Financial Management & Risk Analysis

BBACO302
Module -1

MEANING OF FINANCE

Finance may be defined as the art and science of managing money. It includes
financial service and financial instruments. Finance also is referred as the
provision of money at the time when it is needed. Finance function is the
procurement of funds and their effective utilization in business concerns

Definition:

According to GUTHMANN and DOUGALL, business finance may be broadly

defined as “the activity concerned with the planning, raising, controlling and
administering the funds used in the business.”

Financial decisions refer to decisions concerning financial matters of a business

firm. There are many kinds of financial management decisions that the firm
makers in pursuit of maximizing shareholder‟s wealth, viz., kind of assets to be
acquired, pattern of capitalization, distribution of firm‟s income etc. We can
classify these decisions into three major groups:

 Investment decisions
 Financing decision.
 Dividend decisions.
 Working capital decisions.

NATURE OF FINANCE FUNCTION:

I. In most of the organizations, financial operations are centralized. This

results in economies.

II. Finance functions are performed in all business firms, irrespective of

their sizes /legal form of organization.
III. They contribute to the survival and growth of the firm.

IV. Finance function is primarily involved with the data analysis for use in
decision making.

V. Finance functions are concerned with the basic business activities of a

firm, in addition to external environmental factors which affect basic
business activities, namely,production and marketing.

VI. Finance functions comprise control functions also

VII. The central focus of finance function is valuation of the firm. Finance
makes use of economic tools. From Micro economics it uses theories
and assumptions. From Macro economics it uses forecasting models.
Even
SCOPE OF FINANCIAL MANAGEMENT:

The main objective of financial management is to arrange sufficient finance

for meeting short term and long term needs. A financial manager will have
to concentrate on the following areas of finance function.

1. Estimating financial requirements:

The first task of a financial manager is to estimate short term and long term
financial requirements of his business. The amount required for purchasing
fixed assets as well as needs for working capital will have to be ascertained.

2. Deciding capital structure:

Capital structure refers to kind and proportion of different securities for
raising funds. After deciding the quantum of funds required it should be
decided which type of securities should be raised. A decision about various
sources for funds should be linked to the cost of raising funds.

3. Selecting a source of finance: An appropriate source of finance is

selected after preparing a capital structure which includes share capital,
debentures, financial institutions, public deposits etc. If finance is needed
for short term periods then banks, public deposits and financial institutions
may be the appropriate. On the other hand, if long term finance is required
then share capital and debentures may be the useful.

4. Selecting a pattern of investment: When funds have been procured

then a decision about investment pattern is to be taken. A decision will
have to be taken as to which assets are to be purchased? The funds will
have to be spent first on fixed assets and then an appropriate portion will be
retained for working capital and for other requirements.

5. Proper cash management: Cash management is an important task of

finance manager. He has to assess various cash needs at different times and
then make arrangements for arranging cash. Cash may be required to
purchase of raw materials, make payments to creditors, meet wage bills and
meet day to day expenses. The idle cash with the business will mean that it
is not properly used.

6. Implementing financial controls: An efficient system of financial

management necessitates the use of various control devices. They are ROI,
break even analysis, cost control, ratio analysis, cost and internal audit.
ROI is the best control device in order to evaluate the performance of
various financial policies.

7. Proper use of surpluses: The utilization of profits or surpluses is also an

important factor in financial management. A judicious use of surpluses is
essential for expansion and diversification plans and also in protecting the
interests of share holders. A balance should be struck in using funds for
paying dividend and retaining earnings for financing expansion plans.
EVOLUTION OF FINANCE FUNCTION:

Financial management came into existence as a separate field of study from

finance function in the early stages of 20th century. The evolution of
financial management can be separated into three stages:

1. Traditional stage (Finance up to 1940): The traditional stage of

financial management continued till four decades. Some of the important
characteristics of this stage are:

i) In this stage, financial management mainly focuses on specific

events like formation expansion, merger and liquidation of the firm.

ii) The techniques and methods used in financial management are

mainly illustrated and in an organized manner.

iii) The essence of financial management was based on principles

and policies used in capital market, equipments of financing and

lawful matters of financial events.
iv) Financial management was observed mainly from the

prospective of investment bankers, lenders and others.

2. Transactional stage (After 1940): The transactional stage started in the
beginning years of 1940‟s and continued till the beginning of 1950‟s. The
features of this stage were similar to the traditional stage. But this stage
mainly focused on the routine problems of financial managers in the field
of funds analysis, planning and control. In this stage, the essence of
financial management was transferred to working capital management.
3. Modern stage (After 1950): The modern stage started in the middle of
1950‟s and observed tremendous change in the development of financial
management with the ideas from economic theory and implementation of
quantitative methods of analysis. Some unique characteristics of modern
stage are:
 i) The main focus of financial management was on proper utilization

of funds so that wealth of current share holders can be maximized.

ii) The techniques and methods used in modern stage of financial

management were analytical and quantitative.

Since the starting of modern stage of financial management many
important developments took place. Some of them are in the fields of
capital budgeting, valuation models, dividend policy, option pricing theory,
behavioral finance etc.

ROLE OF FINANCIAL MANAGEMENT IN CONTEMPORARY

SCENARIO:
GOALS OF FINANCE FUNCTION
Effective procurement and efficient use of finance lead to proper utilization
of the finance by the business concern. It is the essential part of the
financial manager. Hence, the financial manager must determine the basic
objectives of the financial management. Objectives of Financial
Management may be broadly divided into two parts such as:

1. Profit maximization

2. Wealth maximization.

1 .Profit Maximization

Main aim of any kind of economic activity is earning profit. Profit is the
measuring techniques to understand the business efficiency of the concern.
Profit maximization is also the traditional and narrow approach, which aims
at, maximizing the profit of the concern. Profit maximization consists of the
following important features.

1. Profit maximization is also called as cashing per share

maximization. It leads to maximize the business operation for

 profit maximization.
2. Ultimate aim of the business concern is earning profit, hence, it

considers all the possible ways to increase the profitability of the

concern.
3. Profit is the parameter of measuring the efficiency of the business

concern. So it shows the entire position of the business concern.

4. Profit maximization objectives help to reduce the risk of the business.

Unfavorable Arguments and Drawbacks for Profit Maximization

The following important points are against the objectives of profit maximization:

(i) Profit maximization leads to exploiting workers and consumers.

(ii) Profit maximization creates immoral practices such as corrupt

practice, unfair trade practice, etc.

(iii) Profit maximization objectives leads to inequalities among the

stake holders such as customers, suppliers, public shareholders, etc.

Profit maximization objective consists of certain drawback also:
 (i) It is vague: In this objective, profit is not defined precisely or
correctly. It creates some unnecessary opinion regarding earning
habits of the business concern.
(ii) It ignores the time value of money: Profit maximization does

not consider the time value of money or the net present value of the
cash inflow. It leads certain differences between the actual cash
inflow and net present cash flow during a particular period.
(iii) It ignores risk: Profit maximization does not consider risk of

the business concern. Risks may be internal or external which will

affect the overall operation of the business concern.

Wealth Maximization

Wealth maximization is one of the modern approaches. The term wealth

means shareholder wealth or the wealth of the persons those who are
involved in the business concern. Wealth maximization is also known as
value maximization or net present worth maximization. This objective is an
universally accepted concept in the field of business .

