Module code: AFU 07303

Module Name: CORPORATE FINANCE

Academic year 2021/2022

BAC 2, BBF 2 $ BEF 2

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 Learning Outcomes:
i. Describe the nature, significance and scope of corporate finance.
ii. Apply various tools of financial analysis, forecasting and
planning techniques.
iii. Apply principles of working capital management.
iv. Describe concepts of dividend policy
v. Describe risk-return relationship and to identify efficient
portfolio
vi. Analyze valuation of companies for merger and acquisition
decisions
vii. Explain different sources of short-term and long-term financing
and their costs.
viii. Explain financial leverage and capital structure policy
ix. Apply various techniques to evaluate investment projects.

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 MODULE ASSESSMENT
General Assessment:
o Coursework = 40%
o Final Exam = 60%

Composition of Coursework
o Class Test 1 = 15 Marks
o Class Test 2 = 15 Marks
o Tutorial Assessment = 10 Marks

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The Nature, Significance and Scope
of Corporate Finance
 Corporate Finance Mind Map

MARKETS
NPV
PORTFOLIO THEORY

COST OF CAPITAL

AGENCY THEORY
INVESTMENTS

CAPITAL
DIVIDEND POLICY STRUCTURE

SHAREHOLDER
VALUE
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 The nature, significance and scope of
Corporate Finance
 Every decision made in a business has financial
implications, and any decision that involves the use of
money is a corporate financial decision.

Corporate finance is mainly concerned with

 procurement of fund, and
 Efficient utilization of funds.

Corporate finance sometimes is referred to as Managerial

Finance, Business Finance or Financial Management.

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 The Role of the Financial Manager

Every discipline has first principles that govern

and guide everything that gets done within it.
All of corporate finance is built on three
principles, which are usually referred to as roles of
the financial manager necessary for financial
decision-making:
 Investment decision,
 Financing decision and
 Dividend decision.

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 i) The Investment Decision
 Invest in assets and projects that yield a return
greater than the minimum acceptable hurdle rate.

 The hurdle rate should be higher for riskier projects

and should reflect the financing mix used - owners’
funds (equity) or borrowed money (debt).

 With regard to this type of decision, the financial

manager needs to identify the profitable investment
opportunities.
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 ii) The Financing Decision

Choose a financing mix (debt and equity)

that maximizes the value of the investments
made and match the financing to nature of
the assets being financed.

financial manager is faced with challenges

of determining how the investments of the
firm will be financed.

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 iii)The Dividend Decision:

If there are no profitable investments, return the

cash to the owners of the business. In the case of
a publicly traded firm, the form of the return -
dividends or stock buybacks - will depend upon
what stockholders prefer.

The financial manager needs to take into

considerations the following questions in order
to formulate the dividend pay out decisions.
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 The Dividend Decision…
Should the firm distribute high dividends
and finance the business growth through
new issues of equities or debt?
Should the firm distribute low dividends
and use the retained earnings to finance the
business expansions? or
Should the firm pay zero dividends and use
the whole earnings for profitable investment
opportunities?
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 The Objectives of The Firm
Different organisations have different
objectives to accomplish depending upon the
nature and situation of the business. The
following can be considered as the objectives
of the firm;
Maximization of shareholders wealth
Maximization of profits
Maximization of sales
Minimizing costs

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 Objectives …
Survival of the firm
Creating an ever expanding empire
Maximization of managerial salaries
Maximization of personal objectives
Achieving the target market share, etc

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 Objectives …
In practice, it is quite impossible for companies
to have all these objectives in place at once.
The most widely accepted objective of the firm
is to maximize the wealth of owners
(shareholders), which is achieved by increasing
the market value of share.
The wealth of corporate owners is measured by
the share price of the stock, which in turn is
based on the timing of returns (cash flows), their
magnitude, and their risk.
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 Forms of Business Organization

Three forms namely:

soleproprietorship,
partnership and
a company.

Sole proprietorship
A sole proprietorship is a business that is owned and
operated by one person. This individual has a right
to all the profits and bears all of the liability for the
debts and obligations of the business.

