Corporate Finance

You would have heard a lot about this term “Corporate Finance”, if you belong to the finance domain. Corporate Finance forms the most
basic component of how a business is run. I am sure you would be interested to know why. But before we dig into the details of this broad
area, let’s take this example. Suppose you want to start a business. Let me ask you this, apart from the skills and ideas that you would
require to begin with it, what is the other most basic element required? Yes it’s quite simple, the answer is money. Any economic activity
whether big or small requires finance, rightly considered to be the life blood of business. There are various sources through which you
would raise funds such as your personal savings, borrowing from friends, family etc. You would not only require finance to start your
business as promotional finance but also as development finance to sustain in the long run. This same concept applies to corporations.
Read on to get a gist of all you wanted to know about Corporate Finance and any inhibitions you have had regarding it.

Business involves decisions which have financial consequences and any decision that involves the use of money is said to be a corporate
finance decision. Corporate finance is one of the most important part of the finance domain as whether the organization is big or small
they raise and deploy capital in order to survive and grow. There are various roles that corporate finance plays, which are very interesting
and challenging, one of the main roles is that of being a finance adviser. Corporate finance in investment banks is different from
departments like sales or trading, as in they are not trading or making markets but rather they help companies with certain financial
situations. In simple words they act as a broker or consultant when companies need to raise capital, are considering to merge or buy
another company or want to issue debt – all of which may enhance the value of their company. This can comprise helping to manage
investments or even suggesting a mergers and acquisitions (M&A) strategy. Along with this, the corporate finance people at the
investment bank will help the M&A deals go through as well.

In short as a corporate financier you would be working for a company to aid them find sources through which funds could be raised,
expand business, plan the future course of actions, manage money and ensure sound profitability and economic viability.

The objective of maximizing the value of the corporation while minimizing the risk is the soul of corporate financial theory.

Corporate Finance Principles

Let’s understand the three most fundamental principles in corporate finance which are- the investment, financing, and dividend principles.

Investment Principle:
This principle revolves around the simple concept that businesses have resources which need to be allocated in the most efficient way. The
first and important decision that needs to be made in corporate finance is to do this wisely, i.e. decisions that not only provide revenue
opportunities but also saves money for future. This also encompasses the working capital decisions such as the credit days to be allotted to
the customers etc. Corporate finance also measures the return on a planned investment decisions by comparing it to the minimum
tolerable hurdle rate and deciding if the project/investment is feasible to be undertaken.

Financing Principle:

Most often businesses are funded with either debt or equity or both. In the investment decision that we earlier discussed once we have
finalized the mix of equity and debt and its effects for the minimum acceptable hurdle rate, the next step would be to determine if the mix
is the right one in the financing principle section.
The job here for the corporate financier is to make sure that the business has right amount of capital and the right mix of debt, equity and
other financial instruments.

Business Valuation CourseEquity Research CourseProject Finance Course

In order to determine the optimal mix we need to study conditions where the optimal financing mix minimizes the acceptable hurdle rate.
We also need to analyze the effects on firm value due to the change in capital structure. After we have defined the optimal financing mix,
next we need to consider would be whether it would be a long term or a short term financing. We then include other considerations such
as taxes and land up with strong decisions on the structure of financing.
“The risk return tradeoff” – Riskier assets yield higher expected returns.
Dividend Principle:

Businesses reach a stage in their life cycle where they grow and mature and the cash flow they generate exceeds the expected hurdle rate.
At this stage the company needs to determine the ways of rewarding the owners with it. So the basic discussion here is that if the excess
cash should be left in the business or given away to the investors/owners. A company that is publicly held has the option of either pay off
dividends or buy back stocks.
Understanding the Concepts

Corporate finance is a very vast area of finance. There are so many fundamentals and concepts which need you should have a knack of.
Let’s understand a few of them;
1. Capital budgeting

Capital budgeting is the process of planning expenditures on assets (fixed assets) whose cash flows are expected to extend beyond one
year. Managers study projects and decide which ones to include in the capital budget.

 The “capital” refers to long-term assets.

 The “budget” is a plan which details projected cash inflows and outflows during future period.

