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Fundamental Concepts
Agenda
1. 2. 3. 4. Introduction to Financial Management Time value of Mooney Risk and Return Cost of capital
Financial Management
Management of Money Systematic efforts of the management to efficiently manage its finances Application of general management principles to particular financial operation
Dividend Decision
Profit Maximization
Agency Problem
Agency problem : The possibility of conflict of interest between stockholders and management of a firm. Conflicts of interest among stockholders, bondholders, and managers
The Time Value of Money (TMV) is based on the concept that a rupee today is worth more than it would be tomorrow.
FV
TVM
PV
What is PV?
Present Value is a value today of a sum of money to be received at a future points of time. We know that FV=PV ( 1 + r )n
So, PV = FVn / ( 1 + r)n Finding the PV of a cash flow or series of cash flows when compound interest is applied is called discounting (the reverse of compounding).
Worth of a Firm
Conceptually, a firm should be worth the present value of the firms cash flows. The tricky part is determining the size, timing, and risk of those cash flows.
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What is return ?
Return is difference between an investment amount today and when initially invested
Invested Rs. 1000 one year ago Today that investment is worth Rs.1200 Return ? Return is Rs.200
Expected Return
Expected Return is a weighted average of the individual possible returns
r j pj r
j 1
The symbol for expected return, r, is called r hat. r = Sum (all possible returns their probability)
Risk
Risk refers to the potential variability of returns from a project or portfolio of projects
Risk Premium
Risk Premium is the difference between the expected return on the proposed investment and the risk free rate.
R i RF i ( R M RF )
Expected return on a security RiskBeta of the = + free rate security
ej
ej
=>
Cost of Capital
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Agenda
Cost of Debt and
Cost of Preference
Cost of Equity
Weighted Average Cost of Capital
Note
Cost of capital is also called as
hurdle rate, cut-off rate, target rate, minimum required rate of return, standard return
Cost of Debt
kd after taxes = kb (1 tax rate) where kb is before tax cost of debt and kd is after tax cost of debt.
WACC is calculated by multiplying the cost of each capital component by its proportional weighting and then summing them.
Ends..