Unit 1 - Notes

FIN212

Unit 1: Financial Management and Time Value of Money

1. Introduction to Financial Management

Financial Management is concerned with the efficient acquisition and allocation of funds. It acts as the specific area of management that deals with the financial decision-making process, aimed at maximizing the value of the firm.

Key Definitions

General Definition: The art and science of managing money.
Corporate Definition: Planning, organizing, directing, and controlling the financial activities such as procurement and utilization of funds of the enterprise.

Evolution

Traditional Phase: Focused primarily on the procurement of funds from external sources. It was episodic (occurring only during events like incorporation or liquidation).
Modern Phase: Focuses on both the acquisition of funds and their effective utilization. It is an ongoing, analytical process involving critical decision-making.

2. Scope of Finance

The scope of financial management is broad and includes all financial decisions taken within a business. It generally encompasses the following areas:

Estimating Financial Requirements: Determining how much capital is needed for both short-term (working capital) and long-term (fixed assets) operations.
Deciding Capital Structure: Determining the proper mix of debt (borrowed funds) and equity (owner's funds).
Selecting Sources of Finance: Choosing between shares, debentures, bank loans, or public deposits based on cost and risk.
Investment Pattern: Deciding where to allocate funds (profitable projects vs. safe assets).
Cash Management: Ensuring sufficient liquidity to meet daily obligations.
Financial Controls: Using ratio analysis, financial forecasting, and cost control techniques to monitor performance.

3. Financial Goals: Profit Maximization vs. Wealth Maximization

The objective of financial management guides the decision-making process. There are two primary schools of thought:

A. Profit Maximization

This is the traditional objective of a firm. It suggests that actions that increase profits should be undertaken and those that decrease profits should be avoided.

Rationale: Profit is the measuring rod of efficiency and essential for survival.
Limitations:
1. Vague: "Profit" can be interpreted as gross profit, net profit, earnings per share, or return on capital.
2. Ignores Time Value of Money: It treats $1 received today the same as $1 received a year later.
3. Ignores Risk: It does not account for the fluctuation or uncertainty of future earnings.
4. Short-term Focus: May lead to cutting necessary R&D or maintenance to boost immediate numbers.

B. Wealth Maximization (The Superior Goal)

This is the modern, universally accepted objective. It implies maximizing the Net Present Value (NPV) of a course of action or maximizing the market value of the firm's shares.

Definition: Maximizing the current price of the company's stock held by shareholders.
Advantages:
1. Considers Time Value of Money: Recognizes timing of cash flows.
2. Considers Risk: Higher risk implies a higher discount rate, lowering value.
3. Universal: Focuses on the long-term health of the company.
4. Market-based: Reflects the collective judgment of the financial market.

Conclusion: Wealth maximization is the superior goal because it encompasses both the quantity and quality (risk/timing) of benefits.

4. Finance Function (The Three Major Decisions)

Financial management revolves around three critical decisions, often referred to as the pillars of finance:

1. Investment Decision (Capital Budgeting)

Concerned with the allocation of capital to long-term assets.
Objective: To select assets where the return on investment exceeds the cost of capital.
Examples: Buying new machinery, launching a new product, acquiring a company.

2. Financing Decision (Capital Structure)

Concerned with the mix of debt and equity used to finance the firm.
Objective: To determine the optimal capital structure that minimizes the Cost of Capital (WACC).
Trade-off: Debt is cheaper (tax-deductible) but riskier (mandatory interest); Equity is safer but more expensive.

3. Dividend Decision

Concerned with how much of the profit should be distributed to shareholders (dividends) vs. how much should be retained for reinvestment (retained earnings).
Objective: To satisfy shareholder expectations while ensuring the firm has funds for growth.

5. Role of Finance Manager

The Finance Manager acts as the intermediary between the firm’s operations and the financial markets.

Key Responsibilities:

Financial Forecasting and Planning: Estimating future fund requirements.
Acquisition of Funds: Negotiating with banks, issuing stocks/bonds.
Investment of Funds: Allocating funds to profitable projects.
Cash Management: Managing cash flow to ensure solvency.
Risk Management: Hedging against interest rate or currency fluctuations.
Performance Evaluation: Analyzing financial statements to suggest improvements.

6. Concept of Time Value of Money (TVM)

Core Principle: A specific amount of money available today is worth more than the same amount available at a future date.

Underlying Logic: Money has an earning capacity. If you have money today, you can invest it to earn interest, making it grow over time.
Relevance: Financial decisions (investments, loans) involve cash flows occurring at different points in time. To compare them validly, they must be adjusted to a common point in time.

7. Time Preference for Money

Why do individuals prefer to receive money now rather than later?

Investment Opportunities: Money received today can be invested to earn a return.
Inflation: Purchasing power of money generally declines over time due to rising prices.
Risk/Uncertainty: The future is uncertain. There is a risk the promisor may default.
Preference for Consumption: Most people prefer current consumption over future consumption (subjective urgency).

8. TVM Techniques: Compounding and Discounting

Compounding: The process of finding the Future Value (FV) of a current cash flow. (Moving forward on the timeline).
Discounting: The process of finding the Present Value (PV) of a future cash flow. (Moving backward on the timeline).

Notations used:

$PV$ = Present Value (Principal)
$FV$ = Future Value
$r$ = Interest rate per period (also called $k$ or $i$ )
$n$ = Number of periods (years)
$A$ = Annuity amount (periodic payment)

A. Future Value of a Single Cash Flow

How much will a lump sum today grow to in the future?

Formula:

FV_n = PV \times (1 + r)^n

The term $(1 + r)^n$ is called the Future Value Interest Factor (FVIF).

Example:
Deposit $1,000 at 10% for 3 years.

FV = 1000 \times (1 + 0.10)^3

FV = 1000 \times 1.331 = \$1,331

B. Present Value of a Single Cash Flow

How much is a future lump sum worth today?

Formula:

PV = \frac{FV_n}{(1 + r)^n} = FV_n \times (1 + r)^{-n}

The term $(1 + r)^{-n}$ is called the Present Value Interest Factor (PVIF) or Discount Factor.

Example:
You need $1,331 in 3 years. Interest is 10%. How much to deposit today?

PV = \frac{1331}{(1.10)^3} = \frac{1331}{1.331} = \$1,000

C. Future Value of an Annuity

An Annuity is a series of equal cash flows occurring at equal intervals.

Ordinary Annuity: Payments occur at the end of each period.
Annuity Due: Payments occur at the beginning of each period.

(Note: Unless specified, "Annuity" usually refers to Ordinary Annuity).

Formula (Ordinary Annuity):

FV_{annuity} = A \times \left[ \frac{(1 + r)^n - 1}{r} \right]

The term in brackets is the Future Value Interest Factor for an Annuity (FVIFA).

Example:
Deposit $1,000 at the end of each year for 3 years at 10%.

FV = 1000 \times \left[ \frac{(1.10)^3 - 1}{0.10} \right]

FV = 1000 \times \left[ \frac{0.331}{0.10} \right] = 1000 \times 3.31 = \$3,310

D. Present Value of an Annuity

What is the current worth of a stream of equal future payments? This is used for loan amortization and pension calculations.