The most common approaches that are used in project selection are discussed below:

Net Present Value (NPV):

This method discounts all cash flows (including both inflows and outflows) at the project’s cost of capital and then sums those cash flows.
The project is accepted if the NPV stands positive.
NPV = Σ [CFt/ (1 + k) t]

Where CFt is the expected cash flow at period t, k is the projects where CFT is the expected cash flow at period t, k is the project’s cost of

capital and n is its life.

Internal Rate of Return (IRR):

It is the discount rate that forces a project’s NPV to equal to zero.
NPV = Σ[CFt/(1 + IRR)t]

Note this formula is simply the NPV formula solved for the particular discount rate that forces the NPV to equal zero. The IRR is the
expected rate of return on a project. The NPV and IRR approaches will usually lead to the same accept or reject decisions.

Payback period: It is the expected number of years required to recover the original investment. Payback happens when the cumulative net
cash flow equals 0. The shorter the payback period, the better it is. A firm should establish a benchmark payback period and reject the
proposal if payback is greater than benchmark.

2. Time value of money “A dollar today is worth more than a dollar tomorrow”

If you have a dollar today, you can earn interest on it and have more than a dollar next year. For example, $100 of today’s money invested
for one year and earning 8% interest will be worth $108 after one year.
Annuity

An Annuity is a bunch of structured payments or equal payments made regularly, like every month or every year
Perpetuity
A perpetuity is a special kind of annuity – it has an infinite number of cash flows, all of the same dollar amount. Thus, it is an annuity that
never ends!
3. Cost of capital
Capital is an essential factor of production, and has a cost. The suppliers of capital require a return on their money. A firm must evidently
ensure that stockholders or those that have lent the firm money, such as banks, receive the return that they seek. The cost of capital is
significant for a firm to calculate, as this is the rate of return that must be used when evaluating capital projects. The return from the project
must be superior than the cost of the project in order for it to be acceptable.
One of the methods to calculate the cost of capital is Weighted Average Cost of Capital (WACC).The weighted average cost of capital
(WACC) is defined as the weighted average cost of the component costs of debt, preferred stock and common stock or equity. It is also
referred to as the marginal cost of capital (MCC) which is the cost of obtaining another dollar of new capital.
4. Working capital management

Working capital management involves the relationship between a firm’s short-term assets and its short-term liabilities. The goal of working
capital management is to ensure that a firm is able to continue its operations and that it has adequate ability to satisfy both maturing
short-term debt and upcoming operational expenses. The management of working capital encompasses managing inventories, accounts
receivable and payable, and cash.
5. Measures of leverage
Leverage, in the sense we use it here, refers to the amount of fixed costs a firm has. These fixed costs might be fixed operating expenses,
such as building or equipment leases, or fixed financing costs, such as interest payments on debt. Greater leverage leads to greater
variability of the firm’s after-tax operating earnings and net income.
With this we have touched upon the important concepts of corporate finance. There is lot more to learn in this vast area.

Corporate Finance Career Overview

As we all know that business make money which has to be managed well, which is when corporate finance team comes into picture.
Corporate finance professionals are accountable to manage the money of the organization i.e. to know from where to source it, deciding
how to spend it to get the maximum returns at the lowest possible risk. They seek to find ways to ensure flow of capital, increasing the
profitability and decreasing the expenses. They have to monitor the other departments on their expenditure and if the company is in a
position to take the risk of additional expenditure. They explore the best ways to help company expand whether it is through acquisition or
investing internally.
Well there is a different career profile of corporate finance in Investment Banks, here the corporate financiers must not only be aware about
the finance world, but also have clear viewpoints on investing, stocks and how to value companies. They can use their creativity here by
listening to what the client wants to achieve and then suggesting interesting and potentially revolutionary ways they can go about making
their thoughts a reality. Yes, the corporate finance team does get a lot of the glory and while salaries can go sky high, you’ll have to work
hard for it.
Corporate Finance Theory

Very general meaning of CORPORATE FINANCE is “Financial activities associated with running a business” The questions which are
answered by Corporate Finance are decision making about capital, finding the sources of capital, decisions regarding payment of dividend,
Finance involved in Mergers and Acquisitions processes of the corporate finance companies.
Corporate finance theory includes planning, raising, investing and monitoring of finance in order to achieve the financial objectives of the
company.
  TRaising seed, startup, expansion or development capital.
 Mergers, demergers, acquisitions or the sale of private companies
 Mergers, demergers, takeovers of public companies
 Raising capital via the issue of other forms of equity, debt and related securities for the refinancing and restructuring of businesses
 Financing joint ventures, project finance, infrastructure finance, public-private partnerships
 Raising debt and restructuring debt, especially when linked to the types of transactions listed above

Skeleton of Corporate Finance Theory and practice

Capital budgeting (Investment analysis)

 The “capital” refers to long-term assets.