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 Partnership
A partnership is an association of two or more
persons acting as co-owners of a business for profit.
Each partner contributes money, property, labor,
skills, and each share in the profits as well as the loss
of the business.

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 Corporation
A corporation (company) is a legal entity separate from
its owners:
Corporations can borrow money and own property (acquire assets),
can sue and be sued by its own name, and can enter into contracts.
A company is owned by shareholders but controlled
or managed by directors.
A company pays taxes on its profits.
 The remaining profits are distributed to the
shareholders who pay personal income tax on this
income. This system is referred to as double
taxation.
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 Concept Check
 You are a shareholder in ABC company. The company earns
TZS10,000 per share before taxes. After it has paid taxes, it will
distribute the rest of its earnings to you as a dividend (we make this
simplifying assumption, but should note that most corporations
retain some of their earnings for reinvestment). The dividend is
income to you, so you will then pay taxes on these earnings. The
corporate tax rate is 40% and your tax rate on dividend income is
15%. How much of the earnings remains after all taxes are paid?
 TZS10,000 per share * 0.40 = TZS4000 in taxes at the corporate level, leaving
$TZS10,000 – TZS4,000 = TZS6,000 in after corporate tax earnings per share to
distribute.
 You will pay TZS6,000 * 0.15 = TZS900 in taxes on that dividend, leaving you
with TZS5,100 from the original TZS10,000 after all taxes.
 Thus, your total effective tax rate is 400+900/10,000 = 49%.

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 Difference Between PLC vs. Ltd
Companies are categorised as Public limited company (plc.) or Private
limited company (Ltd).
PLC can quote shares in a stock exchange whereas the Ltd Company
cannot.
Talking of shares, the government may hold a majority of shares in a
Public Limited Company. This does not happen in a Ltd company as the
majority of the shares will be with a family or with private individuals.
In a public Limited Company, the shares can be transferred freely. This
can not be done with the Ltd Company.

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 Difference Between PLC vs. Ltd...
The shares in a PLC can be bought and sold through the
stock exchange and there is no need to consult the owners
for selling and buying shares. On the other hand, the
shares of Ltd Company are normally sold to close friends
and others and that can only be done if all the
shareholders agree.
While an Ltd company thinks more of profit from the
business, the Public Limited Company cares less of profit
as it is concerned with services and goods for the public.
If something goes wrong with a Public Limited
Company, it has very adverse impact on the public.
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 The Agency Problem
This constitutes:
o Agency problem
o Agency theory
o Agency costs
Agency problems arise when there is a conflict between
the interests of the agent (e.g. the managers) and those of
the principal (e.g. shareholders).
Agency costs are the costs associated with the agency
problem and arise mainly due to the conflict of interest
between the managers and the shareholders.

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 Agency Theory
An agency relationship exists when one or more
persons, called principals (shareholders),
 hires one or more persons, called agents (directors), to
perform some service,
And delegates decision-making authority to them.

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 Ways to reduce agency conflict:
Mitigate agency problems through:
Threat of firing or Sackings
Threat of takeover and selling shares
Granting share options to directors and senior
managers
Maintaining good relationship
Profit related pay
Direct intervention by shareholders.

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 TIME VALUE OF MONEY

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 Time Value of Money
Basic Problem:
How to determine value today of cash flows that
are expected in the future?
Time value of money refers to the fact that a dollar
in hand today is worth more than a dollar promised
at some time in the future
Which would you rather have [TZS1,000,000
today or TZS1,000,000 in 5 years]?
Obviously, TZS1,000,000 today; why?

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 Time Value of Money…
A dollar received today is worth more than a dollar received
tomorrow:
This is because a dollar received today can be invested to earn
interest
Another reason behind this concept is that, future cash flows
are not only subject to risk but also inflation.
Money received sooner rather than later allows one to
use the funds for investment or consumption purposes.
This concept is referred to as the Time value of money!!
TIME allows one the opportunity to postpone
consumption and earn Interest.

