Corporate Finance
Dr Rakesh Kumar Sharma
.
What Is Finance?
Virtually all individuals and organizations earn or raise
money and spend or invest money. Finance is the
processes by which money is transferred (financing
and investing) among businesses, individuals, and
governments
FINANCE-MEANING
Finance is a field that deals with the study
of investments. It includes the dynamics of
assets and liabilities over time under conditions of
different degrees of uncertainty and risk. Finance can
also be defined as the science of money management.
Contd....
A key point in finance is the time value of money,
which states that purchasing power of one unit of
currency can vary over time.
Finance aims to price assets based on their risk level
and their expected rate of return. Finance can be
broken into three different sub-categories: public
finance, corporate finance and personal finance.
CF0 -100000
CF1 10000
CF2 20000
CF3 50000
CF4 40000
CF5 30000
BREAKING DOWN 'Finance
The study of finance can also take many forms,
depending on the field or area of finance which one
wishes to study.
For instance, economics is considered a pillar of
financial science, where both macro and
microeconomic factors affect virtually levels of
financial decisions and outcomes at all levels.
Forms of Business Organisation
Sole Proprietorship
HUF
Partnership
Private Limited Company
Public Limited Company
Public Enterprises
Sole Proprietorship
One man Control
Top secrecy
Limited Capital
Limited sources
Unlimited liabilities
Small in size
Partnership
Partners (2 to 20 and in case of banking 2 t0 10)
Partnership Deed
Unlimited Liabilities
Secrecy
Active partners and sleeping partners
Private Limited Company
Members 2 to 50
Limited Liabilities
Special privileges
No offer to public (NO IPO)
Commencement of business
Documents for incorporation
Public Limited Company
Members 7 to unlimited
Limited Liabilities
No Special privileges
Offer to public
Commencement of business
Documents for incorporation
Large in size
Huge resources
Financial Market
Introduction
‘FM’ may be defined as the art & science of managing money.
FM is concerned with the duties of the financial managers in
the business firm.
Relationship of financial management and other supportive
disciplines is:Decision Areas
Financial
Primary Disciplines
Support 1. Accounting
1. Investment analysis 2. Macroeconomics
2. Working Capital Management 3. Microeconomics
3. Sources and cost of funds
4. Determination of capital structure
5. Dividend Policy
6. Analysis of risk and returns
Support
Other Related Disciplines
1. Marketing
2. Production
Resulting in 3. Quantitative methods
Shareholder wealth maximization
Functions of Finance under
Modern Approach
Financial Management in the modern sense of
the firm can be broken down into three major
decisions as functions of finance. These are :
The investment decision
The financing decision
The dividend decision
Organisation of Finance Function
Board of Directors
Managing Director /Chairman
Vice President /Director (Finance)/ Chief finance Officer
(CFO)
Treasurer Controller
Financial Cash Credit Foreign Tax
planning and Exchange Manager Cost
Manager Manager Accounting
fund-raising Manager
manager Manager
Financial
Capital
Pension Corporate Accounting
Expenditure Fund Accounting Manager
Manager Manager Manager
The Investment Decision
The investment decision relates to the selection
of assets in which funds will be invested by a firm.
The assets which can be acquired fall into two broad
categories
Long term assets (which yield return over a period over a time in
future.) –Capital Budgeting.
Short term or current assets (convertible into cash usually within
one year.) –Working Capital Management.
•Capital Budgeting
Capital budgeting is the most crucial financial decision
of the firm. It refers to selection of an asset or investment
proposal or course of action whose benefits are likely to be
available in future over the lifetime of the project. The main
elements of capital budgeting are:
Choice of the new assets out of the alternatives available or
relocation of the capital when an existing asset fails to justify
the funds committed.
Capital budgeting decision is the analysis of risk and
uncertainty.
The concept and measurement of cost of capital.
•Working Capital Management (wcm)
WCM is concerned with the management of current
assets. The key strategies and considerations in ensuring a
tradeoff between profitability and liquidity is one of the
major dimensions of WCM. The management of working
capital has two basic ingredients:
An overview of working capital management as a
whole
Efficient management of the individual current
assets such as cash, receivables and inventory.
The Financing Decision
The investment decision is broadly
concerned with the assets–mix or the composition
of the assets of the firm. A capital structure with a
reasonable proportion of debt and equity capital is
called the Optimal Capital Structure. The two
aspects of financing decision are :
The of capital structure theory
The capital structure decision
The Dividend Decision
The dividend should be analysed in relation to the
financing decision of the firm. Two alternatives are
available in dealing with the profits of a firm:
They can be distributed to the shareholders in the form of the
dividends
They can be retained in the business itself.
