Principles of finance

Jagannath University

Our Presentation On

Prepared by: The Executives

Md. Rasul Amin ChowdhuryB130202119

Introduction To FinanceWhat is Finance?The Science and the Art of managing

money.Finance means the money resources that

areused to run a business , an activity or a

project.Finance means the activity of managing the

money resources by a government or a commercial organization.

Introduction To Finance

In a business context , finance involveshow firms raise money from investor,

how firms invest money in an attempt to earn a profit, and how they decide whether to reinvest profits in the business or distribute them back to investors.

Categories Of Finance

Personal FinanceCorporate FinancePublic Finance

Categories Of Finance: Personal Finance

• Personal Finance may involve paying for education, financing durable goods such as real estate and cars, buying insurance , e.g. health and property insurance , investing and saving for retirement.

• It may involve paying for a loan ,or debt obligation

Categories Of Finance: Personal Finance

• Financial Position • Adequate Protection• Tax Planning• Investment and Accumulation goals• Retirement Planning• Estate Planning

Categories Of Finance: Corporate Finance

• Corporate Finance is the area of financing dealing with the sources of funding and the capital structure of corporations and the actions that mangers take to increase the value of the firm to the shareholders, as well as the tools and analysis used to allocate financial resources.

Categories Of Finance: Public Finance

• Public Finance describes as related to sovereign states and sub-national entities (states/ provinces, countries, municipalities, etc.) and related public entities (e.g. school districts) or agencies.

Functions Of Finance

• Financial Planning: Estimating the funds requirements of a firm and determining the sources of funds.

• Identification of sources of Fund: Identifying the cost effective sources of fund that ensure the profit of the firm.

• Raising of Fund: Soliciting and gathering money or other financial resources from the cost effective sources of fund.

Functions Of Finance

• Investment of Fund: Utilization of fund in appropriate times and in proper sequence to make profit.

• Protection of Investment: Making Investment wisely by considering risk of loss and protection of fund.

• Distribution of Profit: Deciding the distribution of all profits to the shareholders or retaining them in the firm for reinvestment.

Treasurer

• Capital Budgeting• Cash Management• Commercial Banking and investment• Banking Relationship• Credit Management• Dividend Disbursement• Financial analysis and planning• Investor relation• Pension Management• Insurance/ Risk Management• Tax analysis and planning

Controller

• Cost accounting• Cost Management• Data Processing General Ledger (Payroll,

accounts receivable/ payable• Government reporting • Internal Control• Preparing Financial statements• Preparing Budgets• Preparing Forecasts

Goal Of Finance

• Profit Maximization: means maximizing the taka (monetary value) income of the firms. Firms commonly measure profits in terms of earning per share (EPS), which represents the amount earned during the period on behalf of each outstanding share of common stock.

Goal Of Finance

• Wealth Maximization: Wealth maximization means the net present value (or wealth) of a course of action to shareholders. Its focus on the genuine economic profit. NPV is the difference between PV of benefits and PV of its costs.

Principles Of Finance

• Principle 1: The Risk- Return Trade- Off

Saving allow for more future consumption.

Borrowers pay for using your savings.

Investors demand higher return for added risk


• Principles 2: The Time Value Of Money

Money has a value with respect to the time.

Money received today is worth more than money received in the future.

Compound interest- interest paid on interest.


• Principles 3: Cash- Not Profit –is KingWe should use cash flows to measure

the benefits that accrue from taking on anew project.

We will concerned with----- When the money hits our hand When we can invest it & start earning

interest on it


• Principles 4: Diversification Reduces Risk

Don’t put all your eggs in one basket.To diversify , place money in several

investments, not just one.Diversification reduces risk without

affecting expected return.


• Principles 5: All Risk Is Not EqualSome risk cannot be diversified

away.If stocks move in opposite directions,

combining them can eliminate variability.

If stocks move in same direction not all variability can be diversified away.


