Introduction to Corporate

Finance
 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 theprovisionof resources
(where funds are raised from)

 Allocation of resources (where funds are deployed to)

 Control of resources(whether funds arebeing used

effectively or not)
 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 fundamentalconceptsin 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 actualreturnbeing 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.
 Compoundin
g
 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
Example: Rs. 20 deposited for five years at an annual interest
occurs
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.
 Discountin
g
 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
Example: flow
Investor
occurschoice 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 should be to make decisions that
objective the value of the company for its
 maximise

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
the value of dividends and capital gains
 Capital Gains


that shareholders receive over time.

 Corporate
Structure
Sole Proprietorships

Partnerships
 Corporate
Structure
Sole Proprietorships
Unlimited Liability
Personal tax on profits
Partnerships
 Corporate
Structure
Sole Proprietorships
Unlimited Liability
Personal tax on profits
Partnerships

Corporations
 Corporate
Structure
Sole Proprietorships
Unlimited Liability
Personal tax on profits
Partnerships

Limited Liability

Corporations Corporate tax on profits +

Personal tax on
dividends
 Chief Financial Officer

The Finance Function

 The Finance
Function

Chief Financial Officer

Treasurer Comptroller
 Role of The Financial
Manager
(1)

Firm's Financial Financial

operations markets
manager

(1) Cash raised from investors

 Role of The Financial
Manager
(2) (1)

Firm's Financial Financial

operations markets
manager

(1) Cash raised from investors

(2) Cash invested in firm
 Role of The Financial
Manager
(2) (1)

Firm's Financial Financial

operations markets
manager
(3)

(1) Cash raised from investors

(2) Cash invested in firm
(3) Cash generated by operations
 Role of The Financial
Manager
(2) (1)

Firm's Financial Financial

(4a)
operations markets
manager
(3)

(1) Cash raised from investors

(2) Cash invested in firm
(3) Cash generated by operations
(4a) Cash reinvested
 Role of The Financial
Manager
(2) (1)

Firm's Financial Financial

(4a)
operations markets
manager
(3) (4b)

(1) Cash raised from investors

(2) Cash invested in firm
(3) Cash generated by operations
(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.
 Role of The Financial
Manager
 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).
 Role of The Financial
Manager
 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 &
Investment:Dividend DecisionsDividends:
Finance:
Company decides to Company will need If finance is not available from
take on a large number raise financetoin order to external sources, dividends may
of attractive take up projects need to be cut in order
investment projects
new increase
to internal financing.
Dividends: Finance: Investment:
Company decides to pay Lower level of retained If finance is not available from
higher levels of earnings available external sources than company
dividend to its investment for means may to postpone future
shareholders company may have investment
have projects.
find to from
external
finance sources.
Finance: Investment: Dividends:
Company finances itself Due to a higher cost of The company’s ability to
using more expensive capital the pay of dividends in the future will
sources, resulting in a projects attractive
number to thebe
higher cost of capital. company decreases. adversely affected.
 Role of The Financial
Manager
 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.
Agency & Corporate
Governance
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 & Corporate
Governance
 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.
Agency & Corporate
Governance
 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.
Agency & Corporate
Governance
 Monitoring and performance-related benefits
are two potential ways to optimise
managerial behavior and encourage ‘goal
congruence’.
Agency & Corporate
Governance
 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.
Agency & Corporate
Governance
 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.
Agency & Corporate
Governance
 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
Agency & Corporate
Governance
 UK corporate governance systems have
traditionally stressed internal controls
and financial reporting rather than
external legislation.
Agency & Corporate
Governance
 Corporate governance in the UK was
addressed by the 1992 Cadbury Report and
its Code of Best Practice, and the 1995
Greenbury Report.
Agency & Corporate
Governance
 A financial manager can maximise a
company’s market value by making good
investment, financing and dividend
decisions.