 The “budget” is a plan which details projected cash inflows and outflows during the future period

When a firm is in a plan of doing long-term investments, for different purposes like, replacing the old machinery, buying of new machinery,
investing in new plants, developing new products, research and developments, it needs to do analysis of whether these projects are worth
funding of cash through the firm’s capital structure. Hence this entire process of analysis is called as capital budgeting. The capitalization
structure may include debt, equity and retained earnings.
Maximizing shareholder value

Financial management has the major goal of increasing the shareholder value. For this corporate
finance managers must balance between the investments in projects which will increase the firm’s profitability as well as sustainability and
paying of the excess cash in the form of dividends to shareholders.
With the resources and surplus cash, managers can invest these for the purpose of company expansion. So managers must do a proper
analysis to determine the appropriate allocation of the firm’s capital resources and cash surplus between projects and payment
of dividends to the shareholders.

Return on investment

Whenever we do any investment in the projector in terms of cash the purpose behind it is to earn on that
investment. In corporate finance theory, the same concept is applied to investing in some asset such that it will yield an appreciation of
value to the organization. Return on investment is the term which is used to measure the return earned in comparison with the capital
invested.
 Leveraged buyout
In terms of Mergers and Acquisitions, LBO is the very commonly used concept. LBO’s can have many different forms such as Management
Buy-Out(MBO), Management Buy-In (MBI), Secondary Buyout and tertiary buyout.
Growth Stock
A growth stock as the name suggests is a stock of a company which generates significant positive cash flow and its revenues are expected
to increase more rapidly than the companies from the same industry.
Popular Course in this category

Efficient-Market Hypothesis
The general meaning of this Efficient Market Hypothesis is,” the financial markets are efficient in terms of information”. The three major
forms of this hypothesis are: “weak”, “semi-strong”, and “strong”.
The weak form titles that prices on traded assets reflect all past publicly available information. The semi-strong form reflects all publicly
available information and that prices instantly change to reflect the new public information. Strong form claims that the prices instantly
reflect even hidden information.
Capital Structure
The firm can use the self-generated fund as a capital or can go for external funding which is obtained by issue of debt and equity. Debt
financing, of course, comes with an obligation which is to be made through cash flows regardless of project’s level of success.
Whereas equity financingis less risky with respect to cash flow payments but has a consideration in the ownership, control, and earnings of
the organization. Management should use optimal mix in terms of capital structure with due consideration to the timing and cash flow.

Working Capital
In order to sustain ongoing business operations, corporate needs to manage its working capital. Working capital is the subtraction of
current liabilities from current assets. Working capital is measured through the difference between cash or readily convertible into cash
(Current Assets) and cash requirements (Current Liabilities).

Assets

Assets on a Balance sheet are classified as Current assets and long terms assets. The duration for which certain assets and liabilities a firm

has in hand is very useful.

Bank Loans

Depending on the duration for which the loan is availed the bank loan is classified as short-term(one year or less) loans and long-
term(known as a term) loans.

Which are the sources of capital?

