but resource mobilization has to be undertaken through innovative ways or financial products which may meet the needs of investors. We are constantly seeing new and creative sources of funds which are helping the modern businesses to grow faster. For example trading in Carbon Credits is turning out to be another source of funding. Funds procured from different sources have different characteristics in terms of risk, cost and control. The cost of funds should be at the minimum level for that a proper balancing of risk and control factors must be carried out. Another key consideration in choosing the source of new business finance is to strike a balance between equity and debt to ensure the funding structure suits the business. Let us discuss some of the sources of funds: a) Equity The funds raised by the issue of equity shares are the best from the risk point of view for the firm, since there is no question of repayment of equity capital except when the firm is under liquidation. From the cost point of view, however, equity capital is usually the most expensive source of funds. This is because the dividend expectations of shareholders are normally higher than prevalent interest rate and also because dividends are an appropriation of profit, not allowed as an expense under the Income Tax Act. Also the issue of new shares to public may dilute the control of the existing shareholders. b) Debentures Debentures as a source of funds are comparatively cheaper than the shares because of their tax advantage. The interest the company pays on a debenture is free of tax, unlike a dividend payment which is made from the taxed profits. However, even when times are hard, interest on
1.4
Financial Management debenture loans must be paid whereas dividends need not be. However, debentures entail a high degree of risk since they have to be repaid as per the terms of agreement. Also, the interest payment has to be made whether or not the company makes profits.
c) Funding from Banks Commercial Banks play an important role in funding of the business enterprises. Apart from supporting businesses in their routine activities (deposits, payments etc) they play an important role in meeting the long term and short term needs of a business enterprise. Different lending services provided by Commercial Banks are depicted as follows:Lending Services (Banks)
Fund Based
Non-Fund Based
Cash Credit
Overdraft
Term Loans
Guarantee
Letters of Credit
d) International Funding Funding today is not limited to domestic market. With liberalization and globalization a business enterprise has options to raise capital from International markets also. Foreign Direct Investment (FDI) and Foreign Institutional Investors (FII) are two major routes for raising funds from foreign sources besides ADRs (American depository receipts) and GDRs (Global depository receipts). Obviously, the mechanism of procurement of funds has to be modified in the light of the requirements of foreign investors.
2.2
The finance manager is also responsible for effective utilisation of funds. He has to point out situations where the funds are being kept idle or where proper use of funds is not being made. All the funds are procured at a certain cost and after entailing a certain amount of risk. If these funds are not utilised in the manner so that they generate an income higher than the cost of procuring them, there is no point in running the business. Hence, it is crucial to employ the funds properly and profitably. Some of the aspects of funds utilization are:a) Utilization for Fixed Assets The funds are to be invested in the manner so that the company can produce at its optimum level without endangering its financial solvency. For this, the finance manager
Scope and Objectives of Financial Management would be required to possess sound knowledge of techniques of capital budgeting.
1.5
Capital budgeting (or investment appraisal) is the planning process used to determine whether a firm's long term investments such as new machinery, replacement machinery, new plants, new products, and research development projects would provide the desired return (profit). b) Utilization for Working Capital The finance manager must also keep in view the need for adequate working capital and ensure that while the firms enjoy an optimum level of working capital they do not keep too much funds blocked in inventories, book debts, cash etc.
3.
Financial management evolved gradually over the past 50 years. The evolution of financial management is divided into three phases. Financial Management evolved as a separate field of study at the beginning of the century. The three stages of its evolution are: The Traditional Phase During this phase, financial management was considered necessary only during occasional events such as takeovers, mergers, expansion, liquidation, etc. Also, when taking financial decisions in the organisation, the needs of outsiders (investment bankers, people who lend money to the business and other such people) to the business was kept in mind. The Transitional Phase During this phase, the day-to-day problems that financial managers faced were given importance. The general problems related to funds analysis, planning and control were given more attention in this phase. The Modern Phase Modern phase is still going on. The scope of financial management has greatly increased now. It is important to carry out financial analysis for a company. This analysis helps in decision making. During this phase, many theories have been developed regarding efficient markets, capital budgeting, option pricing, valuation models and also in several other important fields in financial management.
4.
Importance of Financial Management cannot be over-emphasized. It is, indeed, the key to successful business operations. Without proper administration of finance, no business enterprise can reach its full potentials for growth and success. Money is to an enterprise, what oil is to an engine. Financial management is all about planning investment, funding the investment, monitoring expenses against budget and managing gains from the investments. Financial management means management of all matters related to an organizations finances.
1.6
Financial Management
The best way to demonstrate the importance of good financial management is to describe some of the tasks that it involves: Taking care not to over-invest in fixed assets Balancing cash-outflow with cash-inflows Ensuring that there is a sufficient level of short-term working capital Setting sales revenue targets that will deliver growth Increasing gross profit by setting the correct pricing for products or services Controlling the level of general and administrative expenses by finding more costefficient ways of running the day-to-day business operations, and Tax planning that will minimize the taxes a business has to pay.
Let us understand this better by taking an example of a company, Cotton Textiles Limited. The company earns money by selling textiles. Let us assume that it earns ` 10 lakhs every month. This is known as revenue. A company has many expenses. Some of the major expenses of the company can be listed as wages to workers, raw materials for making the textile, electricity and water bills and purchase and repair of machines that are used to manufacture the textile. All these expenses are paid out of the revenues. If the revenues are more than the expenses, then the company will make profit. But, if the expenses are more than revenues, then it will face losses. If it continues like that, eventually, it will lose all its assets. In other words it will lose its property and all that it owns. In that case, even the workers may be asked to leave the company. To avoid this situation, the company has to manage the cash inflows (cash coming into the company) and outflows (various expenses that the company has to meet). This is one of the tasks within the ambit of Financial Management.
5.
