Last Lecture Summary

• Analysis of Financial Statements

• Key Financial Ratios
• Limitation of Financial Statements Analysis
• Market value added & Economic value added.
TIME VALUE OF MONEY
 Learning Objectives:
After going through this lecture, you would be
able to have an understanding of the following
concepts.
• Main Concepts of FM.
• Time Value of Money
• Interest Theory and its determinants
• Yield curve theory and its dynamics
 FM Concepts:
There are certain financial management concepts
that should be kept in mind, while making an
analysis of a financial decision. The one-liners given
here would help you in committing these concepts
to your memory.
• A rupee today is worth more than a rupee
tomorrow.
Time Value of Money & Interest
• A safe rupee is worth more than a risky rupee.
- Risk and Return
 FM Concepts:
• Don’t compare apples to oranges
- Discounting & NPV
• Don’t put all your eggs in one basket.
- Portfolio Diversification
• Get insurance because you will break some
eggs.
- Hedging & Risk Management
 Time Value of Money:
• The first concept, time value of money, says that a
rupee in your hand today is worth more than the
rupee that you are going to get tomorrow or the
day after.
• This is because if you have a rupee in hand, you
can put it into a bank (invest it) and can earn
interest (return) on it, and tomorrow you are
going to have more than rupee one, which of
course, is more desirable than having just one
rupee.
 Risk and Return:
• Investors want to earn maximum return on
their investment; however, risk is a constraint
to this objective. Investors dislike risk-bearing,
unless they are adequately compensated for
that. Now the risk and return concept states
that a safe rupee in your hand is better than a
risky rupee which is not in your hand.
 Risk and Return:
• This may imply that the investors would be
willing to bear risk if they are offered more
than a rupee i.e., a certain premium for risk
bearing. However, in the absence of this
additional compensation, a safe rupee is
better than a risky rupee. The details about
the concepts of risk and return would be
discussed in the middle of the course.
Discounting & Net Present Value (NPV):

The third concept is of discounting and net

present value of money. This is a fundamental
mathematical concept and students need to
practice it to perfection. Whether discounting
for an asset or a company, we have to see
what cash flow would it generate during its
future life and then we bring back those future
cash flow to the present, i.e., we discount the
future cash flows to obtain their present value.
Discounting & Net Present Value (NPV):

This exercise is done to make comparison of

cash flows occurring in different time periods,
i.e., comparing apples to apples, rather than
oranges. This concept is relentlessly used
throughout the course in comparing different
investment options in different time periods.
 Portfolio Diversification:
The fourth concept is of portfolio diversification
i.e. how to select different investment options
so as to reduce risk of losing the invested
money. For instance if an investor has a million
rupees and he invests his total wealth in a
single company’s share, he would be exposed
to greater risk. If the company goes out of
business or faces serious loss, the investor is
likely to lose all his investment.
 Portfolio Diversification:
However, if that investor puts his total wealth
into shares of ten different companies, the
chances that all the ten companies would face
loss is comparatively lesser and hence the risk
for the investor is diversified and reduced. The
rule of finance says do not put all your eggs in
one basket, because if you drop the basket
accidentally, you are likely to lose all the eggs.
 Hedging & Risk Management:

