PBBF305: CORPORATE FINANCE ILEVEL 300

PBBA405: CORPORATE FINANCELEVEL 400 

LECTURE NOTES

Course synopsis

• This course introduces students to the investment and financing decisions of the firm. To achieve this prudently, students need to understand amongst other things the current financial position of the company, and also grasp a deep understanding of financial markets; their composition and instruments as well as how they are valued. Specifically, the course discusses the overview of the financial system, financial statements and cash flows, valuation of future cash flows, and valuation of capital market instruments. Finally, the course discusses the alternative methods of issuing securities to the general public to raise capital.

• The course will be taught on face-to-face-lecture discussion format.

Course outcomes

At the end of the course, students would be able to:• Describe the overview of financial management• Grasp a good understanding of financial statements and cash

flows• Compute the present and future value of cash flows• Compute the value of stocks and bonds

Course objectives • To discuss the overview of financial management • To discuss financial statements and cash flows• To discuss the computation of present and future value of cash

flows• To compute the value of stocks and bonds

 COURSEOUTLINE

CHAPTER 1: INTRODUCTION

Overview of the financial system

What is Finance?

Why study Finance?

The special relationship between Finance and Accounting

Corporate Finance

The role of the Finance Manager

The goal of the firm • Profit maximization• Shareholder wealth maximization• Social responsibility

Introduction  The agency theory of corporation

Forms of business organizations

The corporation and Financial Markets

Financial Markets:• Primary and Secondary Markets• Money and Capital Markets• Bond and Stock Markets

CHAPTER 2: FINANCIAL STATEMENTS AND CORPORATE TAXES

The statement of financial position (Balance sheet)

The income statement (Profit & Loss)

The cash flows statement

Taxes

Financial statements analysis

Standardized financial statements

Financial ratio analysis

The Du Pont Identity

Internal and sustainable growth rates

Uses of financial statement information

CHAPTER 3: LONG-TERM FINANCIAL PLANNING AND GROWTH

Long-Term Financial Planning

The Percentage of Sales Model

Pro-Forma Financial Statements

External Financing and Growth Rate The Internal growth rate The sustainable growth rate

CHAPTER 4: INTRODUCTION TO VALUATIONThe time value of money

Future value and compounding

Present value and discounting

Future values of multiple cash flows

Present values of multiple cash flows

Valuing equal cash flows annuities perpetuities

Loan types and repayment plans Pure Discount loans Interest-only loans

The time value of money

Amortized loans

i. Declining total payments

ii. Fixed total payments

CHAPTER 5: THE BOND MARKET, BOND VALUATION AND INTEREST RATES

The Bond Market

Bond characteristics

Other types of bonds

Bond values and Yields

Interest rates and inflation

Term Structure of interest rates

CHAPTER 6: THE STOCK MARKET AND STOCK VALUATION

The Stock Market• Methods of Issuing Shares

Public offer

Private Placement

Rights Issue

Bonus Issue• Types of Shares Ordinary shares Preference shares

Stock valuation

• Stock Valuation Models Zero growth model Constant growth model Variable growth model

Grading system

• Assignments = 15%• Mid semester examination = 20%• End of semester examination = 65%

RECOMMENDED READING LIST

•  Ross, S. A., Westerfield, R. W., Jordan, B. D. and Jeffrey, F J (2011): Core and Applications of Corporate Finance 3rd ed., McGraw-Hill, NY.

• Ross, S. A., Westerfield, R. W., and Jordan, B. D. (2010): Fundamentals of Corporate Finance 9th ed., McGraw-Hill, NY.

• Brealey, R. A., Myers, S. C. and Marcus, A. J. (2007) Fundamentals of Corporate Finance 5th Ed., McGraw-Hill, NY.

• Richard P. and Bill N. (2006) Corporate Finance and Investment: Decisions & Strategies 5th ed., Pearson Education Ltd., London

• Any other relevant material on Corporate Finance

INTRODUCTIONOverview of the financial system

• The Financial System refers to the mechanism for mobilizing funds from

those who have surplus (surplus units) to those in deficit (deficit units) in

an economy.

• It involves key elements namely financial markets, financial institutions,

laws, regulatory institutions and techniques.

• The primary task is to facilitate the movement of funds from those who

save to those who borrow to finance consumption and/or investments. The

financial system also determines both the cost of funds (interest rates) and

how much funds will be available to finance consumption and investments.

Overview of the financial system

• The agents of the financial system are called financial institutions. • They include commercial banks, insurance companies, investment banks,

finance companies, pension funds, mutual funds and venture capital firms. • Their regulators include the Central Bank, Securities and Exchange

Commission, and the Stock Exchange. • The agents and regulators collectively play the role of financial

intermediaries in an economy. • A well functioning financial system is therefore crucial to the economic

health of any country. • The environment in which the financial institutions intermediate between

surplus units and deficit units is called financial market. The market however operates like a network of participants and not a physical geographical location.

What is Finance?

• Finance is a branch of economics concerned with how individuals,

businesses and governments source funds to meet their consumption and

investment decisions.

• For instance an individual can source funds from a bank to buy a car. A

firm can raise money by issuing securities (bonds or shares) to finance its

investment decisions. Governments can raise funds by issuing bonds to

finance infrastructural projects.

• The focus of corporate finance however is on how Corporations source

funds to finance their operational and investment decisions.

Why study Finance? 

• Knowledge of finance is so important that it is offered by all tertiary

educational institutions offering business or management programmes.

• This is because all operations of business and non-business organizations

involve cash flows that must be managed to achieve organizational goals

and objectives.

• Thus, knowledge of finance by Heads of finance unit of organizations

helps in the overall efficient management of organizations’ resources.

• Financial literacy helps individuals to properly plan their future financial

needs and security.

The special relationship between Finance and Accounting

• Accounting is concerned with- Recording (book keeping) and classifications of financial transactions Preparation of periodic financial reports (statements) Dissemination the financial reports to internal and external stakeholders.• The reports therefore provide historical financial information on

performance of past investment and financing decisions of organizations.• Finance on the other hand is about financial decisions based on accounting

information. Thus, while the role of the accounting is provision of accounting information on previous business or investment decisions, the role of the finance is making financial decisions guided by the accounting information.

What is Corporate Finance?

• Corporate finance as an academic discipline discusses how business organizations handle the following three basic business questions:– What investments should the business embark upon?

THE INVESTMENT DECISION– How can funds be raised to pay for the required investments?

THE FINANCE DECISION– Should dividends be paid? If so, how much?

THE DIVIDEND DECISION• The range of decisions from investment to dividend payment involve

cash flows.

• Corporate Finance or Financial Management is therefore concerned

with the management of the flow of funds in a business enterprise to

achieve set goals and objectives.

What is Corporate Finance?Flow of funds

• Business enterprises mobilize funds from various sources (inflows) and

allocate them in their operations (outflows) to achieve business goals and

objectives. This movement of funds is demonstrated below.

Flow of funds

FIRM’S OPERATIONS

(Fixed and Current assets)

FINANCIAL MANAGER

 (Financial      Decisions)

FINANCIALMARKETS  INVESTORS(Shareholders and Creditors)

GOVERMENT

(1) (2)

(3)

RetainedIncome(4a)

(4b) Dividend Interest PaymentTaxes

(4c)

Flow Chart of Funds

(1) Cash proceeds of selling securities (bonds and shares) to investors.

(Sources)

(2) Cash invested to acquire operational fixed and current assets). (Uses)

(3) Cash generated from operations. (Sources)

(4a) Retained cash income. (Source)

(4b) Cash returned to investors. (Uses)

(4c) Cash paid in taxes. (Use)

The Financial Manager

• The financial manager is an individual responsible for carrying out the finance functions of the business hence also referred to as the Chief Finance Officer (CFO).

• The CFO is mainly involved in taking investment and financing decisions and ensuring that such decisions are implemented towards achieving business goals

The Finance Function• In corporations the finance function is structured into Accounting and

Finance sub-functions. • The Accounting sub-function is carried out by the Chief Accountant• The finance sub-function is carried out by the Treasurer.

The Financial Manager

• The chief accountant, manages cost and financial accounting, budgets,

tax issues and prepares financial statements

• The treasurer oversees cash management, credit management, financial

planning, establishes links with the financial markets, and maintains

relationships with banks.

• The chief finance officer oversees the functions of both the treasurer and

accountant, and deeply involved in financial policymaking and corporate

planning. • Also provides answers to the following four basic business questions:

The Financial Manager

1. What are the available investment opportunities and what sorts of buildings, machinery and equipment will be involved? (Investment or capital budgeting decision)

2. Where and how can funds be sourced to pay for the investment? Will the funds be sourced by issuing more shares or by borrowing, or a combination of both? (Financing or capital structure decision)

3. How will the daily financial activities of cash collection and payments be managed? (Working capital management decision)

4. How will the net earnings be sheared between the firm and its shareholders? (Dividend policy decision)

• Corporate Finance as an academic discipline is therefore a study of how

CFOs of corporations manage these decisions to achieve business goals.

