INTRODUCTION TO FINANCE

AND CORPORATE FINANCE

UNIT – I
• Finance may be defined as the art and science of
managing money. It includes financial service
and financial instruments.
• Finance is referred as the provision of money at
the time when it is needed. Finance function is
the procurement of funds and their effective
utilization in business concerns.
According to Khan and Jain, “Finance is the art
and science of managing money”.

According to Oxford dictionary, the word

‘finance’ connotes ‘management of money’
DEFINITION OF FINANCIAL MANAGEMENT

The term financial management has been defined

by Solomon, “It is concerned with the efficient
use of an important economic resource namely,
capital funds”.
The most popular and acceptable definition of
financial management as given by S.C. Kuchal is
that “Financial Management deals with
procurement of funds and their effective
utilization in the business”.
 SCOPE OF FINANCIAL MANAGEMENT

1. Liquidity of Funds
2. Profitability
3. Management
4. Identification of groups
 FUNCTIONS OF FINANCE MANAGER

1. Forecasting Financial Requirements

2. Acquiring Necessary Capital
3. Investment Decision
4. Cash Management
5. Short-term financing
6. Forecasting profits and cash flows
7. Interrelation with Other Departments
8. Managing funds
 FINANCIAL DECISION AREAS
There are three decisions that financial
managers have to take:
• Investment Decision
• Financing Decision and
• Dividend Decision
 INVESTMENT DECISION
A financial decision which is concerned with how the firm’s funds are invested in
different assets is known as investment decision. Investment decision can be long-
term or short-term. It is the decision for creation of assets to earn income. It has to
be decided how the funds realized will be utilized on various investments.
Generally, the assets of a company are of two types — those which yield income
spreading over a year or so and assets which are easily convertible into cash within
a short time. The first type of investment decision is capital budgeting and the
second one is the working capital management.
Factors Affecting Investment Decisions / Capital Budgeting Decisions:
1. Cash flows of the project- The series of cash receipts and payments over the life
of an investment proposal should be considered and analyzed for selecting the best
proposal.
2. Rate of return- The expected returns from each proposal and risk involved in
them should be taken into account to select the best proposal.
3. Investment criteria involved- The various investment proposals are evaluated
on the basis of capital budgeting techniques. Which involve calculation regarding
investment amount, interest rate, cash flows, rate of return etc. It is to be considered
which technique to use for evaluation of projects.
 FINANCING DECISION
A financial decision which is concerned with the amount of finance to be
raised from various long term sources of funds like, equity shares, preference
shares, debentures, bank loans etc. Is called financing decision. This decision
relates to how, when and where funds are to be acquired to meet investment
needs. It is related to the capital structure or financial leverage. This is debt-
equity ratio.
Capital Structure = Owner’s Fund + Borrowed Fund
If more recourse is taken to debt capital, shareholders’ risk is lessened and the
prospects of their dividend earning are reduced. So, in financing decision, the
crucial point is the trade-off between returned risks.
The financing decision— unlike investment decision— relates to the
determination of the capital structure — the proper balance between debt and
equity.
 Factors affecting Financing Decisions
Cost: Financing decisions are all about allocation of funds and cost-cutting.
The cost of raising funds from various sources differ a lot. The most cost-
efficient source should be selected.
Risk: The dangers of starting a venture with the funds from various sources
differ. Larger risk is linked with the funds which are borrowed, than the
equity funds. This risk assessment is one of the main aspects of financing
decisions.
Cash flow position: Cash flow is the regular day-to-day earnings of
the company. Good or bad cash flow position gives confidence or
discourages the investors to invest funds in the company.
Control: In the situation where existing investors need to hold control of the
business then finance can be raised through borrowing money, however,
when they are prepared for diluting control of the business, equity can be
utilized for raising funds. How much control to give up is one of the main
financing decisions.
Condition of the market: The condition of the market matter a lot for the
financing decisions. During boom period issue of equity is in majority but
during a depression, a firm will have to use debt. These decisions are an
important part of financing decisions.
 DIVIDEND DECISION
Dividends decisions relate to the distribution of profits earned by the organization.
The major alternatives are whether to retain the earnings profit or to distribute to the
shareholders.
If sufficient dividend is not paid, shareholders will not be satisfied, the market value
of shares will come down and there may be financial crisis.
If the profits, on the other hand, are distributed to the maximum extent, the
company will lose on important source of self financing. So a judicious decision is a
must. There should be a good combination of distribution and retention.
The dividend decision boils down to the determination of net profits to be paid out
to shareholders as dividends. Here the management is to consider two major factors
— preference of the shareholders and the investment opportunities in the company.
 Factors Affecting Dividend Decisions
Earnings: Returns to investors are paid out of the present and past
income. Consequently, earning is a noteworthy determinant of the
dividend.
Dependability in Earnings: An organization having higher and
stable earnings can announce higher dividend than an organization
with lower income.
Balancing Dividends: For the most part, organizations attempt to
balance out dividends per share. A consistent dividend is given every
year. A change is made, if the organization’s income potential has
gone up and not only the income of the present year.
Development Opportunity: Organizations having great development
openings if they hold more cash out of their income to fund their
required investment. The dividend announced in growing
organizations is smaller than that in the non-development
companies.
OBJECTIVES OF FINANCIAL MANAGEMENT

