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 Money
Solution: 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

Unlimited Liability
Personal tax on profits
Partnerships

Corporate Structure

Unlimited Liability
Partnerships

Corporations

Corporate Structure

Unlimited Liability
Partnerships

Limited Liability

Corporations Corporate tax on profits +
Personal tax on dividends

The Finance Function

Chief Financial Officer

The Finance Function

Chief Financial Officer

Treasurer Comptroller

Role of The Financial Manager

(1)

Firm's Financial Financial
operations manager markets

(1) Cash raised from investors


(2) (1)


(2) Cash invested in firm


(2) (1)


(3)

(3) Cash generated by operations


(2) (1)

(4a)

(3)

(4a) Cash reinvested


(2) (1)

(4a)

(3) (4b)

(4a) Cash reinvested
(4b) Cash returned to investors

Aim of Financial Manager
 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.

 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: Finance: Dividends:
Company decides to Company will need to If finance is not available from
take on a large number raise finance in order to external sources, dividends may
of attractive new take up projects need to be cut in order to
investment projects increase internal financing.
Dividends: Finance: Investment:
Company decides to pay Lower level of retained If finance is not available from
higher levels of dividend earnings available for external sources than company
to its shareholders investment means may have to postpone future
company may have to investment projects.
find finance from
external sources.
Finance: Investment: Dividends:
Company finances itself Due to a higher cost of The company’s ability to pay
using more expensive capital the number of dividends in the future will be
sources, resulting in a projects attractive to the adversely affected.
higher cost of capital. company decreases.

 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 Different Objectives

 Stock prices and returns  Managers vs.
 Issues of shares and stockholders
other securities  Top mgmt vs. operating
 Dividends mgmt
 Financing  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.

Shareholders
including institutions and
Creditors
private individuals
including banks, suppliers
and bond holders

THE COMPANY
Management

Employees

Customers

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.

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