Stockholder‟s current wealth in a firm = (Number of shares owned) x(Current Stock

Price share)

Favorable Arguments for Wealth Maximization

(i) Wealth maximization is superior to the profit maximization

because the main aim of the business concern under this

concept is to improve the value or wealth of the shareholders.
(ii) Wealth maximization considers the comparison of the value to

cost associated with the business concern. Total value detected

from the total cost incurred for the business operation. It
provides extract value of the business concern.
 (iii) Wealth maximization considers both time and risk of the

business concern. (iv)Wealth maximization provides

efficient allocation of resources.
(v) It ensures the economic interest of the society.
Unfavorable Arguments for Wealth Maximization

(i) Wealth maximization leads to prescriptive idea of the business

concern but it may not be suitable to present day business activities.
(ii) Wealth maximization creates ownership-management controversy.
(iii) Management alone enjoy certain benefits.
(iv) The ultimate aim of the wealth maximization objectives is to maximize the
profit.
(v) Wealth maximization can be activated only with the help of the
profitable position of the business concern.

MAXIMIZING VS SATISFYING
As share holders are the real owners of the organization, they appoint
managers to take important decisions with the objective of maximizing
share holder‟s wealth. Though organizations have many more objectives,
but maximizing stock price is considered to be an important objective of all
for many firms.

1) Stock price maximization and social welfare: It is

advantageous for society, if firm maximize its stock price. But, firm
must not have any intentions of forming monopolistic market,
creating pollution and avoiding safety measures. When stock prices
are maximized, it benefits society by:
i) To greater extent the owners of stock are society: In past,

ownership of stock was with wealthy people in society. But now,

with the tremendous growth of pension funds, life insurance
companies and mutual funds, large group of people in society have
ownership of stock either directly or indirectly. Hence, when stock
price is increased, it ultimately improves the quality of life for many
people in society.

ii) Consumers benefit: It is necessary to have effective low-cost

businesses which manufacture good quality of goods and services at

the cheapest cost possible to maximize stock price. Companies
which are interested in maximizing stock price must satisfy all
requirements of customers, provide good services and innovate new
products finally; it must increase its sales by creating value for
customers. Some people believe that firms increase the prices of
goods while maximizing stock price. But it is not true; in order to
survive in competitive market firms does not increase prices
otherwise they may lose their market share.

iii) Employees benefit: In past years, it was an exception that

decreases in level of employees lead to increase in stock price, but

now a successful company which can increase stock price can
develop and recruit more employees which ultimately benefits the
society. Successful companies take advantage of skilled employees
and motivated employees are an important source of corporate
success.

2) Managerial Actions to Maximize Shareholder’s Wealth: In

 order to identify the steps taken by managers to maximize
shareholder‟s wealth, the ability of the organization to generate cash
must be known. Cash flows can be determined in three ways, they
are:
i) Unit Sales: In first determinant, managers can increase the level

of their sales either by satisfying customers or by luck, but which

will not continue in long run.
ii) After Tax Operating Margins: In second determinant,
managers can generate cash flows by increasing operating profit
which is not possible in competitive environment or by decreasing
direct expenses.
iii) Capital Requirements: In third determinant, managers can
increase cash flows by decreasing assets requirements which
ultimately results in increase of stock price.
Investment and financing decisions have an impact on
level, timing and risk of the cash flow of firm and finally on
stock price. It is necessary for manager to make decisions
which can maximize the stock price of the firm.

3) Maximizing Earnings Per Share is Beneficent or Not:

In order to maximize stock price, many analyst focus on cash

flows by evaluating the performance of the company and
also focus of EPS as an accounting measure. Along with cash
flow, EPS also plays an important role in identifying
stockholder‟s value.
DIFFERENCE BETWEEN PROFIT AND WEALTH MAXIMIZATION

Goal Objective Advantages Disadvantages

Profit Large amount of -Easy to calculate profits. -Emphasizes the short

profits term.
maximizatio
n -Easy to determine the -Ignores risk
link oruncertainty.
between financial
decisions -Ignores timing of
the
and
profits. Returns.
-Requires immediat
e
Resources.
Stockholder Highest market value -Emphasizes the long -Offers no clear
of term. relationship
wealth common stock - risk or between financial
Recognize decisions
s
maximizatio Uncertaint and stock price.
n y.
-Consider stockholders -Can lead to
management
return. anxiety and frustration.
PROFIT VS. WEALTH VS. WELFARE

S.NO. PROFITMAXIMIZATI WEALTH WELFAR

ON MAXIMIZATION E
MAXIMIZATION

1) Profits ar earned Wealth is maximized, so Welfare

e that maximization is
maximize so tha firm wealth of share-holders can done with the help of
d, t be micro
can over-come future maximized economic techniques
risks . to
which are examine a
uncertain. locative
distributio
n.
2) Profit maximizati is a In wealt maximizatio In welfar maximization,
on h n e
yards stic for calculatin stockholde current is social is evaluate
k g rs wealth welfare d
efficienc an economic evaluated in order to b calculati economi
y d maximize y ng c
prosperity of the the value of shares in activitie o individua in
concern. the s f ls
market. the
society.
3) Profit is measured in Wealth is measured in Welfare can be measured
 terms terms of in
of efficiency of the market price of shares. two ways, either by pare
firm. to
efficiency or in
units or
dollars.

4) Profit maximization Wealth maximization Wealth maximization

involves
Involves problem problems related to involves problem of
of
uncertainty because maximizin shareholder combini th utilitie of
profits g ‟s ng e s
are uncertain. wealth or wealth of the different
firm people.
AGENCY RELATIONSHIP AND COST:

The relationship that exists in an organization between share holders

and management known as agency relationship. Agency relationship
results when a principal hires an agent to perform part of his duties.

Agency Problem: In this type of relationship there is a chance of

conflicts to occur between the principal and the agent. This conflict is
termed as agency problem.

Agency Costs: The costs incurred by stockholders in order to

minimize agency problem and maximize the owner‟s wealth are
called agency costs.

The two primary agency relationships exists in a business concern are:

1) Shareholders Vs Bondholders

2) Manager Vs Share holders

1) Agency conflict-I (Shareholders Vs Bondholders):

Shareholders are the real owners of the concern, they pay

fixed and agreed amount of interest to bondholders till the
duration of bond is finished but bondholders have a
proceeding claim over the assets of the company. Since
equity investors are the owners of the company they
possess a residual claim on the cash flows of the company.
Bondholders are the only sufferers if decisions of the
company are not appropriate.
When a company invest in project by taking amount from
bondholders and if the project is successful, fixed amount is paid to
bondholders and rest of the profits are for shareholders and suppose
if project fails then sufferers will be the bondholders as their money
have been invested.
 2) Agency conflict-II (Managers Vs Shareholders): Profits

generated from investments in projects can be utilized for

reinvestment or provided back to shareholders as dividends. If
dividends are increased, it may leads to decrease in the resources
which are under the manager‟s control and also strict its growth. As
managers are evaluated on the basis of growth they might go for
unproductive projects which cannot generate appropriate returns,
which make the shareholders, feel shocked. This is the main cause
of conflicts between managers and shareholders.

RISK RETURN TRADE-OFF

The Risk-Return Trade-Off is an essential concept in

finance theory. Risk implies the changes in expected return
like sales, profits or cash flow and it also includes probability
that problem.

Risk analysis is a procedure of calculating and

examining the risk which is related to financial and
investment decision of the company. Finance managers must
focus on expected rate of return by comparing the level of
risks involved in investment decision. When it is expected
that rate of return will be high then it involves high level of
risk and vice versa.

