School of Business and Administration

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Corporate Finance
BBF304/05

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 Unit 1
OVERVIEW OF CORPORATE FINANCE

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INTRODUCTION TO CORPORATE FINANCE:
What is Corporate Finance?

 Corporate finance is a scope of study on firm’s business financial decision.

However, the term corporate finance does not constraint the study to only
corporate firm, and excludes small and private businesses from its purview.

 What or where should you invest your capital?

This decision is not constraining to investing into financial asset such as stocks
or bonds, this is also a critical decision in every aspect in running a business.

 Where to get the money to finance your investment?

A decision between debt financing and equity financing.

 How to manage your profit?

This decision relates to retaining resource for current use or for future use.

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 The Scope of Corporate Finance

 The three core decisions in corporate finance :

i. The Investment Decision
The decision in which a business or a firm invests in assets (current and non-
current) to generate income.

ii. The Financial Decision

The decision in which the firm acquire the financing, in order to acquire the
assets.

iii. The Distributing Decision

The decision in repaying the stockholders, mostly in the form of dividend
payout.

 Corporate finance is mainly concerned with how to optimally decide on the

three corporate financial decisions above to maximize the shareholder value.

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The Scope of Corporate Finance (cont.)

 The conventional way of introducing corporate finance is to focus around three

topics:

i. Capital budgeting (Long-term investment decision)

Capital budgeting deals with identification of investment value based on the
net present value of all the list of projects available relative to their cost of
financing.

ii. Capital Structure (Long term financing structure of the firm)

It is about the relative weight of debt and equity financing.

iii. Working Capital Management (Short term financing issues)

The main objective of working capital management is to ensure firm day-to-
day operations are not interrupted.

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 The Forms of Business Organization

In Malaysia, there are three different types of business entities:

 Sole Proprietorship (also known as Sole Trader)

 Partnership business entity

 Company (Incorporation)

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 The Basic Corporate Structure

Figure 1.1 General Corporate Structure

 Corporate structure refers to the
various department a Shareholders

corporation allocates tasks,

coordinates and supervises in Board of Directors

the process of achieve the

corporate mission and Chief Executive Officer
(CEO)
objectives.

 It is commonly known there is Chief Operating Officer Chief Financial Officer

(COO) (CFO)
a separation between owners
and managers in a modern
corporation. Vice Vice Vice
President
Vice
President
President President

Directors & Directors & Directors & Directors &

Managers Managers Managers Managers

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 The Role of Financial Manager

 Some common titles for financial managers are chief financial officers
(CFO), treasures, controllers, credit managers and cash managers.

 The major decisions of financial managers can be aggregated to three main

areas, capital budgeting, capital structure and working capital
management.

 Financial managers are involved in planning, organizing, evaluating, and

controlling the operation of financial and accounting departments.

 Financial managers will need to monitor the liquidity, assess the risk, raise
capital, analyze investments of the firm, and communicate with stockholders
and other investors at the same time aligning their decisions to the long-term
goals of their organization.

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 Globalization and Corporate Finance

 As we are now living in a world of globalization, business entities today are

quite impossible to isolate themselves from the influences and challenges
outside the local market.

 With the continue liberalization of international trade, the competition in the

corporate world is getting stiff and unavailable, and the internationalization
of consumption through the popularity of internet buying has force firms to
open up themselves to international business.

 When firm engage in international business, the extent of internationalization

of their corporate finance will depends on the extent of their involvement in
international business. To a large extent, a firm can grow into a Multinational
Corporation (MNC).

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 THE OBJECTIVE OF FIRMS:
The Classical Objective of Firms: Maximize the value of the firm

 For every profit-oriented firm with going concern, most of them share the
same ultimate goal, which is to maximize the value of the firm.

 Argument: Maximizing the value of firm does not conform to the

maximizing shareholders’ wealth, as the value of firm includes other
stakeholders’ claims such as debt holders, preferred stockholders, etc.

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 Maximizing Stock Price

 First, stock price is the most observable that used to evaluate the performance
of a public listed firm and stock price is constantly reflecting the new
information concerning the firm.

 Secondly, stock price should reflect the long-term effects of decisions made
by the firm in a rational and efficient market.

 Argument: This approach could be flawed if the financial markets are

inefficient in the means where the stock price does not reflect the long-term
consequences and prospect of the firm.

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 Shareholders and Managers
 In a corporation, managers are hired to act and manage the corporation in the
best interests of shareholders.

 Agency problem: Potential conflicts between shareholders and managers

where the managements are not making decisions that are not maximizing the
shareholders’ wealth.

 Agency cost: The cost of the conflicts of interest between managers and
shareholders. There are two types of agency costs.

i. Direct agency cost: involving the cost to the shareholders.

ii. Indirect agency cost: lost opportunity.

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 Shareholders and Bondholders

 Bondholders (lenders) are the creditors whose have a claim on the cash flow of
the firm. Creditors borrow money to the firm who in return receive fixed
interest payment. By law, creditors have the first claim on the cash flow if the
firm is liquidated or declaring bankruptcy.