Debt capital
Debt can be obtained through bank loans, notes payable or bonds issued to the public. For debt through Bonds requires an organization
to make regular interest payments on the borrowed capital until it reaches its maturity date after which it must be paid back in full. In some
cases, if the interest expenses cannot be made by corporations through cash payments then the firm may also use collateral assets as a
form of repaying their debt obligations.
Equity Capital
A company can raise the capital through selling the shares in the stock market. Thus investors which are also called as shareholders buy the
shares with a hope of getting an appropriate return (dividends and increased shareholders value) from the company. Thus investors invest
only in those corporate finance companies which have positive earnings.
Preferred stock
It’s a combination of properties which are not possessed by equity and a debt instruments. These stocks do not carry voting rights but have
a priority over common stock in terms of dividend payments, assets allocation at the time of liquidation.
Cost of Capital
It is the rate of return which must be realized in order to satisfy investors. Cost of debt is the return required by the investors who invest in
the firm’s debt. Cost of debt is largely related to the interest the firm pays on its debt. Whereas the cost of equity is calculated as:
Cost of Equity = Risk Free Rate+Beta*Equity Risk Premium
The return from the project must be greater than the cost of the project in order for it to be acceptable.
The weighted average cost of capital (WACC) is defined as the weighted average cost of the component costs of debt, preferred stock,
and common stock or equity. It is also referred to as the marginal cost of capital (MCC) which is the cost of obtaining another dollar of new
capital.
WACC = E/V*Re+D/V*Rd(1-Tc)
Where:
Re = cost of equity
Rd = cost of debt
E = market value of the firm’s equity
D = market value of the firm’s debt
V=E+D
E/V = percentage of financing that is equity
D/V = percentage of financing that is debt
Tc = corporate tax rate

Investment and project valuation

Project’s value is estimated using a Discounted Cash Flow (DCF) valuation and the highest Net Present Value (NPV)
project will be selected. For finding out this, cash flows from the project are measured and then they are discounted to find their present
value. The summation of these present values is NPV.
There are some other measures as well, including discounted payback period, IRR, ROI, Residual Income Valuation, MVA / EVA.
Revenue, Expenses, and Inventory
An organization’s income is calculated by subtracting expenses from its revenue.
Not all the costs are considered as expenses, hence accounting standards have made certain specifications regarding which costs to be
allocated to the income statement as expenses and which costs to be allocated to inventory account and appear as an asset on balance
sheet.
Financial Ratios
Certain financial ratios are very helpful in evaluating firms performance. These a ratios are used to measure:
1. Leverage
2. Profitability
3. Turnover rates
4. Return on Investments
5. Liquidity
Cash Cycle
The time between the date the inventory (or raw materials) is paid for ant the date the cash is collected from the sale of the inventory is
termed as Cash cycle.
The corporate finance formula for calculating the cash cycle is:
Days in inventory + days in receivables – days in payables.

As cash cycle affects the need for financing it is very important from a corporate point of view.

Dividend policy
Payment of the dividend is mainly related to the dividend policy which is determined on the basis of a financial policy of the company. All
the matters regarding the issue of dividends, amount of dividends to be issued is determined by the company’s excess cash after payment
of all the dues. If the company has surplus cash and if it is not required by the business, in that case, a company can think about payment
of some or all of the surplus earnings in the form of dividends.

Sustainable Growth

Company’s Sustainable growth rate is calculated by multiplying the ROE by the earnings retention rate.

Risk Premiums

As we know the risk that a firm can face is Business Risk, Financial Risk, and Total corporate risk.

Business Risk: This risk associated with a firms operations. A measure of the business risk is the asset beta, which is also known as
unlevered beta.

Financial Risk: This risk is associated with the firm’s capital structure. It is affected by the firms financing decision.

Total Corporate Risk: This is the sum of Business and Financial risks and it is measured by the equity beta which is also called as levered
beta.

Share Buyback

Sometimes, a firm has extra cash on hand, so it may choose to buy back some of its outstanding shares. This eventually has an added
advantage, as a firm has its own information which market doesn’t have. Therefore, a share buyback could serve as a signal that the share
price has potential to rise at above-average rates.

Corporate finance theory and practice – Mergers and Acquisitions

Based on some financial or nonfinancial (expansion) reasons companies may merge. The target firm is acquired with the purpose that
synergies from the merger will exceed the price premium.

Though the word Corporate Finance theory sounds very limited, it has an association with the activities, and methodical aspects of a
company’s finances and capital.
In the area of Investment banking, the transactions in which capital is raised for the organization include:

 Seed capital, startup.

