CORPORATE FINANCE

Topic 1

Nature of Corporate Finance

Objectives:

To understand about meaning of Business

finance;

Importance of corporate finance; Types of corporate firms;

To understand financial assets & financial system;

Significance and areas of financial decision making (Finance Functions); To understand role of finance manager; To study financial goals of an organization.

Introduction: Finance
Finance is concerned with Value and also

concerned
decisions.

with

how

to

make

best

Finance is defined as the provision of money at the time when it is required Finance: Management of flows of money

through an organisation.

Finance as to

providing of funds needed by a business.

Business Finance
Business Finance as an activity or a process which is concerned with ; - Acquisition of funds - Use of funds - Distribution of profit by a business Business finance can be classified into; * Sole proprietary finance * Partnership finance * Company or Corporate finance

Business Organization from Start-up to a Major Corporation

Sole proprietorship Partnership Corporation

Starting as a Proprietorship

Advantages:

Ease of formation Subject to few regulations No corporate income taxes

Limited life Unlimited liability Difficult to raise capital to support growth

Disadvantages:

Starting as or Growing into a Partnership

A partnership has roughly the same advantages and disadvantages as a sole proprietorship.

Advantages and Disadvantages of a Corporation

Advantages:

Unlimited life
Easy transfer of ownership Limited liability

Ease of raising capital

Double taxation Cost of set-up and report filing

Disadvantages:

Why is corporate finance important to all managers?

Corporate finance provides the skills managers need to:

Identify and select the corporate strategies and individual projects that add value to their firm. Forecast the funding requirements of their company, and devise strategies for acquiring those funds.

Real & Financial Assets

1) Real Assets: (i) Tangible real assets (ii) Intangible real assets

2) Financial Assets

What are Real Assets & Financial assets?

Real Assets: Tangible real assets Intangible real assets Financial Assets: A financial asset is a contract that entitles the owner to some type of payoff or they are also called as Securities Debt Equity Derivatives In general, each financial asset involves two parties, a provider of cash (i.e., capital) and a user of cash.

Equity and Borrowed Funds

Shares represent ownership rights of their holders. Shareholders are owners of the company. Shares can of two types:

Equity Shares Preference Shares

Loans, Bonds or Debts: represent liability of the firm towards outsiders. Lenders are not owners of the company. These provide interest tax shield.

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Equity and Preference Shares

Equity Shares are ordinary shares.

also

known

as

Do not have fixed rate of dividend. There is no legal obligation to pay dividends to equity shareholders.

Preference Shares have preference for dividend payment over ordinary shareholders.

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They get fixed rate of dividends. They also have preference of repayment at the time of liquidation.

FINANCIAL SYSTEM:
Funds
Deposits / Shares

FINANCIAL INSTITUTIOS Commercial Banks Insurance companies Mutual funds Provident funds NBFC

Funds Loans

Suppliers of funds

Individual
Business Government

Funds Private Placements Securities

Demanders of funds Individuals Business Government

FINANCIAL MARKETS

Funds Securities

Money Market Capital Market

Funds Securities

Significance of Corporate Finance

Corporate Finance is broadly concerned with

acquisition and use of funds by a business firm.

It scope may be;

How large should the firm be and how fast

should it grow?

What should be the composition of the firms assets?

What should be the mix of firms financing?

How should the firm analyse, plan and control its financial affairs?

Finance Functions / Objectives;

Long-Term Decision:

a) Investment or Long Term Asset Mix Decision

b) Financing or Capital Mix Decision c) Dividend or Profit Allocation Decision

Short-Term decision: Liquidity or Short Term Asset Mix Decision

Areas of Financial Decision Making

Capital Budgeting Decision - Investment

- Identification of Investment Opportunities

- Evaluation of capital projects - Selection of capital projects

Capital Structure Decision - Finance - Determining optimal debt-equity mix - Measurement of cost of capital - Mobilization of finance

