FOUNDATIONS

FOR FINANCE
 Money and Its need
What is Money?

Money is any item or medium of exchange that is accepted by people for the payment of
goods and services, as well as the repayment of loans. Money makes the world go 'round.
Economies rely on money to facilitate transactions and to power financial growth.

Typically, it is economists who define money, where it comes from, and what it's worth.

Money is not everything, but money is something very important. Beyond the basic needs,
money helps us achieve our life's goals and supports — the things we care about most
deeply — family, education, health care, charity, adventure and fun.
 It helps us get some of life's intangibles — freedom or independence, the opportunity to make
the most of our skills and talents, the ability to choose our own course in life, financial security.
With money, much good can be done and much unnecessary suffering avoided or eliminated.

 But, money has its own limitations too. It can give us the time to appreciate the simple things in
life more fully, but not the spirit of innocence and wonder necessary to do so. Money can give us
the time to develop our gifts and talents, but not the courage and discipline to do so. Money can
give us the power to make a difference in the lives of others, but not the desire to do so. It can
give us the time to develop and nurture our relationships, but not the love and caring necessary to
do so.

 Thus, Money is something that people use every day. We earn it and spend it but don't often
think much about it.
 Financial Planning
Meaning of Financial Planning
 Financial Planning is the process of estimating the capital required and determining it’s
competition. It is the process of framing financial policies in relation to procurement, investment
and administration of funds of an enterprise.

 Financial planning is the practice of putting together a plan for your future, specifically around
how you will manage your finances and prepare for all of the potential costs and issues that may
arise. The process involves evaluating your current financial situation, identifying your goals and
then developing and implementing relevant recommendations.

 Financial planning is holistic and broad, and it can encompass a variety of services, which we
detail below. Rather than focusing on a single aspect of your finances, it views clients as real
people with a variety of goals and responsibilities. It then addresses a number of financial
realities to figure out how to best enable people to make the most of their lives.
 Objectives of Financial Planning
 Determining capital requirements- This will depend upon factors like cost of current
and fixed assets, promotional expenses and long- range planning. Capital requirements
have to be looked with both aspects: short- term and long- term requirements.

 Determining capital structure- The capital structure is the composition of capital, i.e.,
the relative kind and proportion of capital required in the business. This includes
decisions of debt- equity ratio- both short-term and long- term.

 Framing financial policies with regards to cash control, lending, borrowings, etc.

 A finance manager ensures that the scarce financial resources are maximally utilized in
the best possible manner at least cost in order to get maximum returns on investment.
 Importance of Financial Planning
 Adequate funds have to be ensured.

 Financial Planning helps in ensuring a reasonable balance between outflow and inflow of
funds so that stability is maintained.

 Financial Planning ensures that the suppliers of funds are easily investing in companies
which exercise financial planning.

 Financial Planning helps in making growth and expansion programmes which helps in
long-run survival of the company.

 Financial Planning reduces uncertainties with regards to changing market trends which
can be faced easily through enough funds.

 Financial Planning helps in reducing the uncertainties which can be a hindrance to growth
of the company. This helps in ensuring stability an d profitability in concern.
 Life Goals and Financial Goals of an
Individual
 Goals are important in life. They give you the energy and motivation to do
extraordinary things. So What Are Life Goals? Life goals are all the things you want to
accomplish in your life. Often your life goals are very meaningful to you and can make
a lasting impact on your life. They can be large and challenging goals, or they can be
smaller and more personal. It all depends on what you want to achieve.

 As we know Money drives many decisions that we make day to day. Setting goals can
help us take control and feel more confident about those decisions. But what is
financial goals? A financial goal can change your perspective about life and money.
You will start evaluating your everyday decisions in greater detail.
 A financial goal is a scientifically defined financial milestone that you plan to achieve or reach.
Financial goals comprise earning, saving, investing and spending in proportions that match your
short-term, medium-term or long-term plans. Every financial goal will have the following three
details associated with them:

 - What is the purpose?