Objectives of Financial Management may be

broadly divided into two parts such as:

1. Profit maximization
2. Wealth maximization.
 Profit Maximization

A business concern is also functioning mainly for

the purpose of earning profit. Profit is the
measuring techniques to understand the business
efficiency of the concern. Profit maximization is
also the traditional and narrow approach, which
aims at, maximizes the profit of the concern.
 Drawbacks of Profit Maximization
Profit maximization objective consists of certain drawback also:

(i) It is vague: In this objective, profit is not defined precisely or

correctly. It creates some unnecessary opinion regarding earning
habits of the business concern.

(ii) It ignores the time value of money: Profit maximization does not
consider the time value of money or the net present value of the cash
inflow. It leads certain differences between the actual cash inflow and
net present cash flow during a particular period.

(iii) It ignores risk: Profit maximization does not consider risk of the
business concern. Risks may be internal or external which will affect the
overall operation of the business concern.
 Wealth Maximization

The term wealth means shareholder wealth or

the wealth of the persons those who are involved
in the business concern. Wealth maximization is
also known as value maximization or net present
worth maximization. This objective is an
universally accepted concept in the field of
business.
 Favourable Arguments for Wealth
Maximization
(i) Wealth maximization is superior to the profit maximization
because the main aim of the business concern under this
concept is to improve the value or wealth of the
shareholders.
(ii) Wealth maximization considers the comparison of the
value to cost associated with the business concern. Total
value detected from the total cost incurred for the business
operation. It provides extract value of the business concern.
(iii) Wealth maximization considers both time and risk of the
business concern.
(iv) Wealth maximization provides efficient allocation of
resources.
(v) It ensures the economic interest of the society.
 IMPORTANCE OF FINANCIAL MANAGEMENT

• Financial Planning
• Acquisition of Funds
• Proper Use of Funds
• Financial Decision
• Improve Profitability
• Increase the Value of the Firm
• Promoting Savings
 Definition of Corporate Finance:

• Corporate finance is the area of finance dealing with the

sources of funding and the capital of corporations and the
actions that managers take to increase the value of the firm to
the shareholders, as well as the tools and analysis used to
allocate financial resources. The primary goal of corporate
finance is to maximize or increase shareholder.
• Corporate finance covers the financing and investing activities
of a company , Corporate finance is a subset of Financial
Management & it deals with raising of funds , management of
liquidity and working capital and working on investments.
Nature of Corporate Finance
Scope of Corporate finance
 Importance of Corporate Finance

• Decision Making
• Research and Development
• Fulfilling Long Term and Short Term Goals
• Depreciation of Assets
• Minimizing Cost of Production
• Raising capital
• Optimum Utilization of Resources
• Efficient Functioning
• Expansion and Diversification
• Meeting Contingencies
 AGENCY PROBLEM
A conflict of interest inherent in any relationship where one party is expected to act in
another's best interests. The problem is that the agent who is supposed to make the
decisions that would best serve the principal is naturally motivated by self-interest, and
the agent's own best interests may differ from the principal's best interests. The agency
problem is also known as the "principal–agent problem.“
In corporate finance, the agency problem usually refers to a conflict of interest between
a company's management and the company's stockholders. The manager, acting as the
agent for the shareholders, or principals, is supposed to make decisions that will
maximize shareholder wealth. However, it is in the manager's own best interest to
maximize his own wealth.
For example, a publicly-traded company's board of directors may disagree
with shareholders on how to best invest the company's assets. It especially applies
when the board wishes to invest in securities that would favor board members' outside
interests.
While it is not possible to eliminate the agency problem completely, the manager can
be motivated to act in the shareholders' best interests through incentives such as
performance-based compensation, direct influence by shareholders, the threat of firing
and the threat of takeovers.
 Corporate Governance
• Corporate governance is the combination of rules, processes or laws by
which businesses are operated, regulated or controlled. The term
encompasses the internal and external factors that affect the interests of
a company's stakeholders, including shareholders, customers, suppliers,
government regulators and management.
• Corporate governance structure specific the distribution of rights and
responsibilities among different participants in the corporation, such as the
board, managers, shareholders and other stakeholders, and spell out the
rules and procedures for making decisions on the corporate affairs.
 Principles of corporate governance
• All shareholders should be treated equally and fairly. Part of this is making
sure shareholders are aware of their rights and how to exercise them.