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 Simple and Compound Interests

 Simple Interest
Is interest paid or earned only on the principal. The
Principal is the original amount of money you
deposit or borrow.
 Compound Interest
Is interest earned not only on the principal, but also
on the interest that has already been earned, i.e.
earning interest on interest.
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 Types of TVM Calculations
There are many types of TVM calculations
The basic types that will be covered in this class
include:
Present value of a lump sum
Future value of a lump sum
Present and future value of cash flow streams
Present and future value of annuities
Keep in mind that these forms can, should, and
will be used in combination to solve more complex
TVM problems.

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 Compounding and Future value

Compounding is the way to determine the future value

of a sum of money invested now:
For example in a bank account, where interest is left in
the account after it has been paid.
Interest is earned on re-invested interest in the future.
Future value is calculated using the formula:

FVt  P0 (1  r ) t or FVt  P0  FVIFr ,t

Where: (1+r)n is called the compounding factor

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 Future Value of a Lump Sum
A lump sum is a one-time payment or repayment of
funds at a particular point in time. A lump sum can
be either a present value or future value.
Future value determines the amount that a sum of
money invested today will grow to in a given period
of time
The process of finding a future value is called
“compounding”.
Compounding is the process of earning interest on
previous interest earned, along with the interest
earned on the original investment.
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 Future Value of a Lump Sum
Example

How much money will you have in 3 years if

you invest TZS1million today at a 10% rate of
return?
Formula: FVt = P0 × (1+r)t
FV3 = $1,000,000 × (1+0.1)3
FV5 = $1,331,000

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 Future Value of a Lump Sum
Exercise

1. XYZ wants to know how large the deposit of

TZS10million today will become at a compound
annual interest rate of 10% for 5 years.
years
2. If you invest $1,000 today at an interest rate of 10
percent, how much will it grow to be after 5 years?
3. If you invest $11,000 in a mutual fund today, and
it grows to be $50,000 after 8 years, what
compounded, annualized rate of return did you
earn?

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 Present Value of a Lump Sum

Present value calculations determine what the value of a

cash flow received in the future would be worth today.
The process of finding a present value is called
“discounting”
Discounting is the procedure used to calculate the
present value of an individual payment or a series of
payments that will be received in the future based on an
assumed interest rate or return on investment.
The interest rate used to discount cash flows is
generally called the discount rate.
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 Present Value of a Lump Sum

The interest rate used to discount cash flows is

generally called the discount rate

FVt
PV  PV  FVt  PVIFr ,t
(1  r ) t

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 Present Value of a Lump Sum
Example
How much would $100 received five years from
now be worth today if the current interest rate is
10%?
PV = FVt / (1+r)t
PV = 100 / (1 + .1)5
PV = $62.09

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 Present Value of a Lump Sum
More Examples

1. Assume that you need to have exactly $4,000 saved

10 years from now. How much must you deposit
today in an account that pays 6% interest,
compounded annually, so that you reach your goal
of $4,000?

2. Joann needs to know how large of a deposit to make

today so that the money will grow to $2,500 in 5
years. Assume today’s deposit will grow at a
compound rate of 4% annually
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 Present Value of a Cash Flow Stream

A cash flow stream is a finite set of payments that an

investor will receive or invest over time.
The PV of the cash flow stream is equal to the sum of
the present value of each of the individual cash flows
in the stream.

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 Example of PV of a Cash Flow Stream

Joe made an investment that will pay $100 the first

year, $300 the second year, $500 the third year and
$1000 the fourth year. If the interest rate is ten
percent, what is the present value of this cash flow
stream?
You can use a timeline:

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 PV of a Cash Flow Stream
Example …

Draw a timeline:
100 300 500 1000

0 1 2 3 4
?
?
r = 10%
?
?
PV = $90.91 + $247.93 + $375.66 + $683.01
PV = $1397.51
PV= [FV1/(1+r)1]+[FV2/(1+r)2]+[FV3/(1+r)3]+[FV4/(1+r)4]
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 Future Value of a Cash Flow Stream

The future value of a cash flow stream is equal to the

sum of the future values of the individual cash flows.
With unequal periodic cash flows, treat each of the
cash flows as a lump sum and calculate its future value
over the relevant number of periods.
Sum up the individual future values to get the future
value of the multiple payment streams.

