CORPORATE

FINANCE
PRIMER
 The primary goal of corporate finance is to figure out how to maximize a company's
value by making good decisions about investment, financing and dividends.
• How should businesses allocate scarce resources to minimize expenses and
maximize revenues?
• How should companies acquire these resources - through stock or bonds, owner capital
or bank loans?
• What should a company do with its profits? How much should it reinvest into the
company, and how much should it pay out to the business's owners?

▪ Working Capital Management

Investing
▪ Merges & Acquisitions
Decision
▪ Capital Expenditure
▪ Successful outcomes for the highest
▪ Dividend Policy
Payout
▪ Share Buyback
Decision
▪ Stock Split and Bonus Shares
▪ Successful outcomes for the highest
▪ IPO/FPO/QIP
Financing
▪ Debt/Equity/Warrants
Decision
▪ Foreign Market Vs Domestic Market
▪ Successful outcomes for the highest

Common Terms Used

• Equity: Ownership in the assets of the company by virtue of ownership of

shares of the company
• Payout options: Can be a Share Buyback, Capital Gains or Dividend payout
• Financing Options:
- Initial Public Offering (IPO): First listing of the company in a stock market
- Follow-on Public Offering (FPO): Money raising by an already listed firm
- Qualified Institutional Placement (QIP): Restricted to Institutional
Investors
- Rights Issues: Raising capital from existing shareholders
• Underwriter: Firm (Investment Bank) that buys the shares from the company
and sells it to the investors. If the shares are not sold, the bank guarantees
buying the shares
• French Auction: Helps in price discovery if no historic price is available as
there is no upper limit on bidding. Allotment on price-priority basis
• Traditional Auction: Bidding within a band of price. Allotment at a single price
• Green Shoe Option: A percentage of shares allotted to the Investment Bank to
stabilize the share prices immediately after listing

Debt / Bonds/ Debentures

• Capital issued against the assets of the company at an interest
• Assets can be liquidated if debt is not repaid (in case of a secured debt)
• Limited Liability: Shareholders are not liable to pay the debt

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 Convertible Bonds
• Option of converting to equity after a certain period of time
• Interest payment on the outstanding balance converted to principal (PIK Bonds)

Preferred Equity
• Ownership of the company share
• Fixed dividend payment annually before common shareholders are paid

Warrants
Entitles holders to buy shares at a pre-determined price. Issued warrants can be
exercised if the share price is more than the fixed price. Otherwise, they expire
unexercised.

Book Rate of Return

Book Rate of Return - Average income divided by average book value over project
life. Also called accounting rate of return

ARR = Book Income / Book Assets

Payback Period
• The payback period of a project is the number of years it takes before the
cumulative forecasted cash flow equals the initial outlay
• Decision rule:
• Accept if: Project Payback Period < Desired time frame
• For alternative projects: Choose one with lowest payback
• This method is flawed, primarily because it ignores later year cash flows and the present value
of future cash flows

NPV
• Takes care of Time Value of Money
• Estimate Cash Flows on an Incremental basis
• Include all incidental effects & Working Capital needs
• Include opportunity cost
• Don’t include Sunk Costs (costs that have been incurred already and cannot be
recovered)
• Treat inflation consistently
• Decision rule:
• Accept If: NPV > 0
• Reject If: NPV < 0
For alternative projects: Choose one with highest NPV

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IRR
• The implicit rate of return on a project, which equals the cost outlay of the project
to the cash inflows from the project over its lifetime
• Decision rule:
• Accept If: Project IRR > hurdle rate
• Reject If: Project IRR < hurdle rate
• For Alternative projects: Choose one with highest IRR
Normally same decision as NPV method, especially for Accept-Reject decisions, though some
exceptional situations exist
Profitability Index
• When resources are limited, the profitability index (PI) provides a tool for selecting
among various project combinations and alternatives
• PI = PV of inflows / PV of outflows
• A set of limited resources and projects can yield various combinations
• The highest weighted average PI can indicate which projects to select

Payout - Dividend Policy

• Cash Dividend: Payment of cash by the firm to its shareholders
• Stock Dividend: Distribution of additional shares to a firm’s stockholders
(also called bonus shares). Bonus shares do not change Fair value (FV) or par
value of shares. It changes the book value and are issued out of reserves and
surplus, hence also called capitalization of reserves
• Stock Splits: Issue of additional shares to firm’s stockholders. Number of shares
increase while per share price decreases leaving the total equity value unchanged.
However, unlike bonus shares, FV, BV, and MV all change in a stock split
• Stock Repurchase: Firm buys back stock from its shareholders

Companies prefer bonus shares because:

➢ A firm might be profitable but not liquid (low on cash) which makes it difficult to
do a stock split
➢ A firm might have enough cash but need it for positive NPV projects
➢ With bonus shares, a firm gives out returns to shareholders without maintaining
expectations of future dividends

The Dividend Decision

• Firms have longer term target dividend payout ratios
• Managers focus more on dividend changes than on absolute levels
• Dividends changes follow shifts in long-run, sustainable levels of earnings rather
than short- run changes in earnings
• Managers are reluctant to make dividend changes that might have to be reversed
• Firms repurchase stock when they have accumulated a large amount of unwanted
cash or wish to change their capital structure by replacing equity with debt

Dividend Policy
• Dividend Irrelevance: Since investors do not need dividends to convert shares to
cash, they will not pay higher prices for firms with higher dividend payouts
• In other words, dividend policy will have no impact on the value of the firm
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 • Signaling: Dividend increases send good news about cash flows and earnings.
Dividend cuts send bad news
• Taxation Implication: Companies can convert dividends into capital gains by
shifting their dividend policies. If dividends are taxed more heavily than capital
gains, taxpaying investors should welcome such a move and value the firm more
favorably

The capital budgeting process involves five key principles

1. Decisions are based on cash flows, not accounting income:
a. The relevant cash flows to consider as part of the capital budgeting process are
incremental cash flows, the changes in cash flows that will occur if the project
is undertaken
b. Sunk costs are costs that cannot be avoided, even if the project is not
undertaken. Because these costs are not affected by the accept/reject
decision, they should not be included in the analysis. An example of a sunk cost
is a consulting fee paid to a marketing research firm to estimate demand for a
new product prior to a decision on the project
c. Externalities are the effects the acceptance of a project may have on other
firm cash flows. The primary one is a negative externality called
cannibalization, which occurs when a new project takes sales from an existing
product. When considering externalities, the full implication of the new project
(loss in sales of existing products) should be taken into account. An example of
cannibalization is when a soft drink company introduces a diet version of an
existing beverage. The analyst should subtract the lost sales of the existing
beverage from the expected new sales of the diet version when estimated
incremental project cash flows. A positive externality exists when doing the
project would have a positive effect on sales of a firm's other product lines.’
d. A project has a conventional cash flow pattern if the sign on the cash flows
changes only once, with one or more cash outflows followed by one or more
cash inflows. An unconventional cash flow pattern has more than one sign
change. For example, a project might have an initial investment outflow, a
series of cash inflows, and a cash outflow for asset retirement costs at the end
of the project's life
2. Cash flows are based on opportunity costs. Opportunity costs are cash flows that a
firm will lose by undertaking the project under analysis:
a. These are cash flows generated by an asset the firm already owns that would
be forgone if the project under consideration is undertaken
b. Opportunity costs should be included in project costs. For example, when
building a plant, even if the firm already owns the land, the cost of the land
should be charged to the project because it could be sold if not used.
3. The timing of cash flows is important. Capital budgeting decisions account for the time
value of money, which means that cash flows received earlier are worth more than
cash flows to be received later.
4. Cash flows are analysed on an after-tax basis. The impact of taxes must be considered
when analysing all capital budgeting projects. Firm value is based on cash flows they
get to keep, not those they send to the government
5. Financing costs are reflected in the project's required rate of return. Do not consider
financing costs specific to the project when estimating incremental cash flows. The
discount rate used in the capital budgeting analysis takes account of the firm's cost of
capital. Only projects that are expected to return more than the cost of the capital
needed to fund them will increase the value of the firm

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Evaluation and selection of Capital projects

Independent vs. Mutually Exclusive Projects

Independent projects are projects that are unrelated to each other and allow for each
project to be evaluated based on its own profitability. For example, if projects A and B
are independent, and both projects are profitable, then the firm could accept both
projects. Mutually exclusive means that only one project in a set of possible projects
can be accepted and that the projects compete with each other. If projects A and B
were mutually exclusive, the firm could accept either Project A or Project B, but not
both. A capital budgeting decision between two different stamping machines with
different costs and output would be an example of choosing between two mutually
exclusive projects.

Project Sequencing
Some projects must be undertaken in a certain order, or sequence, so that investing
in a project today creates the opportunity to invest in other projects in the future. For
example, if a project undertaken today is profitable, that may create the opportunity to
invest in a second project a year from now. However, if the project undertaken today
turns out to be unprofitable, the firm will not invest in the second project.

Unlimited Funds vs. Capital Rationing

If a firm has unlimited access to capital, the firm can undertake all projects with
expected returns that exceed the cost of capital. Many firms have constraints on the
amount of capital they can raise and must use capital rationing. If a firm's profitable
project opportunities exceed the amount of funds available, the firm must ration, or
prioritize, its capital expenditures with the goal of achieving the maximum increase in
value for shareholders given its available capital.

Methods to evaluate a Single capital project:

Net Present Value (NPV)

The NPV is the sum of the present values of all the expected incremental cash flows if a
project is undertaken. The discount rate used is the firm's cost of capital, adjusted for
the risk level of the project. For a normal project, with an initial cash outflow followed
by a series of expected after-tax cash inflows, the NPV is the present value of the
expected inflows minus the initial cost of the project.

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A positive NPV project is expected to increase shareholder wealth, a
negative NPV project is expected to decrease shareholder wealth, and a zero
NPV project has no expected effect on shareholder wealth.
For independent projects, the NPV decision rule is simply to accept any project
with a positive NPV and to reject any project with a negative NPV.

Internal Rate of Return (IRR)

For a normal project, the internal rate of return (IRR) is the discount rate that makes
the present value of the expected incremental after-tax cash inflows just equal to the
initial cost of the project. More generally, the IRR is the discount rate that makes the
present values of a project's estimated cash inflows equal to the present value
of the project's estimated cash outflows. That is, IRR is the discount rate that makes
the following relationship hold:
PV (inflows) = PV (outflows)
The IRR is also the discount rate for which the NPV of a project is equal to zero:

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To calculate the IRR, you may use the trial-and-error method. That is, just keep
guessing IRRs until you get the right one, or you may use a financial calculator or
excel.
IRR decision rule: First, determine the required rate of return for a given project. This
is usually the firm's cost of capital. Note that the required rate of return may be higher
or lower than the firm's cost of capital to adjust for differences between project risk and
the firm's average project risk.

IRR
=

Both projects should be accepted because their IRRs are greater than the 10 % required
rate of return.
Advantages of IRR

• The IRR method is very clear and easy to understand. An investment is

considered acceptable if its internal rate of return is greater than an established
minimum acceptable rate of return or cost of capital
• The IRR method recognizes the time value of money and also uses cash
flows
• The internal rate of return is a rate quantity, an indicator of the efficiency,
quality, or yield of an investment

Disadvantages of IRR
• IRR, as an investment decision tool, should not be used to rate mutually
exclusive projects, but only to decide whether a single project is worth investing in
• IRR does not consider cost of capital; it should not be used to compare
projects of different duration
• IRR does not distinguish between lending and borrowing rates
• In the case of positive cash flows followed by negative ones and then by
positive ones, the IRR may have multiple values

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Multiple IRRs

• The IRR may have multiple values in certain exceptional cases of positive
cash flows being followed by negative ones and then by positive ones again
• It has been shown that with multiple internal rates of return, the IRR approach can still
be interpreted in a way that is consistent with the present value approach provided that
the underlying investment stream is correctly identified as net investment or net
borrowing

NPV vs IRR considerations

• IRR is relative, NPV is absolute

• Always consider NPV if both NPV and IRR are giving different outcomes
• NPV remains the “more accurate” reflection of value to the business. IRR,
as a measure of investment efficiency may give better insights in capital
constrained situations. However, when comparing mutually exclusive projects,
NPV is the appropriate measure
Payback Period
The payback period (PBP) is the number of years it takes to recover the initial cost of
an investment.
Because the payback period is a measure of liquidity, for a firm with liquidity
concerns, the shorter a project's payback period, the better. However, project
decisions should not be made on the basis of their payback periods because of the
method's drawbacks.
The main drawbacks of the payback period are that it does not take into account either
the time value of money or cash flows beyond the payback period, which means terminal
or salvage value wouldn't be considered. These drawbacks mean that the payback
period is useless as a measure of profitability.
The main benefit of the payback period is that it is a good measure of project liquidity.
Firms with limited access to additional liquidity often impose a maximum payback period
and then use a measure of profitability, such as NPV or IRR, to evaluate projects that
satisfy this maximum payback period constraint.

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Discounted Payback Period
Discounted payback period is next level of payback period where the cashflows are
discounted before calculating the period of payback.
Some companies prefer to calculate the payback period as it considers the time value
of money. The discounting can be done using the WACC (Weighted average cost of
capital) or IRR (Internal rate of return) or bank rate company got the lending or
government risk-free bond rate. The most appropriate rate to discount cash flows is
WACC (Weighted average cost of capital) or IRR (Internal rate of return). Let’s take an
example for calculating the discounted payback period.