• Legal, contractual and social obligations to non-shareholder stakeholders

must be upheld. This includes always communicating pertinent information
to employees, investors, vendors and members of the community.

• The board of directors must maintain a commitment to ensure

accountability, fairness, diversity and transparency within corporate
governance. Board members must also possess the adequate skills
necessary to review management practices.

• Organizations should define a code of conduct for board members and

executives, only appointing new individuals if they meet that standard.

• All corporate governance policies and procedures should be transparent or

disclosed to relevant stakeholders.
 Characteristics of Corporate governance

• Trusteeship
• Transparency
• Empowerment
• Control
• Ethical Behaviour
 Essence of Good Corporate Governance

• The fundamental objectives of CG is the

enhancement of shareholders value keeping in
view the interest of other stockholders. Good
CG is built around three interrelated elements:
1. Accountability & Responsibility
2. Integrity & Trusteeship
3. Transparency & Disclosures.
 Corporate Valuation Model
• The process of financial evaluation begins with determining
the value of the target firm, which the acquiring firm should
pay. The following are some of the factors which have a
bearing on the value of a target firm:
i. Tangible and Intangible assets of the target firm.
ii. Market/Realizable value of the assets.
iii. Earnings of the firm.
The value of the firm should be assessed on the basis of the facts
and figures collected from various sources including the
published financial statements of the target firm.
 ASSET-BASED VALUATION METHODS

Asset-based business valuation methods center on the company’s

book value. It begins with a clear cut look at company’s total net
asset value, less total liabilities, according to our balance sheet.
In order to find out the assets value per share the preference share
capital, if any, is deducted from the net assets and the balance is
divided by the number of equity shares.
The method becomes less clear-cut when adding the value of
intangible assets like customer lists, branding, trademarks, and
copyrights is to be done.

Value of all Assets xxxx

Less:- External liabilities xxxx
Net Assets or Value. xxxx
• The assets valuations of the target firm may be based on :
➢ Book value of the assets
➢ Realizable value of the assets
A) Book value of the assets:
In this case the value of various assets given in the latest
balance sheet of the firm are taken as worth of the assets.
The assets valuations based on the book values of the
assets suffers from a shortcoming i.e., it is based upon
the historical values which may be irrelevant at present.
B ) Realizable value of the assets:
In this case. The current market prices on the realizable
values of all the tangible and intangible assets of the target
firm are estimated and from this the expected external
liabilities are deducted to find out the net worth of the target
firm
In case, the firm has been regularly revaluing its assets, there
wouldn’t be much difference between the BV and RV of the
assets.
There are two main approaches to an asset-based valuation:

GOING CONCERN
Going Concern is the approach to asset-based valuation methods
for a company that expects to continue operating and growing.
After referring to the balance sheet, negotiations will likely
focus on the assumed value of those intangible assets.

LIQUIDATION
Liquidation is the approach to asset-based valuation methods for
a company that is closing and liquidating its assets. This is an
important distinction from the Going Concern approach because
the liquidation value of assets is typically below fair market
value.
 EARNINGS-BASED VALUATION METHODS

Earnings-based business valuation methods value your company

by its ability to be profitable in the future. It is best to use
earnings-based valuation methods for a company that is stable
and profitable. the profits of the firm can either be past profits or
future expected profit .
The acquiring firm shows interest in taking over the target firm
for the synergistic efforts or the growth of the new firm . These
cash flows are then discounted at an appropriate rate of discount
to find out the present worth.
This present worth may be divided by the number of shares to
arrive at the value per share, which the acquiring firm should be
ready to pay to the shareholders of the target firm.
 Valuation based on earnings