As an integral part of the overall management, financial management is mainly concerned with acquisition and use of funds by an organization. Based on financial management guru Ezra Solomons concept of financial management, following aspects are taken up in detail under the study of financial management: (a) (b) (c) (d) Determination of size of the enterprise and determination of rate of growth. Determining the composition of assets of the enterprise. Determining the mix of enterprises financing i.e. consideration of level of debt to equity, etc. Analysis, planning and control of financial affairs of the enterprise.
The scope of financial management has undergone changes over the years. Until the middle of this century, its scope was limited to procurement of funds under major events in the life of the enterprise such as promotion, expansion, merger, etc. In the modern times, the financial management includes besides procurement of funds, the three different kinds of decisions as well namely investment, financing and dividend. All the three types of decisions would be dealt in detail during the course of this chapter.
1.7
The given figure depicts the overview of the scope and functions of financial management. It also gives the interrelation between the market value, financial decisions and risk return trade off. The finance manager, in a bid to maximize shareholders wealth, should strive to maximize returns in relation to the given risk; he should seek courses of actions that avoid unnecessary risks. To ensure maximum return, funds flowing in and out of the firm should be constantly monitored to assure that they are safeguarded and properly utilized.
6.
Efficient financial management requires the existence of some objectives or goals because judgment as to whether or not a financial decision is efficient must be made in the light of some objective. Although various objectives are possible but we assume two objectives of financial management for elaborate discussion. These are:
6.1
Profit Maximisation
It has traditionally been argued that the primary objective of a company is to earn profit; hence the objective of financial management is also profit maximisation. This implies that the finance manager has to make his decisions in a manner so that the profits of the concern are maximised. Each alternative, therefore, is to be seen as to whether or not it gives maximum profit. However, profit maximisation cannot be the sole objective of a company. It is at best a limited objective. If profit is given undue importance, a number of problems can arise. Some of these have been discussed below: (i) The term profit is vague. It does not clarify what exactly it means. It conveys a different meaning to different people. For example, profit may be in short term or long term period; it may be total profit or rate of profit etc.
1.8 (ii)
Financial Management Profit maximisation has to be attempted with a realisation of risks involved. There is a direct relationship between risk and profit. Many risky propositions yield high profit. Higher the risk, higher is the possibility of profits. If profit maximisation is the only goal, then risk factor is altogether ignored. This implies that finance manager will accept highly risky proposals also, if they give high profits. In practice, however, risk is very important consideration and has to be balanced with the profit objective.
(iii) Profit maximisation as an objective does not take into account the time pattern of returns. Proposal A may give a higher amount of profits as compared to proposal B, yet if the returns of proposal A begin to flow say 10 years later, proposal B may be preferred which may have lower overall profit but the returns flow is more early and quick. (iv) Profit maximisation as an objective is too narrow. It fails to take into account the social considerations as also the obligations to various interests of workers, consumers, society, as well as ethical trade practices. If these factors are ignored, a company cannot survive for long. Profit maximisation at the cost of social and moral obligations is a short sighted policy.
6.2
We will first like to define what is Wealth / Value Maximization Model. The shareholder value maximization model holds that the primary goal of the firm is to maximize its market value and implies that business decisions should seek to increase the net present value of the economic profits of the firm. Using Ezra Solomons symbols and methods, the net present worth can be calculated as shown below: (i) W=VC Where, W = Net present worth; V = Gross present worth; C = Investment (equity capital) required to acquire the asset or to purchase the course of action. (ii) V = E/K Where, E = Size of future benefits available to the suppliers of the input capital; K = The capitalization (discount) rate reflecting the quality (certainty/ uncertainty) and timing of benefit attached to E. (iii) E = G-(M+T+I) Where, G = Average future flow of gross annual earnings expected from the course of
Scope and Objectives of Financial Management action, before maintenance charges, taxes and interest and other prior charges like preference dividend;
1.9
M = Average annual reinvestment required to maintain G at the projected level; T= Expected annual outflow on account of taxes; I = Expected flow of annual payments on account of interest, preference dividend and other prior charges. (iv) The operational objective of financial management is the maximization of W in Point (i) above. The W (Wealth) can also be expressed symbolically by a short-cut method as follows:W = A1/(1+K) + A2/(I+K) + ..+ An/(1+K) - C Where, A1, A2,..An represents the stream of cash flows expected to occur from a course of action over a period of time; K is the appropriate discount rate to measure risk and timing; and C is the initial outlay to acquire that asset or purse the course of action. People buy the shares of a company as an investment with an expectation to gain from increase in wealth of the company. It means that they expect these shares to give them some returns. It is the duty of the finance manager to see that the shareholders get good returns on the shares. Hence, the value of the share should increase in the share market. The share value is affected by many things. If a company is able to make good sales and build a good name for itself, in the industry, the companys share value goes up. If the company makes a risky investment, people may lose confidence in the company and the share value will come down. So, this means that the finance manager has the power to influence decisions regarding finances of the company. The decisions should be such that the share value does not decrease. Thus, wealth or value maximization is the most important goal of financial management. How do we measure the value/wealth of a firm? According to Van Horne, Value of a firm is represented by the market price of the company's common stock. The market price of a firm's stock represents the focal judgment of all market participants as to what the value of the particular firm is. It takes into account present and prospective future earnings per share, the timing and risk of these earnings, the dividend policy of the firm and many other factors that bear upon the market price of the stock. The market price serves as a performance index or report card of the firm's progress. It indicates how well management is doing on behalf of stockholders.
1.10
Financial Management
Why Wealth Maximization Works? Before we answer this question it is important to first understand and know what other goals a business enterprise may have. Some of the other goals a business enterprise may follow are: Achieving a higher growth rate Attaining a larger market share Gaining leadership in the market in terms of products and technology Promoting employee welfare Increasing customer satisfaction Improving community life, supporting education and research, solving societal problems, etc. Though, the above goals are important but the primary goal remains to be wealth maximization, as it is critical for the very existence of the business enterprise. If this goal is not met, public/institutions would lose confidence in the enterprise and will not invest further in the growth of the organization. If the growth of the organization is restricted than the other goals like community welfare will not get fulfilled. To achieve wealth maximization, the finance manager has to take careful decision in respect of: a) Investment decisions: These decisions relate to the selection of assets in which funds will be invested by a firm. Funds procured from different sources have to be invested in various kinds of assets. Long term funds are used in a project for various fixed assets and also for current assets. The investment of funds in a project has to be made after careful assessment of the various projects through capital budgeting. A part of long term funds is also to be kept for financing the working capital requirements. Asset
1.11
management policies are to be laid down regarding various items of current assets. The inventory policy would be determined by the production manager and the finance manager keeping in view the requirement of production and the future price estimates of raw materials and the availability of funds. b) Financing decisions: These decisions relate to acquiring the optimum finance to meet financial objectives and seeing that fixed and working capital are effectively managed. The financial manager needs to possess a good knowledge of the sources of available funds and their respective costs and needs to ensure that the company has a sound capital structure, i.e. a proper balance between equity capital and debt. Such managers also need to have a very clear understanding as to the difference between profit and cash flow, bearing in mind that profit is of little avail unless the organisation is adequately supported by cash to pay for assets and sustain the working capital cycle. Financing decisions also call for a good knowledge of evaluation of risk, e.g. excessive debt carried high risk for an organizations equity because of the priority rights of the lenders. A major area for risk-related decisions is in overseas trading, where an organisation is vulnerable to currency fluctuations, and the manager must be well aware of the various protective procedures such as hedging (it is a strategy designed to minimize, reduce or cancel out the risk in another investment) available to him. For example, someone who has a shop, takes care of the risk of the goods being destroyed by fire by hedging it via a fire insurance contract. Dividend decisions: These decisions relate to the determination as to how much and how frequently cash can be paid out of the profits of an organisation as income for its owners/shareholders. The owner of any profit-making organization looks for reward for his investment in two ways, the growth of the capital invested and the cash paid out as income; for a sole trader this income would be termed as drawings and for a limited liability company the term is dividends.
c)
The dividend decision thus has two elements the amount to be paid out and the amount to be retained to support the growth of the organisation, the latter being also a financing decision; the level and regular growth of dividends represent a significant factor in determining a profit-making companys market value, i.e. the value placed on its shares by the stock market. All three types of decisions are interrelated, the first two pertaining to any kind of organisation while the third relates only to profit-making organisations, thus it can be seen that financial management is of vital importance at every level of business activity, from a sole trader to the largest multinational corporation.
7.
In any company, the management is the decision taking authority. As a normal tendency the management may pursue its own personal goals (profit maximization). But in an organization where there is a significant outside participation (shareholding, lenders etc.), the management may not be able to exclusively pursue its personal goals due to the constant supervision of the various stakeholders of the company-employees, creditors, customers, government, etc.
1.12
Financial Management
Every entity associated with the company will evaluate the performance of the management from the fulfillment of its own objective. The survival of the management will be threatened if the objective of any of the entities remains unfulfilled. The wealth maximization objective is generally in accord with the interests of the various groups such as owners, employees, creditors and society, and thus, it may be consistent with the management objective of survival. Owing to limitation (timing, social consideration etc.) in profit maximization, in todays real world situations which is uncertain and multi-period in nature, wealth maximization is a better objective. Where the time period is short and degree of uncertainty is not great, wealth maximization and profit maximization amount to essentially the same. The table below highlights some of the advantages and disadvantages of both profit maximization and wealth maximization goals:Goal Profit Maximization Objective Large amount of profits (i) (ii) Advantages Easy to calculate profits Easy to determine the link between financial decisions and profits. (i) Disadvantages Emphasizes the short term gains risk or
(iii) Ignores the timing of returns (iv) Requires resources. (i) immediate
(i)
(iii) Recognises the (ii) Can lead to management anxiety and frustration. timing of returns (iv) Considers shareholders return. Illustration 1: Profit maximization can be achieved in the short term at the expense of the long term goal, that is, wealth maximization. For example, a costly investment may experience losses in the short term but yield substantial profits in the long term. Also, a firm that wants to show a short term profit may, for example, postpone major repairs or replacement, although such postponement is likely to hurt its long term profitability. Another example can be taken to understand why wealth maximization is a preferred objective
1.13
Illustration 2: Profit maximization does not consider risk or uncertainty, whereas wealth maximization considers both risk and uncertainty. Suppose there are two products, X and Y, and their projected earnings over the next 5 years are as shown below: Year 1. 2. 3. 4. 5. Product X Product Y
`
10,000 10,000 10,000 10,000 10,000 50,000
`
11,000 11,000 11,000 11,000 11,000 55,000
A profit maximization approach would favour product Y over product X. However, if product Y is more risky than product X, then the decision is not as straightforward as the figures seem to indicate. It is important to realize that a trade-off exists between risk and return. Stockholders expect greater returns from investments of higher risk and vice-versa. To choose product Y, stockholders would demand a sufficiently large return to compensate for the comparatively greater level of risk.
8.
Modern financial management has come a long way from the traditional corporate finance. As the economy is opening up and global resources are being tapped, the opportunities available to finance managers virtually have no limits. A new era has ushered during the recent years for chief financial officers. His role assumes significance in the present day context of liberalization, deregulation and globalisation. To sum it up, the chief financial officer of an organisation plays an important role in the companys goals, policies, and financial success. His responsibilities include: (a) Financial analysis and planning: Determining the proper amount of funds to employ in the firm, i.e. designating the size of the firm and its rate of growth. (b) Investment decisions: The efficient allocation of funds to specific assets. (c) Financing and capital structure decisions: Raising funds on favourable terms as possible i.e. determining the composition of liabilities. (d) Management of financial resources (such as working capital). (e) Risk management: Protecting assets. The figure below shows how the finance function in a large organization may be organized.
