Financial Management
Lecture 1 & 2
Key Terms:
Principal (Loan Amount): This is the core amount borrowed (e.g., $350,000 for a mortgage) or the
remaining balance owed. It does not include fees or interest.
Interest (Cost of Borrowing): The fee charged for using the lender's money, calculated based on an
interest rate and the outstanding principal. It compensates the lender for risk.
Public Company: A publicly held company (or public company) is a corporation whose ownership
is distributed among the general public and is publicly listed on stock exchange.
Compounding: Adding interest on interest is called compounding.
Simple Interest → Interest only on original amount
Compound Interest → Interest on original + previous interest
Discounting: In mathematics (especially financial math), discounting is the process of finding the
present value (PV) of a future amount of money.
Simple Discounting → Discount is calculated only on the original (future) amount.
Compound Discounting → Discount is calculated on the amount after previous discounts
(present value keeps reducing each period).
Compounding → “If I invest today, how much will I get later?”
Discounting → “If I get money later, what is it worth today?”
Capital: Huge Sum of money used to start or run a business to generate income.
Free Cash Flow: It is an available amount that can be distributed among capital or finance
providers. It is the cash left after a company pays for its operating expenses and capital
expenditures (the action of spending funds).
Coupon Payment: A coupon payment is the regular, periodic interest payment made by a bond
issuer to an investor throughout the life of a debt instrument.
Inflation: Reduction of Buying Power.
Nominal: unadjusted not real value
Premium: Additional Cost on something
Default: It is the failure to fulfill the legal obligations of a loan or debt, such as missing interest or
principal payments on a bond or loan.
Maturity: In finance, maturity (or the maturity date) refers to the specific, pre-agreed date when a
loan, bond ends and the final payment is due.
Bond: A bond is a fixed-income financial instrument representing a loan made by an investor to a
borrower (typically corporate or governmental)
Treasury Bonds: Treasury bonds are long-term, safe-haven debt securities issued by the State with
20 or 30-year maturities.
Corporate Yield: Corporate yield is the rate of return investors demand from a corporate bond (a
bond issued by a company).
It is higher than Treasury yield because companies carry more risk.
Corporate Yield = r* + IP + MRP + DRP + LP
Real Risk-Free Rate = r*
Inflation Premium = IP
Maturity Risk Premium = MRP
Default Risk Premium = DRP
Liquidity Premium = LP
Corporate Yield = Treasury Yield + Extra Premiums
Treasury yield: A Treasury yield is the rate of return investors earn on a government bond. Because
it is issued by the government, it is considered default-risk free.
Treasury Yield=r∗ + IP + MRP
Maturity Risk Premium = MRP
Real Risk-Free Rate = r*
Inflation Premium = IP
Business Finance
Problem: In Introduction to Business Finance, we ask how to generate capital?
Solution:
We generate capital by two means
1. Equity (i.e. Shareholder or Owner equity)
2. Debt (i.e. From Financial Institutions or Bonds)
Financial Management
Problem: How to manage the capital? (Management is the objective)
In Finance we don’t discuss non-financial data or the data that is not measurable.
Objective:
The primary and fundamental objective of financial management is Value Maximization.
The fundamental tool is Forecasting.
Profit Maximization
Short Term
Accounting Based
Ignore risk and time
Value Maximization
Long Term
Market Based
Consider risk and time
Example: A company invests 15% for R &D annually, for profit maximization they cut off that
investment so temporarily profit is increased on balance sheet but it will decrease its value
because it does know the future trends or technology and company will not be relevant in the
coming event.
Capital or Finance Providers
Capital or Finance Providers are individuals, institutions, or entities that supply financial resources
(capital) to businesses, projects, or governments to enable them to operate, grow, and generate
returns.
Capital or Finance Providers are as follows:
1. Share or Stock Holder (gets return or dividend)
2. Bond Holder (gets interest or coupon payment)
Different perspective of Interest and Return
From company point of view:
A company gets capital and give extra charges back to the investor. It is an expense for the company
and also called cost.
From Investor point of view:
An investor invests in a company and get the extra charges the company needs to pay for borrowing
money. It is revenue for Investor. It is also called return.
As return and cost are used interchangeably.
Company
Expense
Cost
Investor
Revenue
Return
Present and Future Value
Question: There is a person who says that I will give you 1000 Rs Now or that same 1000 Rs after 1
year. We will definitely take the first one (now).
Why? Because There are 3 Reasons for this
Investment opportunity
We can invest that same amount or give at interest of 10% so we will get 1100 after a Year so why
take 1000 after a year.
Inflation
Inflation is another factor e.g. if I want to buy something today of 1000 Rs but it becomes of 1050 a
year later so it will exceed my buying capacity.
Risk of uncertainty
Example: May be is he is not able to pay that money after a year.