 Mergers and Demergers of the companies.
 Management Buyout (MBO’s), Leveraged Buyout (LBO’s)
 Capital raising through equity, debt
 Restructuring of the business

Financial Risk Management

Risk management has a very important role in every aspect of a business. Financial risk management is related to management of
corporate value in the event of adversarial changes in stock prices, commodity prices, exchange rates, interest rates.
Cost of Equity

Investors in a company’s equity require a rate of return appropriate to the risk they take in holding such equity. This cost reflects the
uncertainty of cash flows associated with the stock, primarily the combination of its dividends and capital gains. The cost of equity is,
essentially, the discount rate applied to expected equity cash flows which helps an investor determine the price he or she is willing to pay
for such cash flows. A higher discount rate (or cost of equity) will result in an issuing company receiving a lower price for its equity capital.
Thus, it has less to invest in the assets which generate returns for all capital holders (debt and equity).
The cost of equity varies with the risk of an issue. As with debt, a higher risk will result in a higher cost associated with taking this risk. In
general terms, it has been observed over time that the cost of equity is typically higher than the cost of debt. If a company goes bankrupt,
equity holders only receive a return after debt holders are paid. This is because debt holders have a prior claim on assets which reduces the
residual claim of equity holders. Conversely, if a company performs well, equity holders receive all the benefits of the upside while debt
holders receive only their contracted payments. The increased range of possible outcomes for equity holders, especially in companies with
high levels of debt, makes equity more risky and therefore an equity investor will demand a greater return than a holder of debt.

The risk of a given equity to an investor is composed of diversifiable and non diversifiable risk. The former is risk which can be avoided by
an investor by holding the given equity in a portfolio with other equities. The effect of diversification is that the diversifiable risks of various
equities can offset each other. The risk that remains after the rest has been diversified away is non diversifiable or systematic risk.
Systematic risk cannot be avoided by investors. Investors demand a return for such risk because it cannot be avoided through
diversification. Thus, investors demand a return for the systematic risk associated with a stock (as measured by its variability compared to
the market) over the return demanded on a risk-free investment. Beta measures the correlation between the volatility of a specific stock
and the volatility of the overall market. As a measure of a company’s or portfolio’s systematic risk, beta is used as a multiplier to arrive at
the premium over the risk-free rate of an equity investment.
n our last tutorial, we have learnt about estimation of cost of equity.In this article we will find beta for private company.

To find the Beta of a private company, we should first of all find all the listed comparables whose Beta’s are readily available. We will use
the average implied Beta of the comparable listed companies to calculate the Beta of the Private company. However, Higher amount of
Debt leads to higher variability in earnings (Financial Leverage). Higher financial leverage implies higher sensitivity to the stock prices.. The
beta of listed companies includes the effects of leverage and hence, these betas must be unlevered to obtain an unlevered beta. Hence, for
comparison of companies within a sector, we should remove the effect of financial leverage (capital structure).

Beta used in CAPM must be calculated by a three step process

Step 1 – Find the observed Beta’s of Comparables.

 Identify a set of comparable listed companies

 Find the Beta from each company’s stock price returns from Bloomberg or other database. This may also be calculated by
performing a regression of the stock returns against relevant index returns (regression with the relevant index returns)

If the mean of different companies’ Beta is not meaningful then it must not be used for analysis. This is because the capital structures of
different companies may be very different from the Industry structure
Step 2: Calculate the Unlevered Beta of the comparables
Unlevered Beta is calculated using the formula below

For Company 1, the Unlevered Beta Calculation is as follows

This removes the effect of capital structure on a company. This unlevered number can then be relevered to reflect an expected or target
level of debt. It is this relevered beta which is used in the CAPM formula.

The average unlevered beta = 0.60

Step 3: Relever the Beta
We then relever the beta at an optimal capital structure as defined by industry parameters or management expectations. The relevered

beta is used in the CAPM formula to calculate the cost of equity (Ke). The calculation for the relevered beta is as follows:

Use of gross debt or net debt in beta calculation

In the delevering of the beta of comparable companies, net debt is commonly used instead of gross debt. However, in situations where a
company has significant amount of cash in its balance sheet, its beta can be dramatically affected. Therefore, in these circumstances, gross
debt has to be used to delever the beta of the company. Subsequently we would have to adjust the obtained Beta (unlevered) to take into
account the cash component.

The beta of operating assets would then be used to calculate the beta of the company we want to value.