Corporate Finance

Corporate FinanceImportant Business Activities2Production MarketingFinanceFinance is the provision of money at the time when it is required.Corporate Finance defined as the management of flow of funds in a firm and its deals with the financial decision making of the firm.

It is that part of the management activity, which is concerned with the planning, and controlling of the firms financial resources. It also deals with various sources of raising of the funds for the firm and its effective utilizationScope of Finance Function Overall financial planning and control, Raising funds from different sources, Selection of fixed assets, Management of working capital, and Any other individual financial event.Finance Functions6Finance functions or decisions can be divided as followsLong-term financial decisionsLong-term asset-mix or investment decision or capital budgeting decisions. Capital-mix or financing decision or capital structure and leverage decisions. Profit allocation or dividend decision Short-term financial decisionsShort-term asset-mix or liquidity decision or working capital management. FINANCE FUNCTIONSInvestment decision (those relating to resource allocation)

Liquidity decision (those relating to investment in current assets)

Financing or capital structure decision (those covering the financing of these investments)

Dividend decision (those determining how much cash be taken out and how much reinvested)Investment DecisionsThe investment decisions include those decisions that create revenues and profits such as:introducing a new product line introducing a more efficient distribution system. The investment decisions are the decisions relating to assets composition of the firm. Assets represent investment or uses of the funds that the firm makes in expectation of earning a return for its investors. The assets can be classified into fixed assets and current assets, and therefore the investment decisions of fixed assets are known as Capital Budgeting decisions and the investment decisions of current assets are known as Liquidity decisions/ Working Capital Management.Capital Budgeting DecisionsIncludes Which asset should be purchased out of different alternative options, To buy an asset or to get it on lease, To produce a part of the final product or to procure it from some other supplier, To buy or not an other firm as a running concern, Proposal of merger of other group firms to avail the synergies of consolidation, etc. All these decision have long-term implications and are generally irreversible. The objective of Capital Budgeting decisions is to identify those assets, which are worth more than they cost.

Liquidity DecisionLiquidity decision deals with the management of current assets of the firm. The current assets do not contribute directly to the earnings, yet their existence is necessitated for the proper, efficient and optimum utilization of fixed assets.

A finance manager has to ensure sufficient and adequate working capital to the firm.

A trade-off between liquidity and profitability is required. Finance manager has to take various decisions like how much and what inventory to be maintained, and whether and how much credit be given to customers, etc.

Financing DecisionsFinancing Decisions deal with the financing pattern of the firm. As firms make decisions concerning where to invest these resources, they have also to decide how they should raise resources.

There are two main sources of finance for any firm.Shareholders fundsBorrowed funds

The employment of these sources in combination is also known as financial leverage. Any combination of borrowed funds and shareholders funds i.e., any financial leverage can be selected and implemented by the firm as it is related to the value of the firm. A finance manager has to evaluate different such combinations and adopt one which is optimum for the firm.

Dividend DecisionDividend decisions deal with the appropriation of after tax profits. These profits are available to be distributed among the shareholders (subject to legal provisions) or can be retained by the firm for reinvestment with in the firm.

All firms whether small or big, have to decide how much of the profits should be reinvested back in the business and how much should be taken out in form of dividend) i.e. return on capital. It depends upon:

Reinvestment opportunities available to the firm,The opportunity rate of return of the shareholdersFinance Managers Role18Raising of FundsAllocation of FundsProfit PlanningUnderstanding Capital Markets

GOAL OR OBJECTIVE OF THE FINANCIAL MANAGEMENTA goal of the firm may be defined as a target against which the firm's operating performance can be measured. There are several goals of financial management such as maximization of sales revenue, net profit, return of investment, size of the firm, percentage market share, etc. The two essential objectives of the financial management are:The maximization of the profits of the firmThe maximization of the shareholders wealth.

Profit Maximization21Maximizing the rupee income of firm Resources are efficiently utilizedAppropriate measure of firm performanceServes interest of society also

Objections to Profit Maximization22It is VagueIt Ignores the Timing of ReturnsIt Ignores RiskAssumes Perfect CompetitionIn new business environment profit maximization is regarded as UnrealisticDifficultInappropriate ImmoralMaximizing Profit after Taxes or EPS23Maximising PAT or EPS does not maximise the economic welfare of the owners. Ignores timing and risk of the expected benefitMarket value is not a function of EPS. Maximizing EPS implies that the firm should make no dividend payment so long as funds can be invested at positive rate of returnsuch a policy may not always work.Shareholders Wealth Maximization24Maximizes the net present value of a course of action to shareholders.Accounts for the timing and risk of the expected benefits.Benefits are measured in terms of cash flows.Fundamental objectivemaximize the market value of the firms shares.Need for a Valuation Approach25SWM requires a valuation model.The financial manager must know,How much should a particular share be worth? Upon what factor or factors should its value depend?Risk-return Trade-off26 Financial decisions of the firm are guided by the risk-return trade-off.The return and risk relationship: Return = Risk-free rate + Risk premiumRisk-free rate is a compensation for time and risk premium for risk. Risk Return Trade-off27Risk and expected return move in tandem; the greater the risk, the greater the expected return.

27Overview

Agency Problems: Managers Versus Shareholders Goals29There is a Principal Agent relationship between managers and shareholders.

In theory, Managers should act in the best interests of shareholders.

In practice, managers may maximise their own wealth (in the form of high salaries and perks) at the cost of shareholders.

Agency Problems: Managers Versus Shareholders Goals30Managers may perceive their role as reconciling conflicting objectives of stakeholders. This stakeholders view of managers role may compromise with the objective of SWM.

Managers may avoid taking high investment and financing risks that may otherwise be needed to maximize shareholders wealth. Such satisfying behaviour of managers will frustrate the objective of SWM as a normative guide.

This conflict is known as Agency problem and it results into Agency costs.Agency Costs31Agency costs include the less than optimum share value for shareholders and costs incurred by them to monitor the actions of managers and control their behavior.

Refers to the set of rules, processes and customs that affects the manner in which an organisation is administered.The need of CG emerges on account of divergence of interest, particularly between the owners and management.

Corporate GovernanceTransparencyFull disclosureIndependent monitoringFairness to all stakeholdersFour pillars of CG