• Principle 6: The curse of Competitive Investment Markets

In efficient markets, information is instantly reflected in prices.

Cannot earn higher than expected profits from public information.

Difficult to “beat the market”– “bargains” don’t remain so for very long.


• Principles 7: Taxes Bias Business Decisions

Taxes influence the realized return of investments.

Maximize after –tax return.Compare investment alternatives on

an after-tax bias.


• Principles 8: Stuff Happens, or the Importance of Liquidity

Have funds available for the unexpected situation.

Without liquid funds: Long –term investments must be

liquidated. Results in lower price , tax

consequences, or missed opportunities.


• Principles 9: Nothing Happens Without a Plan

People spend money without thinking , but you can’t save without thinking about it.

Saving must be planned— Start off with a modest ,

uncomplicated plan. Later modify and expand your plan.

Md. Ibrahim KhalilB130202157


• Principles 10: The Best Protection Is Knowledge

Take responsibility for your financial affairs.

Protect yourself from incompetent advisors.

Take advantage of changes in the economy and interest rates.


• Principles 11: Protect Yourself Against Major Catastrophes

Have the right insurance begore a tragedy occurs.

Know your policy coverage.Insurance focus should be on major

catastrophes which can be financially devastating.


• Principles 12: The Time Dimension Of investing

Take more risk on Long-Term investments.

20 years –old investing retirement money likely earn more in the stock market than other investment alternatives.


• Principles 13: The Agency Problem Beware of the Sales Pitch

The agency problem- those who act as your agent may actually act in their own interests.

Find an advisor who fits your needs, is ethical and effective.


• Principles 14: Pay Yourself FirstFor most people , savings are residual.

Spend what you like , save what is left.

Pay yourself first so what you spend becomes the residual.

Reinforce the importance of long-term goals, ensuring goals get funded.


• Principles 15: Money Isn’t Everything.

Extend financial plans to achieve future goals.

See more than just Tk-know what is important in life.

Money doesn’t bring happiness , but facing expenses without the funding brings on anxiety.


• Principles 16: Just Do It !Making the commitment to get

started is difficult , but the following steps wil be easier.

One of your investment allies –TIME is stronger now than it ever will be.


• Principles 17: Transparency & Accountability in Finance

Information in financial report should be easy & communicative.

All information Should be included in financial report in order to take correct decisions that are made by users.


• Principles 18: Ethical Behavior is doing the right thing & ethical dilemmas are everywhere in finance

• Because unethical behavior eliminate trust , & without trust , business cannot interact.

Asha Akter MuktyB130202165

Interest Rate &

Term Structure

Interest Rate

• Interest rate is an equilibrium price ,expressed in percentage terms, at which demand and supply of funds (or Capital ) meet ,i.e. the rate at which the lenders are ready to lend and buyers are ready to buy.

• Equilibrium Price (Interest rate ) varies from one market to another.

Interest Rate

• Example :The “price” of capital in the property

market is different from the “price” of capital in the cotton market

Required Return

• It reflects the fund suppliers level of expected return.

• The minimum annual percentage earned by an investment that will induce individuals or companies to put money into a particular security or project

• The required rate of return (RRR) is used in both equity valuation and in corporate finance.

Determinants of Markets Interest Rate

• The quoted (or nominal) interest rate on a debt security (k) is composed of a real risk-free rate of interest ,K* plus several premium that reflect inflation, the risk of the security, and the marketability (or Liquidity).

K=K* + IP + DRP + LP + MRP + SR

Determinants of Markets Interest Rate

• K= The quoted or nominal rate of interest on a given security

• K*= The real risk-free rate of interest• IP= Inflation Premium• DRP= Default Risk Premium• LP= Liquidity Premium• MRP= Maturity Risk Premium• SP= Sovereign Risk

Real Risk-Free Rate of Interest (K*)

• K* is defined as the interest rate that would exist on a government –issued security (T-Bill) with a guaranteed payoff if no inflation were expected.

