Finance
Complete Notes

What is Finance?

Finance is the management of money and investments. Studies how businesses raise capital and invest it to maximize shareholder value.

Goals of Financial Management

• Maximize shareholder wealth: Increase stock price
• Maximize profit: Generate highest returns
• Ensure liquidity: Ability to pay short-term obligations
• Sustainable growth: Long-term value creation
• Manage risk: Balance safety with returns

Functions of Financial Manager

Areas of Finance

• Corporate Finance: Decisions within business
• Personal Finance: Individual wealth management
• Public Finance: Government fiscal policy
• International Finance: Cross-border transactions

Concept of TVM

Time Value of Money means money available today is worth more than the same amount in the future because you can invest it and earn returns.

Why TVM Matters?

• You can earn interest on money invested today
• Inflation reduces purchasing power
• Opportunity cost of capital
• Risk: Future is uncertain

Simple Interest vs Compound Interest

Key Formulas

Present Value (PV): What is it worth today?
PV = FV / (1 + r)^n

Future Value (FV): What will it be worth tomorrow?
FV = PV × (1 + r)^n

Where:
PV = Present Value
FV = Future Value
r = Interest rate per period
n = Number of periods

Practical Example

If I invest Rs. 10,000 today at 10% annual interest:
- After 1 year: FV = 10,000 × (1.10)^1 = 11,000
- After 5 years: FV = 10,000 × (1.10)^5 = 16,105.10

If I receive Rs. 20,000 after 5 years, worth in today's rupees?
PV = 20,000 / (1.10)^5 = 20,000 / 1.6105 = 12,418.64

Annuity Definition

Annuity is series of equal cash flows occurring at equal intervals. Examples: salaries, loan payments, insurance premiums.

Types of Annuities

Annuity Formulas

Future Value of Ordinary Annuity:
FVA = PMT × [((1 + r)^n - 1) / r]

Present Value of Ordinary Annuity:
PVA = PMT × [1 - (1 + r)^-n] / r

Perpetuity (forever):
PV = PMT / r

Where:
PMT = Periodic payment
r = Interest rate
n = Number of periods

Practical Example

You save Rs. 5,000 per year for 10 years at 8% interest.
FV = 5,000 × [((1.08)^10 - 1) / 0.08]
   = 5,000 × 14.4866
   = Rs. 72,433.09

Preferred dividends of Rs. 10,000 forever at 5% discount:
PV = 10,000 / 0.05 = Rs. 200,000

Bond Basics

Bond is a debt security where investor lends money to issuer. Issuer pays periodic interest (coupon) and returns principal at maturity.

Bond Features

• Face Value (Par): Amount repaid at maturity (usually Rs. 1,000)
• Coupon Rate: Annual interest rate (e.g., 8%)
• Coupon Payment: Annual interest paid (8% × 1,000 = Rs. 80)
• Maturity: Date when principal repaid
• Yield: Actual return earned

Bond Valuation

Bond Price = Sum of PV of all coupon payments + PV of face value

Example: 
Bond with Rs. 1,000 face, 8% coupon, 5 years, 10% market yield

Coupon payment = 1,000 × 0.08 = Rs. 80 annually

Bond Price = 80/(1.10) + 80/(1.10)^2 + ... + 80/(1.10)^5 + 1,000/(1.10)^5
           = Rs. 924.16

Bond Price Movement

• Interest rates ↑ → Bond price ↓
• Interest rates ↓ → Bond price ↑
• At maturity → Bond price = Face value

Bond Ratings

Stock Basics

Stock represents ownership in company. Stockholders entitled to profits (dividends) and appreciation.

Types of Stocks

Stock Valuation Methods

Dividend Discount Model (DDM)

Gordon Growth Model (constant growth):
P = D1 / (r - g)

Where:
P = Stock price
D1 = Next year's dividend
r = Required return (discount rate)
g = Constant growth rate

Example:
D1 = Rs. 50, r = 12%, g = 5%
P = 50 / (0.12 - 0.05) = 50 / 0.07 = Rs. 714.29

P/E Multiple Method

Stock Price = Earnings Per Share × P/E Multiple

If EPS = Rs. 10 and P/E = 15
Stock Price = 10 × 15 = Rs. 150

Factors Affecting Stock Price

• Company earnings and profitability
• Dividend payments
• Market conditions and economy
• Industry trends
• Management quality
• Interest rates

Capital Budgeting Definition

Capital Budgeting process of evaluating and selecting long-term investments (projects that affect company for multiple years).