Types of Risk:
1. Systematic Risk:
Market risk, interest rate risk and purchasing power risk are grouped under systematic risk.
They are explained as under:
(i) Market Risk:
It is referred to as stock variability due to changes in investor’s attitudes and expectations. The
investor’s reaction towards tangible and intangible events is the chief cause affecting market
risk. Market risk cannot be eliminated but it can be reduced. Market risk includes such factors
as business recessions, depressions and long term changes in consumption in the economy.
(ii) Interest Rate Risk:
There are four types of movements in prices of stocks in the market. These may be termed as
long term, cyclical, intermediate and short term. Traditionally, investors could attempt to
forecast cyclical savings in interest rates and prices merely by forecasting ups and downs in
general business activity.
The effect of interest rate can be different for lending institution and borrowing institution. In
India, a combination of factors have produced a situation where it is difficult to accurately find
out the changes in interest rates.
(iii) Purchasing Power Risk:
It is also known as inflation risk. It arises out of changes in the prices of goods and services and
technically it covers both inflation and deflation periods. In India, purchasing power risk is
associated with inflation and rising prices. All investors should have an approximate estimate in
their minds before investing their funds of the expected return after making an allowance for
purchasing power risk.
2. Unsystematic Risk:
It arises out of the uncertainty surrounding a particular firm or industry due to factors like
labour strike, consumer preferences and management policies.
The two kinds of unsystematic risks in a business organisation are business risk and
financial risk which are explained below:
(i) Business Risk:
Every firm has its own objectives and aims at a particular gross profit and operating income. It
also hopes to plough back some profits. Business risk is also classified into internal business
risk and external business risk. Internal business risk may be represented by a firm’s limiting
environment within which it conducts its business. External risks are due to many factors and
some of the important factors are business cycle, demographic factors, political policies,
monetary policy and the economic environment of the economy.
(ii) Financial Risk:
It is associated with the method through which it plans its financial structure. If the capital
structure of a company tends to make earnings unstable, the company may fail financially.
Large amounts of debt financing also increase the risk. Financial risk can be stated as being
between Earnings before Interest and Taxes, and Earnings Before Taxes.
Measurement of Risk:
A number of techniques have been suggested by economists to deal with risk in investment
appraisal.
Some of the popular techniques used for this purpose are as follows:
1. Risk Adjusted Discount Rate Method:
This method calls for adjusting the discount rate to reflect the degree of the risk of the project.
The risk adjusted discount rate is based on the presumption that investors expect a higher rate of
return on risky projects as compared to less risky projects.
The rate requires determination of (i) risk free rates and (ii) risk premium rate. Risk free rate is
the rate at which the future cash inflows should be discounted. Risk premium rate is the extra
return expected by the investor over the normal rate.
The adjusted discount rate is a composite discount rate. It takes into account both time and risk
factors.
Illustration:
A project with an outlay of Rs. 4,00,000, its risk adjusted discount rate is estimated at 18
per cent. The data on cash flow is as follows:
Should the project be accepted or rejected?
Accept the project: if NPV > 1
Reject the project: if NPV < 1
Using the risk adjusted discount rate we find that

2. The Certainty Equivalent Approach:

According to this method, the estimated cash flows are reduced to a conservative level by
applying a correction factor termed as certainty equivalent coefficient. The correction factor is
the ratio of riskless cash flow to risky cash flow.
The certainty equivalent coefficient which reflects the management’s attitude towards risk is
Certainty Equivalent Coefficient = Riskless Cash Flow/Risky Cash Flow
Example:
A project is expected to generate a cash of Rs. 40,000. The project is risky but management
feels that it will get at least a cash flow of Rs. 24,000. It means that certainty equivalent
coefficient is 0.6.
Under the certainty equivalent method the net present value is calculated as:

Where
αt = Certainty Equivalent Coefficient
At = Expected Cash Flow for year t
I = Initial outlay on the project
i = Discount rate
Illustration:
Pioneer Concern is considering a project with initial outlay of Rs. 18,00,000 with a risk free
discount rate of 1.05 per cent. The expected cash flow and certainty equivalent coefficient are
given below. What is NPV of the project?

3. Sensitivity Analysis:
The future is not certain and involves uncertainties and risk, the cost and benefits projected over
the lifetime of the project may turn out to be different. This deviation has an important bearing
on the selection of a project.
If the project can stand the test of changes in the future, affecting costs and benefits, the project
would qualify for selection. The technique to find out this strength of the project is covered
under the sensitivity analysis of the project. This analysis tries to avoid over estimation or
underestimation of the cost and benefits of the project.
In sensitivity analysis, we try to find out the critical elements which have a vital bearing on the
costs or benefits of the project. In investment decision, one has to consider as many elements of
uncertainty as possible on costs or benefits side and then arrive at critical elements which effect
the expected costs or benefits of the project.
How many variables should be tested to carry out the sensitivity analysis in order to find out its
impact on costs or benefits of the projects is a matter of judgement. In sensitivity analysis, one
has to consider the changes in the various factors correlated with changes in the other. In order
to arrive at the degree of uncertainty, the decision maker has to make alternative calculation of
costs or benefits of the project.
Sensitivity analysis is a simulation technique in which key variables are changes and the
resulting change in the rate of return is observed. Some of the key variables are cost, prices,
project life, market share, etc.
Usually this analysis provides information about cash flows under the assumptions:
(i) Pessimistic,
(ii) Most likely, and
(iii) Optimistic.
It explains how sensitive the cash flows are under these three different situations. If the differ-
ence is larger between the optimistic and pessimistic cash flows, the more risky is the project.
Illustration:
Pioneer Company Ltd. is attempting to evaluate two projects A and B. Each project requires a
net investment of Rs. 10,000 and the annual cash flows from each of the project is estimated at
Rs. 2,000 p.a. in the next 15 years. The company’s cost of capital may be taken at 10%. In order
to arrive at a decision about the selection of the project, the following data have been
ascertained regarding the NPV of cash flows of each project.

