Principles of

Corporate Finance

Session 1 & 2

Unit I: INTRODUCTION

Why study Managerial Finance?

• Prepare for the workplace of tomorrow.• Broadening expectations of financial

knowledge and skills.• Use and understand financial

terminology and concepts in team communication.

• Developing cross-functional capabilities.• Critical thinking.

Career Opportunities in FinanceCapital Budgeting Analyst

Banking & Financial Institutions

Investments

Financial Analyst

Personal Financial Planning

Real Estate

Insurance

Project Finance Manager

Cash Manager

Pension Fund Manager

What is Finance?

• Finance is the art and science of managing

money.

• Finance affects all individuals, businesses,

and governments in the process of the transfer

of money through institutions, markets, and

instruments.

Managerial Finance• Managerial finance is concerned with the duties of the

financial manager in the business firm.

• The financial manager actively manages the financial

affairs of any type of business, whether private or

public, large or small, profit-seeking or not-for-

profit.

• Increasing globalization has complicated the

financial management function.

• Changing economic and regulatory conditions also

complicate the financial management function.

Principles of

Corporate Finance

Session 3

Firm and its Legal forms

• A Firm is a transformation unit, which transforms inputs ( 5 M’s) into Outputs (Goods & Services)

Firm and its Legal forms

Four basic forms of business organization Four basic forms of business organization (Firm):(Firm):

• Sole Proprietorships

• Partnerships (general and limited)

• Corporations

• Limited liability companies

Sole ProprietorshipSole Proprietorship

• A business form for which there is one owner. This single owner has unlimited liability for all debts of the firm.

• Oldest form of business organization.

Summary for Sole ProprietorshipSole Proprietorship

AdvantagesAdvantages

• Simplicity

• Low setup cost

• Quick setup

• Single tax filing on individual form

DisadvantagesDisadvantages

• Unlimited liability

• Hard to raise additional capital

• Transfer of ownership difficulties

PartnershipPartnership

• A business form in which two or more individuals act as owners.

• Types of Partnerships– General Partnership General Partnership – all partners have unlimited

liability and are liable for all obligations of the partnership.

– Limited Partnership Limited Partnership – limited partners have liability limited to their capital contribution (investors only). At least one general partner is required and all general partners have unlimited liability.

Summary for PartnershipPartnership

AdvantagesAdvantages• Can be simple• Low setup cost, higher

than sole proprietorship• Relatively quick setup• Limited liability for limited

partners

DisadvantagesDisadvantages• Unlimited liability for

the general partner• Difficult to raise

additional capital, but easier than sole proprietorship

• Transfer of ownership difficulties

CorporationCorporation

• A business form legally separate from its owners.

• An artificial entity that can own assets and incur liabilities.

Summary for Corporation

AdvantagesAdvantages

• Limited liability

• Easy transfer of ownership

• Unlimited life

• Easier to raise large quantities of capital

DisadvantagesDisadvantages

• Double taxation

• More difficult to establish

• More expensive to set up and maintain

Limited Liability CompaniesLimited Liability Companies

• A business form that provides its owners (called “members”) with corporate-style limited personal liability and the federal-tax treatment of a partnership.

Principles of

Corporate Finance

Session 4 & 5

The Managerial Finance Function

• The primary economic principal used by financial

managers is marginal analysis which says that

financial decisions should be implemented only when

benefits exceed costs.

Relationship to Economics

The Managerial Finance Function

• One major difference in perspective and

emphasis between finance and accounting is

that accountants generally use the accrual

method while in finance, the focus is on cash

flows.

• The significance of this difference can be

illustrated using the following simple

example.

Relationship to Accounting

The Managerial Finance FunctionRelationship to Accounting

• The Zasloff Corporation experienced the following

activity last year:

Sales: $100,000 (50% still uncollected)

Cost of Goods: $ 60,000 (all paid in full under supplier terms)

Expenses: $ 30,000 (all paid in full)

• Now contrast the differences in performance under the

accounting method versus the cash method.

The Managerial Finance FunctionRelationship to Accounting

INCOME STATEMENT SUMMARY

ACCRUAL CASH Sales $100,000 $ 50,000 -COGS (60,000) (60,000)Gross Margin $ 40,000 $(10,000)-Expenses (30,000) (30,000)Net Profit/(Loss) $ 10,000 $(40,000)

Principles of

Corporate Finance

Session 6

Key Activities of the Financial Manager

Investment Decisions

• What is the optimal firm size?

• What specific assets should be acquired?

• What assets (if any) should be reduced or eliminated?

Most important of the three Most important of the three decisions.decisions.

Financing Decisions

• What is the best type of financing? • What is the best financing mix?• What is the best dividend policy (e.g.,

dividend-payout ratio)?• How will the funds be physically acquired?

Determine how the assets (LHS of Determine how the assets (LHS of balance sheet) will be financed (RHS of balance sheet) will be financed (RHS of

balance sheet).balance sheet).

Asset Management Decisions

• How do we manage existing assets efficiently?

• Financial Manager has varying degrees of operating responsibility over assets.

• Greater emphasis on current asset management than fixed asset management.

Principles of

Corporate Finance

Session 7

Goal of the Financial Manager

Profit maximization (profit after tax)

Shareholder’s Wealth Maximization

Profit Maximization• Maximizing the Rupee Income of Firm

– Resources are efficiently utilized– Appropriate measure of firm performance– Serves interest of society also

Goal of the Financial Manager

Objections to Profit Maximization• It is Vague• It Ignores the Timing of Returns• It Ignores Risk• Assumes Perfect Competition• In new business environment profit

maximization is regarded as – Unrealistic– Difficult– Inappropriate – Immoral.

Goal of the Financial Manager

Goal of the Financial ManagerMaximize Shareholder Wealth!!!

• Why?

• Because maximizing shareholder wealth properly

considers cash flows, the timing of these cash flows,

and the risk of these cash flows.

• This can be illustrated using the following simple

valuation equation:

Share Price = Future Dividends

Required Return

level & timing of cash flows

risk of cash flows

Goal of the Financial ManagerWhat About Other Stakeholders?

• Stakeholders include all groups of individuals who have a direct economic link to the firm including:

– Employees– Customers– Suppliers– Creditors– Owners

• The "Stakeholder View" prescribes that the firm make a conscious effort to avoid actions that could be

detrimental to the wealth position of its stakeholders.• Such a view is considered to be "socially responsible."

Principles of

Corporate Finance

Session 8

Risk-return Trade-off• Risk and expected return move in tandem;

the greater the risk, the greater the expected return.

• Financial decisions of the firm are guided by the risk-return trade-off.

• The return and risk relationship: Return = Risk-free rate + Risk premium

• Risk-free rate is a compensation for time and risk premium for risk.

The Agency Issue

• Whenever a manager owns less than 100% of the

firm’s equity, a potential agency problem exists.

• In theory, managers would agree with shareholder

wealth maximization.

• However, managers are also concerned with their

personal wealth, job security, fringe benefits, and

lifestyle.

• This would cause managers to act in ways that do not

always benefit the firm shareholders.

The Problem

The Agency Issue

• Market Forces such as major shareholders and the

threat of a hostile takeover act to keep managers in

check.

• Agency Costs may be incurred to ensure management

acts in shareholders interests.

•Structure management compensation to make

shareholder interests their own

Resolving the Problem