- How much money is needed?
- How much time? (usually in years)

Examples of financial goals include:

• Paying off debt.

• Saving for retirement.

• Building an emergency fund.

• Buying a home.

• Saving for a vacation.

• Starting a business.

• Feeling financially secure.

 Financial Planning of Young Adults
1. Pay with cash, not credit.

2. Educate yourself on personal finance.

3. Learn to budget.

4. Start Investment.

5. Start an emergency fund.

6. Start saving for retirement early.

7. Stay on top of your taxes.

8. Guard your health.

9. Protect your wealth.

Format of a
Sample Financial
Plan for a young
adult
TIME VALUE OF
MONEY
 Time Value of Money – Meaning
Time Value of Money (TVM) is a fundamental financial concept, stating that the current
value of money is higher than its future value, given its potential to earn in the years to
come. Thus, it suggests that a sum of money in hand is greater in value than the same sum
of money received in the next couple of years.

Present Value of Money Future Value of Money

Could be invested when The same amount is

in hand for better returns subject to uncertainties
in future and loses value in future
 Time Value of Money - Formula
The Time Value of Money formula is expressed below:

OR

Here,
• PV = Present value of money
• FV = Future value of money
• i = Rate of interest or current yield on similar investment
• t = No. of years
• n = No. of compounding periods of interest each year
 Compounding

 Compounding is a powerful investing concept that involves earning returns on both

your original investment and on returns you received previously. For compounding to
work, you need to reinvest your returns back into your account. For example, you
invest $1,000 and earn a 6% rate of return. In the first year, you would make $60,
bringing your total investment to $1,060, if you reinvest your return.

 Next year, you would earn a return on your total $1,060 investment. If your return were
once again 6%, you’d make $63.60, bringing your total investment to $1,123.60.
 Simple Interest
 Simple interest is a quick and easy method to calculate interest on the money, in the
simple interest method interest always applies to the original principal amount, with the
same rate of interest for every time cycle. When we invest our money in any bank, the
bank provides us interest on our amount. The interest applied by the banks is of many
types one of them is simple interest. Now, before going deeper into the concept of
simple interest, let's first understand what is the meaning of a loan.

 A loan is an amount that a person borrows from a bank or a financial authority to fulfill
their needs. Loan examples include home loans, car loans, education loans, and
personal loans. A loan amount is required to be returned by the person to the authorities
on time with an extra amount, which is usually the interest you pay on the loan.
 Simple Interest Formula
Simple interest is calculated with the following formula: S.I. = P × R × T, where P = Principal, R = Rate of Interest in % per

annum, and T = Time, usually calculated as the number of years. The rate of interest is in percentage r% and is to be written as

r/100.

Principal: The principal is the amount that initially borrowed from the bank or invested. The principal is denoted by P.

Rate: Rate is the rate of interest at which the principal amount is given to someone for a certain time, the rate of interest can be

5%, 10%, or 13%, etc. The rate of interest is denoted by R.

Time: Time is the duration for which the principal amount is given to someone. Time is denoted by T.

Amount: When a person takes a loan from a bank, he/she has to return the principal borrowed plus the interest amount, and

this total returned is called Amount.

Amount = Principal + Simple Interest

A = P + S.I.

A = P + PRT
Simple Interest Formula
 Needs of Simple Interest
 Simple interest is more advantageous for borrowers than compound interest, as it lowers
overall interest payments.

 Car loans, amortized monthly, and retailer installment loans, also calculated monthly, are
examples of simple interest; as the loan balance dips with each monthly payment, so does the
interest.

 Simple interest has very limited usage in modern-day banking and financial activities. It may
sometimes be of use in auto loans or personal loans with a very short maturity period,
generally only a few months.