4. Probability Theory Approach:

Yet another method for dealing with risks is to estimate the value for a result. Each value of
prospective result is assigned a probability. Here one has to see a range of possible cash flows
from the most optimistic to the most pessimistic for each pertinent year. Probability means the
likelihood of happening an event.
It may be objective or subjective. An objective probability is based on a large number of
observations under independent and identical conditions repeated over a period of time. A
subjective probability is based on personal judgement. In capital budgeting decisions the
probabilities are of a subjective type since they are based on a single event.
Process of Assigning Probabilities:
Here let us see the process of assigning probabilities.
It is subject to certain rules and they are:
(i) List of events collectively expansive
(ii) Events must be mutually exclusive
(iii) The numerical probabilities must add up to 1.
Basic Probability Theorem:
We must see certain basic theorems relating to a probability theory.
These are as follows:
(i) The probability of an event is always a number between 0 and 1 inclusive. If an event is sure
to occur, its probability is by definition equal to 1. If it is certain that it will not occur its
probability is 0.
(ii) If ‘n’ events are equally likely and only one of them may happen, then the probability of
that event is 1/n.
(iii) If two events are mutually independent and the probabilities of one is PI while that of other
P2, the probability of the events occurring together is the product of P1, P2.
(iv) If the events are mutually exclusive and the probability of the one is PI while that of the
other is P2, the probability of either one or the other occurring is the sum P1+P2.
Illustration:
Pioneer Company Ltd. has given the following possible cash inflows for two of their projects A
and B. Both the projects will require an equal investment of Rs. 5,000. Let us compute expected
monetary values for the projects A and B.
The above table shows that Project B has higher monetary value as compared to Project A.
Therefore, Project B is preferable.
5. Standard Deviation:
Subjective judgment of the decision makers plays a crucial role in practice to resolve the prob-
lem which may turn out to be imprecise or biased. There is no precise way to find the
probabilities of different outcomes. This limitation is overcome by adoption of standard
deviation approach.
The standard deviation is defined as the square root of the mean of the squared deviations of all
the items from the mean and it is usual to denote it by the small Greek “Sigma”, σ. In the case
of capital budgeting, this measure is used to compare the variability of possible cash flows of
different projects from their respective mean or expected values.
Steps to be followed for calculating the S.D. of the possible cash flows:
(i) Compute the mean value of the possible cash flows.
(ii) Find out the deviation between the mean value and the possible cash flows.
(iii) Square the deviations.
(iv) Multiply the squared deviations by the assigned probabilities to get the weighted squared
deviations.
(v) The sum of the weighted squared deviations and their square root are calculated. The result
gives the S.D.
.
6. Coefficient of Variation:
Standard deviation is expressed in the units of the original distribution and is called absolute
measure of dispersion. Therefore, absolute measure must be reduced to a form which is free
from the original unit of measurement. This can be done by expressing it in relation to the
average from which variation is measured. This measure of relative variation is obtained by
dividing the absolute measure by that average and is called a coefficient of variation.
The co-efficient of variation can be calculated as follows:
Coefficient of Variation = Standard Deviation/Expected (or Mean) Cash Flow = σ/Erf
On the basis of the data given in the standard deviation approach, the standard deviation for
project A is 1095, while that for project B is 2098. The coefficient of variation of project B is
more as compared to project A. Hence project B is more risky.
7. Decision Tree Analysis:
The decision tree analysis is another technique which is helpful in tackling risky capital invest-
ment proposals. A decision tree is a graphic display of various decision alternatives and the
sequence of events as if they were branches of a tree.
In constructing a tree diagram, it is a convention to use the symbol □ to indicate the decision
point and O denotes the situation of uncertainty or event. Branches coming out of a decision
point are nothing but representation of immediate mutually exclusive alternative options open to
the decision maker.
Branches emanating from the event point ‘O’ represent all possible situations. These events are
not fully under the control of the decision maker and may represent some other factors. The
basic advantage of a tree diagram is that another act subsequent to the happening of each event
may also be represented. The resulting pay-off for each act-event combination may be indicated
in the tree diagram at the outer end of each branch.
Construction of Decision Tree:
The construction of a decision tree requires definition of proposal, identification of alternatives,
graphing the decision tree, forecasting cash flows, and evaluating results.
This process can be undertaken in the following way:
(i) The first step in the construction of the decision tree is the definition of proposal. It means
what is exactly required under the proposal.
(ii) The second step in the decision tree is the identification of alternatives. Each proposal will
have at least two alternatives—accept or reject. In some cases, there may be more than two
alternatives too.
(iii) The third step is graphing the decision tree. Decision tree is a graphical method. It visually
helps the decision maker view his alternatives and outcomes.
Illustration of a Decision Tree Diagram:

(iv) The fourth step is forecasting cash flows. The forecasted cash flows regarding each
decision branch are also shown along with the branch. Probabilities are also assigned to each
cash flow. The probabilities of each event will be different.
(v) The fifth step in construction of a decision tree is evaluating results. The evaluation will be
based on manager’s own experience, consultation with others and information available in this
respect. On the basis of the expected value for each decision, the results are analysed. The firm
may proceed with profitable alternative.
The pay-off for ultimate alternatives has been calculated by taking into account the probabilities
of the ultimate alternative as well as for the previous alternative and multiplied by the expected
pay-off of the first alternative without its probability. By incorporating probabilities of various
events in the decision tree, it is possible to comprehend and trace probability of a decision
leading to results desired.

Cash Flow Statement

1. Meaning of Cash Flow Statement

Cash flow statement provides information about the cash receipts and payments of a firm for a
given period. It provides important information that compliments the profit and loss account
and balance sheet.
The information about the cash flows of a firm is useful in providing users of financial
statements with a basis to assess the ability of the enterprise to generate cash and cash
equivalents and the needs of the enterprise to utilize these cash flows.
The economic decisions that are taken by users require an evaluation of the ability of an
enterprise to generate cash and cash equivalents and the timing and certainty of their
generation.
The statement deals with the provision of information about the historical changes in cash
equivalents of an enterprise by means of a cash flow statement which classifies cash flows
during the period from operating, investing and financing activities.
2. Preparation of Cash Flow Statement
Institute of Chartered Accountants of India (ICAI) has provided 35 Accounting Standards,
which should be followed while preparing any type of financial statement of an organization.
Accounting Standard (AS)-3 laid down two formats, namely direct and indirect methods for
preparing cash flow statements.
The main difference between the two methods is that the data used to calculate cash flow from
direct method is different from the data used in indirect method. Two different proforma are
provided to show the different set of data used in the calculation of cash flow.
Table-1 shows the pro forma of cash flow statement as per the direct method:
The points to be considered while preparing the cash flow statement are as follows:

i. Treat marketable securities as long-term investments. These securities appear in cash flow
from investing activities.
ii. Treat all types of debt (whether short or long) as long-term debt. These debts appear in cash
flow from financing activities.
iii. Treat the payment of dividends as cash outflow. Dividends are considered financing
activities; whereas, interest payments are termed as operating outflow.
iv. Operating activities, such as cash receipts from customers and payment made to suppliers,
are carried out on a day- to-day basis.
Therefore, a separate pro forma is used to calculate cash from operating activities. However,
investing and financing activities, such as issue of share capital and long-term borrowing, do
not take place on a day-to-day basis.
The organization carries out these activities occasionally. Therefore, there is no separate
proforma to calculate cash flow from investing and financing activities. Cash flow from
operating activities can be calculated by two methods, namely direct and indirect.
Table-3 shows the pro forma of calculating cash from operating activity by using the
direct method:

Table-4 shows the pro forma of calculating cash from operating activity by using indirect
method:

3. Limitations of Cash Flow Analysis

The cash flow analysis is criticized for the following reasons:
I. Misleading Inter-Industry Comparison:
Cash flow statements do not measure the economic efficiency of one company in relation to
another. Usually a company with heavy capital investment will have more cash inflow.
Therefore, interindustry comparison of cash flow statements may be misleading.
II. Misleading Inter-Firm Comparison:
The terms of purchases and sales will differ from firm to firm. Moreover, cash inflow does not
always mean profit. Therefore, inter firm comparison of cash flows may also be misleading.
III. Misleading Comparison over a Period of Time:
Just because the company’s cash flow has increased in the current year, a company may not be
better off than the previous year. Thus, the comparison over a period of time can be misleading.
IV. Influenced by Changes in Management Policies:
The cash balance as disclosed by the cash flow statement may not represent the real liquid
position of the business. The cash can be easily influenced by purchases and sales policies, by
making certain advance payments or by postponing certain payments.
V. Cannot be Equated with Income Statement:
Cash flow statements cannot be equated with the Income statement. An Income statement takes
into account both cash as well as noncash items. Hence, net cash flow does not necessarily
mean net income of the business.
VI. Not a Replacement of Other Statements:
Cash flow statement is only a supplement of funds flow statement and cannot replace the
Income statement or the Funds flow statement as each one has its own function or purpose of
preparation.

