Fundamentals of Corporate Finance: Prepared by (M.Zahid Khan)

FUNDAMENTALS OF
CORPORATE FINANCE
Prepared by ( M.ZAHID KHAN )
1-1
Chapter One
Introduction to Corporate Finance
By: Muhammad Zahid Khan
1-2
Chapter Organisation
1.1 1.2 1.3 1.4 1.5 1.6 1.8 1.9 Corporate Finance and the Financial Manager The Statement of Financial Position and Corporate Financial Decisions The Corporate Form of Business Organization The Goal of Financial Management The Agency Problem and Control of the Corporation Financial Markets and the Corporation Outline of the Text Summary and Conclusions
1-3
Chapter Objectives

Understand the basic idea of corporate finance. Understand the importance of cash flows in financial decision making. Discuss the three main decisions facing financial managers. Know the financial implications of the three forms of business organisation. Explain the goal of financial management and why it is superior to other possible goals. Explain the agency problem, and how it can be can be controlled and reduced. Outline the various types of financial markets.
1-4
What is Corporate Finance?
Corporate finance attempts to find the answers to the following questions:
What investments should the business take on? THE INVESTMENT DECISION
How can finance be obtained to pay for the required investments? THE FINANCE DECISION Should dividends be paid? If so, how much? THE DIVIDEND DECISION
1-5
What is Corporate Finance ?

Every Decision that a business make the financial
implications , and any decision which effect the finance of business is a corporate finance decision. Defined broadly , every thing that a business does fit under the rubric of corporate finance .
M ZAHID KHAN
1-6
What is Corporate Finance ?
M ZAHID KHAN
1-7
The Financial Manager

Financial managers try to answer some or all of
these questions. The top financial manager within a firm is usually the General ManagerFinance.
Corporate Treasurer or Financial Manageroversees cash management, credit management, capital expenditures and financial planning. Accountantoversees taxes, cost accounting, financial accounting and data processing.
1-8
The Investment Decision

Capital budgeting is the planning and control of
cash outflows in the expectation of deriving future cash inflows from investments in non-current assets.
Involves evaluating the:

size of future cash flows timing of future cash flows risk of future cash flows.
1-9
Cash Flow Size

Accounting income does not mean cash flow.
For example, a sale is recorded at the time of sale
and a cost is recorded when it is incurred, not when the cash is exchanged.
1-10
Cash Flow Timing

A dollar today is worth more than a dollar at some
future date.
There is a trade-off between the size of an
investments cash flow and when the cash flow is received.
1-11
Cash Flow Timing

Which is the better project?
Future Cash Flows Year Project A Project B
1
2 3 Total
$0
$10 000 $20 000 $30 000
$20 000
$10 000 $0 $30 000
1-12
Cash Flow Risk

The role of the financial manager is to deal with the
uncertainty associated with investment decisions.

Assessing the risk associated with the size and
timing of expected future cash flows is critical to investment decisions.
1-13
Capital Structure
A firms capital structure is the specific mix of debt
and equity used to finance the firms operations.

Decisions need to be made on both the financing
mix and how and where to raise the money.
1-14
Working Capital Management

How much cash and inventory should be kept on
hand?
Should credit terms be extended? If so, what are
the conditions?
How is short-term financing acquired?
1-15
Dividend Decision
Involves the decision of whether to pay a dividend
to shareholders or maintain the funds within the firm for internal growth.
Factors important to this decision include growth
opportunities, taxation and shareholders preferences.
1-16
Corporate Forms of Business Organisation

The three different legal forms of business organisation are: sole proprietorship partnership company.
1-17
Sole Proprietorship
The business is owned by one person.
The least regulated form of organisation. Owner keeps all the profits but assumes unlimited
liability for the businesss debts. Life of the business is limited to the owners life span. Amount of equity raised is limited to owners personal wealth.
1-18
Partnership
The business is formed by two or more owners.
All partners share in profits and losses of the
business and have unlimited liability for debts. Easy and inexpensive form of organisation. Partnership dissolves if one partner sells out or dies. Amount of equity raised is limited to the combined personal wealth of the partners. Income is taxed as personal income to partners.
1-19
Company
A business created as a distinct legal entity

composed of one of more individuals or entities. Most complex and expensive form of organisation. Shareholders and management are usually separated. Ownership can be readily transferred. Both equity and debt finance are easier to raise. Life of a company is not limited. Owners (shareholders) have limited liability.
1-20
Possible Goals of Financial Management

Survival
Avoid financial distress and bankruptcy Beat the competition
Maximise sales or market share

Minimise costs Maximise profits Maintain steady earnings growth
1-21
Problems with these Goals

Each of these goals presents problems.
These goals are either associated with increasing
profitability or reducing risk. They are not consistent with the long-term interests of shareholders. It is necessary to find a goal that can encompass both profitability and risk.
1-22
The Firms Objective

The goal of financial management is to maximise
shareholders wealth.
Shareholders wealth can be measured as the
current value per share of existing shares.