If the current market price of the share is less than this

value, then the acquiring firm may have to pay a
premium on the market price to the shareholders of the
target firm.
• For example , the earnings of a firm are Rs 15,00,000 p.a. and
the capitalization rate is 12%, the valuation is:
Value = Rs. 15,00,000/12 X 100 = Rs. 12500000
Dividend – based Valuation :
In the cost of capital calculation, the cost of
equity capital, ke, is defined (under constant
growth model) as.
Ke = ( Do (1+g)/ Po ) + g = D1/P0 + g
This can be used to find out Po as follows:
• Po = Do (1+g)/ ke – g = D1/ ke – g
• For example, if a company has just paid a
dividend of Rs. 15 per share and the growth rate
in dividends is 7%. At equity capitalization of 20%,
the market price of the share is:

Po = 15(1+0.07)/0.20-0.07 = 16.05/0.13= Rs. 123.46

The dividend yield, like earnings yield can be

calculated as:

Dividend yield= Div. Per Share/ Market Price X 100

 CAPM- based Share Valuation
• CAPM is used to find out the expected rate of return , Rs as
follows:
Rs = Irf + (Rm – Irf)𝛽
Where Rs = Expected rate of return
Irf = Risk free rate of return
Rm = Rate of return on market portfolio
𝛽 = Sensitivity of a share to market

For example, if Rm is 12%, Irf is 8% and 𝛽 is 1.3 , what will be Rs.

What will be market price if Dividend paid is Rs. 20.
 Cash-flow based valuation

Valuation based on what the company can generate in the future

is the most common method of valuation. As in the analysis of
investment/financing projects, these methodologies analyze the
financial flows that the company can generate in the future and
which can be made available to the holders of the capital of the
company (equity and debt).
In this case the Value of the target firm may be arrived at by
discounting the cash flows as in the case of NPV method of
Capital Budgeting.
Expected cash flows may be calculated either from the point of
view of the total firm or from the point of view of the equity
shareholders.
• Cash flows from the point of view of total firm: The cash flows to
the firm are the net operating profit after tax plus depreciation and
other non-cash expenses.
The operating cash flows to firm may be discounted to find out
the valuation of the business.
In this case the valuation of the firm is equal to the present
value of all expected operating cash flows.
• Cash flows from the point of view of equity shareholders: In this
case OCFF is adjusted to find out the free cash flow to equity
shareholders as :

OCFF XXXXX
Less : Interest on loan & debentures XXXX
Less Preference dividend XXX
CF for equity shareholders XX

In order to find out the value of the firm, the cash flows are discounted
at the overall cost of capital, WACC
There are quite large array of methodologies
within cash-flow base methods; some of the
most widespread are:
1. Economic Value Added – EVA.
2. Market Value Added - MVA
 Economic Value Added
• EVA is based upon the concept of economic return
which refers to excess of after tax return on capital
employed over the cost of capital employed.
• The concept of EVA, as developed by Stern Stewart
& Co. of the U.S. compares the return on capital
employed with the cost of capital of the firm.
• EVA is defined in terms of returns earned by the
company in excess of the minimum expected return
of the shareholders.
• EVA is calculated as the net operating profit
(EBIAT) minus the capital charges.
EVA = EBIT – Taxes – Cost of Capital employed.
In India, EVA has emerged as a popular
measure to understand and evaluate financial
performance of accompany. Several companies
have started showing the EVA during a year as a
part of Annual Report.
 Market Value Added
MVA is another concept used to measure the
performance and as a measure of value of a
firm.
MVA is determined by measuring the total
amount of funds that have been invested in the
company and comparing with the current
market value of the securities of the company.
 Arbitrage pricing theory (APT)
• Arbitrage pricing theory (APT) is a multi-
factor asset pricing model based on the
idea that an asset's returns can be
predicted using the linear relationship
between the asset's expected return and a
number of macroeconomic variables that
capture systematic risk. It is a useful tool for
analyzing portfolios from a value
investing perspective, in order to identify
securities that may be temporarily mispriced.
The Formula for the Arbitrage Pricing Theory Model
Is
E(R)i​=E(R)z​+(E(I)−E(R)z​)×βn
where:
E(R)i​=Expected return on the asset
Rz​=Risk-free rate of return
βn​=Sensitivity of the asset price to macro economic
factor n
Ei=Risk premium associated with factor I

The beta coefficients in the APT model are

estimated by using linear regression. In general,
historical securities returns are regressed on the
factor to estimate its beta.
THANK YOU