Evaluation Criteria

Net Present Value (NPV)

NPV = -Initial Investment + CF1/(1+r)^1 + CF2/(1+r)^2 + ... + CFn/(1+r)^n

Example:
Project cost = Rs. 100,000
Cash flows Year 1-3: Rs. 40,000 each
Discount rate = 10%

NPV = -100,000 + 40,000/1.1 + 40,000/1.1^2 + 40,000/1.1^3
    = -100,000 + 36,364 + 33,058 + 30,053
    = -Rs. 525

Since NPV < 0, reject project

Internal Rate of Return (IRR)

Discount rate that makes NPV = 0. Represents project's return.

Risk Concept

Risk is uncertainty of returns. Higher risk investments offer higher potential returns.

Types of Risk

Expected Return

Expected Return = Σ (Probability × Return)

Example: Stock returns
50% chance of 15% return
50% chance of 5% return

E(R) = 0.5 × 15% + 0.5 × 5% = 10%

Variance and Standard Deviation

Variance measures spread of returns (volatility). Higher variance = Higher risk.

Capital Asset Pricing Model (CAPM)

Required Return = Rf + β(Rm - Rf)

Where:
Rf = Risk-free rate
β = Beta (systematic risk measure)
Rm = Market return

If Rf = 5%, β = 1.2, Rm = 12%
Required Return = 5% + 1.2(12% - 5%) = 5% + 8.4% = 13.4%

Capital Structure Definition

Capital Structure is mix of debt and equity used to finance assets. Affects risk and return.

Debt vs Equity

Optimal Capital Structure

Balance point where Weighted Average Cost of Capital (WACC) is minimized.

WACC = (E/V × Re) + (D/V × Rd × (1-Tc))

Where:
E = Market value of equity
D = Market value of debt
V = E + D (Total value)
Re = Cost of equity
Rd = Cost of debt
Tc = Tax rate

Example:
E = 600,000, D = 400,000, V = 1,000,000
Re = 15%, Rd = 8%, Tc = 30%

WACC = (600,000/1,000,000 × 0.15) + (400,000/1,000,000 × 0.08 × 0.70)
     = 0.09 + 0.0224 = 11.24%

Trade-off Theory

• More debt → Interest tax shield benefit (good)
• More debt → Bankruptcy risk increases (bad)
• Optimal point balances both

Financial Market Structure

Stock Exchange (Secondary Market)

• Pakistan Stock Exchange (PSX): Main stock exchange
• KSE-100 Index: Top 100 companies benchmark
• Functions: Liquidity, price discovery, regulation

Efficient Market Hypothesis

• Strong Form: No one can beat market
• Semi-strong: All public info in price
• Weak Form: Past prices don't predict future

Security Types

• Government Securities: Risk-free, backed by government
• Corporate Securities: Issued by companies
• Derivatives: Options, futures, swaps

Portfolio Concept

Portfolio is collection of investments. Combines different assets to achieve risk-return objectives.

Portfolio Return

Portfolio Return = Σ (Weight × Individual Return)

Example: 
60% in Stock A (10% return)
40% in Stock B (8% return)

Portfolio Return = 0.6 × 10% + 0.4 × 8% = 9.2%

Portfolio Risk

Depends on:

• Individual asset risks (variance)
• Correlation between assets (diversification benefit)

Key principle: Correlation < 1 reduces portfolio risk
Perfect correlation (r = 1): No diversification benefit
No correlation (r = 0): Maximum diversification benefit
Negative correlation (r = -1): Best diversification

Modern Portfolio Theory

• Efficient Frontier: Best portfolios for each risk level
• Optimal Portfolio: Highest return for given risk
• Diversification: Reduces unsystematic risk

Asset Allocation Strategy