1.14
Financial Management
Preparing internal financial reports for management Pricing analysis Preparing quarterly, annual filings for investors Tax filing
Tracking accounts payable and accounts receivable Overseeing the HR function Travel and entertainment expense management
9.
As an integral part of the overall management, financial management is not a totally independent area. It draws heavily on related disciplines and areas of study namely economics, accounting, production, marketing and quantitative methods. Even though these disciplines are inter-related, there are key differences among them. Some of the relationships
1.15
9.1
The relationship between financial management and accounting are closely related to the extent that accounting is an important input in financial decision making. In other words, accounting is a necessary input into the financial management function. Financial accounting generates information relating to operations of the organisation. The outcome of accounting is the financial statements such as balance sheet, income statement, and the statement of changes in financial position. The information contained in these statements and reports helps the financial managers in gauging the past performance and future directions of the organisation. Though financial management and accounting are closely related, still they differ in the treatment of funds and also with regards to decision making. Some of the differences are:Treatment of Funds In accounting, the measurement of funds is based on the accrual principle i.e. revenue is recognised at the point of sale and not when collected and expenses are recognised when they are incurred rather than when actually paid. The accrual based accounting data do not reflect fully the financial conditions of the organisation. An organisation which has earned profit (sales less expenses) may said to be profitable in the accounting sense but it may not be able to meet its current obligations due to shortage of liquidity as a result of say, uncollectible receivables. Such an organisation will not survive regardless of its levels of profits. Whereas, the treatment of funds, in financial management is based on cash flows. The revenues are recognised only when cash is actually received (i.e. cash inflow) and expenses are recognised on actual payment (i.e. cash outflow). This is so because the finance manager is concerned with maintaining solvency of the organisation by providing the cash flows necessary to satisfy its obligations and acquiring and financing the assets needed to achieve the goals of the organisation. Thus, cash flow based returns help financial managers to avoid insolvency and achieve desired financial goals. Decision - making The purpose of accounting is to collect and present financial data on the past, present and future operations of the organization. The financial manager uses these data for financial decision making. It is not that the financial managers cannot collect data or accountants cannot make decisions. But the chief focus of an accountant is to collect data and present the data while the financial managers primary responsibility relates to financial planning, controlling and decision making. Thus, in a way it can be stated that financial management begins where accounting ends.
9.2
For its day to day decision making process, financial management also draws on other related disciplines such as marketing, production and quantitative methods apart from accounting. For instance, financial managers should consider the impact of new product development and promotion plans made in marketing area since their plans will require capital outlays and have
1.16
Financial Management
an impact on the projected cash flows. Likewise, changes in the production process may require capital expenditures which the financial managers must evaluate and finance. Finally, the tools and techniques of analysis developed in the quantitative methods discipline are helpful in analyzing complex financial management problems.
Impact of Other Disciplines on Financial Management The above figure depicts the relationship between financial management and supportive disciplines. The marketing, production and quantitative methods are, thus, only indirectly related to day to day decision making by financial managers and are supportive in nature while accounting is the primary discipline on which the financial manager draws considerably. Even economics can also be considered as one of the major disciplines which help the financial manager to gain knowledge of what goes on in the world outside the business. SUMMARY Financial Management is concerned with efficient acquisition (financing) and allocation (investment in assets, working capital etc) of funds. In the modern times, the financial management includes besides procurement of funds, the three different kinds of decisions as well namely investment, financing and dividend. Out of the two objectives, profit maximization and wealth maximization, in todays real world situations which is uncertain and multi-period in nature, wealth maximization is a better objective. Today the role of chief financial officer, or CFO, is no longer confined to accounting, financial reporting and risk management. Its about being a strategic business partner of the chief executive officer. The relationship between financial management and accounting are closely related to the extent that accounting is an important input in financial decision making.
2
Time Value of Money
Learning Objectives
After studying this chapter you will be able to: Understand the Concept of time value of money. Understand the relationship between present and future value of money and how interest rate is used to adjust the value of cash flows in-order to arrive at present (discounting) or future (compounding) values. Understand how to calculate the present or future value of an annuity? Know how to use interest factor tables in order to calculate the present or future values?
1.
Lets start a discussion on Time Value of Money by taking a very simple scenario. If you are offered the choice between having ` 10,000 today and having ` 10,000 at a future date, you will usually prefer to have ` 10,000 now. Similarly, if the choice is between paying ` 10,000 now or paying the same ` 10,000 at a future date, you will usually prefer to pay ` 10,000 later. It is simple common sense. In the first case by accepting ` 10,000 early, you can simply put the money in the bank and earn some interest. Similarly in the second case by deferring the payment, you can earn interest by keeping the money in the bank. Therefore the time gap allowed helps us to make some money. This incremental gain is time value of money. Now let me ask a question, if the bank interest was zero (which is generally not the case), what would be the time value of money? As you rightly guessed it would also be zero. As we understood above, the interest plays an important role in determining the time value of money. Interest rate is the cost of borrowing money as a yearly percentage. For investors, interest rate is the rate earned on an investment as a yearly percentage. Time value of money results from the concept of interest. So it now time to discuss Interest.
2.
Simple Interest
It may be defined as Interest that is calculated as a simple percentage of the original principal amount. Please note the word Original. The formula for calculating simple interest is
2.2
Financial Management
SI = P0 (i)(n) Where, SI = simple interest in rupees P0 = original principal i = interest rate per time period (in decimals) n = number of time periods If we add principal to the interest, we will get the total future value (FV). (Future vale is also known as Terminal Value). For any simple interest rate, the future value of an account at the end of n period is:FVn = P0+ SI = P0 + P0(i)(n) Illustration1: If you invest Rs 10,000 (P0) in a bank at simple interest of 7% (i) per annum, what will be the amount at the end of three (n) years? Solution Future Value, FVn = P0 + SI = P0 + P0(i)(n) = 10,000 + 10,000(0.07)(3) = 12,100 Illustration 2: ` 2,000 (P0) is deposited in a bank for two (n) years at simple interest of 6% (i). How much will be the balance at the end of 2 years? Solution Required balance is given by FVn = P0 + P0(i)(n) = 2,000 + 2000 (0.06)( 2) = 2,000 + 240 = ` 2,240. Illustration 3: Find the rate of interest if the amount owed after 6 (n) months is ` 1,050 (A), borrowed amount being ` 1,000 (P0). Solution We know FVn = P0 + P0(i)(n) i.e. 1,050 = 1,000 + 1,000(i)(6/12) Or 1,050-1,000 = 500(i) Therefore (i) = 50/500 = 0.10 i.e. (i) = 10%
3.
