1. introduction to corporate finance

Introduction to Corporate Finance

Topics Covered

What is Corporate Finance Key Concepts of Corporate Finance Compounding & Discounting Corporate Structure The Finance Function Role of The Financial Manager Separation of Ownership and Management Agency Theory and Corporate Governance

Corporate Finance

is concerned with the efficient and effective management of the finances of an organization in order to achieve the objectives of that organization.

This involves Planning & Controlling the provision of resources

(where funds are raised from)

Allocation of resources (where funds are deployed to)

Control of resources (whether funds are being used effectively or not)

Diff. b/w Corporate Finance & Financial Accounting

Corporate Finance is inherently forward-looking and based on

cash flows.

Financial Accounting is historic in nature and focuses on profit rather than

cash.

Diff. b/w Corporate Finance & Management Accounting

Corporate Finance is concerned with raising funds and providing a

return to investors.

Management Accounting is concerned with providing information to assist

managers in making decisions within the company.

Two Key Concepts in Corporate Finance

The fundamental concepts in helping managers to value alternative choices are

Relationship between Risk and Return

Time Value of Money

Relationship between Risk and Return

This concept states that an investor or a company takes on more risk only if higher return is offered in compensation.

Return refers to Financial rewards gained as a result of making an

investment. The nature of return depends on the form of the

investment. A company that invests in fixed assets & business

operations expects return in the form of profit (measured on before-interest, before-tax & an after-tax basis)& in the form of increased cash flows.

Relationship between Risk and Return Risk refers to

Possibility that actual return may be different from the expected return.

When Actual Return > Expected Return

This is a Welcome Occurrence. When Actual Return < Expected Return

This is a Risky Investment. Investors, Companies & Financial Managers are more

likely to be concerned with• Possibility that Actual Return < Expected Return

Investors & Companies demand higher expected return• Possibility of actual return being different from expected

return increases.

Time Value of Money Time value of money is relevant to both

Companies Investors

In wider context, Anyone expecting to pay or receive money over a

period of time.

Time value of money refers to the facts that Value of money changes over time.

Time Value of Money Imagine that your friend offers you either

Rs.1000 today or Rs.1000 in one year’s time. Faced with this choice, you will (hopefully) prefer to take Rs.1000 today.

The question is to ask that why do you prefer

Rs.1000 today?

Time Value of MoneySolution: There are three major factors Time: If you have the money now, you can spend it now. It

is human nature to want things now rather than wait for them. Alternatively, if you do not want to spend money now, you can invest it, so that in one year’s time you will have Rs.1000 plus any investment income earned.

Inflation: Rs.1000 spent now will buy more goods & services that Rs.1000 spent in one year’s time because inflation undermines the purchasing power of your money.

Risk: If you take Rs.1000 now you definitely have the money in your possession. The alternative of the promise of Rs.1000 in a year’s time carries the risk that the payment may be less that Rs.1000 or may not be paid at all.

Compounding is the way to determine the future value of a sum of money

invested now.

FV = C0(1+i)n

Where: FV = Future Value

C0 = Sum deposited now

i = Interest Rate

n = number of years until the cash flow occurs

Example: Rs. 20 deposited for five years at an annual interest rate of 6% will have future value of:

FV = 20 x (1+.06)5 = Rs.26.76

Compounding takes us forward from current value of an investment to its future value.

Discounting is the way to determine the present value of future cash flows.

PV = FV / (1+i)n

Where: FV = Future Value

PV = Present Value

i = Interest Rate

n = number of years until the cash flow occurs

Example: Investor choice between receiving Rs.1000 now & Rs.1200 in one year’s time. Annual Interest rate is 10%.

PV = 1200 / (1 + 0.1)1 = Rs.1091

Alternatively, PV of Rs.1000 into a FV

FV = 1000 x (1 + 0.1)1 = Rs.1110 Discounting takes us backward from future value of a cash

flow to its present value.

Corporate Objectives The objective should be to make decisions that

maximise the value of the company for its owners.

Financial Objective of Corporate Finance is stated as “Maximisation of shareholder wealth”.

Shareholder receive their wealth through increase in value of their shares, in the form of Dividends Capital Gains

Shareholder wealth will be maximised by maximising the value of dividends and capital gains that shareholders receive over time.

