The Quantus Group™

Elevating you

Pre MBA Programme 2009

Introduction to Finance
 Contents

01 Time Value of Money

02 Discounted Cash Flow

03 Understanding Risk

04 Derivatives

05 How Share Markets Function

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 01 Time Value of Money

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 Time Value of Money
Congratulations!!! You have won a cash prize!
You have two payment options:

A. Receive $10,000 now

OR
Ofcourse we
want the money
B. Receive $10,000 in three years NOW!!

Which option would you choose?

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 Time Value of Money

Future value of investment at end of first year:

= ($10,000 x 0.045) + $10,000
= $10,450

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 Calculating Future value of Money
I give you 100 dollars. You take it to the bank. They
will give you 10% interest per year for 2 year.
• The Present Value = $ 100
• Future Value = $121 (including interest for 2 yrs)
• FV= PV (1 + i )NFV = Future Value
• PV = Present Value
• i = the interest rate per period
• n= the number of compounding periods
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 Calculating Future value of Money
Determine Future Value Compounded Annually
What is the future value of $34 in 5 years if the
interest rate is 5%? (i=.05)

• FV= PV ( 1 + i ) N
• FV= $ 34 ( 1+ .05 ) 5
• FV= $ 34 (1.2762815)
• FV= $43.39.

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 Calculating Future value of Money
Determine Future Value Compounded Monthly
What is the future value of $34 in 5 years if the interest rate
is 5%? (i equals .05 divided by 12, because there are 12
months per year. So 0.05/12=.004166, so i=.004166)

• FV= PV ( 1 + i ) N
• FV= $ 34 ( 1+ .004166 ) 60
• FV= $ 34 (1.283307)
• FV= $43.63.

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 Calculating Future value of Money
Determine Present Value Compounded Annually
You can go backwards too. I will give you $1000 in 5
years. How much money should you give me now to
make it fair to me. You think a good interest rate would
be 6% ( You just made that number up). (i=.06)
• FV= PV ( 1 + i ) N
• $1000 = PV ( 1 + .06) 5
• $1000 = PV (1.338)
• $1000 / 1.338 = PV
• $ 747.38 = PV

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 Time Value of money


So now you know
how to move
money back and
forth in time!!

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 Time Value of Money
• But, How do you account for continued
streams of payments over a period of time??

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 Time Value of Annuity
You have a coin you wish to sell. A potential
buyer offers to purchase the coin from you in
exchange for a series of three annual payments
of $50 starting one year from today. What is the
current value of the offer if the prevailing rate of
interest is 7% compounded annually?

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 Time Value of Annuity

This problem is represented graphically in the diagram below...

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 Time Value of Annuity
• In this situation the inputs to the PV of an annuity equation are as
follows...
• PMT = 50
i = 0.07
n=3
• ...and plugging these values into the equation...
• ...tells us that the buyer's offer is worth $131.22 today (rounded).

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 Time Value of Annuity
• Note that the cash flow diagram is drawn from the perspective of
the seller. In a financial transaction there is always some
combination of inflows and outflows. In the drawing above the
seller experiences an outflow at the start of the transaction (the
delivery of the coin to the buyer), followed by a series of inflows
spread over three years (the $50 payments received from the
buyer). It is the initial outflow that we wish to value by setting it
equal to the three annual payments at 7% interest. The horizontal
arrow pointing to the intial outflow indicates we are discounting the
annual payments back to their present value (PV).

• Because the payments are not received today - we have to wait to

receive them - they are worth less than their face value. To quantify
how much less we must "discount" the value of each $50 payment
back to its current value. The sum of the discounted values of all of
these payments is the PV of the annuity.
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 02 Discounted Cash Flow

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 Discounted Cash Flow
• Discounted Cash Flow (DCF) is, what amount
someone is willing to pay today, in order to
receive the anticipated cash flow of future years.
• The DCF method converts future earnings to
today's money. The future cash flows must be
recalculated (discounted) to represent their
present values. In this way the value of a
company or project under consideration as a
whole is determined properly.
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 Calculating DCF
• Discounted Cash Flow calculation investment is calculated by
estimating: the cash that you will have to pay out, and the cash
which you expect to receive back. The timeframes that you expect
to receive the payments must also be estimated.

• Each cash transaction must then be recalculated, by subtracting the

opportunity cost of capital between now and the moment when
you will pay or receive the cash.

• For example, if inflation is 6%, the value of your money would halve
every ±12 years. If you expect that a particular asset will provide
you an income of $30.000 in 12 years from now, that income
stream would be worth $15.000 today if inflation was 6% for the
period. We have now discounted the cash flow of $30.000: it is only
worth $15.000 for you at this moment.

