BASIC FINANCIAL

MANAGEMENT

Corporate Finance
What is corporate finance?
 All decisions that a business makes has financial
implications, and anything which affects the
finances of a business is a corporate finance
decision.
 Defined broadly, everything that a business does
can come under the umbrella of corporate finance.
Basic Construct of a Firm and Its Goals

 A Firm can be defined as any legal entity structure like

Proprietorship, Partnership, LLP, LLC, Pvt. Ltd., Ltd. etc

 A Firm is a separate legal entity that is different from the

Business Owner or Shareholders

 In larger Firms the Management of the Firm may be different

from the Promoters of the business and act like Agents of the
Promoters and Shareholders. In such a case, a Board of
Directors exists representing the promoters and shareholders
of the firm and to this Board the Management is accountable
The Goal of the Firm

 Efficient financial management requires the

existence of some objective or goal, because
judgment as to whether or not a financial decision is
efficient must be made in light of some standard
 Although various objectives are possible, we
assume here that the goal of the firm is to maximize
the wealth of the firm’s present owners
 This is broadly defined as Maximising Value of the
Firm
Financial Management & its First
Principles
 Financial management: Concerns the acquisition,
financing, and management of assets with some
overall goal in mind
 As discussed, the central goal is Maximising Value
Creation
 Judgment as to whether or not a financial decision
is efficient must be made in light of this core
standard
Major Areas of Financial Management -1?

 The Investment Decision: Invest in assets that earn

a return greater than the minimum acceptable hurdle
rate
 The hurdle rate should reflect the riskiness of the
investment and the mix of debt and equity used to
fund it.
 The return should reflect the magnitude and the
timing of the cashflows
Major Areas of Financial Management - 2?
 The Financing Decision: Use the right kind of debt for your
firm and the right mix of debt and equity to fund your
operations
 The optimal mix of debt and equity maximizes firm value
 The right kind of debt matches the tenor of your assets
 The Dividend Decision is a subset of the Financing
Decision and requires that if investments that make the
minimum acceptable rate cannot be found, return cash to
owners of the business as dividends or buybacks
 Quantum of cash that can be returned depends upon current
& potential investment opportunities
Major Areas of Financial Management - 3?

 Asset Management Decision: Once assets have been

acquired and appropriate financing provided, these
assets must still be managed efficiently
 This is divided between the Operating and the
Financial Managers of the Firm
 The Fixed Assets are usually managed by the
Operating Managers
 Decisions concerning management of Current Assets is
usually in the purview of the Financial Managers
Understanding Key Themes of the First
Principles?
 Theme 1: Corporate finance is “common sense”
 Theme 2: Corporate finance is focused on maximizing the value
of the business
 Theme 3: The focus in corporate finance changes across the life
cycle
 Theme 4: Corporate finance is universal. The objective in
corporate finance for all businesses remains the same:
maximizing value. While the constraints and challenges that
firms face can vary dramatically across firms, the first principles
do not change
 Theme 5: If you violate first principles, you will pay a price (no
matter who you are..)
 Time Value of Money?

 Which would you prefer – Rs1,000 today or Rs1,000 ten

years from today?
 Common sense tells us to take the Rs1,000 today because
we recognize that there is a time value to money
 The immediate receipt of Rs1,000 provides us with the
opportunity to put our money to work and earn interest
 The rate of interest can be used to express the time value
of money
 The rate of interest allows us to adjust the value of cash
flows, whenever they occur, to a particular point in time
 Types of Interest?
 Simple Interest: Interest paid (earned)on only the original amount,
or principal, borrowed (lent)
 SI = P0(i )(n); where SI = simple interest, P0 = principal, or original
amount borrowed (lent) at time period 0, i = interest rate per time
period, n = number of time periods
 Future value (terminal value): The value at some future time of a
present amount of money, or a series of payments, evaluated at a
given interest rate
 FVn = P0[1 + (i)(n)]
 Present value: The current value of a future amount of money, or a
series of payments, evaluated at a given interest rate
 PV0 = P0 = FVn /[1 + (i)(n)]
 Types of Interest?
 Compound interest: Interest paid (earned) on any previous interest
earned, as well as on the principal borrowed (lent)
 In general, FVn, the future (compound) value of a deposit at the
end of n periods, is
 FVn = P0(1 + i)n
 Present (or Discounted) Value: Calculating the present value of
future cash flows allows us to place all cash flows on a current
footing so that comparisons can be made in terms of today’s rupees
 PV0 = P0 = FVn /(1 + i)n
 Discount rate (capitalization rate) Interest rate used to convert
future values to present values
 Risk and Return?
 Return: The return from holding an investment over some
period – say, a year – is simply any cash payments
received due to ownership, plus the change in market
price, divided by the beginning price
 For common stock we can define one-period return as
 R= ((Dt + (Pt-Pt-1))/Pt-1
 Risk: The variability of returns from those that are
expected
 Under this definition all securities and ventures carry Risk
other than Treasury Securities that carry zero Default risk
 Using Probability Distributions to
Measure Risk?
  
Probability distribution: A set of possible values that a
random variable can assume and their associated
probabilities of occurrence
 Expected return: The weighted average of possible
returns, with the weights being the probabilities of
occurrence
 = ΣRiPi
 Standard deviation: A statistical measure of the
variability of a distribution around its mean. It is the
square root of the variance
 Diversification and Risk?
 Diversification:The concept of diversification makes such
common sense that our language even contains everyday
expressions that exhort us to diversify (“Don’t put all your eggs
in one basket”)
 The idea is to spread your risk across a number of assets or
investments
 Systematic risk: The variability of return on stocks or portfolios
associated with changes in return on the market as a whole
 Unsystematic risk: The variability of return on stocks or
portfolios not explained by general market movements. It is
avoidable through diversification
 Investment Decision: The Capital-
Asset Pricing Model (CAPM)?

 Capital-asset pricing model (CAPM): A model that describes the relationship

between risk and expected/required return (hurdle rate); in this model, a
security’s expected (required) return is the risk-free rate plus a premium based
on the systematic risk of the security
 The model assumes that capital markets are efficient in that investors are well
informed, transactions costs are low, there are negligible restrictions on
investment, and no investor is large enough to affect the market price of a stock
 Beta: An index of systematic risk. It measures the sensitivity of a stock’s
returns to changes in returns on the market portfolio. The beta of a portfolio is
simply a weighted average of the individual stock betas in the portfolio
 Characteristic line: A line that describes the relationship between an individual
security’s returns and returns on the market portfolio. The slope of this line is
beta
 CAPM contd..?

 Required Rates of Return: If we assume that

unsystematic risk is diversified away, the required rate
of return for stock j is:
 Rj = Rf + (Rm − Rf)βj
 Security market line (SML): A line that describes the
linear relationship between expected rates of return for
individual securities (and portfolios) and systematic
risk, as measured by beta
THANK YOU