Finally, there is this fifth concept of hedging

and risk management. Hedging is a strategy of
risk management that is employed by
investors to reduce or minimize the chances of
loss. Insurance is said to be an effective tools
used to manage risk.
 Hedging & Risk Management:
The concept of hedging and risk management
says that whether you put your eggs in one
basket or in different baskets, chances are
there that you will break your eggs so it is
better to get the eggs insured Insurance is the
best way to avoid loss so that even if the loss
occurs you may get a claim on your damages.
 Interest Theory:
Now, let’s discuss the concept of interest in
detail, first major & technical area in financial
management. Remember, that the basic
objective in financial management is to
maximize shareholders wealth.
 Interest Theory:
• Economic Theory:
Interest rate is an equilibrium price, expressed
in percentage terms, at which demand and
supply of funds (or capital) meet, i.e., the rate
at which the lenders are ready to lend and
buyers are ready to buy. But equilibrium price
(Interest rate) varies from one market to
another.
 Interest Theory:
For example, the “price” of capital in the
property market is different from the “price”
of capital in the cotton market. Markets have
different interest rates guided by the supply &
demand of funds in that market. Although the
interest rates in different markets may differ,
however, all the markets in the country and
the interest rates prevailing there are
interlinked.
 Interest Theory:
Now, we come to the factors that determine
the interest rates. It is important to
understand the factors that make up an
interest rate in the present day business
environment. In business when we talk about
the interest, we usually refer to nominal rate
of interest which is determined with the help
of following factors.
 Interest Theory:
Factors
• i = iRF + g + DR + MR + LP + SR
• i is the nominal interest rate generally quoted in papers. The
“real” interest rate = i – g
• Here i = market interest rate
• g = rate of inflation
• DR = Default risk premium
• MR = Maturity risk premium
• LP = Liquidity preference
• SR = Sovereign Risk
The explanation of these determinants of interest rates is :
 Interest Theory:
Risk Free Interest Rate (RF): Factually speaking,
there is no such thing as a risk-free rate of return
because no investment can be entirely risk-free. All
the investments and securities include a certain
amount of risk. A company may go bankrupt or
close down. However, if we talk about the relevant
risk involved in different securities, the
government-issued securities are considered as
risk-free, since the chances of default of a
government are minimal.
 Interest Theory:
These government issued securities provide a
benchmark for the determination of interest
rates. Internationally the US T-Bills are
considered as risk free rate of return. In
Pakistan, Government of Pakistan T-Bills can
be used as a proxy for risk free rate of return,
however, since Pakistan faces some sovereign
risk, the T-bills would not be considered
entirely risk-free in the true sense.
 Interest Theory:
Inflation (g):
The expected average inflation over the life of
the investment or security is usually inculcated
in the nominal interest rate by the issuer of
security to cover the inflation risk. For
instance, consider a bond with a maturity of 5
years.
 Interest Theory:
If the inflation rate in Pakistan is 8 % and the
bond is also offering 8% percent interest rate,
the investors would not be willing to invest in the
bond since the gains from the interest rate would
be exactly offset by the inflation rate which is
actually eroding the wealth of the investor. To
secure the investor against inflation the issuers,
while quoting nominal interest rates, add the
rate of inflation to the real interest rate.
 Interest Theory:
Default Risk Premium (DR):
Default risk refers to the risk that the company
might go bankrupt or close down & bonds, or
shares issued by the company may collapse.
Default Risk Premium is charged by the investor,
as compensation, against the risk that the
company might goes bankrupt. Companies may
also default on interest payments, something
not very unusual in the corporate world.
 Interest Theory:
In USA, rating agencies like Moody’s and S&P
grade securities (debt and equity instruments)
according to their financial health and thus
identify those companies which have a good
ability to pay off their principal lending and
interest charges and those which might
default on the payments.
 Interest Theory:
The rating from best to worst is: AAA, AA, A,
BBB, BB, B, CCC, CC, C. In Pakistan, Pakistan
Credit Rating Agency (PACRA) and Vital
Information Services (VIS) are actively
conducting analysis of corporate securities
and grading them.
 Interest Theory:
Maturity Risk Premium (MR):
The maturity risk premium is linked to the life
of that security. For example, if you purchase
the long term Federal Investment Bonds
issued by the government of Pakistan, you are
assuming certain risk, because changes in the
rates of inflation or interest rates would
depreciate the value of your investment.
 Interest Theory:

These changes are more likely in the long term

and less likely in the short term. Maturity Risk
Premium is linked to life of the investment.
The longer the maturity period, the higher the
maturity risk premium.
 Interest Theory:
Sovereign Risk Premium (SR):
Sovereign Risk refers to the risk of government
default on debt because of political or
economic turmoil, war, prolonged budget and
trade deficits. This risk is also linked to foreign
exchange (F/x), depreciation, and devaluation.
 Interest Theory:

Now-a-days the individuals as well as

institutions are investing billions of rupees
globally. If a bank wants to invest in Pakistan,
it will have to take view of Pakistan’s political,
economic, and financial environment..
 Interest Theory:

If the bank sees some risk involved it would be

willing to lend at a higher interest rate. The
interest rate would be high since the bank
would add sovereign risk premium to the
interest rate. Here it may be clarified that
Pakistan is not considered as risky as many
other countries of Africa and South America
 Interest Theory:
Liquidity Preference (LP):
Investor psychology is such that they prefer
easily encashable securities. Moreover, they
charge the borrower for forgoing their
liquidity. A higher liquidity preference would
always push the interest rates upwards.
 Yield Curve Theory:
Term Structure and Yield Curve:
Interest rates for any security vary across time
horizon. The supply & demand for funds vary
depending on how long the funds are required.
Normally, short term interest rates are lower than
long term rates, or we can say that the interest
rates depend on their term structure. Based on the
maturity, the securities can be classified into three
categories, although, these classes have been
loosely defined.
 Yield Curve Theory:
• Short Term: Short term means for the period
of one year or less.
• Medium Term: For the period of any where
between one year to five years.
• Long Term: Any where between 15 years to 20
years some people say that medium term is
from 5 year to ten years and long term from
10 years to 20 years and plus.
Nominal or upward sloping yield curve:

The supply & demand of funds or capital

varies depending upon how long funds are
required. For example, today the supply and
demand for short term money might be
different from supply and demand of the long
term money. In another words, the number of
borrowers to take loan for one week may be
different from the borrowers of loan for one
year.
Nominal or upward sloping yield curve:

Short term interest may be different than the

long term interest; normally, short term
interest rates are lower than long term than
interest rates because investors think that
inflation is going to increase. This
phenomenon results in nominal or upward
sloping yield curve.
Nominal or upward sloping yield curve:

Abnormal or downward sloping yield curve:

Sometimes, the reverse is true. This is known
as the Abnormal (or Downward Sloping) Yield
Curve. It is the case where the short term
raters are higher than long term interest tares.
You can also have a mixed or Humped Back
Curve.
Nominal or upward sloping yield curve: