BUSINESS MATHEMATICS AND

FINANCE
INTRODUCTION TO
CORPORATE FINANCE
Piyal Hennayake, 0777562014, [email protected]
 CORPORATE FINANCE AND THE
FINANCE MANAGER

What is Corporate Finance?

Imagine that you were to start your own

business. You would have to answer 3 questions
in some form or another:
1. What long-term investments should you take on?
That is, what lines of business will you be in and
what sorts of buildings, machinery, and equipment
will you need?
2. Where will you get the long-term financing to pay
for that investment? Will you bring other owners or
will you borrow the money?
3. How will you manage your everyday financial
activities such as collecting from customers and
paying suppliers?
The Financial Manager

• In a large corporation the owners

(shareholders) are usually not directly
involved in making business decisions
• Managers who represent owners interest
make decisions
• Financial Manger would be in charge of
answering all 3 questions
 Cash Manager

Credit Manager

Treasurer

Deputy General Capital Expenditure

Manager (DGM) -
Marketing
Managing Director
Chief Executive Officer (CEO)
Financial Planning
Board of Directors
DGM - CFO

Chief Operating Officer (COO) Tax Manager

DGM - Production
Cost Accounting
Manager

Controller

Data Processing
Manager

Financial Accounting
Manager
Financial Management Decisions
Capital budgeting
• The first question concerns the firm’s long-
term investments
• The process of planning and managing a firm’s
long-term investments is called capital
budgeting
• Identify investment opportunities that are
worth more to the firm than they cost to
acquire
Capital budgeting

• The value of the cash flow generated by an

asset exceeds the cost of that asset
• Must be concerned with not only how much
cash they expect to receive, but also when
they expect to receive it and how likely they
are to receive it
• Evaluating the size, timing and risk of future
cash flows is the essence of capital budgeting
Capital Structure

• The second question for the financial manager

– how the firm obtains and manages the long-
term financing it needs to support long-term
investments
• A firm’s capital structure (or financial
structure) refers to the specific mixture of
long-term debt and equity the firm uses to
finance its operations.
Capital Structure

The financial manager has 2 concerns

1. How much should the firm borrow; what mixture
of debt & equity is the best? Mixture chosen will
affect both the risk & value of the firm.
2. What are the least expensive sources of funds for
the firm?
Firms have a great deal of flexibility in choosing
a financial structure. Whether one structure is
better than any other for a particular firm is the
heart of the capital structure issue.
Working Capital Management

• The third question concerns working capital

management
• The phrase working capital refers to a firm’s
short-term assets, such as inventory, and its
short-term liabilities such as money owed to
suppliers
• Managing the firm’s working capital is a day to
day activity that ensures the firm has sufficient
resources to continue its opertaions and avoid
costly interuptions
Working Capital Management

Involves a number of activities related to the firm’s

receipt and disbursement of cash
1. How much cash & inventory should we keep on
hand?
2. Should we sell on credit? If so, what terms will
we offer, and to whom will we extend them?
3. How will we obtain any needed short-term
financing? Will we purchase on credit or will we
borrow short –term and pay cash? If we borrow
short-term, how and where should we do it?
 Corporate Form of Business Organization

• Sole proprietorship – a business owned by a

single individual
• Partnership – a business formed by two or
more individuals or entities
• Company/Corporation – a business created as
a distinct legal entity
 The Goal of Financial Management

Possible goals
If we were to consider possible financial goals, we
might come up with some ideas like the following:
• Survive
• Avoid financial distress & bankruptcy
• Beat the competition
• Maximize sales or market share
• Minimize costs
• Maximize profits
• Maintain steady earnings growth
Each of these possibilities present problems as a goal for the
financial manager.
For example
• It is easy to increase market share or unit sales: all we have
to do is lower our unit prices or relax credit terms
• We can always cut costs by simply doing away with things
such as research and development
• We can avoid bankruptcy by never borrowing any money or
never taking any risks

Profit maximization would probably be the most commonly

cited goal, but even this is not a precise objective. Do we
mean profits this year? If so, then actions such as deferring
maintenance, letting inventories run down, and other short-
run cost cutting measures will tend to increase profits now, but
theses activities are not necessarily desirable.
The goals we have listed are all different but tend to fall
into two classes

Profitability Controlling Risk

Sales Bankruptcy avoidance
Market share Stability
Cost control Safety

• However these two types of goals are somewhat

contradictory
• Pursuit of profit normally involves some element of risk
• It isn't really possible to maximize both safety & profit
• What we need is a goal that encompasses both these
factors
The Goal of Financial Management

• The financial manager in a company makes decisions

for the shareholders of the firm
• Shareholders buy shares because they seek to gain
financially
• What is a good financial management decision?
Which increase value of shares

The goal of financial management is to

maximize the current value per share.
A more General Goal

• What is the appropriate goal when the firm is not listed?