The Financial Manager

• Diagramme of finance function in a typical corporation

Chief Finance Officer

Chief Accountant Treasurer or Cashier

Chief Financial Officer

The Goal of the firm 

• In corporate finance the goal of the firm is to maximize shareholder value,

instead of maximizing profits. The following are the three maximization

goals commonly discussed in finance literature.

1. Profit maximization:

2. Shareholders’ wealth maximization

3. Social Responsibility

Profit maximization: Profit maximization is considered by economists as the

most appropriate goal of a firm and a measure of its performance

• It also implies taking all manner of short-run cost-cutting measures to

increase earnings.

The Goal of the firm

• Modern management philosophy however regards profit maximization as

inappropriate. That it creates room for unethical and immoral business

decisions which results in producing goods and services that are wasteful,

harmful and socially undesirable.

Shareholders’ wealth maximization: This goal stresses the maximization of the

market value of the firm’s shares over the long term and hence the wealth

of its shareholders. It is viewed as the most logical which should guide

investment and financial decisions.

• It implies taking ethical decisions on identified investment opportunities

that are socially desirable and adds value to the firm.

The Goal of the firm

3. Social Responsibility: Despite its credibility, wealth maximization is

viewed by some management scholars as the pursuit of the interest of one

stakeholder-group to the neglect of others.

• That businesses should rather provide satisfactory returns to all

stakeholder-groups for their inputs instead of seeking to maximize the

return of only one of them.

• This thinking resulted into the current concept of corporate social

responsibility, which is the current management philosophy.

• That corporate setup should be viewed as a coalition of suppliers of capital,

suppliers of management skills, suppliers of labour, suppliers of goods and

services, consumers and the wider society.

• The Agency theory describes the relationships between management and

shareholders of a corporation called agency relationship

• Such relationship exists when someone (the principal) hires another (the

agent) to represent his or her interests.

• In corporate setting the shareholders are principals, while the management

is the agent of the shareholders.

• This relationship implies separation of corporate ownership from control.

• In all such relationships there is a possibility of conflict of interest between

the principal and the agent, called the agency problem.

• The financial loss (costs) to the shareholders associated with such conflict

is called agency costs.

The Agency Theory of Corporation

The Agency Theory of Corporation

Management of agency costs:

• Agency problems are managed or mitigated in practice through various

incentives and controls:

1. Incentives take the form of bonuses tied to profits and share (stock) options

as part of the remuneration package.

2. Controls take the form of legal and regulatory requirements applied by

capital market regulatory authorities, monitoring by shareholders and

regulators and conditions imposed by lenders.

 

Forms of Business Organisation

There are three different legal forms of business

organisation namely:

• sole proprietorship

• partnership

• corporation.

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

business’s debts.

• Life of the business is limited to the owner’s life span.

• Amount of equity raised is limited to owner’s personal wealth.

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

Corporation• The business is formed as a distinct legal entity composed of one or more

individuals and/or entities.

• Most complex and expensive form of business 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.

• Two type of corporations exist: Public and Private

Private corporation and Public corporation

The Corporation and Financial Markets

• Financial markets are mechanisms or arrangements through which funds

are mobilized by businesses by issuing financial securities (equity & debt).

• It facilitate financing and investments by individuals, organizations and

government agencies.

• The financial markets are commonly discussed under the following

categorization:

The primary market is the segment of the financial markets that

facilitates the raising of new capital by issuing new securities to the general

public during a specified period at a stated price.

The secondary market facilitates the trading (exchanging) of previously

issued securities among market participants.

The Financial Markets

The Money market is the segment of the financial markets through which

short term funds are mobilized by corporations and governments by

issuing short term securities called money market securities.

The Capital market is the segment of the financial market through which

long-term funds are raised by corporations and government by issuing long

term securities called capital market securities.

The Bond market is therefore the segment of the capital market through

which corporations and government borrow long term funds from the

general public by the issuing debt securities called bonds.

Stock market is the market for raising needed equity capital from the

general public by issuing shares (stocks).

Structure of Financial Markets

Financial Markets

Money Market Capital Market

Bond Market Stock Market

Primary Market Secondary Market Primary Market Secondary Market