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 FV of a Cash Flow Stream
Time Line

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 FV of a Cash Flow Stream

Example: Future Value of an Uneven Cash Flow

Stream
Jim deposits $3,000 today into an account that pays
10% per year, and follows it up with 3 more deposits
at the end of each of the next three years. Each
subsequent deposit is $2,000 higher than the previous
one. How much money will Jim have accumulated in
his account by the end of three years?

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 FV of a Cash Flow Stream
Example…

FV of Cash Flow at T0 = $3,000 x (1.10)3 = $3,000 x 1.331= $3,993.00

FV of Cash Flow at T1 = $5,000 x (1.10)2 = $5,000 x 1.210 = $6,050.00
FV of Cash Flow at T2 = $7,000 x (1.10)1 = $7,000 x 1.100 = $7,700.00
FV of Cash Flow at T3 = $9,000 x (1.10)0 = $9,000 x 1.000 = $9,000.00
Total = $26,743.00
Note:
Be aware that some CFs occur at the beginning of each
period while others occur at the end of each period.

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 FV of a Cash Flow Stream
Exercise
Joe made an investment that will pay $100 the first
year, $300 the second year, $500 the third year and
$1000 the fourth year. If the interest rate is ten
percent, what is the future value of this cash flow
stream if each cash flow occur
i. At the beginning of each period
ii. At the end of each period

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 Annuity Streams

An annuity is a cash flow stream in which the cash

flows are all equal and occur at regular intervals.
Annuity can be categorized as:
 Annuity Due: Payments or receipts occur at the
beginning of each period; e.g. house rent
 Ordinary Annuity: Payments or receipts occur at
the end of each period; e.g. salary.

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 Future Value of Ordinary Annuity
Compounding and summing for each payment.
 The formula for calculating the future value of an
annuity stream is as follows:

(1  r )  1
n
FV A  A[ ] FVA  A  FVIFA r ,n
r

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 FV of Ordinary Annuity
example

Example: Future Value of an Ordinary Annuity

Stream
Jill has been faithfully depositing $2,000 at the end of each
year for 10 years into an account that pays 8% per year.
How much money will she have accumulated in the
account?

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 FV of Ordinary Annuity
solution
Future Value of Payment One = $2,000 x = $3,998.01
1.089
Future Value of Payment = $2,000 x = $3,701.86
Two 1.088
Future Value of Payment = $2,000 x = $3,427.65
Three 1.087
Future Value of Payment = $2,000 x = $3,173.75
Four 1.086
Future Value of Payment = $2,000 x = $2,938.66
Five 1.085
Future Value of Payment Six = $2,000 x = $2,720.98
1.084
Future Value of Payment = $2,000 x = $2,519.42
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 FV of Ordinary Annuity
solution using formula
Using the formula

(1  0.08)  1
10
FV A  2,000[ ]
0.08
 $2,000 14.4866
 $28,973.1250

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 FV of Ordinary Annuity
Exercise
Suppose you want to accumulate $500,000 at the
end of 30 years as your retirement money. The
interest rate you can make annual deposits is 8%.
How much should you deposit each year, so that
you will have $500,000 at the end of 30 years?
Assume that Sally owns an investment that will
pay her $100 each year for 20 years. The current
interest rate is 15%. What is the FV of this
annuity?