Compound Interest
If interest is calculated on original principal amount it is simple interest. When interest is calculated on total of previously earned interest and the original principal it compound interest. Naturally, the amount calculated on the basis of compound interest rate is higher than when calculated with the simple rate. Refer Illustration 2 discussed earlier for Simple Interest and just make a change in the way we calculate interest. Instead of simple we would now choose compound interest (Compounded Annually). The result would be as follows:-
Time Value of Money Step 1:- Balance at the end of 1st Year would be:FV1 = P1 + P1(i)(n) = 2,000 + 2000 (0.06)( 1) = 2,000 + 120 = ` 2,120 Step 2:- Balance at the end of 2nd Year would be:FV2 = P2 + P2(i)(n) = 2,120 + 2,120 (0.06)( 1) = 2,000 + 128 = ` 2,248 (Rounded off)
2.3
In our above example we chose the compounding period to be annually. This time interval between successive additions of interests is known as conversion (or payment) period. Typical conversion periods are given below: Conversion Period 1 day 1 month 3 months 6 months 12 months Description Compounded daily Compounded monthly Compounded quarterly Compounded semiannually Compounded annually
Thus, the accrued amount FVn on a principal P after n payment periods at i (in decimal) rate of interest per payment period is given by:
FVn = P0 (FVIFi,n), Where, FVIFi,n is the future value interest factor at i% for n periods equal (1 + i)n . Computation of FVn shall be quite simple with a calculator. However, compound interest tables as well as tables for (1+i)n at various rates per annum with (a) annual compounding; (b) monthly compounded and (c) daily compounding are available. It should be remembered that i and n are with respect to per period, which can be different than a year. For example, annual interest can be payable, on monthly, quarterly or half-yearly basis. This will be clear from the illustrations given.
2.4
Financial Management
FVIFr, n
12%
6% 2
0 percent
Periods 2 4 6 8 10 12 14 16
Graphic View of Compounding Illustration 4: Determine the compound interest for an investment of Rs 7,500 at 6 % compounded halfyearly. Given that (1+i)n for i = 0.03 and n = 12 is 1.42576. Solution
i=
6 = 0.03 , 2 100
n = 6 2 = 12,
P = 1,000
Compound Amount = 7,500(1+0.03)12 = 7,500 1.42576 = 10,693.20 Compound Interest = 10,693.20 7,500 = 3,193.20
Illustration 5: ` 2,000 is invested at annual rate of interest of 10%. What is the amount after 2 years if the compounding is done:
(a) Annually?
Solution
(c) Monthly?
(d) Daily?
= 2,000 (1.1)2 = 2,000 1.21 = ` 2,420 (b) For Semiannual compounding, n = 2 2 = 4, i = 0.1/2 = 0.05 FV4 = 2,000 ( 1 + 0.05)4 = 2,000 1.2155 = ` 2,431 (c) For monthly compounding, n = 12 2 = 24, i = 0.1/12 = 0.00833 FV24 = 2,000 (1.00833)24 = 2,000 1.22029 = ` 2440.58
2.5
(d) For daily compounding, n = 365 2 = 730, i = 0.1/(365) = 0.00027 FV730 = 2,000 (1.00027)730 = 2,000 1.22135 = ` 2,442.70
Illustration 6: Determine the compound amount and compound interest on ` 1,000 at 6% compounded semiannually for 6 years. Given that (1+i)n = 1.42576 for i = 3% and n = 12. Solution
i = (6/2) = 3%, n = 6 2 = 12, P = 1,000 Compound amount = P (1 + i)n = 1,000 (1 + 3%)12 = 1,000 1.42576 = ` 1,425.76 Compound interest = 1,425.76 1,000 = ` 425.76
Illustration 7: What annual rate of interest compounded annually doubles an investment in 7 years? Given that 21/7 = 1.104090. Solution
If the principal be P, FVn = 2P Since, FVn = P(1 + i)n, 2P = P(1 + i)7, Or, Or, Or, 2 = (1 + i)7 21/7 = 1 + i 1.104090 = 1 + i i.e., i = 0.10409
(a) The initial investment earned interests for April June and July September quarter, i.e. for 2 quarters. In this case, i =
6 1 1 = 1 %, n = 2 and the compounded amount = 800 1 + 1 % 4 2 2
2
2.6
Financial Management
= 800 1.03022500 = ` 824.18 The additional amount = ` (1,000 824.18) = ` 175.82 (b) In this case, the Time Deposit earned interest compounded monthly for 2 quarters.
Here, i = 6 1 = %, n = 6, P = 1,000 12 2
6
1 Required maturity value 1,000 1 + % = 1,000 1.03037751 = Rs. 1,030.38 2 (c) Total interest earned = (24.18 + 30.38) = ` 54.56
Illustration 9: Ramanuj has taken a 20 month car loan of ` 6,00,000. The rate of interest is 12 per cent per annum. What will be the amount of monthly loan amortization? Solution
A=
3.1
The given figure shows graphically the differentiation between compound interest and simple interest. The top two ascending lines show the growth of ` 100 invested at simple and compound interest. The longer the funds are invested, the greater the advantage with compound interest. The bottom line shows that ` 38.55 must be invested now to obtain ` 100 after 10 periods. Conversely, the present value of ` 100 to be received after 10 years is ` 38.55.