Corporate Structure

Sole Proprietorships

Partnerships

Corporate Structure


Partnerships

Unlimited Liability

Personal tax on profits

Corporate Structure


Corporations

Partnerships

Unlimited Liability


Corporate Structure


Corporations

Partnerships

Unlimited Liability


Limited Liability

Corporate tax on profits +

Personal tax on dividends

The Finance Function

Chief Financial Officer

The Finance Function

Chief Financial Officer

ComptrollerTreasurer

Role of The Financial Manager

Financial

managerFirm's

operations

Financial

markets

(1) Cash raised from investors

(1)


Financial

managerFirm's

operations

Financial

markets


(2) Cash invested in firm

(1)(2)


Financial

managerFirm's

operations

Financial

markets



(3) Cash generated by operations

(1)(2)

(3)


Financial

managerFirm's

operations

Financial

markets




(4a) Cash reinvested

(1)(2)

(3)

(4a)


Financial

managerFirm's

operations

Financial

markets




(4a) Cash reinvested

(4b) Cash returned to investors

(1)(2)

(3)

(4a)

(4b)

While accountancy plays an important role within corporate finance, the fundamental problem addressed by corporate finance is economic, i.e. how best to allocate the scarce resource of capital.

Aim of Financial Manager is the optimal allocation of the scarce resources available to them.

Aim of Financial Manager

Financial managers are responsible for making decisions about raising funds (the financing decision), allocating funds (the investment decision) and how much to distribute to shareholders (the dividend decision).


The high level of interdependence existing between these decision areas should be appreciated by financial managers when making decisions

Can you think how these decisions may be inter-related?


Interrelationship b/w Investment, Financing & Dividend Decisions

Investment: Company decides to take on a large number of attractive new investment projects

Finance: Company will need to raise finance in order to take up projects

Dividends:If finance is not available from external sources, dividends may need to be cut in order to increase internal financing.

Dividends: Company decides to pay higher levels of dividend to its shareholders

Finance: Lower level of retained earnings available for investment means company may have to find finance from external sources.

Investment: If finance is not available from external sources than company may have to postpone future investment projects.

Finance: Company finances itself using more expensive sources, resulting in a higher cost of capital.

Investment: Due to a higher cost of capital the number of projects attractive to the company decreases.

Dividends: The company’s ability to pay dividends in the future will be adversely affected.

Maximisation of a company’s ordinary share price is used as a surrogate objective to that of maximisation of shareholder wealth.


Ownership vs. Management

Difference in Information

Stock prices and returns Issues of shares and other securities Dividends Financing

Different Objectives

Managers vs. stockholders Top mgmt vs. operating mgmt Stockholders vs. banks and lenders

Agency & Corporate Governance

Managers do not always act in the best interest of their shareholders, giving rise to what is called the ‘agency’ problem.


Customers

Shareholdersincluding institutions and

private individualsCreditors

including banks, suppliersand bond holders

Management

Employees

THE COMPANY

Diagram showing the agency relationships that exist between the various stakeholders of a company


Agency is most likely to be a problem when there is a divergence of ownership and control, when the goals of management differ from those of shareholders and when asymmetry of information exists.


An example of how the agency problem can manifest itself within a company is where managers diversify to reduce the overall risk of the company, thereby safeguarding their job prospects.

Shareholders could achieve this themselves by diversification.


Monitoring and performance-related benefits are two potential ways to optimise managerial behavior and encourage ‘goal congruence’.


Due to difficulties associated with monitoring, incentives such as performance-related pay and executive share options can be a more practical way of encouraging goal congruence.


Institutional shareholders now own approximately 60 per cent of all UK ordinary share capital. Recently, they have brought pressure to bear on companies who do not comply with corporate governance standards.


The problem of corporate governance has received a lot of attention following a number of high profile corporate collapses and a plethora of self-serving executive remuneration packages.

In the UK, we have the example of Transport and Banking


UK corporate governance systems have traditionally stressed internal controls and financial reporting rather than external legislation.


Corporate governance in the UK was addressed by the 1992 Cadbury Report and its Code of Best Practice, and the 1995 Greenbury Report.

A financial manager can maximise a company’s market value by making good investment, financing and dividend decisions.


1. introduction to corporate finance

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