Introduction to Corporate

Finance

Topics Covered
What is Corporate Finance
Key Concepts of Corporate Finance
Compounding & Discounting
Corporate Structure
The Finance Function
Role of The Financial Manager
Separation of Ownership and Management
Agency Theory and Corporate Governance

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 the provision of resources

(where funds are raised from)

Allocation of resources (where funds are deployed to)

Control of resources (whether funds are being used

effectively or not)

Diff. b/w Corporate Finance &

Financial Accounting
Corporate Finance

is inherently forward-looking and based on

cash flows.

Financial Accounting

is historic in nature and focuses on profit rather than

cash.

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 fundamental concepts in 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 aftertax 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 actual return being 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 years 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 years 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 years 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 years time carries the risk that the payment
may be less that Rs.1000 or may not be paid at all.

Compounding
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 occurs

Example:
interest

Rs. 20 deposited for five years at an annual

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.

Discounting
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 flow occurs

Example: Investor choice between receiving Rs.1000 now &

Rs.1200 in one years 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 objective should be to make decisions that
maximise the value of the company for its 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
Capital Gains

Shareholder wealth will be maximised by maximising

the value of dividends and 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

The Finance Function

Chief Financial Officer

The Finance Function

Chief Financial Officer

Treasurer

Comptroller

Role of The Financial Manager

(1)

Firm's
operations

Financial
manager

(1) Cash raised from investors

Financial
markets

Role of The Financial Manager

(2)

Firm's
operations

(1)

Financial
manager

(1) Cash raised from investors

(2) Cash invested in firm

Financial
markets

Role of The Financial Manager

(2)

(1)

Financial
manager

Firm's
operations
(3)

(1) Cash raised from investors

(2) Cash invested in firm
(3) Cash generated by operations

Financial
markets

Role of The Financial Manager

(2)

(1)

Financial
manager

Firm's
operations

(4a)

(3)
(1) Cash raised from investors
(2) Cash invested in firm
(3) Cash generated by operations
(4a) Cash reinvested

Financial
markets

Role of The Financial Manager

(2)

(1)

Financial
manager

Firm's
operations

(4a)

(4b)

(3)
(1) Cash raised from investors
(2) Cash invested in firm
(3) Cash generated by operations
(4a) Cash reinvested
(4b) Cash returned to investors

Financial
markets

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 & Dividend Decisions
Investment:
Company decides to
take on a large number
of
attractive
new
investment projects

Finance:
Dividends:
Company will need to If finance is not available from
raise finance in order to external sources, dividends may
take up projects
need to be cut in order to
increase internal financing.

Dividends:
Finance:
Company decides to pay Lower level of retained
higher levels of dividend earnings available for
to its shareholders
investment
means
company may have to
find
finance
from
external sources.

Investment:
If finance is not available from
external sources than company
may have to postpone future
investment projects.

Finance:
Company finances itself
using more expensive
sources, resulting in a
higher cost of capital.

Dividends:
The companys ability to pay
dividends in the future will be
adversely affected.

Investment:
Due to a higher cost of
capital the number of
projects attractive to the
company decreases.

Role of The Financial Manager

Maximisation of a companys 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.

stockholders
Issues of shares and
Top mgmt vs. operating
other securities
mgmt
Dividends
Stockholders vs. banks
Financing
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
private individuals

Creditors
including banks, suppliers
and bond holders

THE CO MPANY
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 performancerelated 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
companys market value by making good
investment, financing and dividend decisions.