2.7
4.
It is the actual equivalent annual rate of interest at which an investment grows in value when interest is credited more often than once a year. If interest is paid m times in a year it can be found by calculating:
i Ei = 1 + 1 m
m
Illustration 10: If the interest is 10% payable quarterly, find the effective rate of interest. Solution
0 .1 E = 1 + 1 = 0.1038 or 10.38% 4
4
5.
Present Value
Lets first define Present Value. Simple definition is Present Value is the current value of a Future Amount. It can also be defined as the amount to be invested today (Present Value) at a given rate over specified period to equal the Future Amount. If we reverse the flow by saying that we expect a fixed amount after n number of years, and we also know the current prevailing interest rate, then by discounting the future amount, at the given interest rate, we will get the present value of investment to be made. The present value of a sum of money to be received at a future date is determined by discounting the future value at the interest rate that the money could earn over the period. This process is known as Discounting. The figure below shows graphically how the present value interest factor varies in response to changes in interest rate and time. The present value interest factor declines as the interest rate rises and as the length of time increases.
PVIFr, n 0 percent 100
Periods 2 4 6 8 10 12
2.8
Financial Management
Since finding present value is simply the reverse of finding Future Value (FV), the formula for Future Value (FV) can be readily transformed into a Present Value formula. Therefore the P0, the Present Value becomes:P0 = FVn (1 + i)
n
OR P0 = FVn (1 + i) n Where, FVn i n = = = Future value n years hence Rate of interest per annum Number of years for which discounting is done.
As mentioned earlier, computation of P may be simple if we make use of either the calculator or the Present Value table showing values of (1+i) n for various time periods/per annum interest rates. For positive i, the factor (1 + i) n is always less than 1, indicating thereby, future amount has smaller present value.
Illustration 11: What is the present value of Re. 1 to be received after 2 years compounded annually at 10%? Solution
Here FVn = 1, i = 0.1 Required Present Value = FVn (1+i) n = FVn (1+i)
n
1 (1.1)
2
Thus, Re. 0.83 shall grow to Re. 1 after 2 years at 10% compounded annually.
Illustration 12: Find the present value of ` 10,000 to be required after 5 years if the interest rate be 9 per cent. Given that (1.09)5 = 1.5386 Solution
n = 5, = FVn (1 + i) n
FVn = 10,000
2.9
Now, I = 8% n = 10 years
10
Illustration 14: What is the present value of ` 50,000 to be received after 10 years at 10 per cent compounded annually? Solution
It is a two-part problem. First being determination of maturity value of the investment of ` 12,000 and then finding of present value of the obtained maturity value. Maturity value of the investment may be found from FVn = P (1+i)n, Where P = 12,000, i =
12 = 1%, n = 5 12 = 60. 12
Now, FVn = 12,000 (1+1%)60 = 12,000 1.81669670 = 21,800.36040000 = ` 21,800.36 Thus, maturity value of the investment in real estate = ` 21,800.36 The present value, P of the amount FVn due at the end of n interest periods at the rate of i% interest per period is given by P = FVn (1 + i) n
2.10
Financial Management
We have in the present case, FVn = ` 21,800.36, i = Thus, P = 21,800.36 (1+ 2%)20 = 21,800.36 0.67297133 = ` 14,671.02
8 = 2%, n = 5 4 = 20. 4
Mr. X should not sell the property for less than ` 14,671.02
6.
Annuity
An annuity is a stream of regular periodic payment made or received for a specified period of time. In an ordinary annuity, payments or receipts occur at the end of each period.
6.1
Expressed algebraically, FVAn is defined as future (compound) value of an annuity, R the periodic receipt (or payment), and n the length of the annuity, the formula for FVAn is:FVAn = R(I + i) n1 + R (1+i) n2 + + R(I + i) 1 + R (1+i)0 As we can see, FVAn is simply equal to the periodic receipt (R) times the sum of the future value interest factors at i percent for time periods 0 to n-1. As a shortcut, If R be the periodic payments, the amount FVAn of the annuity is given by: FVAn = R OR
(1+i)n -1
i FVAn = R (FVIFAi,n)
Where FVIFAi,n stands for the future interest factor of an annuity at i% for n periods. Table for FVAn at different rates of interest may be used conveniently, if available, to workout problems. (1 + i)n 1 or FVIFAi,n can easily be found through financial tables. The value of expression i
Illustration 16: Find the amount of an annuity if payment of ` 500 is made annually for 7 years at interest rate of 14% compounded annually. Solution
Here
R = 500, n = 7,
i = 0.14
2.11
FVA
(1+i) n -1 R i
` 5,000 (4.507) = ` 22,535
Illustration 18: ` 200 is invested at the end of each month in an account paying interest 6% per year compounded monthly. What is the amount of this annuity after 10th payment? Given that (1.005)10 = 1.0511 Solution
We have A (n, i) =
(1 + i)n1 , i being the interest rate (in decimal) per payment period over n payment
i
period. Here, i = .06/12 = .005, n = 10. Required amount is given by A = P.A (10, .005) = 200 10.22 = ` 2,044.
6.2
Sometimes instead of a single cash flow the cash flows of the same amount is received for a number of years. The present value of an annuity may be expressed as follows : PVAn = R
1
(1+i ) (1+i )
R
2
+...
(1+i )
n -1
(1+i ) n
1 1 1 1 =R + + ... + 1 2 n 1 (1 + i ) (1 + i ) n (1 + i ) (1 + i ) = R (PVIFi,1 + PVIFi,2 + PVIFi,3 + ..+ PVIFi,n) = R (PVIFi,n) Where, PVAn = Present value of annuity which has duration of n years R i ,n = Constant periodic flow = Discount rate. and, = Present value interest factor of an (ordinary) annuity at i percent for n periods.