The decision as to which course should be followed
depends largely on the significant dividend decision, the
dividend –pay –out ratio, i.e. what proportion of net profits
should be paid out to the shareholders.
OBJECTIVES OF FINANCIAL
MANAGEMENT
The objective provide a framework for
optimum financial decision making. They are
concerned with designing a method of operating the
internal investment and financing of a firm.there are
two widely discussed approaches under this, these are:
Profit Maximisation
Wealth Maximisation
Profit Maximisation
Profit /EPS maximisation should be undertaken and those
that decrease profits or EPS are to be avoided. Profit is the
test of economic efficiency. It leads to efficient allocation
of resources, as resources tend to be directed to uses which
in terms of profitability are the most desirable. Financial
management is mainly concerned with the efficient
economic resources namely capital. The main technical
flaws of this criteria are :
Ambiguity
Timing of benefits
Uncertaininity or Quality of Benefits
Ambiguity
The term 'profit maximization' as a criterion for
financial decision is vague and ambiguous concept.
The term 'profit' is amenable to different
interpretations by different people.
For example, profit may be long-term or short-
term. It may be total profit or rate of profit. It may
be net profit before tax or net profit after tax. It
may be return on total capital employed or total
assets or shareholders equity and so on.
Timing of Benefits
Another technical objection to the profit
maximization criterion is that It Ignores the
differences in the time pattern of the benefits
received from Investment proposals or courses of
action.
When the profitability is worked out the bigger
the better principle is adopted as the decision is
based on the total benefits received over the
working life of the asset, Irrespective of when they
were received.
Quality of Benefits
Another Important technical limitation of profit
maximization criterion is that it ignores the quality
aspects of benefits which are associated with the
financial course of action.
The term 'quality' means the degree of certainty
associated with which benefits can be expected.
Therefore, the more certain the expected return, the
higher the quality of benefits.
As against this, the more uncertain or fluctuating the
expected benefits, the lower the quality of benefits.
Profit Maximization is not
Operationally Feasible
The profit maximization criterion is not appropriate
and suitable as an operational objective.
It is unsuitable and inappropriate as an operational
objective of Investment financing and dividend
decisions of a firm.
It is vague and ambiguous. It ignores important
dimensions of financial analysis viz. risk and time
value of money.
Contd....
An appropriate operational decision criterion for
financial management should possess the
following quality.
a) It should be precise and exact.
b) It should be based on bigger the better principle.
c) It should consider both quantity and quality
dimensions of benefits.
d) It should recognize time value of money.
Wealth Maximisation
Wealth maximisation is also known as Value or Net
present worth maximisation. Its operational features satisfy all
the three requirements of the operational of the financial course
of action namely, exactness, quality of benefits, and the time
value of money. Two important issues related to the value/share
price maximisation are:
Focus on stakeholders ,stakeholders include groups such as
employees, customers, suppliers, creditors, owners and others who
have a direct link to the firm.
EVA (Economic Value Added) –EVA is equal to the after-tax
operating profits of a firm less the cost of the firm to finance
investments.
Advantages of Wealth
Maximization
Cash Flow Approach :Firstly, the wealth
maximization is based on cash flows and not on
profits.
Unlike the profits, cash flows are exact and
definite and therefore avoid any ambiguity
associated with accounting profits.
Profit can easily be manipulative, if there is a
change in accounting assumption/policy, there is a
change in profit.
Longer Period Concept
Secondly, profit maximization presents a shorter
term view as compared to wealth maximization.
Short-term profit maximization can be achieved by the
managers at the cost of long-term sustainability of the
business.
Time Value of Money
Thirdly, wealth maximization considers the time
value of money. It is important as we all know that
a dollar today and a dollar one-year latter do not
have the same value. In wealth maximization, the
future cash flows are discounted at an appropriate
discounted rate to represent their present value.
Contd....
Suppose there are two projects A and B, project A
is more profitable however it is going to generate
profit over a long period of time, while project B is
less profitable however it is able to generate return
in a shorter period.
In a situation of an uncertainty, project B may be
preferable. So, timing of returns is ignored by
profit maximization, it is considered in wealth
maximization.
Risk and Uncertainty Factor
Fourthly, the wealth-maximization criterion considers
the risk and uncertainty factor while considering the
discounting rate. The discounting rate reflects both
time and risk. Higher the uncertainty, the discounting
rate is higher and vice-versa.