Meaning of Time Value of Money

The time value of money is one of the basic theories of financial management, it states that ‘the
value of money you have now is greater than a reliable promise to receive the same amount of
money at a future date’.
The time value of money (TVM) is the idea that money available at the present time is worth
more than the same amount in the future due to its potential earning capacity. This core
principle of finance holds that, provided money can earn interest, any amount of money is
worth more the sooner it is received.
The time value of money is the greater benefit of receiving money now rather than receiving
later. It is founded on time preference. The principle of the time value of money explains why
interest is paid or earned? Interest, whether it is on a bank deposit or debt, compensates the
depositor or lender for the time value of money.
2. Concept of Time Value of Money
Important terms or concepts used in computing the time value of money are-
(1) Cash-flow
(2) Cash inflow
(3) Cash outflow
(4) Discounted Cash flow
(5) Even cash flows /Annuity cash flows
(6) Uneven/mixed streams of cash flows
(7) Single cash flows
(8) Multiple cash flows
(9) Future value
(10) Present value
(11) Compounding
(12) Discounting
(13) Effective interest rate / Time preference rate
(14) Risks and types of risks
(15) Uncertainty, and
ADVERTISEMENTS:
(16) Doubling Period.
The above concepts are briefly explained below:
(1) Cash-Flow:
Cash flow is either a single sum or the series of receipts or payments occurring over a specified
period of time. Cash flows are of two types namely, cash inflow and cash outflow and cash flow
may be of much variety namely; single cash flow, mixed cash flow streams, even cash flows or
uneven cash flows.
(2) Cash Inflow:
Cash inflows refer to the receipts of cash, for the investment made on the asset/project, which
comes into the hands of an individual or into the business organisation account at a point of
time/s. Cash inflow may be a single sum or series of sums (even or uneven/mixed) over a period
of time.
(3) Cash Outflow:
Cash outflow is just opposite to cash inflow, which is the original investment made on the
project or the asset, which results in the payment/s made towards the acquisition of asset or
getting the project over a period of time/s.
(4) Discounted Cash Flow- The Mechanics of Time Value:
The present value of a future cash flow (inflows or outflows) is the amount of current cash that
is of equivalent value to the decision maker today. The process of determining present value of
a future payment (or receipts) or a series of future payments (or receipts) is called discounting.
The compound interest rate used for discounting cash flows is called discount rate.
(5) Even Cash Flows /Annuity Cash Flows:
Even cash flows, also known as annuities, are the existence of equal/even/fixed streams of cash
flows may be a cash inflow or outflow over a specified period of time, which exists from the
beginning of the year.
Annuities are also defined as ‘a series of uniform receipts or payments occurring over a number
of years, which results from an initial deposit.’
In simple words, constant periodic sums are called annuities.
Annuity Aspects:
It is essential to discuss some of the aspects related to annuities, which are discussed as
below:
1. Annuitant
2. Status
3. Perpetuity
4. Various types of Annuity-
i. Annuity Certain
ii. Annuity Contingent
iii. Immediate or Ordinary annuity
iv. Annuity due
v. Perpetual annuity
vi. Deferred annuity
5. Annuity factor-
(i) Present Value Annuity factor, and
(ii) Compound value annuity factor.
A brief description each of the above aspects is as follows:
i. Annuitant is a person or an institution, who receives the annuity.
ii. Status refers to the period for which the annuity is payable or receivable.
iii. Perpetuity is an infinite or indefinite period for which the amount exists.
iv. a. Annuity Certain refers to an annuity which is payable or receivable for a fixed number of
years.
b. Annuity Contingent refers to the payment/receipt of an annuity till the happening of a certain
event/incident.
c. Immediate annuities are those receipts or payments, which are made at the end of the each
period.
d. A series of cash flows (i.e., receipts or payments) starting at the beginning of each period for
a specified number of periods is called an Annuity due. This implies that the first cash flow has
occurred today.
e. Perpetual annuities when, annuities payments are made for ever or for an indefinite or infinite
periods.
f. Deferred annuities are those receipts or payments, which starts after a certain number of
years.
v. (a) Present Value of Annuity factor is the sum of the present value of Re. 1 for the given
period of time duration at the given rate of interest;
(b) Compound value/Future value of annuity factor is the sum of the future value of Re. 1 for
the given period of time duration at the given rate of interest. This is the reciprocal of the
present value annuity discount factor.
Note – When the interest rate rises, the present value of a lump sum or an annuity declines. The
present value factor declines with higher interest rate, other things remaining the same.
vi. Sinking fund is a fund which is created out of fixed payments each period (annuities) to
accumulate to a future some after a specified period. The compound value of an annuity can be
used to calculate an annuity to be deposited to a sinking fund for ‘n’ period at ‘i’ rate of interest
to accumulate to a given sum.
(6) Uneven/Mixed Streams of Cash Flows:
Uneven cash flows, as the concept itself states, is the existence of un-equal or mixed streams of
cash inflows emanating from the investment made on the assets or the project.
(7) Single Cash Inflows:
A single cash inflow is a single sum of receipt of cash generated from the project during the
given period, for which the present value is ascertained by multiplying the cash inflow by the
discount factor.
(8) Multiple Cash Inflows:
Multiple cash inflows (even or mixed cash inflows) are the series of cash flows, may be
annuities/mixed streams of cash inflows which are generated from the project over the entire
life of the asset.
(9) Future Value/Compound Value [FV/CV]:
The future value concept states as to how much is the value of current cash flow or streams of
cash flows at the end of specified time periods at a given discount rate or interest rate. Future
value refers to the worth of the current sum or series of cash flows invested or lent at a specified
rate of return or rate of interest at the end of specified period.
In simple terms, future value refers to the value of a cash flow or series of cash flows at some
specified future time at specified time preference rate for money.
(10) Compounding:
The process of determining the future value of present money is called compounding. In other
words, compounding is a process of investing money, reinvesting the interest earned & finding
value at the end of specified period is called compounding.
In simple words, calculation of maturity value of an investment from the amount of investment
made is called compounding.
Under compounding technique the interest earned on the initial principal become part of
principal at the end of compounding period. Since interest goes on earning interest over the life
of the asset, this technique of time value of money is also known as ‘compounding’.
The simple formula to calculate Compound Value in different interest time periods is-
(a) If Interest is added at the end of each year or compounded annually-
FV or CV = PV (1 + i)n
Where, FV or CV = Future Value or Compound Value, PV= Present Value,
(1 + i)n = Compound Value factor of Re.1 at a given interest rate for a certain number of years.
(b) If Interest is added/computed semi-annually and other compounding periods/multi-
compounding-
Say for example;
(i) When Compounding is made semi-annually, then m=2 (because two half years in one year).
(ii) When Compounding is made quarterly, then m= 4 (because, 4 quarter years in one year).
(iii) When Compounding is made monthly, then m= 12 (because, 12 months in one year).
(11) Present Value:
The present value is just opposite to the future value. Present value refers to the present worth
of a future sum of money or streams of cash flows at a specified interest rate or rate of return. It
is also called a discounted value.
In simple terms it refers to the current value of a future cash flow or series of cash flows.
(12) Discounting:
The inverse of the compounding process is discounting technique. The process of determining
the present value of future cash flows is called discounting.
Discounting or Present Value technique is more popular than compounding technique, since
every individual or an organisation intends to have/hold present sums, rather than getting some
amount of money after some time, because of time preference for money.
(13) Effective Interest Rate / Time Preference Rate:
Time preference rate is used to translate the different amounts received at different time
periods; to amounts equivalent in value to the firm/individual in the present at common point
reference. This time preference rate is normally expressed in ‘percent’ to find out the value of
money at present or in future.
(14) Risk:
In business, the finance manager is supposed to take number of decisions under different
situations. In all such decisions, there is an existence of risk and uncertainty.
Risk is the ‘variability of returns’ or the ‘chance of financial losses’ associated with the given
asset. Assets that are having higher chances of loss or the higher rate of variability in returns are
viewed as ‘risky assets’ and vice versa. Hence care should be taken to recognize and to measure
the extent of risk associated with the assets, before taking the decision to invest on such risky
assets.
3. Importance of Time Value of Money
The Consideration of time is important and its adjustment in financial decision making is also
equally important and inevitable. Most financial decisions, such as the procurement of funds,
purchase of assets, maintenance of liquidity and distribution of profits etc., affect the firm’s
cash flows/movement of cash in and out of the organization in different time periods.
Cash flows occurring in different time periods are not comparable, but they should be properly
measurable. Hence, it is required to adjust the cash flows for their differences in timing and
risk. The value of cash flows to a common time point should be calculated.
To maximize the owner’s equity, it’s extremely vital to consider the timing and risk of cash
flows. The choice of the risk adjusted discount rate (interest rate) is important for calculating
the present value of cash flows.
For instance, if the time preference rate is 10 percent, it implies that an investor can accept
receiving Rs.1000 if he is offered Rs.1100 after one year. Rs.1100 is the future value of
Rs.1000 today at 10% interest rate.
Thus, the individual is indifferent between Rs.1000 and Rs.1100 a year from now as he/she
considers these two amounts equivalent in value. You can also say that Rs.1000 today is the
present value of Rs.1100 after a year at 10% interest rate.
Time value adjustment is important for both short-term and long-term decisions. If the amounts
involved are very large, time value adjustment even for a short period will have significant
implications.
However, other things being same, adjustment of time is relatively more important for financial
decisions with long range implications than with short range implications. Present value of
sums far in the future will be less than the present value of sums in the near future.
The concept of time value of money is of immense use in all financial decisions.
The time value concept is used
1. To compare the investment alternatives to judge the feasibility of proposals.
2. In choosing the best investment proposals to accept or to reject the proposal for investment.
3. In determining the interest rates, thereby solving the problems involving loans, mortgages,
leases, savings and annuities.
4. To find the feasible time period to get back the original investment or to earn the expected
rate of return.
5. Helps in wage and price fixation.
4. Reasons for Time Preference of Money / Reasons for Time Value of Money
There are three primary reasons for the time value of money- reinvestment opportunities;
uncertainty and risk; preference for current consumption.
These reasons are explained below:
1. Reinvestment Opportunities:
The main fundamental reason for Time value of money is reinvestment opportunities.
Funds which are received early can be reinvested in order to earn money on them. The basic
premise here is that the money which is received today can be deposited in a bank account so as
to earn some return in terms of income.
In India saving bank rate is about 4% while fixed deposit rate is about 7% for one year deposit
in public sector banks. Therefore even if the person does not have any other profitable invest-
ment opportunity to invest his funds, he can simply put his money in a savings bank account
and earn interest income on it.
Let us assume that Mr. X receives Rs.100000 in cash today. He can invest or deposit this
Rs.100000 in fixed deposit account and earn 7% interest p.a. Therefore at the end of one year
his money of Rs.100000 grows to Rs.107000 without any efforts on the part of Mr. X.
If he deposits Rs.100000 in two years fixed deposit providing interest rate 7% p.a. then at the
end of second year his money will grow to Rs.114490 (i.e. Rs.107000+ 7% of Rs.107000). Here
we assume that interest is compounded annually i.e. we do not have a simple interest rate but
compounded interest rate of 7%.
Thus Time value of money is the compensation for time.
2. Uncertainty and Risk:
Another reason for Time value of money is that funds which are received early resolves
uncertainty and risk surmounting future cash flows. All of us know that the future is uncertain
and unpredictable. At best we can make best guesses about the future with some probabilities
that can be assigned to expected outcomes in the future.
Therefore given a choice between Rs.100 to be received today or Rs.100 to be received in
future say one year later, every rational person will opt for Rs.100 today. This is because the
future is uncertain. It is better to get money as early as possible rather than keep waiting for it.
The underlying principle is “A bird in hand is better than two in the bush.”
It must be noted that there is a difference between risk and uncertainty.
In a Risky situation we can assign probabilities to the expected outcomes. Probability is the
chance of occurrence of an event or outcome. For example I may get Rs.100 with 90%
probability in future. Therefore there is 10% probability of not getting it at all. In a risky
situation outcomes are predictable with probabilities.
In case of an uncertain situation it is not possible to assign probabilities to the expected
outcomes. In such a situation the outcomes are not predictable.
3. Preference for Current Consumption:
The third fundamental reason for Time value of money is preference for current consumption.
Everybody prefers to spend money today on necessities or luxuries rather than in future, unless
he is sure that in future he will get more money to spend.
Let us take an example, Your father gives you two options – to get Wagon R today on your
20th birthday OR to get Wagon R on your 21st birthday which is one year later.
Which one would you choose? Obviously you would prefer Wagon R today rather than one
year later. So every rational person has a preference for current consumption. Those who save
for future, do so to get higher money and hence higher consumption in future.
In the above example of a car if your father says that he can give you a bigger car, say Honda
City on your 21st birthday, then you may opt for this option if you think that it is better to wait
and get a bigger car next year rather than settling for a small car this year.
Thus we can say that the amount of money which is received early (or today) carries more value
than the same amount of money which is received later (or in future). This is Time Value of
Money.
5. Valuation Concepts
There are the following two valuation concepts:
1) Compound Value Concept (Future Value or Compounding)
2) Present Value Concept (Discounting)
1) Compound Value Concept:
The compound value concept is used to find out the Future Value (FV) of present money. A
Future Value means that a given quantity of money today is worth more than what will be
received at some point of time in future.
It is the same as the concept of compound interest, wherein the interest earned in a preceding
year is reinvested at the prevailing rate of interest for the remaining period. Thus, the
accumulated amount (principal + interest) at the end of a period becomes the principal amount
for calculating the interest for the next period.

