Principles of Corporate Finance

Principles ofCorporate 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 Finance Capital Budgeting Analyst Project Finance Manager Cash Manager Banking & Financial Institutions Personal Financial Planning Investments Pension Fund Manager Real Estate Insurance Financial Analyst

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 ofCorporate 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 (Firm): • Sole Proprietorships • Partnerships (general and limited) • Corporations • Limited liability companies

Sole 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.

Advantages Simplicity Low setup cost Quick setup Single tax filing on individual form Disadvantages Unlimited liability Hard to raise additional capital Transfer of ownership difficulties Summary for Sole Proprietorship

Partnership • A business form in which two or more individuals act as owners. • Types of Partnerships • General Partnership – all partners have unlimited liability and are liable for all obligations of the 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.

Advantages Can be simple Low setup cost, higher than sole proprietorship Relatively quick setup Limited liability for limited partners Disadvantages Unlimited liability for the general partner Difficult to raise additional capital, but easier than sole proprietorship Transfer of ownership difficulties Summary for Partnership

Corporation • A business form legally separate from its owners. • An artificial entity that can own assets and incur liabilities.

Advantages Limited liability Easy transfer of ownership Unlimited life Easier to raise large quantities of capital Disadvantages Double taxation More difficult to establish More expensive to set up and maintain Summary for Corporation

Limited 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 ofCorporate Finance Session 4 & 5

The Managerial Finance Function Relationship to Economics • The primary economic principal used by financial managers is marginal analysis which says that financial decisions should be implemented only when benefits exceed costs.

The Managerial Finance Function Relationship to Accounting • 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.

The Managerial Finance Function Relationship 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 Function Relationship to Accounting INCOME STATEMENT SUMMARY ACCRUALCASH 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)

Key Activities of the Financial Manager

Investment Decisions Most important of the three decisions. • What is the optimal firm size? • What specific assets should be acquired? • What assets (if any) should be reduced or eliminated?

Financing Decisions Determine how the assets (LHS of balance sheet) will be financed (RHS of balance sheet). • 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?

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.

Goal of the Financial Manager • Profit maximization (profit after tax) • Shareholder’s Wealth Maximization

Goal of the Financial Manager 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 Maximize 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: level & timing of cash flows Share Price = Future Dividends Required Return risk of cash flows

Goal of the Financial Manager What 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."

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 The Problem • 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 Agency Issue Resolving the Problem • 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

Principles of Corporate Finance