Areas of Financial Decision Making

Dividend Decision

- Determination of Dividend policy

- Deciding interim dividends - Deciding stock dividends

- Tax considerations

Working Capital Management - Cash Management

- Receivables Management
- Inventory Management - Financing of WC requirement

Finance Managers Role

Raising of Funds Allocation of Funds Profit Planning Understanding Capital Markets

Role of finance manager

Firms Financial Operation
2

Finance Manager

1 4(b)

Capital Markets

4(a)

1. Tapping financing sources 2. Investment 3. CF generated 4. (a) Reinvestments (b) Return of capital

Status and Duties of Finance Executives Board of Directors Managing Director

Production Manager
Financial Manager Marketing Manager

Personnel Manager

TRESURER

CONTROLLER Planning and Budgeting

Performance Evaluation

Auditing

Credit Management
Cost Control

Inventory Management
Accounting

Retirement Benefits

Status and Duties of Finance Executives

The exact organisation structure for financial management will differ across firms. The financial officer may be known as the financial manager in some organisations, while in others as the vice-president of finance or the director of finance or the financial controller.

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Role of Treasurer and Controller

Two officersthe treasurer and the controllermay be appointed under the direct supervision of CFO to assist him or her. The treasurers function is to raise and manage company funds while the controller oversees whether funds are correctly applied.

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The Goal of Financial Management

Possible Goals:
Survive Avoid financial distress & bankruptcy

Beat the competition

Maximize sales or market share Minimize costs

Maximize profits
Maintain steady earning growth

Financial Goals

(a) Profit maximization (profit after tax)

(b) Maximizing Earnings per Share (c) Shareholders Wealth Maximization

(a) Profit Maximization

Maximizing the Rupee Income of Firm

Resources are efficiently utilized

Appropriate measure of firm performance

Serves interest of society also

Objections to Profit Maximization

It Ignores the Timing of Returns

It Ignores Risk Assumes Perfect Competition

In new business environment profit maximization is regarded as

Unrealistic

Difficult
Inappropriate

(b) Maximizing EPS

Market value is not a function of EPS. Hence maximizing EPS will not result in highest price for company's shares

Maximizing EPS implies that the firm should make no dividend payment so long as funds can be invested at positive rate of return

such a policy may not always work

I. M. Pandey, Financial Management, 9th ed., Vikas.

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(c) Shareholders Wealth Maximization

Maximizes the net present value of a course of action to shareholders. Accounts for the timing and risk of the expected benefits.

Benefits are measured in terms of cash flows.

Fundamental objectivemaximize the market value of the firms shares.

Value creation based on;

- Accounting profit vs cash flows - Timing of cash flows

- Risk of cash flows (situation like pessimistic, optimistic)

Profit maximization v/s Wealth Maximization

Ex:
Year 1 Year 2 Year 3 Total

Option 1
200 300 500 1000

Option 2
500 300 200 1000

Option 3
333.33 333.33 333.33 1000.00

Option-2 will maximize shareholders wealth though

it offers earlier returns.

Comparison of Profit & Wealth objectives:

Profit Max.
Returns Time factor Risk factor Yes No No

Wealth Max.
Yes Yes Yes

Need for a Valuation Approach

SWM requires a valuation model. The financial manager must know,

How much should a particular share be worth? Upon what factor or factors should its value depend?

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Risk-return Trade-off
Financial decisions of the firm are guided by the risk-return trade-off. The return and risk relationship: Return = Risk-free rate + Risk premium Risk-free rate is a compensation for time and risk premium for risk.

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Risk Return Trade-off

Risk and expected return move in tandem; the greater the risk, the greater the expected return. 35

What do firms do?

Business firms often persue several goals;

They seek to achieve high rate of growth Enjoy substantial market share Attain product and technological leadership Promote employee welfare

Employees & Customers satisfaction Support education and research

Finance Objectives
Capital Budgeting Decision
Capital Structure Decision

RETURN Market Value Of Firm

Dividend Decision

RISK
Working capital Decision