• The government –issued securities are considered as risk-free , since the chances of default of a government are minimal.

• Internationally the US T-bills are considered as risk –free rate of return.

Nominal/Quoted risk-free rate of interest (Krf)

• Krf is defined as the rate of interest on a security that is free of all risk.

• It is composed of both the real risk-free (k*) rate of interest and inflation Premium (IP).

Krf = K* + IP

Risk Premiums

• Inflation Premium (IP) :The expected average inflation over a life of the investment or security is usually inculcated in the nominal interest rate by the issuer of security to cover the inflation risk.

• Default Risk Premium (DRP): Default refers to the risk that the company might go bankrupt or close down & bonds or shares issued by the company may collapse.

Risk Premiums

• Liquidity Premium (LP) : A premium that investors will demand when any given security cannot be easily converted into cash , and converted at the fair market value.

• Maturity Risk Premium (MRP): The Maturity Risk Premium is linked to life of the security investment. The longer the maturity period , the higher the maturity risk premium.

Risk Premiums

• Sovereign Risk Premium (SRP) : Sovereign Risk is the additional risk associated with investing in an international company rather than the domestic market .The Sovereign Risk is higher for developing markets than for developed nations.

Term Structure Of Interest Rate

Term Structure Of Interest Rate

• Term Structure of Interest Rates show the relationship between the interest rate and the term to maturity of securities.

• Yield Curve: Yield Curve depicts the term structure of Interest rates.

• It is a graph of the relationship between the debts remaining time to maturity (x axis) and its yield to maturity (y axis).

Yield Curve

• Inverted Yield Curve• Normal Yield Curve• Flat Yield Curve

Inverted Yield Curve

• Inverted Yield Curve is a downward sloping yield curve that indicates generally cheaper long-term borrowing costs than short-term borrowing costs.

Normal Yield Curve

• Normal Yield Curve is an upward-slopping yield curve that indicates generally cheaper short-term borrowing costs than long-term borrowing costs.

ProblemsLahey Industries has outstanding a $1,000par value bond with an 8% coupon interestrate. The bond has 12 years remaining to itsmaturity date.a. If interest is paid annually, find the value of the

bond when the required return is : (1) 7% (2) 8% and(3) 10%b. Indicate for each case in part A whether the bond

is selling at a discount, at a premium, or at its par value.

c. Using the 10% required return , find the bond’s value when interest is paid annually.

Problems

• Calculate the risk premium for each of the following rating classes of long-term securities, assuming that the yield to maturity (YTM) for comparable Treasuries is 4.51%.

Rating class

Nominal Interest rate

AAA 5.12%

BBB 5.78%

B 7.82%

Problems

• The real rate of interest is currently 3%; the inflation expectation and risk premiums for a number of securities follow.

Security

Premium

Risk Premium

A 6% 3%

B 9 2

C 8 2

D 5 4

E 11 1

Problems• You have two assets and must

calculate their values today based on their different payment streams and appropriate required returns .Asset 1 has a required return of 15% and will produce a stream of 10% and will produce an end-of-year cash flow of $1200 in the first year, $1500 in the second year, and $850 in its third and final year.

Problems• Midland Utilities has outstanding a bond

issue that will mature to its $1000 par value in 12 years. The bond has a coupon interest rate of 11% and pays interest annually.

i. Find the value of the bond if the required return is (1) 11%, (2) 15% and (3) 8%.

ii. Plot your findings in part A on a set of required return (x axis) –market value of bond (y axis) axes.

Cost Of Equity

Cost Of Equity

• Cost of equity share capital may be defined as the minimum rate of return that a firm must earn on the equity part of the total investment in project in order to leave unchanged the market price of such share,

Cost Of Equity

• For the determination of cost of equity capital it may be divided into two categories:

External equity or new issue of equity shares.

