10/19/2022

Corporate Finance
L Ramprasath

Introduction

The central concerns of financial management:

How do you select projects? What investments should you
make?
How will you raise money to pay for these investments? How do
you decide on the optimal financing mix for these projects?
How much of the generated profits should be returned to
stockholders?
How will you handle the day-to-day financial activities like
collecting your receivables and paying your suppliers?

Objective function: Maximizing firm value

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Headings for these key functions

What is the goal for Financial management?

Maximize profit?
Minimize costs?
Maximize market share?

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“In a market-based economy that recognizes the rights of private

property, the only social responsibility of business is to create
shareholder value and to do so legally and with integrity.

“…It would be a profound error to view increases in a

company's value as concern just for its shareholders. Enlightened
managers and public officials recognize that increases in stock
prices reflect improvement in competitiveness - an issue that
affects everyone with a stake in the company - or the economy.

It would not be wrong to say that the goal of Financial

management is to Maximize shareholder wealth.

Are we overlooking
Customers?
Employees?
Suppliers?

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So how do you reconcile the above?

Only by focusing on creating value for its shareholders can a

firm ensure that it has durable and mutually beneficial
relationships with their customers, employees and suppliers.

With this understanding of the goal of FM, let’s look at the

first main concern of a firm.
How do you select projects? What investments should you
make?

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Why is the process of allocating or budgeting capital the most

important issue in Corporate Finance?

“Airlines, for example, are airlines because they operate

airplanes, regardless of how they finance them”

How do firms create value for its shareholders?

What is the real challenge?

Net Present Value (NPV) of an investment is the difference

between the investment’s market value and its costs.

How is it implemented in practice?

Capital budgeting becomes more difficult when we cannot

observe the market price of comparable investments.

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You are managing a firm in the agri sector. Suppose you get a
business proposal for producing and selling organic fertilizers.
Is this a good investment?
Cash revenues: 20 lakhs p.a.
Cash costs: 14 lakhs p.a.
Life of the business: 8 yrs with salvage value of 2 lakhs
Set-up costs: 30 lakhs
We will use a 15% discount rate on projects like this one.

If there are 1 lakh shares of stock outstanding, what will be

the effect on the price per share from taking the investment?

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NPV rule
Consistent with our goal of increasing shareholder’s wealth

Remarks
Process of discounting is not the challenging part, the task of
coming up with the CFs and the disc rate is much more
challenging.
Validating the estimate

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Another popular method: How long does it take the project

to “pay back” its initial investment?

Year A B C D E
0 -100 -200 -200 -200 -50
1 30 40 40 100 100
2 40 20 20 100 -75
3 50 10 10 -200
4 60 130 200
PB

(figures in ₹ ‘000s)

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Suppose we agree on an appropriate Payback period – 2 yrs

or less.
Year Long Short
0 -250 -250
1 100 100
2 100 200
3 100 0
4 100 0

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Despite its shortcomings, Payback period rule is often used

by large companies for making relatively minor decisions.

Many decisions do not warrant detailed analysis

Small investment decisions are made by the hundreds every day
in large organizations at all levels.
Require a PB of 2 yr or less for all investments < 50,000.
Investments higher than this will be subject to greater
scrutiny.

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What is discounted PB?

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Internal Rate of Return – IRR

With the IRR, we find a single rate of return that summarizes

the merits of a project.
And more importantly, this rate is internal !

Why is this important?

Many a times there are heated debates on what should be the
correct discount (risk-adjusted) rate.

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IRR: the discount rate that sets NPV to zero

IRR rule: Accept if the IRR exceeds the required return

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Suppose we have a mining project that requires a 60ℓ

investment. CFs in the first year will be 155ℓ and in the
second year, you incur a cost of 100ℓ in order to reclaim the
land as part of environment regulations.
Is this a value creating project, worth taking up?

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Modified IRR

To address the multiple IRR problem, a modified version is

sometimes used.

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The founder of Startech, the most successful company in the

last 20 yrs, has just retired. He receives an offer of $1m
dollar upfront, if he agrees to write a book on his corporate
experiences.

The timeline for the project is 3 yrs and he estimates that the
time he spends writing will cause him to forego alternative
sources of income amounting to $500,000 per year.

If he uses a discount rate of 10% to account for the riskiness

of his alternative sources of income and uses the IRR rule,
will he take up this offer?

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Consider the following investment. Suppose you don’t have

the time to get the complete NPV profile diagram.

Year CFs
0 -100
1 50
2 40
3 40
4 30

Is there a guarantee that this will have an unique IRR? (you’re

solving a 4th degree equation!)

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Two investments, X and Y, are said to be mutually exclusive if

taking one of them means we cannot take the other.
What should be the acceptance rule?

Independent Projects: accepting or rejecting one project does

not affect the decision of the other projects.
Must exceed a MINIMUM acceptance criteria

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Consider this situation

Year A B
0 -100 -100
1 50 20
2 40 40
3 40 50
4 30 60

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An extension of mutually exclusive investments: Capital

rationing.

Benefit cost ratio (also known as Profitability Index)

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Try this

An online retailer is planning to build a warehouse and it has

two choices. The size of the warehouse can be either small
or big at two different locations (not both) with the following
cash flows.
CF at date 0 CF at date 1
Small -10 mn 40 mn
Large -25 mn 65 mn

A 25% discount rate is considered appropriate for both the

investments.
Which one should they choose?

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