 Source of conflicts:
(i) Limited upside potential - These lenders is enjoying limited upside
potential (they only receive fixed interest payment) while exposing to the risk
of losing their loans.

(ii) Dividend policy - From the bondholders’ perspective, dividend payments

reduce the cash available to the firm, thus it is deemed more risky and decrease
the price of bond. Interestingly, it is the opposite from the effect on stock price,
where increase in dividend lead to higher stock price, ceteris paribus.

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 Firm and Financial Markets
 The assumption on the efficiency of the financial markets is essential in centring
the ultimate goal of firm on maximizing stock price. If the market is not efficient,
market price would not reflect the true value of the firm.

 In the below two scenarios, the decisions of stock price maximization may not be
consistent with the long term shareholders’ wealth maximization:

(i) The problem lies in the information in the market.

There are situations where those material information is hidden, delayed or
misleading, the market will not truly reflecting the intrinsic value of the firm.

(ii) The problem that could be traced to the financial market itself.
Despite the free flowing of information in the markets, still the market price
would not totally unbiased reflecting the intrinsic value of the firm. Irrationality
of investors, overreaction to information, insider trading, and characteristics in
the human nature would cause significant differences between the market price
and intrinsic price

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Firm and Society

 Every management decision does have its social consequences, where

potential side costs involving the welfare of society.

 Even if management are aware of the social costs involved, yet it may be
ignored and choose to focus on the sole objective of shareholders’ wealth
maximization, which in turn, is the benchmark of their performance.

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Some Other Alternatives of Firm Objective

 Maximize Market Share

 Profit Maximization

 Size/Revenue Objectives

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Corporate Governance and Conflict Resolutions

 Corporate governance is the system and approaches practised by

corporation to monitor and motivate the managers to act in the best interests
of the shareholders of the corporation.

 Conflict Resolutions :
i. Shareholders and Managers - managerial compensation / more effective
board of directors
ii. Shareholders and Bondholders - include the covenants in the debt such as
restrict the dividend policy and additional borrowing.
iii. Firm and Financial Markets - Can be improved and governed by the
regulatory bodies such as Securities Commission and Central Bank.
iv. Firm and Society - Appropriate laws and restrictions should be in place in
order to govern and punish the offenders to instil the awareness of social
responsibility among corporate leaders

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THE ROLE OF FINANCIAL STATEMENTS IN CORPORATE FINANCE: The importance
of Financial Statements in Corporate Finance
 Financial statements are the key sources of information for financial status of
a company.

 Internally, financial managers often rely on the numbers derived from these
statements to evaluate the operating, financing and investing decisions and
maximizing the shareholders’ wealth.

 Externally, financial statements are used by customers, suppliers, creditors as

well as investors.

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How to Evaluate Balance Sheet
 Balance sheet is the statement where it summarizes the assets owned by a firm,
the liabilities owed by a firm and the difference between the two, which is
belong to the shareholders.
 Total Assets = Total Liabilities + Shareholders’ Equity
One Corporation
2012 Balance Sheet
(RM mil)
Current Assets Current Liabilities
Cash & Bank Balances
75 Trade & other payables, derivatives 308
Inventories
393 Notes Payable 560
Receivables 893 868
1361 Non-Current Liabilities
LT Debt 241
Non-Current Assets 241
Net Plant and Equipment 928 Shareholders' Equity
Intangibles 100 Common share and share premium 1050
1028 Retained Earnings 230
1280
Total Assets wou.edu.my20
2389 Total Liabilities and Equity 2389
 How to Evaluate Income Statement
 Income statement illustrates the information on the revenue and related
expenses from the operating business of the firm in a financial year. It measures
the performance of the firm over the given period.

One Corporation
2012 Income Statement
(RM mil)

Sales 4072
Cost of Goods Sold 3588
Gross Profit 484
Salary 274
Depreciation 61
Interest Expense 48
Profit before tax 162
Taxes 40
Net Profit 122

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 How to Evaluate Statement of Cash Flow

 Statement of cash flow summarizes One Corporation

2012 Statement of Cash Flow
the sources and the uses of cash of (RM mil)
the firm from operating, investing, Net Income 122
Depreciation 61
and financing activities in a financial Changes in Working Cap (101)
year. Cash From Operation Activities 83

Disposal of PPE 31
 Both the income statement and Purchase of PPE (117)
Dividend received 6
balance sheets are based on accrual Cash From Investing Activities (80)
methods of accounting, which does
Dividend paid 35
not involve any cash exchange. In Net loans & borrowings 20
contrast, the statement of cash flows Cash From Financing Activities 55
recognizes the transactions in which
Net change in cash 57
it involved cash. Cash at beginning of year 125
Cash at end of year 182

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 The Use of Standardized Financial Statement

 Standardized financial statements are needed to enable meaningful

comparison.