This goal overcomes the problems encountered
with the goals outlined above.
1-23
Agency Relationships
The agency relationship is the relationship
between the shareholders (owners) and the management of a firm.

The agency problem is the possibility of conflict of
interests between these two parties.

Agency costs refer to the direct and indirect costs
arising from this conflict of interest.
1-24
Do Managers Act in Shareholders Interests?

The answer to this will depend on two factors:
how closely management goals are aligned with
shareholder goals
the ease with which management can be replaced
if it does not act in shareholders best interests.
1-25
Alignment of Goals
The conflict of interests is limited due to:
management compensation schemes
monitoring of management
the threat of takeover other stakeholders.
1-26
Cash Flows between the Firm and the Financial Markets

Total Value of Firms Assets Total Value of the Firm to Investors in the Financial Markets
B. Firm invests in assets Current Assets Fixed Assets
A. Firm issues securities
Financial Markets Short-term debt Long-term debt Equity shares
E. Retained cash flows
F. Dividends and debt payments
C. Cash flow from firms assets
D. Government
1-27
Financial Markets
Financial markets bring together the buyers and
sellers of debt and equity securities. Money markets involve the trading of short-term debt securities. Capital markets involve the trading of long-term debt securities. Primary markets involve the original sale of securities. Secondary markets involve the continual buying and selling of issued securities.
1-28
Structure of Financial Markets
Financial Markets
Money Market
Capital Market
Primary Market
Secondary Market
Primary Market
Secondary Market
1-29
T1.3 A Simplified Organizational Chart (Figure 1.1)
T1.6 The Goal of Financial Management

The Goal of Financial Management
What are firm decision-makers hired to do?

General Motors is not in the business of making automobiles. General Motors is in the business of making money.
--Alfred P. Sloan
Possible goals Three equivalent goals of financial management: Maximize shareholder wealth Maximize share price Maximize firm value
T1.8 Financial Markets

Financial Markets
What is the role of financial markets in corporate finance?

Cash flows to and from the firm Money markets and capital markets Primary versus Secondary markets
How do financial markets benefit society?
T1.10 Financial Institutions

Banks are Intermediaries

Intermediaries provide scale economies in services
This allows them to earn income on services provided:

Earn interest on the spread between loans and borrowings Service fees (e.g. bankers acceptance, stamping fee)
Direct finance - services to clients without holding funds
T1.9 Cash Flows Between the Firm and the Financial Markets (Figure 1.2)

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FUNDAMENTALS OF

Prepared by ( M.ZAHID KHAN )

By: Muhammad Zahid Khan

By: Muhammad Zahid Khan

By: Muhammad Zahid Khan

What is Corporate Finance?

Corporate finance attempts to find the answers to the following questions:

By: Muhammad Zahid Khan

What is Corporate Finance ?

What is Corporate Finance ?

The Financial Manager

By: Muhammad Zahid Khan

The Investment Decision

Cash Flow Size

Cash Flow Timing

investments cash flow and when the cash flow is received.

Cash Flow Timing

Cash Flow Risk

uncertainty associated with investment decisions.

timing of expected future cash flows is critical to investment decisions.

and equity used to finance the firms operations.

mix and how and where to raise the money.

Working Capital Management

opportunities, taxation and shareholders preferences.

Corporate Forms of Business Organisation

Possible Goals of Financial Management

Maximise sales or market share

Problems with these Goals

The Firms Objective

current value per share of existing shares.

with the goals outlined above.

between the shareholders (owners) and the management of a firm.

interests between these two parties.

arising from this conflict of interest.

Do Managers Act in Shareholders Interests?

if it does not act in shareholders best interests.

Cash Flows between the Firm and the Financial Markets

B. Firm invests in assets Current Assets Fixed Assets

A. Firm issues securities

Financial Markets Short-term debt Long-term debt Equity shares

E. Retained cash flows

F. Dividends and debt payments

C. Cash flow from firms assets

Structure of Financial Markets

T1.3 A Simplified Organizational Chart (Figure 1.1)

T1.6 The Goal of Financial Management

What are firm decision-makers hired to do?

T1.8 Financial Markets

What is the role of financial markets in corporate finance?

How do financial markets benefit society?

T1.10 Financial Institutions

Intermediaries provide scale economies in services

This allows them to earn income on services provided:

Direct finance - services to clients without holding funds

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