• Total value of shares in a company is equal to the value of
owner’s equity – Maximize the market value of owner’s
equity
• Our goal does not imply that the financial manager
should take illegal or unethical actions in the hope of
increasing the value of equity in the firm
• Financial manger best serves the owners of the business
by identifying goods & services that add value to the firm
because they are desired and valued in free market place
The Agency Problem and the Control of the
Company
Agency Relationship
The relationship between shareholders & management
Agency Problem
The possibility of conflicts of interest between the shareholders
and the management of the firm
Management Goals / Agency cost
• Firm has a new investment under consideration
• It will favorably impact the share value, relatively risky
• Owners of the firm whish to take the investment
• Management may not, if it turns bad will lose the job
• If management does not take the investment, shareholders
lose a valuable opportunity
Agency costs

• Agency costs refer to the costs of the conflict of interests

between shareholders and management
• Indirect agency cost is a lost opportunity we have described
• Direct agency costs come in two ways.
1. Corporate expenditure that benefits management but costs the
shareholders
2. Expense that arises from the need to monitor management actions

It is sometimes argued that, left to themselves, managers

would tend to maximize the amount of resources over
which they have control or, more generally corporate
power or wealth.
Management may tend to overemphasize organizational
survival to protect job security. Also management may dislike
outside interference, so independence and corporate self-
sufficiency may be important goals.
 Do Managers act in the Shareholders’ Interest?

It depends on two factors.

1. How closely the management goals are aligned with
shareholder goals?
This question relates to the way managers are compensated.
2. Can management be replaced if they do not pursue
shareholder goals?
This issue relates to control of the firm

There are number of reasons to think that, even in the

largest of the firms, management has a significant
incentive to act in the interest of shareholders.
Managerial Compensation

Management will frequently have a significant economic

incentive to increase share value for two reasons;
1. Management compensation, particularly at the top, is
usually tied to financial performance in general and
share value in particular
Given option to buy shares at bargain price. The more the stock is worth
more valuable is this option.
2. Managers have better job prospects. Better performers
within the firm will get promoted. Managers who are
successful in pursuing shareholder goals will be greater
in demand in the labor market/ higher salaries
Control of the firm

• Control of the firm ultimately rests with the

shareholders. They elect the board of directors, who in
turn, higher and fire management.
• The mechanism by which unhappy shareholders can act
to replace existing management is called proxy fight. It
develops when a group solicits proxies in order to replace
the existing board, and thereby replace existing
management.
• Another way management can be replaced is by
takeover. Poorly managed firms are more attractive as
acquisitions.
• Avoiding a takeover by another firm gives management
another incentive to act in the shareholders’ interest.
Stakeholders

• It was assumed management and shareholders are

the only parties with an interest in firm’s decisions.
This is an over simplification.
• Employees, customers, suppliers, and even the
government have a financial interest in the firm.
• These various groups are called stakeholders in the
firm.
• In general stakeholder is someone other than a
shareholder or creditor who potentially has a claim
on the cash flows of the firm.
Figure 2
Cash flow between the firm and financial markets

Total Value of Total Value of the Firm

Firm's Assets to investors in
the financial markets

A. Firm issues securities

B. Firm invests Financial
in Assets Markets
E. Retained CF F. Dividends
Current Assets and Debt Paymt Short-term debt
Fixed Assets C. Cash Flow from Lomg-term debt
firm's assets Equity Shares

D. Government

A. Firm issues securities to raise Cash, B. Firm invest in assets, C. Firm's operations generates
cash flow, D. Cash is paid to government as taxes, E. Retaines Cash flows are received in firm
F. Cash is paid out to investors in the form of interest and dividends
 Financial Markets and the Company