Retained Earnings

Cost Of External Equity, Ke

• The cost of common stock equity is the rate at which investor discount the expected dividends of the firm to determine its share value.

Cost Of Common Stock ke

• Dividend Yield/ Dividend Price Approach

• Dividend Yield plus Growth in dividend Methods

• Earnings Yield Method• CAPM Approach

Dividend Yield/ Dividend Price Approach

• According to this approach , the cost of equity will be the rate of expected dividends which will maintain the present market price of equity shares.

• It ignores the importance of retained earnings on the market price of equity shares.

Dividend Yield/ Dividend Price Approach

Ke= D/NP (For new equity shares)

Ke= D/MP (For existing equity shares)

NP= Net Proceeds MP= Market Price D= Dividend

Dividend yield plus Growth in dividend methods

• According to this method , the cost of equity is determined on the basis of the expected dividend rate plus the rate of growth in dividend.

• This method is used when dividends are expected to grow at a constant rate.

Dividend yield plus Growth in dividend methods

Ke=D1/NP+g (For new equity shares)

Ke=D1/MP+g (for existing equity shares)

• g=growth rate in dividend

• D1=Expected dividend per share at the end of the year =D0(1+g)

Earning Yield Method

• According to this approach , the cost of equity is the discount rate that capitalizes a stream of future earnings to evaluate the shareholdings. It is called by taking earnings per share (EPS) into consideration.

Earning Yield Method

Ke=EPS/NP (For new equity shares)

Ke= EPS/MP (For existing equity shares)

• EPS=Earning Per Share = Net Profit Available to Common

Stock / Number of Shares Outstanding

CAPM Approach

Ke= Rrf +(Rm-Rrf) × β

Rrf = The expected risk –free return in market (government bond yield)

• Rm= Average return on market Portfolio

• β= Beta co-efficient for a particular company = The sensitivity to market risk for the security.

Cost Of Retain Earnings (kr)

• Retain earnings refer to undistributed profits of a firm.

• Retain earnings has a opportunity cost of dividends that are earned by the stockholder if they receive such earnings as dividend and invest this is another investment alternatives.

• Hence , shareholders expect a return on retained earnings at least equity.


• So the cost of Retain Earnings Kr is approximately equal to Ke.

Kr =Ke= D1/MP+g


• While calculating cost of retained earnings, two adjustment should be made:

• Income Tax Adjustment• Adjustment for Brokerage Cost


• Therefore , after these adjustments, cost of retained earnings is calculated as :

• Kr = Ke × (1-t) × (1-b)

• Ke =Cost of equity

• t= Rate of tax• b=cost of purchasing new securities

or brokerage cost.

Problems• Duke Energy has been paying

dividends steadily for 20 years. During that time , dividends have grown at a compound annual rate of 7%. If Duke Energy’s current stock price is $78 and the firm plans to pay a dividend of $6.50 next year , what is Duke’s cost of common stock equity?

ProblemsCost of common stock equity –CAPM . J&MCorporation common stock has a beta, β, of

1.2.The risk-free rate is 6% ,and the market

return is11%.a) Determine the risk premium on J&M

common stock.b) Determine the required return that J&M

common stock should provide.c) Determine J&M’s cost of common equity

using the CAPM.

Problems• Your firm Peoples Consulting group,

has been asked to consult on a potential preferred stock offering by Brave New World. This 15% preferred stock issue would sold at its par value of $35 per share. Flotation costs would total $3 per share. Calculate the cost of this Preferred stock.

Problems

• Ross Textiles wishes to measure its cost of common stock equity. The firm’s stock is currently selling for $57.50. The firm expects to pay a $3.40 dividend at the end of the year (2013).The dividends for the past 5 years are shown in the following table:

Year Dividend

2012 $3.10

2011 2.92

2010 2.60

2009 2.30

2008 2.12

Principles of finance

Business

Transcript of Principles of finance