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 tasks.

• 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 owners.

Partnerships

• 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

• 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 business’s 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 company’s 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 financing.

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 required.

Financial Planning

Financial planning is the process of solving financial problems and achieving financial goals by developing and implementing a corporate "game plan."

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 model –

• 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 (P&L 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 & GrowthGrowth – 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 maximisation.

A. Rappaport, Creating Shareholder Value: The New Standard for Business Performance (New

York: Free Press, 1986)

Financial Planning & GrowthRecall from the example that the –

1. Firm’s assets will grow in proportion to the sales.

2. Firm is reluctant to meet in financial requirement through external equities.

3. Net Income is a constant proportion of the sales because cost of sales remains constant.

4. Firm has given determined dividend-payout policy.

Asset = Debts + Equities

Therefore,

Changes in Assets = Changes in Debts + Changes in Equity.

Financial Planning & GrowthVariables 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.

ΔS: changes in sales (S1 – S0).

Financial Planning & GrowthDonaldson 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 through –

• 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 & GrowthTotal Capital Spending (TΔS) – to achieve growth

Equity Financing: (S1 * p) * (1 – d)

External Borrowings: [(S1 * p) * (1 – d)] * L

Therefore,

TΔS: [(S1 * p) * (1 – d)] + [(S1 * p) * (1 – d)] * L]

Given the above equation, we can now derive the sales growth

p * (1 - d) * (1 + L)

T – [p * (1 – d) * (1 + L)]=

ΔS

S0

Financial Planning & GrowthT: 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 + 1)]

= 0.10 or 10 percent

Financial Planning & GrowthCan 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 and futures 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.

• IPO market, Primary markets and Secondary markets

Financial Markets

S1

D1

D2 Recession Induced

Interest Rate

Low Risk Securities High Risk Securities

8

1012

Interest Rate

D1

S1S Rate Hike

Interest Rate and DeterminantsQuoted / Nominal Interest Rate – refers to the rate of interest rate

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 interest.

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 DeterminantsReal 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 DeterminantsInflation 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 @ $1000.

Forward spot price of oil @ 10% inflation rate - $1.10

$1000 @ 5% = $1050.

NPV = $955.

Cost of Oil: $1 @ 10 %

= $1.10

Interest Rate and DeterminantsDefault 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 payments.

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 rates.