 In instances where such interest is applicable, there is a rule. If a borrower pays an installment,
he pays the interest portion first, and the balance is then deducted from the principal portion.
If an installment is paid late, the interest portion gets higher as it is calculated on the number
of days. The payment towards the principal amount gets lesser.
 Problems on Simple Interest

Example 1: Swathi owes $38,000 in students loans for college. The interest rate is 7.25%
and the loan will be paid off over 10 years. How much will swathi pay altogether?
Solution:
P = $38,000, R = 7.25% and T = 10
S.I = P*R*T
S.I = (38000)*(.0725)*(10) = $27,550.00
Answer: Swathi will have to pay $38,000 in principal plus $27,550 in interest for a total of
$65,550.00.
 Problems on Simple Interest
Example 2: When Kevin bought a new office phone, he borrowed $1,200 at a rate of 18%
for 9 months. How much interest did he pay?
Solution: P = $1,200, R = 0.18 and T = 0.75
Remember that the interest formula asks for the time in years. However, the time was given
in months. So to get the time in years we represent 9 months as 9/12 of a year, or 0.75.
S.I = P*R*T
S.I = (1200)*(0.18)*(0.75) = 162.00
Answer: Kevin paid $162.00 in interest.
 Compound Interest
 Compound interest is the interest calculated on the principal and the interest
accumulated over the previous period. It is different from simple interest, where
interest is not added to the principal while calculating the interest during the next
period.

 Compound interest finds its usage in most of the transactions in the banking and
finance sectors and other areas. Some of its applications are:
1. Increase or decrease in population.
2. The growth of bacteria.
3. Rise or Depreciation in the value of an item.
 Compound Interest Formula
 The standard formula for compound interest (CI) can be modified for annual, quarterly, monthly, semi-
annually or daily calculations. Let us go through this formula.

 Given below is an elaboration of the elements in the above equation and their relevance:
• A denotes the final amount, which is the total amount an investor will get in future;
• P represents the principal sum invested, i.e., the initial amount of investment;
• r is the interest rate or rate of return at which the compounding takes place, say a 7% interest is written as
0.07 in the formula;
A = P (1 + r / n) nt
• n signifies the number of the times the interest is compounded on the given amount. If compounding takes
place semi-annually, n = 6, indicating interests paid twice in a year.
• t is the period of investment in years, i.e., the number of years you want to keep your funds invested.
 The amount of interest receivable in future is calculated as:
CI=A-P
 We can calculate CI by deducting the initial investment from the future value of the invested amount.
 Needs of Compound Interest
• Reinvestment - The interest earned will be reinvested into the same deposit.

• Higher value of the deposit - Compound interest leads to a higher value of the deposit.
Upon maturity, your deposit will be more than a deposit with simple interest.

• Long-term savings - Compound interest deposits encourage long-term savings as the

return on investment is much higher after 10 years or more.

• Increased Earnings - Options of compounding monthly, quarterly, and half-yearly

increase the interest earned.
 Financial platforms where compound interest is
applicable
Compound interest is used for both debit and credit aspects of the financial world. Listed below
are some of the investments and credit options that use compound interest.
 Investments
• Savings Accounts
• Fixed Deposits
• Recurring Deposits
• Other Certificates of Deposits
• Reinvested Dividend Stocks
• Retirement Funds
 Debt
• Loans
• Credit cards
• Mortgages
When it is used in case of deposits and investments, we stand to benefit. On the other hand, when
compound interest is charged on loans and debt, the banks and lenders stand to gain
 Problems on Compound Interest
 Example 1: Find the compound interest on Rs. 7500 at 4% per annum for 2 years,
compounded annually.
 Solution: Given, P= Rs. 7500,R=4%,n=2 years

Compound Interest = A-P

Compound Interest = Rs. (8112−7500​)= Rs. 612
Problems on Compound Interest
 Example 2: Find the compound interest on rupees 5000 for 2 years at the rate of
5% compounded half yearly
 Discounting

 Discounting refers to a technique used

to determine the present value (PV) of
a future payment or a sequence of cash
flows that will be received in the
future. It is an important technique in
the valuation process and price
estimation
 For example, a dollar received 50 years
from now may be valued less than a
dollar received today—discounting
measures this relative value.
 Present Value of a Single Cash Flow
Present value of a single cash flow refers to how much a single cash flow in the future will
be worth today. The present value is calculated by discounting the future cash flow for the
given time period at a specified discount rate.
The formula used to calculate the present value of a single amount is:

In this formula, the following variables are defined as:

•PV = Present value of the amount
•FV = Future value of the amount (amount to be received in future)
•i = Interest rate (in percentage terms)
•n = Number of periods after which the amount will be received in future
Problems on Present Value of a Single
Cash Flow
Example 1; Suppose a company expects to receive $8,000 after 5 years. Calculate the present value of this
sum if the current market interest rate is 12% and the interest is compounded annually.
Solution
The way to solve this is to apply the above present value formula. In this example, the number of periods (n) is
5 and the interest rate (i) is 12%. Therefore, the present value (PV) is calculated as follows:
PV = FV x 1 / (1+i)n
= 8,000 x 1 / (1+12%)5
= 8,000 x 1 / (1+0.12)5
= 8,000 x 1 / (1.12)5
= 8,000 x 1 / 1.7623
= 8,000 x 0.5674
= $4,540
According to these results, the amount of $8,000, which will be received after 5 years, has a present value of
$4,540.
This example shows that if the $4,540 is invested today at 12% interest per year, compounded annually, it will
grow to $8,000 after 5 years.
 Future Value of single cash flow
The future value of a single amount is equal to the amount of
money invested or saved, multiplied by one plus the interest rate to
the nth power, where n is the number of compounding periods
during which the principal is held or invested. If there is more than
one compounding per year, you would divide the interest rate by
the number of compoundings per year to get the i value and
multiply the number of years by the number of compoundings per
year to get the n value.
 Problems on Future Value of single cash
flow
 Example 1: Sam was getting $1000 for 6 years every year at an interest rate
of 5%. Find the future value of single cash flow at the end of 6 years?
 Solution: PV = 1000; N = 6; I = 5%

 FV = 1000 x ( 1 + 0.05) ^ 6
 FV = 1000 X (1.34009564063)
 FV = 1340.095
 Series of Cash Inflow

 The present value (PV) of the series of cash flows is equal to the sum of the present value of
each cash flow, so valuation is straightforward: find the present value of each cash flow and
then add them up.

 Often, the series of cash flows is such that each cash flow has the same future value. When
regular payments are at regular intervals and each payment is the same amount, that series of
cash flows is an annuity. Most consumer loan repayments are annuities, as are installment
purchases, mortgages, retirement investments, savings plans, and retirement plan payouts.
Fixed-rate bond interest payments are an annuity, as are stable stock dividends over long
periods of time. You could think of your paycheck as an annuity, as are many living expenses,
such as groceries and utilities, for which you pay roughly the same amount regularly.
 Annuity

Meaning Features of annuity

1. Safe investment option: Annuity plans are low
An annuity is a contract between you and risk plans that are not market-linked. The
amount you receive is guaranteed1 and is fixed
an insurance company that requires the at the time of the purchase of the plan
2. Financial security: Annuity plans provide you
insurer to make payments to you, either with an income for life. This helps you stay
financially independent during your retirement
immediately or in the future. An Annuity
3. Flexibility: These plans offer you the flexibility
plan offers a fixed amount of money for to choose how you want to receive your income.
You can choose to receive the income from the
the rest of your life in return for a lump plan monthly, quarterly, half-yearly or yearly.
Some annuity plans also offer you the flexibility
sum payment or a series of instalments. to pay your premiums monthly, half-yearly,
yearly or all at once as per your convenience
 Annuity Formula

 The annuity formula for the present value of an annuity and the future value of an
annuity is very helpful in calculating the value quickly and easily. The Annuity
Formulas for future value and present value are:
 The future value of an annuity, FV = P×((1+r)n−1) / r
 The present value of an annuity, PV = P×(1−(1+r)-n) / r
 Problems on Annuity