The compounding technique to find out the FV to present money can be explained with
reference to:
i) The FV of a single present cash flow,
ii) The FV of a series of equal cash flows and
iii) The FV of multiple flows.
i) FV of a Single Present Cash Flow: The future value of a single cash flow is defined in
term of equation as follows:

Illustration:
Mr. A makes a deposit of Rs. 10,000 in a bank which pays 10% interest compounded annually
for 5 years. You are required to find out the amount to be received by him after 5 years.
Solution:

ii) Future Value of Series of Equal Cash Flows or Annuity of Cash Flows:
Quite often a decision may result in the occurrence of cash flows of the same amount every year
for a number of years consecutively, instead of a single cash flow. For example, a deposit of Rs.
1,000 each year is to be made at the end of each of the next 3 years from today.
This may be referred to as an annuity of deposit of Rs. 1,000 for 3 years. An annuity is thus, a
finite series of equal cash flows made at regular intervals.
In general terms, the future value of an annuity is given as:

It is evident from the above that future value of an annuity depends upon three variables, A, r
and n. The future value will vary if any of these three variables changes. For computation
purposes, tables or calculators can be made use of.
Illustration:
Mr. A is required to pay five equal annual payments of Rs. 10,000 each in his deposit account
that pays 10% interest per year. Find out the future value of annuity at the end of four years.
Solution:

iii) Future Value of Multiple Flows:

Illustration:
Suppose the investment is Rs. 1,000 now (beginning of year 1), Rs.2,000 at the beginning of
year 2 and Rs.3,000 at the beginning of year 3, how much will these flows accumulate at the
end of year 3 at a rate of interest of 12 percent per annum?
Solution:
To determine the accumulated sum at the end of year, add the future compounded values
of Rs. 1,000, Rs.2, 000 and Rs.3, 000 respectively:

2) Present Value Concept:

Present values allow us to place all the figures on a current footing so that comparisons may be
made in terms of today’s rupees. Present value concept is the reverse of compounding technique
and is known as the discounting technique.
As there are FVs of sums invested now, calculated as per the compounding techniques, there
are also the present values of a cash flow scheduled to occur in future.
The present value is calculated by discounting technique by applying the following
equation:

The discounting technique to find out the PV can be explained in terms of:
i) Present Value of a Future Sum:
The present value of a future sum will be worth less than the future sum because one forgoes
the opportunity to invest and thus forgoes the opportunity to earn interest during that period. In
order to find out the PV of future money, this opportunity cost of the money is to be deducted
from the future money.
The present value of a single cash flow can be computed with the help of following
formula:

Illustration:
Find out the present value of Rs.3, 000 received after 10 years hence, if the discount rate is
10%.
Solution:

Illustration:
Mr. A makes a deposit of Rs. 5000 in a bank which pays 10% interest compounded annually.
You are required to find out the amount to be received after 5 years.
Solution:

ii) PV of a Series of Equal Future Cash Flows or Annuity:

A decision taken today may result in a series of future cash flows of the same amount over a
period of number of years.
For example, a service agency offers the following options for a 3-year contract:
a) Pay only Rs.2, 500 now and no more payment during next 3 years, or
b) Pay Rs.900 each at the end of first year, second year and third year from now. A client
having a rate of interest at 10% p.a. can choose an option on the basis of the present values of
both options as follows:
Option I:
The payment of Rs.2, 500 now is already in terms of the present value and therefore does not
require any adjustment.
Option II:
The customer has to pay an annuity of Rs.900 for 3 years.

In order to find out the PV of a series of payments, the PVs of different amounts accruing at
different times are to be calculated and then added. For the above example, the total PV is Rs.2,
238. In this case, the client should select option B, as he is paying a lower amount of Rs.2, 238
in real terms as against Rs.2, 500 payable in option A.
The present value of an annuity may be expressed as follows:

Illustration:
Find out the present value of a 5 years annuity of Rs.50, 000 discounted at 8%.
Solution:
6. Techniques Used to Understand the Concept of Time Value of Money
Basically two techniques are used to find the time value of money.
They are:
1. Compounding Technique or Future Value Technique
2. Discounting Technique or Present Value technique
1. Compounding Technique:
Compounding technique is just reverse of the discounting technique, where the present sum of
money is converted into future sum of money by multiplying the present value by the
compound value factor for the required rate of interest and the period.
Hence Future Value or Compound Value is the ‘product’ of the present value of a given sum of
money and the factor.
The simple formulas are used to calculate the Compound value of a single sum:
(a) If interest is compounded annually is-
FV = PV (1 + i)n = PV (CVFni)
Note- (1 + i)n is the formula for future value or compound value factor and
CVFni = Compound Value factor for the given number of years at required rate of interest.
(b) If Interest is added semi-annually and other compounding periods-
2. Discounting Technique or Present Value Technique:
Discounting technique or present value technique is the process of converting the future cash
flows into present cash flows by using an interest rate/time preference rate/discount rate.
The simple formula used to calculate the Present Value of a single sum is:

Where;
P= Present Value, PVF= Present value factor of Re.1, DF= Discount factor of Re.1, A= Future
Value or Compound Value, i = interest rate & n= number of years or time period given for 1 to
n years and (1 + i)n = The compound value factor.
So from the above formula, it is very clear that the present value of future cash flows is the
product of the ‘future sum of money and the discount factor’ or ‘the quotient of the future sum
of money and the compound value factor (1 + i)1-n.
Note – Present value can be computed for all types of cash flows, say single sum/ multiple
sums, even / annuity sums and mixed/un-even sums.
Alternatively, PVF/DF, CVF of a rupee and also the annuity discount factor (PADF) and the
compound value annuity factor (CVAF) at the given rate of interest for the expected period can
be referred through the tables also.
7. Present Value Technique or Discounting Technique
It is a process of computing the present value of cash flow (or a series of cash flows) that is to
be received in the future. Since money in hand has the capacity to earn interest, a rupee is worth
more today than it would be worth tomorrow.
Discounting is one of the core principles of finance and is the primary factor used in pricing a
stream of future receipts. As a method, discounting is used to determine how much these future
receipts are worth today.
It is just the opposite of compounding where compound interest rates are used in determining
the present value corresponding to a future value. For example, Rs. 1,000 compounded at an
annual interest rate of 10% becomes Rs. 1,771.56 in six years.
Conversely, the present value of Rs. 1,771.56 realized after six years of investment is Rs. 1,000
when discounted at an annual rate of 10%. This present value is computed by multiplying the
future value by a discount rate. This discount rate is computed as reciprocal of compounding.
Present value calculations determine what the value of a cash flow received in the future would
be worth today (that is at time zero). The process of finding a present value is called
discounting; the discounted value of a rupee to be received in future gets smaller as it is applied
to a distant future.
The interest rate used to discount cash flows is generally called the discount rate. How much
would Rs.100 received five years from now be worth today if the current interest rate is 10%?
Let us draw a timeline.

The arrow represents the flow of money and the numbers under the timeline represent the time
period. It may be noted that time period zero is today, corresponding to which the value is
called present value.
A generalized procedure for calculating the future value of a single amount compounded
annually is as given below:

I. Ascertaining the Present Value (PV):

The discounting technique that facilitates the ascertainment of present value of a future
cash flow may be applied in the following specific situations:
(a) Present Value of a Single Future Cash Flow:
The future value of a single cash flow may be ascertained by applying the usual compound
interest formula as given below:

Let us understand the computation of present value with the help of an example that
follows:
Example:
Mr. Aman shall receive Rs.25,000 after 4 years. What is the present value of this future receipt,
if the rate of interest is 12% p.a.?

(b) Present Value of Series of Equal Cash Flows (Annuity):

An annuity is a series of equal cash flows that occur at regular intervals for a finite period of
time. These are essentially a series of constant cash flows that are received at a specified
frequency over the course of a fixed time period. The most common payment frequencies are
yearly, semi-annually, quarterly and monthly.
There are two types of annuities – ordinary annuity and annuity due. Ordinary annuities are
payments (or receipts) that are required at the end of each period. Issuers of coupon bonds, for
example, usually pay interest at the end of every six months until the maturity date. Annuity due
are payments (or receipts) that are required in the beginning of each period.
Payment of rent, lease etc., are examples of annuity due. Since the present and future value
calculations for ordinary annuities and annuities due are slightly different, we will first discuss
the present value calculation for ordinary annuities.
The formula for calculating the present value of a single future cash flow may be extended
to compute present value of series of equal cash flow as given below:

Example:
An LED TV can be purchased by paying Rs.50,000 now or Rs.20,000 each at the end of first,
second and third year respectively. To pay cash now, the buyer would have to withdraw the
money from an investment, earning interest at 10% p.a. compounded annually. Which option is
better and by how much, in present value terms?
Solution:
Let paying Rs.50,000 now be Option I and payment in three equal installments of
Rs.20,000 each be Option II, the present value of cash outflows of Option II is computed
as:

(c) Present Value of a Series of Unequal Cash Flows:

The formula for computing present value of an annuity is based on the assumption that cash
flows at each time period are equal.
However, quite often cash flows are unequal because profits of a firm, for instance, which
culminate into cash flows, are not constant year after year.
The formula for calculating the present value of a single future cash flow may be extended
to compute present value of series of unequal cash flows as given below:

Example:
Ms. Ameeta shall receive Rs.30,000, Rs.20,000, Rs.12,000 and Rs.6,000 at the end of first,
second, third and fourth year from an investment proposal. Calculate the present value of her
future cash flows from this proposal, given that the rate of interest is 12% p.a.
Solution:
Implication:
If Ms. Ameeta lends Rs.55,086 @ 12%p.a, the borrower may settle the loan by paying
Rs.30,000, Rs.20,000, Rs.12,000 and Rs.6,000 at the end of first, second, third and fourth year.
(d) Perpetuity:
It refers to a stream of equal cash flows that occur and last forever. This implies that the annuity
that occurs for an infinite period of time turns it to perpetuity. Although it may seem a bit
illogical, yet an infinite series of cash flows have a finite present value.
Examples of Perpetuity:
(i) Local governments set aside funds so that certain cultural activities are carried on a regular
basis.
(ii) A fund is set-up to provide scholarship to meritorious needy students on a regular basis.
(iii) A charity club sets up a fund to provide a flow of regular payments forever to needy
children.
The present value of perpetuity is computed as:

Example:
A philanthropist wishes to institute a scholarship of Rs.25,000 p.a., payable to a meritorious
student in an educational institution. How this amount should he invest @ 8% p.a. so that the
required amount of scholarship becomes available as yield of investment in perpetuity.