If we invest 1000 Rs today at 10% interest rate we will get 1100 Rs after a year so
Present Value (PV)
1000 Rs
Future Value (FV)
1100 Rs
Equation for calculating Present Value:
𝐹𝑉
𝑃𝑉 = (1+𝑖)𝑛
𝑖 𝑛𝑡
𝐹𝑉 = 𝑃𝑉 × (1 + )
𝑛
PV = Final amount
FV = Future Value
i = Annual interest rate (in decimal, e.g., 10% = 0.10)
n = Number of times interest is compounded per year
t = Time in years
If compounded once a Year or Annually:
𝐹𝑉 = 𝑃𝑉 × (1 + 𝑖)𝑡
The Present Value could be of anything e.g.
PV→ Sale
PV→ Asset
PV→ Cash Flow
DCF – Discounted Cash Flow
The value of a firm is the present value of future cash flows
𝑛
𝑉=∑
𝑡=1
𝐹𝐶𝐹𝑡
(1 + 𝑖)𝑡
If we are valuing whole company
𝑛
𝑉=∑
𝑡=1
𝐹𝐶𝐹𝑡
(1 + 𝑊𝐴𝐶𝐶)𝑡
V = Value of Firm
𝐹𝐶𝐹𝑡 = Free cash flow at time t
WACC = Risk/Cost
T = Time
Relation between Value of Firm and Free cash flow and Risk/cost.
V ∝ 𝐹𝐶𝐹𝑡
The Value of Firm (V) has direct relation with 𝐹𝐶𝐹𝑡 or Free Cash Flow at time t, it means if one value increases
the other also increases.
1
V ∝ 1+𝑊𝐴𝐶𝐶
The Value of firm has an inverse relation with WACC (cost/risk), It Means if one value increases the
other value decreases.
It is mostly used to increase the stock price by reducing cost or risk as much as possible.
Different Perspective and usage of this Formula:
V = Value of Firm
Value of the firm → Firm Perspective
Maximizing shareholder wealth → Investor Perspective
Maximizing the stock price → Market Perspective
Time:
Time is an important factor in calculation a value of anything either it is a firm or a stock price.
There are two times one is present and other is future. Calculation the value of the given thing at
present or future can come in handy.
To calculate the Present Value, we use Discounting.
𝑃𝑉 =
𝐹𝑉
(1 + 𝑖)𝑛
PV = Final amount
FV = Future Value
n = Number of times interest is compounded per year
i = Annual interest rate (in decimal, e.g., 10% = 0.10)
t = Time in years
To calculate The Future value, we use compounding.
𝐹𝑉 = 𝑃𝑉 × (1 + 𝑖)𝑡
Pillars in Financial Management:
There are two pillars in financial management.
The main and fundamental pillar is Interest rate and that pillar is erected on another pillar of
forecasting. Forecasting is also called Projection and Estimation.
Q) Why we need Forecasting?
The fundamental reason for forecasting is that because our consumption pattern is different.
Some people consume more some consume less and save. That saving of extra resources is the
basis of interest.
e.g.
resource
Saver
Borrower
Q) Ahmad wants to borrow 500 Rs. He goes to his one friend A who says he will have to give 530 Rs
at the end of year, now he goes to his second friend B who says he will need to pay 520 Rs, now he
goes to his third friend C who says he need to pay only 510 Rs at the end of the year.
We see from this statement that different people have different interest rates, The Question is Why?
Ans) There are different factors that determinate interest rate as what interest rate it should be.
Real Risk-Free Rate:
Definition:
The theoretical interest rate that would exist if there were no inflation and no risk of default.
Denotation:
It is denoted by r*
Nominal Risk-Free Rate:
Nominal (unadjusted not real value)
Nominal Risk-Free Rate is that rate that is risk free but without Inflation.
Premium (Additional Cost)
Nominal Risk-Free Rate = r* (Real Risk-Free Rate) + IP (Inflation Premium)
If there is no Risk involved and no risk of default but we still get a premium because of time claim.
“Economics is called the mother of social sciences”.
Economics is the social science that studies how individuals, businesses, governments, and
nations make choices about allocating limited or scarce resources—such as time, money, and raw
materials—to satisfy unlimited wants.
DRP (Default Risk Premium):
A default risk premium is the additional interest rate for holding a bond or loan from a borrower with
a risk of defaulting.
State bank have your credit history and gives your debt burden ratio to banks from where you want
to avail a loan.
MRP (Maturity Risk Premium):
A maturity risk premium is the extra return for holding long-term bonds instead of short-term ones,
compensating for risks like interest rate changes and inflation over time.
LRP (Liquidity Risk Premium):
A liquidity risk premium is the additional return or higher yield investors demand for holding assets
that cannot be easily converted into cash at fair market value e.g. A bank cannot easily sell a real
estate that easily but it can sell a car quickly.