2.12
Financial Management
Illustration 19: Find out the present value of a 4 year annuity of ` 20,000 discounted at 10 per cent. Solution
P VA Now, i N PVA
= Amount of annuity Present value (r, n) = 10% = 4 years (1+0.1) 4 -1 = ` 20,000 = ` 20,000 0.683 4 0.1 1+0.1 ( ) = ` 13,660
Illustration 20: Y bought a TV costing ` 13,000 by making a down payment of ` 3,000 and agreeing to make equal annual payment for 4 years. How much would be each payment if the interest on unpaid amount be 14% compounded annually? Solution
In the present case, present value of the unpaid amount was (13,000 3,000) = ` 10,000. The periodic payment, R may be found from
R = PVA 10,000 10,000 = = = Rs. 3,431.71 PVIF(i, n) PVIF (0.14, 4) 2.914
Illustration 21: Z plans to receive an annuity of ` 5,000 semi-annually for 10 years after he retires in 18 years. Money is worth 9% compounded semi-annually.
How much amount is required to finance the annuity? What amount of single deposit made now would provide the funds for the annuity? How much will Mr. Z receive from the annuity? Let us first find the required present value for the 10 years annuity by using PVA = R[PVIF(i,n)] = 5,000 [PVIF(4.5%, 20)] = 5,000 13.00793654 = ` 65,039.68 Since, PVIF ( 4.5%, 20) =
=
Solution
(1
+ 4.5% ) 1
20
.045(1 + 4.5%)20
(b)
We require the amount of single deposit that matures to ` 65,039.68 in 18 years at 9% compounded semi-annually. We use the following formula:-
2.13
P0 = FVn (1 + i) n
Where FVn = 65,039.68, n = 18 2 = 36, i = 1 Thus, P0 = 65,039.68 1 + 4 % 2
(c)
36
9 1 = 4 %, P 0 = ? 2 2
As the present value of an annuity of ` 700 has to be computed. The present value factor of an annuity of Re. 1 at 8 per cent for 6 years is 4.623. Therefore, the present value of an annuity of ` 700 will be: 4.623 ` 700 = ` 3,236.10
Illustration 23: Determine the present value of ` 700 each paid at the end of each of the next six years. Assume an 8 per cent of interest. Solution
As the present value of an annuity of ` 700 has to be computed. The present value factor of an annuity of Re. 1 at 8 per cent for 6 years is 4.623. Therefore, the present value of an annuity of ` 700 will be: 4.623 ` 700 = ` 3,236.10.
7.
Perpetuity
Perpetuity is an annuity in which the periodic payments or receipts begin on a fixed date and continue indefinitely or perpetually. Fixed coupon payments on permanently invested (irredeemable) sums of money are prime examples of perpetuities. The formula for evaluating perpetuity is relatively straight forward. Two points which are important to understand in this regard are:. (a) (b) The value of the perpetuity is finite because receipts that are anticipated far in the future have extremely low present value (today's value of the future cash flows). Additionally, because the principal is never repaid, there is no present value for the principal.
Therefore the price of perpetuity is simply the coupon amount over the appropriate discount rate or yield.
7.1
The formula for determining the present value of multi-period perpetuity is as follows:
2.14
Financial Management
PVA =
(1 + i )
+ 1
(1 + i ) 2 (1 + i ) 3
+ ....... +
R R R = = n i (1 + i ) n =1 (1 + i )
Where: R = the payment or receipt each period i = the interest rate per payment or receipt period
Illustration 24: Ramesh wants to retire and receive ` 3,000 a month. He wants to pass this monthly payment to future generations after his death. He can earn an interest of 8% compounded annually. How much will he need to set aside to achieve his perpetuity goal? Solution
Substituting these values in the above formula, we get PVA = Rs. 3,000 0.00667
= ` 4,49,775 If he wanted the payments to start today, he must increase the size of the funds to handle the first payment. This is achieved by depositing ` 4,52,775 which provides the immediate payment of ` 3,000 and leaves ` 4,49,775 in the fund to provide the future ` 3,000 payments.
7.2
A stream of cash flows that grows at a constant rate forever is known as growing perpetuity. The formula for determining the present value of growing perpetuity is as follows:
PVA=
2 ) = R(1+ g)n1 = R + R(1+ g) + R(1+ g) +.......+ R(1+ g n i g 1 2 3 (1+i) =1 (1+i) n (1+i) (1+i) (1+i)
R
Illustration 25: Assuming that the discount rate is 7% per annum, how much would you pay to receive ` 50, growing at 5%, annually, forever? Solution
PVA =
2.15
8.
Sinking Fund
It is the fund created for a specified purpose by way of sequence of periodic payments over a time period at a specified interest rate. Size of the sinking fund deposit is computed from FVA=R[FVIFA(i,n)], where FVA is the amount to be saved, R, the periodic payment, n, the payment period.
Illustration 26: How much amount is required to be invested every year so as to accumulate ` 3,00,000 at the end of 10 years if the interest is compounded annually at 10%? Solution
Here, Since,
FVA= 3,00,000
n = 10
i = 0.1
FVA=R[FVIFA(i,n)] = R* 6.1146
Therefore, R =
R = ` 18,823.62
Illustration 27: ABCL Company has issued debentures of ` 50 lakhs to be repaid after 7 years. How much should the company invest in a sinking fund earning 12 percent in order to be able to repay debentures? Solution
= =
50,00,000 50,00,000
` 4.96 lakhs.
Illustration 28: XYZ Company is creating a sinking fund to redeem its preference capital of ` 10 lakhs issued on April 6, 2010 and maturing on April 5, 2021. The first annual payment will be made on April 6, 2010. The company will make equal annual payments and expects that the fund will earn 12 percent per year. How much will be the amount of sinking fund payment? Solution
XYZ Company wants to accumulate a future sum of ` 10,00,000. Since the annual payments will be made in the beginning of the year, the formula for the compound value of an annuity can be used. A(CVFAn, i ) (1+ i) = 10,00,000
2.16
Financial Management
= = =
Illustration 29: Assume that it is now January 1, 2010 and Shyam needs ` 1,000 on January 1, 2014.
