Corporate Finance

Capital Structure, Financial Planning,

Financial Markets, Growth, Cost of Money
Business Organisation
What is an Organisation ?

Organisation is a social arrangement which pursues collective goals,

which controls its own performance, and which has a boundary
separating it from its environment.

Types of Business Organisation:

• Sole Proprietorships.

• Partnerships.

• Corporations.

• Limited Companies.

• Limited Liability Companies.

• Non-Profit Organisations.
Sole Proprietorship
• Easily and inexpensively formed.

• Corporate tax obligations are eliminated.

• Less prone to complex government regulations.

• Raising capital from the market is a tedious tasks.

• Full ownership of all liabilities associated with the organisation.

• In many cases, the life of the organisation is linked to the life

of the individual who creates it. Complexities may arise in
terms of transfer of ownerships and liabilities from previous
owners.
Partnerships
• Partnerships may operate under different degrees of formality
ranging from informal, oral understandings to formal agreements.

• Unlimited Liabilities.

• Limited life of an organisation and difficulty in transferring

ownership.

• Difficulty in raising capital.

• Enjoys certain tax advantages similar to that of a sole

proprietorships.

• Partners can potentially loose all of their assets in case of

bankruptcy.

• All partners are deemed to have equal share in both growth and
bankruptcy.
Corporations
• Corporations are legal entity created by the state and it is
distinct and separate from its owners and managers.

• Unlimited life.

• Easy transferability of ownership interest. Ownership may

come in the form of shares.

• Limited liability – losses limited to the actual fund invested.

• Subject to comparatively higher taxation.

• Setting up a corporation is time consuming. It requires drawing

up charters, articles of association and Memorandum of
Association.
LLP, Limited Company, NPO
• In an LLP, also called Limited Liability Company, all partners
enjoy limited liability with regards to the business’s liability. LLP
combines the advantages of having limited liability to the tax
advantages enjoyed by partnership.

• Non-Profit Organisations – Government organisations, & Non-

Governmental organisations. More prone to organisations
slacks. Profit maximisation is not seen an objective and they do
not obviously work towards achieving it.
Capital Structure
Capital Structure refers to the way a corporation finances its
assets through some combination of equity, debt or hybrid
securities.

In other words, a firm capital structure is the composition or

structure of its liabilities.

Financing can be done from within its own resources i.e. cash at
its disposal, through issue of equities or through debt financing
i.e. tapping the money market.

Firms can consider changing its capital structure through issue of

further shares, converting existing convertible assets like
bonds, rights issues, bonus issues, warrants etc.
Capital Structure
• Capital structure, therefore, forms an important aspect in
assessing the company’s value.

• In a perfect market, the value of the firm is not so affected by its

capital structure.

Example: Proponents of the perfect market and classical tax

system argue that there is deduction of taxes from interests on
debt financing which makes external financing a lot more
attractive and internal financing is of lesser value.

• In reality, however, we know that such perfect market and market

norms is incorrect and that there is cost associated to its external
financing structure.

• Bankruptcy costs, Agency Costs, Asymmetric Information all adds

up to the risk associated with long term external financing.
Capital Structure
Capital structure, in real world -

Trade off theory - explains the fact that firms or corporations usually
are financed partly with debt and partly with equity. There is an
advantage to financing with debt - the Tax Benefit of Debt and the
cost of financing with debt, the costs of financial distress including
Bankruptcy Costs of debt and non-Bankruptcy costs such as employee
attrition, suppliers demanding disadvantageous payment terms.

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.

Bankruptcy Costs of Debt are the increased costs of financing with

debt instead of equity that result from a higher probability of
bankruptcy.
Capital Structure
Pecking Order Theory - It states that companies prioritize their
sources of financing (from internal financing to equity)
according to the law of least effort, or of least resistance,
preferring to raise equity as a financing means “of last resort”.

Once internal funds have been used and on its depletion, debts
are issued, and when it is not sensible to issue any more debt
or once the marginal benefits coming from debt financing
reduces, equity is issued.

This theory maintains that businesses adhere to a hierarchy of

financing sources and prefer internal financing when available,
and debt is preferred over equity if external financing is
required.
Financial Planning
Financial planning is the process of solving financial problems and
achieving financial goals by developing and implementing a
corporate "game plan."

Financial Planning do NOT focus on one aspect or process. It is a

series of processes that culminates into end-results which are
likely to be achieved in the long run. The process may require
many adjustments as economic scenarios can change. Short
run adjustment may be required to accommodate for the
changes in the long run.

In other words, most decisions pertaining to financial planning

have a long lead times, which means that they take a long
time to implement.
Financial Planning
Various component that go into financial planning model –

• Sales forecast – all financial plans require near accurate sales forecast.
Forecasting sales, however, cannot be predicted accurately and depends
significantly on prevailing and future macroeconomic conditions.

• Pro-forma statement – based on forecasted sales and costs (P&L

statements), and various balance sheet components, financial planning can be
conducted and adjusted.

• Asset requirement – the plan will describe projected capital spending. The
use of net working capital can also be discussed.

• Feasibility – different / alternative financial plans must fit into overall

corporate objective of maximizing shareholders wealth.
Financial Planning
• Financial requirements and options – provides the opportunity for
the firm to work through various investment and financing
options.

• Economic Assumption – the plan must explicitly include the

current state of economic affairs and the likely consequences
from such economic indicators i.e. the prevailing and forecasted
rate of interest

See: the sample example.