Cash flows to and from the Firm

• The interplay between a company and the financial
markets is illustrated in the Figure 2.
• A financial market, like any market, is just a way of
bringing buyers and sellers together
• In financial markets, it is debt and equity securities
that are bought and sold
Primary versus Secondary Markets

Financial markets function as both primary and

secondary markets for debt and equity
securities.
• Primary market – refers to the original sale of
securities
• Secondary market – these securities are
bought & sold after original sale
BUSINESS MATHEMATICS AND
FINANCE
FINANCIAL STATEMENTS
 THE BALANCE SHEET

• The balance sheet is a snapshot of the firm.

• It is a convenient means of organizing and
summarizing what a firm owns (its assets), what a
firm owes (its liabilities), and the difference between
the two (the firm’s equity) at given point in time
• Financial statement showing a firm’s accounting
value on a particular date
Assets: The left-hand side

• Assets are classified as either current or fixed

• Fixed assets can either be tangible, such as property
or vehicle or intangible such as a trademark or patent
• Current asset has a life of less than 12 months
– Inventory would normally be purchased and sold within
one year
– Cash
– Accounts receivable/debtors (money owed to the firm by
customers)
Liabilities and owners’ equity : the right hand side

• Current liabilities
– Have a life of less than 1 year
– Accounts payable
• Long-term liabilities
– A debt that is not due in coming year
– A loan that a firm pay in 5 years
• Shareholder’s equity
– The difference between the total value of assets (current &
fixed) and the total value of liabilities (current & long-term)
• Assets = Liabilities + Shareholder’s equity
Net Working Capital

• The difference between a firm’s current assets and

its current liabilities is called net working capital.
• Net working capital is positive when current assets
exceeds current liabilities
• Based on the definitions of current assets & current
liabilities, this means that the cash that will become
available next 12 months exceeds the cash that must
be paid over the same period
• Net working capital is usually positive in a healthy
company
Figure 1
The balance sheet. Left side, total value of assets.
Right side, total value of liabilities and shareholders’ equity

Total Value of Assets Total Value of Liabilities

and Shareholders' equity

Net Current Liabilities

Working
Current Assets
Capital

Long-Term Debt

Fixed Assets

1. Tangible Fixed assets

2. Intangible Fixed assets
Shareholders' Equity
Example 1- Building the balance sheet

A firm has current assets of $100, net fixed assets of

$500, short-term debt of $70, and long-term debt of
$200. What does the balance sheet look like? What is
shareholders' equity? What is net working capital?
In this case
Total assets are 100+500=600
Total liabilities are 70+200=270
Shareholders‘ equity is the difference 600-270=330
The balance sheet would look like

Assets Liabilities & Shareholders’ funds

Current assets 100 Current liabilities 70
Net fixed assets 500 Long-term debt 200
Shareholders’ funds 330
Total liabilities and
Total assets 600 Shareholders’ funds 600
=== ===

Net working capital is the difference between current

assets and current liabilities, or $100 – 70 = $30
Table 1
US Company
Balance Sheets as of December 31, 2018 and 2019
($ in millions)
2018 2019 2018 2019
Liabilities and
Assets Owners's Equity
Current assets Current liabilities
Cash 104 160 Accounts payable 232 266
Accounts receivable 455 688 Notes payable 196 123
Inventory 553 555 428 389
Total 1,112 1,403
Long-term debt 408 454
Fixed assets
Property Plant and Owner's equity
equipment 1,644 1,709 Stated Capital 600 640
Retained earnings 1,320 1,629
Total 1,920 2,269

Total assets 2,756 3,112 Total liabilities and 2,756 3,112

owner's equity
Liquidity

• Liquidity refers to speed and ease with which an asset

can be converted to cash
• Liquidity really has 2 dimensions: ease of conversion
versus loss of value
• Any asset can be converted to cash quickly if we reduce
the price
• A highly liquid asset – one that can be quickly sold
without significant loss of value
• An illiquid asset – one that cannot be quickly converted
to cash without a substantial price reduction
Debt versus Equity
• When firm borrows money, it gives first claim to the
firm’s cash flow to creditors
• Equity holders are entitled to residual value
• Shareholders’ funds = Assets – Liabilities
• This is true in accounting sense & economic sense
• Use of debt in a firm’s capital structure is called financial
leverage
• Financial leverage increases the potential reward to
shareholders
• It also increases potential for financial distress and
business failure
The Income Statement