His bank compounds interest at an 8 per cent annual rate. (a) How much must he deposit on January 1, 2011, to have a balance of ` 1,000 on January 1, 2014? (b) If he wants to make equal payments on each January 1 from 2011 through 2014 to accumulate the ` 1,000 how large must each of the 4 payments be? (c) If his friend were to offer either to make the payments calculated in part (b) (` 221.92) or to give him a lump sum of ` 750 on January 1, 2011, which would he choose?
(d) If he had only ` 750 on January 1, 2011, what interest rate, compounded annually, would he have to earn to have the necessary ` 1,000 on January 1, 2014? (e) Suppose he can deposit only ` 186.29 each from January 1, 2011 through 2014 but he still needs ` 1,000 on January 1, 2014. What interest rate, with annual compounding, must he seek out to achieve his goal? (f) To help Shyam reach ` 1,000 goal, his father offers to give him ` 400 on January 1, 2011. He will get a part-time job and make 6 additional payments of equal amount search 6 months thereafter. If all of this money is deposited in a bank that pays 8 per cent, compounded semiannually, how large must each of the 6 payments be? (g) What is the effective annual rate being paid by the bank in part (f)?
Solution (a)
Shyams deposit will grow for 3 years at 8 per cent. The fact that it is now January 1, 2010, is irrelevant. The deposit on January 1, 2011, is the present value, PV, and the future value, FV, is ` 1,000. Solving for PV:
PV = FV
n
(1 + i) n
= Rs. 793.83.
(b) Here, we are dealing with a 4 year annuity whose first payment occurs one year from today, on 1/1/11, and whose future value must equal ` 1,000. When N = 4, I = 8, PV = 0, FV = 1,000, then PMT = ` 221.92.
2.17
This problem can be approached in several ways. Perhaps the simplest is to ask this question: If Shyam received ` 750 on 1/1/11 and deposited it to earn 8 per cent, would he have the required ` 1,000 on 1/1/14? The answer is No. FV3 = ` 750(1.08)(1.08)(1.08) = ` 944.78. This indicates that Shyam should let his father make the payments rather than accept the lump sum of ` 750. He should also compare the ` 750 with the PV of the payments as shown: Using N = 4, I = 8, PMT = 221.92, FV = 0, PV can be solved as PV = ` 735.03. PMT (PVIFA8%,4) = PVA4
1 1 (1 + 0.08) 4 ` 221.92 0.08 = PVA 4
` 221.92 (3.3121) = ` 735.02 = Present value of the required payments. This is less than the ` 750 lump sum offer, so Shyams initial reaction might be to accept the lump sum of ` 750. However, this would be a mistake. The problem is that when the ` 735.03 PV of the annuity is found, the value of the annuity today, on January 1, 2010. He is comparing ` 735.03 today with the lump sum of ` 750 1 year from now. This is, of course, invalid. What he should have done was take the ` 735.03, recognize that this is the PV of an annuity as of January 1, 2010, multiply ` 735.03 by 1.08 to get ` 793.83, and compare ` 793.83 with the lump sum of ` 750. He should then take his fathers offer to make the payments rather than take the lump sum on January 1, 2011.
(d) (e)
Using N = 3, PV = 750, PMT = 0, FV = 1,000, I can be solved as 10.0642%. Using N = 4, PV = 0, PMT = 186.29, FV = 1,000, I can be solved as 19.9997%. Shyam might be able to find a borrower willing to offer him a 20 per cent interest rate, but there would be some risk involved he or she might not actually pay him his ` 1,000.
(f)
Find the future value of the original ` 400 deposit: FV6 = PV (1.04)6 = ` 400 (1.2653) = ` 506.13. This means that on January 1, 2014, he needs an additional sum of ` 493.87:
2.18
Financial Management
` 1,000.00 ` 506.13 = ` 493.87. This will be accumulated by making 6 equal payments that earn 8 per cent compounded semiannually, or 4 per cent each 6 months. PMT (FVIFA4%,6) = FVA6
(1 + 0.04) 6 1 = Rs. 493.88 PMT 0.04 PMT = Rs. 493.88 = Rs. 74.46. 6.6330
(g)
i Nom m Effective annual rate = 1 + - 1.0 m 2 0.08 2 = 1 + 1 = (1.04) 1 2 = 1.0816 1 = 0.0816 = 8.16%.
Illustration 30: Bank of Delhi pays 8 per cent interest, compounded quarterly, on its money market account. The managers of Bank of Gurgaon want its money market account to equal Bank of Delhis effective annual rate, but interest is to be compounded on monthly basis. What nominal, or quoted, or APR rate must Bank of Gurgaon set?
Solution
Bank of Delhis effective annual rate is 8.24 per cent: 0.08 4 Effective annual rate = 1 + 1.0 4 = (1.02)4 1 = 1.0824 1 = 0.0824 = 8.24%. Now, Bank of Gurgaon must have the same effective annual rate: 12 i 1 + 1.0 = 0.0824 12 12 i 1 + = 1.0824 12
2.19
1+ 1+
i = (1.0824)1/12 12 i = 1.00662 12
i = 0.00662 12
i = 0.07944 = 7.94%. Thus, the two banks have different quoted rates Bank of Delhis quoted rate is 8%, while Bank of Gurgaons quoted rate is 7.94%; however, both banks have the same effective annual rate of 8.24%. The difference in their quoted rates is due to the difference in compounding frequency.
SUMMARY Money has time value. A rupee today is more valuable than a rupee a year hence. We use rate of interest to express the time value of money. Simple Interest may be defined as Interest that is calculated as a simple percentage of the original principal amount.
Formula : SI = P0 (i)(n)