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Corporate Finance


Corporate Finance Capital Structure, Financial Planning, Financial Markets, Growth, Cost of Money – PowerPoint PPT presentation

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Title: Corporate Finance

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
  • 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

  • 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 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 businesss 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 companys 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
  • 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

Financial Planning
  • Financial planning is the process of solving
    financial problems and achieving financial goals
    by developing and implementing a corporate "game
  • 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
  • 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 (PL 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
  • 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
  • Firms assets will grow in proportion to the
  • Firm is reluctant to meet in financial
    requirement through external equities.
  • Net Income is a constant proportion of the sales
    because cost of sales remains constant.
  • Firm has given determined dividend-payout policy.
  • Asset Debts Equities
  • Therefore,
  • Changes in Assets Changes in Debts Changes in

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.
  • ?S 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
  • 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 (T?S) to achieve growth
  • Equity Financing (S1 p) (1 d)
  • External Borrowings (S1 p) (1 d) L
  • Therefore,
  • T?S (S1 p) (1 d) (S1 p) (1 d)
  • Given the above equation, we can now derive the
    sales growth

p (1 - d) (1 L)

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
  • 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, futures and options 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 and Derivatives Market.
  • IPO market, Primary markets and Secondary markets

Financial Markets
Interest Rate
Interest Rate
Low Risk Securities
High Risk Securities
Financial Markets
  • Recessionary conditions in the economy -
  • Market clearing equilibrium interest rate _at_ 10 .
  • Anticipating recessionary conditions in the
    economy, the demand curve shifts to the left
    downwards D2
  • New Equilibrium _at_ 8 with lower borrowings and

Market A - 1
Financial Markets
  • Fed Bank rate hike scenario
  • Hike in interest rate is done to slow down the
    economy as a result the supply curve shifts
  • Hike in rates will move the supply curve to the
    left consequences of that would be higher
    borrowing rates and lower borrowings.

Financial Markets
  • Market A low risk securities, Interest Rate _at_
    10 and 8.
  • Borrowers with better credit rating borrow at 8
    and borrowers with comparatively poorer rating
    borrow at 10.
  • Lenders would lend less at a lower rate also
    charge less to borrowers with higher ratings.
  • Market A - I Interest rate _at_ 8 at times of
  • Lending and borrowing would be less i.e. it will
    reflect the recession mood on both investors
    (borrowers and lenders).
  • Market B Interest rate _at_ 12 for high risk
    securities higher risk higher scope for

Financial Markets
  • Equilibrium in the two markets
  • Investors willing to take additional risks will
    move from A to B in anticipation of higher
    returns. The additional risk premium i.e. 12 -
    10 2.
  • At times of recessions, the risk premium expected
    will increase from 12 - 8 6.
  • Consequences Both market will come under
    equilibrium conditions
  • The supply curve in Market A will move to the
    left interest rate parity i.e. lending rate will
    rise to compensate the lenders for the
    opportunity lost for staying in Market A. The
    supply curve in Market B will move to the right
    increased participation by the lender to take
    advantage of higher risk premium. Imp risk
    premium will drop as lenders compete.

Interest Rate and Determinants
  • Quoted / Nominal Interest Rate refers to the
    rate of interest 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
  • 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
  • Investment Horizon 1 year
  • TTM 1 year.
  • Inflation Rate 10
  • Investment Product Oil at 1 per gallon
  • In the spot market
  • 1000 gallons _at_ 1000.

Forward spot price of oil _at_ 10 inflation rate -
1.10 1000 _at_ 5 1050. NPV 955. Cost of
Oil 1 _at_ 10 1.10
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
  • 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

References and Bibliography
  • Michael C. Ehrhardt Eugene F. Brigham,
    Corporate Finance A Focused Approach.
  • Ross Westerfield Jaffe, Corporate Finance, 7th
  • Vishwanath, Corporate Finance.
  • Hirschey Nofsinger, Investment Analysis and
  • Bodie, Kane, Marcus Mohanty Investments, 6th

Value of Capital Budgeting
  • Chapter 2 Topics
  • Time Value of Money.
  • Different techniques for Capital budgeting
  • Valuation of Cash Flows based on perpetuities and
  • Term Structure of Interests.
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