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 Why Discounted Cash Flow?
• The DCF method is an approach for valuation, whereby
projected future cashflows are discounted at an interest
rate (also called: Rate of Return), that reflects the perceived
amount of risk of the cash flows. In fact, the discount rate
reflects two things:

1. The time value of money. Any investor would prefer to

have cash immediately than having to wait. Therefore
investors must be compensated by paying for the delay.
2. The risk premium that represents the extra return which
investors demand, because they want compensation for
the risk that the cash flow might not materialize.

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 03 Understanding Risk

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 Risk
• In all countries, laws and regulations require
companies and financial institutions to develop and
maintain proper books and accounting records. It is
generally recognized that 'Accounting Risks' can arise
from the failure of management:

– To maintain proper books and records, accounting systems

and to have proper accounting policies.
– To establish proper internal accounting controls.
– To prepare periodic financial statements that reflect an
accurate financial position.
– To be transparent and fully disclose all important and
relevant matters.
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 Risk
Some examples:
• credit risk liquidity risk,
• capital adequacy risk,
• foreign exchange risk,
• market risk,
• settlement risk

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 04 Derivatives

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 Derivatives
'By far the most significant event in finance during
the past decade has been the extraordinary
development and expansion of financial
derivatives. These instruments enhance the ability
to differentiate risk and allocate it to those
investors most able and willing to take it - a
process that has undoubtedly improved national
productivity growth and standards of living.' --
-Alan Greenspan, Chairman, Board of Governors of
the US Federal Reserve System.
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 Derivatives
• The primary objectives of any investor are to
maximise returns and minimise risks.
Derivatives are contracts that originated from
the need to minimise risk.
Derivatives are so called because they have no
value of their own. They derive their value
from the value of some other asset, which is
known as the underlying.

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 Derivatives
• For example, a derivative of the shares of
Infosys (underlying), will derive its value from
the share price (value) of Infosys.

• Similarly, a derivative contract on soybean

depends on the price of soybean.

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 Derivatives
• Derivatives are specialised contracts which signify
an agreement or an option to buy or sell the
underlying asset of the derivate up to a certain
time in the future at a prearranged price, the
exercise price.
• The contract also has a fixed expiry period mostly
in the range of 3 to 12 months from the date of
commencement of the contract. The value of the
contract depends on the expiry period and also
on the price of the underlying asset.
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 Derivatives Example
• For example, a farmer fears that the price of soybean
(underlying), when his crop is ready for delivery will be lower
than his cost of production.

• Let's say the cost of production is Rs 8,000 per ton. In order to

overcome this uncertainty in the selling price of his crop, he
enters into a contract (derivative) with a merchant, who
agrees to buy the crop at a certain price (exercise price), when
the crop is ready in three months time (expiry period).
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 Derivatives Example (cont.)
• In this case, say the merchant agrees to buy the crop at
Rs 9,000 per ton. Now, the value of this derivative
contract will increase as the price of soybean decreases
and vice-a-versa.
• If the selling price of soybean goes down to Rs 7,000
per ton, the derivative contract will be more valuable
for the farmer, and if the price of soybean goes down
to Rs 6,000, the contract becomes even more valuable.
- This is because the farmer can sell the soybean he has
produced at Rs .9000 per tonne even though the
market price is much less. Thus, the value of the
derivative is dependent on the value of the underlying.

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 Basic Derivative Instruments
• Futures
A 'Future' is a contract to buy or sell the underlying asset for a specific
price at a pre-determined time. If you buy a futures contract, it means that
you promise to pay the price of the asset at a specified time. If you sell a
future, you effectively make a promise to transfer the asset to the buyer of
the future at a specified price at a particular time.

• The difference between the price of the underlying asset in the spot
market and the futures market is called 'Basis'. (As 'spot market' is a
market for immediate delivery)
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 Basic Derivative Instruments
• Options
Options contracts are instruments that give the holder of the instrument the right
(not the obligation) to buy or sell the underlying asset at a predetermined price.

• A call option gives the buyer, the right to buy the asset at a given price. This 'given
price' is called 'strike price'. It should be noted that while the holder of the call
option has a right to demand sale of asset from the seller, the seller has only the
obligation and not the right. For eg: if the buyer wants to buy the asset, the seller
has to sell it. He does not have a right.

• Similarly a 'put' option gives the buyer a right to sell the asset at the 'strike price'
to the buyer. Here the buyer has the right to sell and the seller has the obligation
to buy.
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 05 How Share Markets Function

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 How Share markets function
• Applying the Demand and Supply rule to share
markets
• “An Equity Share”
• Types of financial markets
• Money Markets
• Capital Markets
– Primary
– Secondary

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 How Share markets function
• Market Infrastructure
•Stock exchange
•Clearing and settlement
•Education and training
•Investors’ protection
•Rating agency

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 How Share markets function
• Instruments
– Equity
• Most popular investing instruments
• Stocks and shares
• Bonus issues
• Rights issues
– Bonds
• Corporate
• Government

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 “At any point in time, the
price of previously issued
stock is determined by the
ebb and flow of supply and
demand”

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 Questions??

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