8. Valuation of Preference Shares and Equity Shares

Valuation of Preference Shares:
Preference shares have preference over ordinary shares in terms of payment or dividend and
repayment of capital if the company is wound up. They may be issued with or without a
maturity period.
The preference shares unlike bonds has an investment value as it resembles both bond as well as
common stock. It is a hybrid between the bond and the equity stock. It resembles a bond as it
has a prior claim on the assets of the firm at the time of liquidations.
Like the common stock the preference shareholders receive dividend and have similar features
as common stock and liabilities at the time of liquidation of a firm.
Types of Preference Shares:
a. Redeemable preference shares are shares with maturity.
b. Irredeemable preference shares are shares without any maturity.
Features of Preference Shares:
i. Dividend
The dividend rate is fixed in the case of preference shares.
ii. Claims
Preference shareholders have a claim on assets and income prior to ordinary shareholders.
iii. Redemptions
Redeemable preference shares have a maturity date while irredeemable preference shares are
perpetual.
iv. Conversions
A company can issue convertible preference shares and can be converted as per the norms.
Valuation of Equity Shares
Equity Shares:
Equity shares are also referred to as common stock, unlike bonds, equity shares are instruments
that do not assure a fixed return.
Equity is fundamentally different from debt. Debt is commonly issued by security known as
bond/debenture. Financial markets deal with the transfer of these securities from one person to
another. The price at which such transfer takes place is determined by market forces.
Features of equity share:
(a) Ownership and management,
(b) Entitlement to residual cash flows,
(c) Limited liability,
(d) Infinite life,
(e) Substantially different risk profile.
Challenges in Valuation of Equity:
The valuation of equity shares is relatively more difficult.
The difficulty arises because of two factors:
(i) Rate of Dividend on Equity Shares is not known.
(ii) Estimates of the Amount and timing of the cash flows expected by equity shareholders are
more uncertain.
9. Risk and Return Analysis
What is risk?
Risk is the variability which may likely to accrue in future between the expected returns and the
actual returns. So, the risk may also be considered as a chance of variation or chance of loss.
Types of Risk:
Risk can be classified in the following two parts:
1. Systematic Risk or Market Risk:
Systematic risk is that part of total risk which cannot be eliminated by diversification.
Diversification means investing in different types of securities. No investor can avoid or
eliminate this risk, whatsoever precautions or diversification may be resorted to. So, it is also
called non diversifiable risk, or the market risk.
This part of the risk arises because every security has a built in tendency to move in line with
the fluctuations in the market. The systematic risk arises due to general factors in the market
such as money supply, inflation, economic recession, industrial policy, interest rate policy of
the government, credit policy, tax policy etc. These are the factors which affect almost every
firm.
2.Unsystematic Risk:
The unsystematic risk is one which can be eliminated by diversification. This risk represents the
fluctuation in returns of a security due to factors specific to the particular firm only and not the
market as a whole.
These factors may be such as worker’s unrest, strike, change in market demand, change in
consumer preference etc. This risk is also called diversifiable risk and can be reduced by
diversification. Diversification is the act of holding many securities in order to lessen the risk.
The effect of diversification on the risk of a portfolio is represented graphically in the
below figure:

The above diagram shows that the systematic risk remains the same and is constant irrespective
of the number of securities in the portfolio as shown by OA in the above diagram and is fixed
for any number of securities.
For only security it is OA & for 20 security also it is OA. However, the unsystematic risk is
reduced when more and more securities are added to the portfolio. As from the above diagram
we can see that earlier it was OD & by increasing the number of securities it decreases to C.
10. Methods of Risk Management
Risk is inherent in business and hence there is no escape from the risk for a businessman.
However, he may face this problem with greater confidence if he adopts a scientific approach
by dealing with risk. Risk management may, therefore, be defined as adoption of a scientific
approach to the problem dealing with risk faced by a business firm or an individual.
Broadly, there are five methods in general for risk management:
i) Avoidance of Risk
A business firm can avoid risk by not accepting any assignment or any transaction which
involves any type of risk whatsoever. This will naturally mean a very low volume of business
activities and losing of too many profitable activities.
ii) Prevention of Risk
In case of this method, the business avoids risk by taking appropriate steps for prevention of
business risk or avoiding loss, such steps include adaptation of safety programmes, employment
of night security guard, arranging for medical care, disposal of waste material etc.
iii) Retention of Risk
In the case of this method, the organization voluntarily accepts the risk since either the risk is
insignificant or its acceptance will be cheaper as compared to avoiding it.
iv) Transfer of Risk
In case of this method, risk is transferred to some other person or organization. In other words,
under this method, a person who is subject to risk may induce another person to assume the
risk. Some of the techniques used for transfer of risk are hedging, sub-contracting, getting
surety bonds, entering into indemnity contracts etc.
v) Insurance
This is done by creating a common fund out of the contribution (known as premium) from
several persons who are equally exposed to the same loss. Fund so created is used for
compensating the persons who might have suffered financial loss on account of the risks
insured against.
11. Types of Investors
There are three types of investor which may be classified as:
a) Risk Averse
Under this category those investors appear who avoid taking risk and prefer only the
investments which have zero or relatively lower risk. These investors ignore the return from the
investment. Generally risk averse investors are – Retired persons, Old age persons and
Pensioners.
b) Risk Seekers
Under this category those investors are nominated who are ready to take risk if the return is
sufficient enough (according to their expectations). These investors may be ready to take –
Income risk, Capital risk or both.
c) Neutrals
Under this category those investors lie who do not care much about the risk. Their investments
decisions are based on consideration other than risk and return.
What is return?
Return is the amount received by the investor from their investment. Everyone needs high
returns over invested amounts. Each and every investor who invests or wants to invest their
amount in any type of project, first expects some return which encourages them to take risk.
Risk and Return Trade Off:
The principle that potential “return rises with an increase in risk”. Low levels of uncertainty
(low risk) are associated with low potential returns, whereas high levels of uncertainty (high
risk) are associated with high potential returns. According to the risk-return tradeoff, invested
money can render higher profits only if it is subject to the possibility of being lost.
Because of the risk- return tradeoff, you must be aware of your personal risk tolerance when
choosing investments for your portfolio. Taking on some risk is the price of achieving returns;
therefore, if you want to make money, you can’t cut out all risk. The goal instead is to find an
appropriate balance – one that generates some profit, but still allows you to sleep at night.
We can see this in the following figure:
Risk and return analysis emphasizes over the following characteristics:
(i) Risk and Return have parallel relations.
(ii) Return is fully associated with risk.
(iii) Risk and return concepts are basic to the understanding of the valuation of assets or
securities.
(iv) The expected rate of return is an average rate of return. This average may deviate from the
possible outcomes (rates of return).