Example: A project is having a cash outflow of $ 30,000 with annual cash inflows of $
6,000, so let us calculate the discounted payback period, in this case, assuming
companies WACC is 15% and life of the project is 10 years.

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 Year Cash flow Present Present value Cumulative
value factor of cash flows present value
@ 15% of cash flows

1 $ 6,000 0.870 $ 5,220 $ 5,220

2 $ 6,000 0.756 $ 4,536 $ 9,756

3 $ 6,000 0.658 $ 3,948 $ 13,704

4 $ 6,000 0.572 $ 3,432 $ 17,136

5 $ 6,000 0.497 $ 2,982 $ 20,118

6 $ 6,000 0.432 $ 2,592 $ 22,710

7 $ 6,000 0.376 $ 2,256 $ 24,966

8 $ 6,000 0.327 $ 1,962 $ 26,928

9 $ 6,000 0.284 $ 1,704 $ 28,632

10 $ 6,000 0.247 $ 1,482 $ 30,114

In this case, the cumulative cash flows are $ 30,114 in 10th year as, so payback period
is approx. 10 years. However, if you calculate the same in simple payback, the payback
period is 5 years ($30,000/$6,000).

Advantages and Disadvantages

Advantage: Discounted payback period is more reliable than simple payback period
since it accounts for time value of money. It is interesting to note that if a project has
negative net present value it won't pay back the initial investment.
Disadvantage: It ignores the cash inflows from project after the payback period.

Payback Period vs. Discounted Payback Period

The payback period is the amount of time for a project to break even in cash collections
using nominal dollars. Alternatively, the discounted payback period reflects the amount
of time necessary to break even in a project based not only on what cash flows occur,
but when they occur and the prevailing rate of return in the market. These two
calculations, although similar, may not return the same result due to discounting of
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 cash flows. For example, projects with higher cash flows toward the end of the project
life will experience greater discounting due to compound interest. For this reason, the
payback period may return a positive figure, while the discounted payback period
returns a negative figure.

COST OF CAPITAL

To value future cash flows today, we need to use a discount rate. The discount rate
should reflect the time value of money, risk of cash flows and should be market based.

Key points before using a discount rate:

• WACC (see below) is the appropriate discount rate for Free Cash flow to Firm
• Cost of Equity is the appropriate discount rate for Free Cash flow to Equity
• Currency of discount rate should match that of cash flows
• Cost of capital changes with change in leverage as risk changes
• In case of acquisition, acquiree’s Cost of Capital should be used

In order to calculate WACC, you need Cost of Debt and Cost of Equity:

Cost of Debt

COD is the return that the debt investors require. Cost is supposed to reflect the target long term
capital structure.
There are various ways to compute the same, keeping the following in mind:
• Debt which is listed on stock exchanges – Yield to maturity
• Debt which is rated but not listed on stock exchanges – Risk free rate or the
Government bond rate (for the relevant number of years as per instrument) + Spread
• Neither of the above – Understand the credit profile and benchmark against peers

Cost of equity

Cost of equity (rE) is the rate of return demanded by the investors. It is effectively the
opportunity cost of investing in the firm for equity holders.
Since, creditors have the first claim on the assets of the company; cost of equity is greater
than the cost of debt. Estimation of cost of equity presents considerably more challenge
compared to the cost of debt.
The method most commonly used is CAPM
As per CAPM,
𝐶𝑜𝑠𝑡 𝑜𝑓 𝐸𝑞𝑢𝑖𝑡𝑦=𝑅𝑖𝑠𝑘 𝐹𝑟𝑒𝑒 𝑅𝑎𝑡𝑒+𝛽∗(𝐸𝑞𝑢𝑖𝑡𝑦 𝑅𝑖𝑠𝑘 𝑃𝑟𝑒𝑚𝑖𝑢𝑚)
𝐾𝑒=𝑅𝑓+𝛽∗(𝑅𝑚−𝑅𝑓)

Rf or the risk-free rate accounts for the time value of money. This is usually taken to be
return on 10-year government bonds.

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The beta is a measure of how much risk the investment will add to a portfolio that looks
like the market. If a stock is riskier than the market, it will have a beta greater than one. If
a stock has a beta of less than one, the formula assumes it will reduce the risk of a
portfolio.

Equity Risk premium or Rm-Rf is the return expected from the market above the risk-free
rate.

