Principles of finance

Our Presentation On
Prepared by:
The Executives

Md. Rasul Amin Chowdhury
B130202119

Introduction To Finance
What is Finance?
The Science and the Art of managing money.
Finance means the money resources that are
used 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 involves
how 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 Finance
Corporate Finance
Public 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

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

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.

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 King
We 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 Equal
Some 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.

• 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 First
For 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.

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.

Problems
Lahey Industries has outstanding a $1,000
par value bond with an 8% coupon interest
rate. The bond has 12 years remaining to its
maturity 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.
Securi
ty
Premiu
m
Risk
Premiu
m
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 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?

Problems
Cost of common stock equity –CAPM . J&M
Corporation common stock has a beta, β, of 1.2.
The risk-free rate is 6% ,and the market return
is
11%.
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

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