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 Present Value of Ordinary Annuity
Discounting and summing for each payment.
The generalized formula is

n
1  (1  r )
PVA  A[ ] PVA  A  PVIFA
r

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 PV of Ordinary Annuity
time line at r = 8%

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 PV of Ordinary Annuity
example
Example: Present Value of an Annuity.
John wants to make sure that he has saved up
enough money prior to the year in which his
daughter begins college. Based on current
estimates, he figures that college expenses will
amount to $40,000 per year for 4 years (ignoring
any inflation or tuition increases during the 4 years
of college). How much money will John need to
have accumulated in an account that earns 7% per
year, just prior to the year that his daughter starts
college?
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 PV of Ordinary Annuity
solution

For; r = 7% and n = 4, PVIFA =3.3872

PVA = A*PVIFA = 40,000 × 3.3872
= $135,488

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 APPLICATION OF PV OF ANNUITY
LOAN AMORTIZATION
 An amortized loan is a loan paid off in equal payments –
consequently, the loan payments are an annuity.
 Examples: Home mortgage loans, Auto loans
 In an amortized loan, the present value can be thought of as
the amount borrowed, n is the number of periods the loan
lasts for, i is the interest rate per period, and payment is the
loan payment that is made.
 Example 1: Suppose you plan to get a $9,000 loan from a
furniture dealer at 18% annual interest with annual payments
that you will pay off in over five years. What will your
annual payments be on this loan?
55  PMT=PV*i/[1-1/(1+i)n] =2,878.00. 09/12/21 04:56
 APPLICATION OF PV OF ANNUITY
LOAN AMORTIZATION
Year Amount Owed Annuity Interest Repayment Outstanding
on Principal Paymen Portion of the Loan
at the t (2) of the Principal Balance at
Beginning of Annuity (3) Portion of Year end,
the Year (1) = (1) × the Annuity After the
18% (4) = Annuity
(2) –(3) Payment (5)
=(1) – (4)

1 $9,000 $2,878 $1,620.00 $1,258.00 $7,742.00

2 $7,742 $2,878 $1,393.56 $1,484.44 $6,257.56

3 $6257.56 $2,878 $1,126.36 $1,751.64 $4,505.92

4 $4,505.92 $2,878 $811.07 $2,066.93 $2,438.98

5 $2,438.98 $2,878 $439.02 $2,438.98 $0.00

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 APPLICATION OF PV OF ANNUITY
LOAN AMORTIZATION
Example 2: Consider a 4-year loan with annual payments.
The interest rate is 8% and the principal amount is $5,000.

Year Beginning Total Interest Principal Ending

Balance Payment Paid Paid Balance
1 5,000.00 1,509.60 400.00 1,109.60 3,890.40
2 3,890.40 1,509.60 311.23 1,198.37 2,692.02
3 2,692.02 1,509.60 215.36 1,294.24 1,397.78
4 1,397.78 1,509.60 111.82 1,397.78 0.00
Totals 6,038.42 1,038.41 4,999.99

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 Annuity Due

A cash flow stream such as rent, lease, and insurance

payments, which involves equal periodic cash flows
that begin right away or at the beginning of each time
interval, is known as an annuity due.
An annuity due is calculated in reference to an
ordinary annuity. In other words, to calculate either
the present value (PV) or future value (FV) of an
annuity-due:
Annuity Due = Ordinary annuity x (1 + r)

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 Annuity Due
example

Example: Annuity Due versus Ordinary Annuity

Let’s say that you are saving up for retirement and
decide to deposit $3,000 each year for the next 20 years
into an account that pays a rate of interest of 8% per
year. By how much will your accumulated nest egg
vary if you make each of the 20 deposits at the
beginning of the year, starting right away, rather than at
the end of each of the next twenty years?

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 Annuity Due
solution
FV ordinary annuity = $3,000 × [((1.08)20 - 1)/.08]
= $3,000 × 45.76196
= $137,285.89
FV of annuity due = FV of ordinary annuity ×
(1+r)
FV of annuity due = $137,285.89 × (1.08)
= $148,268.76

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 Evaluating Perpetuities

A series of constant cash flows expected to occur

at the end of each year for ever and ever into the
future is known as a perpetuity.

C
PVA 
r

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 Perpetuity
Example
Example 5: PV of a Perpetuity
If you are considering the purchase of a consol that
pays $60 per year forever, and the rate of interest
you want to earn is 10% per year, how much
money should you pay for the consol?
 Answer:
r=10%, A = $60, and PV = ($60/0.1) = $600.
So $600 is the most you should pay for the consol.

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