Weighted Average Cost of Capital (WACC)

In the absence of taxes, ra is also the Weighted Average Cost of Capital (WACC). With
the presence of tax, however, the interest paid by the firm on its debt is tax deductible
and thus the after tax cost of debt becomes rD*(1-T) and thus for the firm, the weighted
average cost of capital comes out to be:

Here,

D = Market value of Debt (can use book value if MV not available)

E = Market value of Equity (ALWAYS use market value)
T = Tax rate
rd = Cost of Debt
re = Cost of Equity

Interest tax shield:

If the return on debt is rd, and the market value of debt is D, then:

Interest payment (I) = rd * D

Since this interest is tax deductible, the effective payment becomes rd*D – T*D = (rd-
T)*D and hence, we see that effective cost of debt become rd*(1-T).

Cost of Capital Considerations

• The expected return on capital must be greater than the cost of capital. The cost
of capital is the rate of return that capital could be expected to earn in an alternative
investment of equivalent risk
• The weighted average cost of capital multiplies the cost of each security (debt or
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 equity) by the percentage of total capital taken up by the particular security, and then
adds up the results from each security involved in the total capital of the company

Trade-off between Debt & Equity

• An important purpose of the trade-off theory is to explain the fact that corporations
are usually financed partly with debt and partly with equity. It states that there is an
advantage to financing with debt (interest rate tax shield)
• The marginal benefit of further increases in debt declines as debt increases while
the marginal cost increases, so that a firm that is optimizing its overall value will focus
on this trade-off when choosing how much debt and equity to use for financing
• One would think that firms would use much more debt than they do in reality. The
reason they do not is because of the risk of bankruptcy and the volatility that can be
found in credit markets-especially when a firm tries to take on too much debt

Pecking Order of Capital Sources

• When it comes to methods of raising capital, companies will prefer following in this
order:
a. Internal financing (Retained earnings)
b. Debt
c. Issue new equity
• Outside investors tend to think managers issue new equity because they feel the
firm is overvalued and wish to take advantage, so equity is a less desired way of
raising new capital. This then gives the outside investors an incentive to lower the
value of the new equity

LEVERAGE
• Operating leverage and financial leverage both tell you different things about a
company's financial health.
• Operating leverage is an indication of how a company's costs are structured and
also is used to determine its breakeven point.
• Financial leverage refers to the amount of debt used to finance the operations of
a company.

Operating Leverage is the relation between Sales & EBIT

Revenue – Variable cost) is also called Contribution. As is clear from the formula,
operating leverage arises from Fixed operating costs (rent, fixed salaries, depreciation).

If Fixed costs are 0, Degree of Operating Leverage (DOL) = 1

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Financial Leverage is the relation between EBIT & EPS

Financial leverage arises from fixed financial costs (interest on debt).

If interest expense is 0, Degree of Financial Leverage (DFL) = 0.

Combined/Total Leverage is the relation between EPS & Sales

LEVERAGE
• Operating leverage and financial leverage both tell you different things about a
company's financial health.
• Operating leverage is an indication of how a company's costs are structured and
also is used to determine its breakeven point.
• Financial leverage refers to the amount of debt used to finance the operations of
a company.

Operating Leverage is the relation between Sales & EBIT

(Revenue – Variable cost) is also called Contribution. As is clear from the formula,
operating leverage arises from Fixed operating costs (rent, fixed salaries, depreciation).

If Fixed costs are 0, Degree of Operating Leverage (DOL) = 1

Financial Leverage is the relation between EBIT & EPS

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 Financial leverage arises from fixed financial costs (interest on debt).

If interest expense is 0, Degree of Financial Leverage (DFL) = 0.

Combined/Total Leverage is the relation between EPS & Sales

Note: A company should not be high on both DOL & DFL

WORKING CAPITAL MANAGEMENT

Working Capital = Current Assets (CA) – Current Liabilities (CL)

Net Working Capital = Non-cash current Assets (CA) – Non-interest bearing current
liabilities (CL)

We remove cash because a large cash can earn fair market return, hence cannot be
viewed as a wasting asset. While other non-cash working capital does not earn any
return and an increase in NWC will be a cash inflow, a decrease will be a cash outflow.
We take non-interest bearing current liabilities because those are only considered in
calculation of Cost of Capital (as seen above).

The analysis of Net Working Capital is important to analyse investments, as the

incremental cash flows on a project are after non-cash working capital cash flows

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 Typical cycle of operations:

Operating and Cash Cycle

Operating cycle is the time between purchasing the inventory and collecting cash from
those sales.
Cash Cycle excludes payable days outstanding from operating cycle.

A company should try to reduce its operating and cash conversion cycle to maintain a
healthy working capital. Good supplier relationships and negotiations can help increase
payable days outstanding, bringing down cash conversion cycle.

Sources:
• CFA Study Material
• Brealey & Meyers

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