Ross Westerfield Jaffe, Corporate Finance, Chap-3, Financial Planning and Growth, pg – 48/49
Financial Planning & Growth
Growth – In simple terms, growth refers to an increase in some
quantity over some time. In economic terms, growth imply an
increment in the “monetary” value of goods and services produced
in the economy.

Growth vs. Value Maximisation

Rappaport – “in applying the shareholder value approach, growth

should not be the goal in itself but rather a consequences of
decisions that maximises shareholder value”.

Growth ideally should not be the principle goal but a secondary

consequences that emerge out of value maximisation.

Quality in Growth is paramount in value maximisation.

A. Rappaport, Creating Shareholder Value: The New Standard for Business Performance (New York: Free

Press, 1986)
Financial Planning & Growth
Recall from the example that the –

1. Firm’s assets will grow in proportion to the sales.

2. Firm is reluctant to meet in financial requirement through

external equities.

3. Net Income is a constant proportion of the sales because cost

of sales remains constant.

4. Firm has given determined dividend-payout policy.

Asset = Debts + Equities

Therefore,

Changes in Assets = Changes in Debts + Changes in Equity.

Financial Planning & Growth
Variables in determining growth rate –

T: ratio of total assets/sales.

p: net profit margin (NP/Sales).

d: dividend payout ratio.

L: debt – equity ratio.

S0: current sales.

S1: projected sales.

ΔS: changes in sales (S1 – S0).

Financial Planning & Growth
Donaldson suggests that “most major industrial companies are
very reluctant to use external equity as a major part of their
financial planning”. Supposing that the firm wants to achieve
growth (sales) through increase sales, how can the firm
increase sales and what could be used as source of funding ?

To increase sales by ∆S, the firms need to increase its assets by

T∆S. T∆S can financed through –

• Retained Earnings / Reserves and Surpluses which is a

component in Equity Funding. Retained earnings is depended
on the sales, dividend-pay out ratio.

• External Borrowings.
Financial Planning & Growth
Total Capital Spending (TΔS) – to achieve growth

Equity Financing: (S1 * p) * (1 – d)

External Borrowings: [(S1 * p) * (1 – d)] * L

Therefore,

TΔS: [(S1 * p) * (1 – d)] + [(S1 * p) * (1 – d)] * L]

Given the above equation, we can now derive the sales growth

ΔS p * (1 - d) * (1 + L)
=
S0 T – [p * (1 – d) * (1 + L)]
Financial Planning & Growth
T: 1

p: 16.5 %

d: 72.4 %

L: 1

Sustainable Growth Rate = 0.165 * (1 – 0.724) * (1 + 1)

1 – [0.165 * (1 – 0.724) * (1 + 1)]

= 0.10 or 10 percent
Financial Planning & Growth
Can growth be achieved beyond the sustainable level ?

In principle it can be done –

• Sell news shares of stock.

• Increase its reliance on debts.

• Reduce its dividend – pay out ratio.

• Increase profits margin.

• Decrease its asset-requirement ratio.

Financial Markets
Physical asset markets are those that primarily deal in physical
assets such as wheat, cars, automobile, machineries. Financial
asset markets deal in stocks, bonds, notes, mortgages and other
financial instruments.

Types of market:

• Spot, forwards and futures markets.

• Money markets – those that deal in short and medium term

highly liquid securities.

• Capital markets – medium and long term debts and corporate

stocks.

• Mortgage Market.

• IPO market, Primary markets and Secondary markets

 Financial Markets

S Rate Hike S1
Interest Rate Interest Rate
S1

12
10

D1

D2 Recession D1
Induced

Low Risk Securities High Risk Securities

Interest Rate and Determinants
Quoted / Nominal Interest Rate – refers to the rate of interest rate
before adjusting for inflation.

Real / Effective Interest Rate - effective rate is the interest rate on a

loan or financial product restated from the nominal interest rate
as an interest rate with annual compound interest.

Consider Debt Security with a quoted/nominal interest rate of “r”.

r = r* + IP + DRP + LP + MRP

Nominal rate “r” is composed of –

r* : Risk-free interest rate. IP: Inflation premium.

DRP: Default risk premium. LP: Liquidity premium.

MRP: Maturity risk premium.

Interest Rate and Determinants
Real Risk-Free Rate (r*) – interest rate on a risk-less security if no
inflation exist. Risk free rate are never static and it is adjusted
with changing economic circumstances.

Therefore,

Nominal Risk-Free Rate (rRF) – risk free rate (r*) plus premium for
expected inflation. Securities that boast of offering such
nominal interest rate tend to enjoy no risk of default, no
maturity risk, no liquidity risk, no risk of loss if inflation rises.

rRF = r* + IP

Inflation Premium is the average expected inflation rate over the

life of the security.
Interest Rate and Determinants
Inflation Premium – Example

Consider:
Investment Amount: $1000.
Market Interest Rate: 5%
Forward spot price of oil
@ 10% inflation rate -
$1.10

Investment Horizon: 1 year $1000 @ 5% = $1050.

TTM: 1 year. NPV = $955.

Inflation Rate: 10%

Cost of Oil: $1 @ 10 %
Investment Product: Oil at $1 per gallon
= $1.10
In the spot market –

1000 gallons @ $1000.

Interest Rate and Determinants
Default Risk Premium – premium added to the interest rate for the
risk that the borrower will default on a loan. In general,
government securities do not have default risk premium as they
are unlikely to default on interest payments.

Liquidity Premium – the risk of not being able to convert the

underlying security into cash at a fair market value.

Maturity Risk Premium – premium added to the expected returns

when the duration of an underlying securities is longer. Since
longer duration leads to longer payment schedules, the risk of
default is higher. Also the underlying security is more prone to
changing interest rates.