Example 1: Dan was getting $100 for 5 years every year at an interest rate of 5%.
Find the future value of this annuity at the end of 5 years? Calculate it by using the
annuity formula.
Solution
The future value
Given: r = 0.05, 5 years = 5 yearly payments, so n = 5, and P = $100
FV = P×((1+r)n −1) / r
FV = $100 × ((1+0.05)5−1) / 0.05
FV = 100 × 55.256
FV = $552.56
Therefore, the future value of annuity after the end of 5 years is $552.56.
 Problems on Annuity
Example 2: If the present value of the annuity is $20,000. Assuming a monthly interest
rate of 0.5%, find the value of each payment after every month for 10 years. Calculate
it by using the annuity formula.
Solution:
Given: r = 0.5% = 0.005; n = 10 years x 12 months = 120, and PV = $20,000
Using formula for present value
PV = P×(1−(1+r)-n) / r
Or, P = PV × ( r / (1−(1+r)−n))
P = $20,000 × (0.005 / (1−(1.005)−120))
P = $20,000 × (0.005/ (1−0.54963))
P = $20,000 × 0.011...
P = $220
Therefore, the value of each payment is $220.
 Perpetuity
The concept of regular payments that extend indefinitely is a common principle in finance. It’s
used in many different valuation theories to evaluate businesses, stock prices, and other
investments
The formula is expressed as follows: –
PV of Perpetuity = ICF / r
Here,
• The identical cash flows are regarded as the CF.
• The interest rate or the discounting rate is expressed as r.
If the perpetuity grows by a constant growth rate, then it would be expressed as described below:
–
PV of Perpetuity = ICF / (r – g)
Here,
• The identical cash flows are regarded as the CF.
• The interest rate or the discounting rate is expressed as r.
• The growth rate is expressed as g.
Problems on Perpetuity

Example 1: The business intends to receive an income of $120,000 for infinite tenure. The
cost of capital for the business is at 13 percent. The cash flows grow at the proportionate
basis of 3 percent. Help the management to determine it.

Solution

PV of Perpetuity = ICF / (r – g)

= $120, 000 / (13% – 3%)

= $1,200,000
Problems on Perpetuity

Example 2: Let us then take the example of the endowment scheme. The scheme intends to
provide an income of $320,000 for infinite tenure. The required rate of return is 10 percent.
Help the investor to determine it?Solution

PV of Perpetuity = ICF / (r – g)

= $320, 000 / 10%

= $3,200,000
VALUATION OF SECURITIES
 DETERMINANTS OF VALUATION
 Valuation requires determination of two things:

Expected Future Required

Dividens
1. Estimation of
Expected Future 2. The required rate rate of return
Cash Inflows of return for these = risk free
Expected Future expected cash flows
Share Price rate + risk
premium
 Valuation of Equity shares
 In finance, valuation is a process of determining the fair market value of an asset.
Equity valuation therefore refers to the process of determining the fair market value of
equity securities.

 Fair market value (FMV) is the price a product would sell for on the open market
assuming that both buyer and seller are reasonably knowledgeable about the asset, are
behaving in their own best interests, are free of undue pressure, and are given a
reasonable time period for completing the transaction.
 Dividend Capitalization Model
 Method for estimating a firm's cost of common (ordinary) equity. This approach
approximates a future dividend stream based on the firm's dividend history and an
assumed growth rate, and computes the market capitalization rate that equates it with
the current market price.
 Earnings Capitalization Approach
 The earnings capitalization model values the company based upon the company
earnings. To determine normalized earnings, you calculate a weighted average of
earnings over a period of years. The earnings reported on financial statements or tax
returns are normalized through several steps. These modifications include the deduction
of extraordinary gains or additions for losses, large employee salaries.

 Earnings are weighted based upon when earned. The most recent earnings are weighted
more heavily than older amounts. The weighting value depends on the stage of life of
the company and the company's growth over the time period. A mature company will
have more consistent earnings and will be weighted less than startup ventures with
rapidly changing annual earnings. The earnings are assumed to continue in perpetuity.