 Without proper standardizing, it is almost impossible to directly compare

the financial statements for two companies due to:
i. Company size difference
ii. Currency difference

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Common-size Financial Statement

 Common-size balance sheets are constructed to express each item as a percentage of

total assets.

One Corporation
2012 Balance Sheet
(RM mil)
Current Assets Current Liabilities
Cash & Bank Balances
3.14% Trade & other payables, derivatives 12.89%
Inventories
16.45% Notes Payable 23.44%

Receivables 37.38% 36.33%

56.97% Non-Current Liabilities
LT Debt 10.09%
Non-Current Assets 10.09%
Net Plant and Equipment 38.84% Shareholders' Equity
Intangibles 4.19% Common share and share premium 43.95%
43.03% Retained Earnings 9.63%
53.58%
Total Assets Total Liabilities and Equity
100.00% 100.00% wou.edu.my24
 Common-Base Year Financial Statement: Trend Analysis

One Corporation
 A common-base year
2012 Balance Sheet (Asset Side)
financial statement presents Common-Base
Assets (RM millions)
each item on the financial Year Assets

statement relative to a 2011 2012 2012

Current Assets
certain base year. Cash & Bank
70 75 1.07
Balances
Inventories 350 393 1.12
 This approach is useful in Receivables 815 893 1.10
the way where we are 1235 1361 1.10
studying the trend of the
given firm; whether the firm Non-Current
Assets
has improved by improving
Net Plant and
the profitability, lowering Equipment
888 928 1.05

the leverage and so on.

Intangibles 100 100 1.00
988 1028 1.04

Total Assets 2223 2389 1.07

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Combined Common-size and Base Year Analysis

 Both common-size and One Corporation

common-base year financial 2012 Balance Sheet (Asset Side)

statements have its own Assets (RM Common-Size

Common-
Combined
Common-

drawbacks. millions) Assets

Base Year
Assets
Size and
Base Year
Assets
 Common-size analysis is 2011 2012 2011 2012 2012 2012

handicapped in Current Assets

understanding the trend of Cash & Bank Balances 70 75 3.15% 3.14% 1.07 1.00

the items while common- Inventories 350 393 15.74% 16.45% 1.12 1.04
Receivables 815 893 36.66% 37.38% 1.10 1.02
base year analysis failed to 1235 1361 55.56% 56.97% 1.10 1.03
recognize the increase of
each item due to total assets Non-Current Assets

growth or inflation effect. Net Plant and

888 928 39.95% 38.84% 1.05 0.97
Equipment

 Combining both analyses Intangibles 100 100 4.50% 4.19% 1.00 0.93
988 1028 44.44% 43.03% 1.04 0.97
into one would eliminate the
issues. Total Assets 2223 2389 100.00% 100.00% 1.07 1.00

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 LONG-TERM FINANCIAL PLANNING AND GROWTH:
What is financial planning?

 Financial planning is a means of systematically establishing guidelines to

achieve financial goals.

 A financial plan spells out what is to be achieved in the future, and it is

usually focuses on the general picture of the business without going into
every single detail.

 The investment, financial and distribution decisions are the basic elements
of a firm's financial policy in a financial plan. All financial planning is to
be synchronized with the ultimate goal in maximizing the shareholders'
wealth.

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The dimensions of financial planning

 Long-term financial planning is typically ranging from two to five years.

 First dimension : Planning horizon or the time period of planning process

focuses on.

 Second dimension : Aggregation process. Aggregation is the process

where smaller investment proposals of each operational unit are added up
and treated as one big project.

 Third dimension : Alternate sets of assumptions on important variables as

the inputs in a financial plan are required. This is to ensure the firm is
better prepared in the event of different possible scenarios.

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 Financial planning models

 In real world, financial planning varies from firm to firm however, there
are some common elements to be considered and basic models that are
used to build a more complex model.

 Financial planning models are built under various different assumptions

and forecast about the future.

 A financial plan usually consists of forecast income statement, balance

sheet and statement of cash flow and they are called pro forma statements.

 Pro forma statements are the output from the financial planning model,
where we use to summarize the different events projected for the future.

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 External financing and growth

 External financing and growth are interrelated; ceteris paribus, the higher
the rate of growth in sales or assets, the greater the need for external
financing.

Beta Corporation
Beta Corporation
Pro forma Income Statement Pro forma Balance Sheet
(RM mil)
(RM mil)
2012 2013F 2012 2013F
2012 2013F Current Assets 1600 2080 Total Debt 1000 1300

Sales 3000
3600
Non-Current
Shareholders' Equity 3000 3036
Cost (70% of sales) 2100 Assets
2520 2400 3120
Retained Earnings 864
Profit before tax 900
1080 Total Liabilities and
Total Assets 4000 5200 4000 5200
Taxes (20%) 180 Equity
216
Net Profit 720 864 Debt to Equity 0.33 0.33

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THANK YOU

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