• The income statement measures performance over some

period of time - usually 1 year
Revenues - Expenses = Income
• The first thing reported on an income statement would
usually be revenue and expenses from the firm’s principal
operations
• Subsequent parts include
– Financing expenses such as interest paid
• Taxes paid are reported separately
• The last item is net income (also expressed as earnings per
share)
Table 2

US Company
2019 Income Statement
($ in millions)

Net sales 1,509

Cost of goods sold 750
Depreciation 65
Earnings before interest and taxes 694
Interest paid 70
Taxable income 624
Taxes 212
Net Income 412

Additions to retained earnings 309

Dividends 103
Example 2 - Calculating Earnings and Dividends per share

Suppose that US had 200 million shares outstanding at the end of

2019. Based on the income statement above, what was EPS?
What were dividends per share?

From the income statement, US had a net income of $412 million

for the year
Since 200 million shares were outstanding, EPS = 412/200 = $2.06
per share
Similarly dividends per share = 103/200 = $0.515 per share
Accrual principle
• Income statement will show revenue when it accrues
• This is not necessarily when cash comes in
• This principle usually means that revenue is
recognized at the time of the sale
• It need not be the same as time of collection
• Costs shown on the income statement are based on
the matching principle
• As a result of the way revenues & costs are realized,
the figures shown on the income statement may not
be at all representative of the actual cash inflows and
outflows that occur during a particular period
 Cash Flow

• What is meant is the difference between the number

of Rupees that came in and the number of Rupees
went out
• If you are an owner of a business, you may be very
interested how much cash you took out of the
business
Cash flow from assets = Cash flow to creditors
+ Cash flow to shareholders
Cash Flow from Assets

The total of cash flow to creditors and cash flow

to shareholders consisting of the following;
1. Operating cash flow
2. Capital spending
3. Additions to net working capital
Operating Cash Flow

To calculate operating cash flow, we want to calculate revenue

minus costs, but we don’t want to include depreciation since it’s
not a cash outflow, and we don’t want to include interest
because it’s a financing expense. We do want to include taxes,
because taxes are paid in cash.
US Company

2019 Operating Cash Flow

Earnings before interest and taxes 694

+ Depreciation 65

- Taxes 212

Operating cash flow 547

We need to consider how much how much of the $547 operating cash
flow was reinvested in the firm.
Capital Spending

Net capital spending is just money spent on fixed assets less money
received from sale of fixed assets. At the end of 2018, net fixed assets
were $1,644. During the year we wrote off (depreciated) $65 worth of
fixed assets in the income statement.
So if we didn’t purchase and fixed assets, net fixed assets would have
been $1,579 at the year’s end. The 2019 balance sheet shows $1,709
in the net fixed assets. So we must have spent 1,709-1,579 = $130 on
fixed assets during the year.
Ending net fixed assets 1,709
- Beginning net fixed assets 1,644
+ Deprecation 65
Net investment in fixed assets 130
$130 is our net capital spending for 2019.
Could net capital spending be negative?
Additions to Net working Capital

In addition to investing in fixed assets, a firm will also invest in

current assets.
End of 2019, US had current assets of $1,403
End of 2018, current assets were $1,112
So during the year US invested in $291 in current assets
Similarly current liabilities will also change
Additions to Net working Capital (NWC)
Ending NWC (1,403 -389) = 1,014
- Beginning NWC (1,112 - 428) = 684
= 330
Net working capital increased by $230.
In other words, company had a net investment of $330 in NWC for 2019.
Cash flow from Assets

US Company
2019 Cash Flow from Assets
Operating cash flow 547
- Net capital spending 130
- additions to NWC 330
Cash flow from assets 87

This $87 cash flow from assets equals the sum of the
firm’s cash flow to creditors and cash flow to
shareholders.
Cash Flow to Creditors and Shareholders
Cash flow to creditors
A firm’s interest payment to creditors less net new
borrowings
Interest paid 70
- Net new borrowings 46
Cash flow to creditors 24
Cash flow to shareholders
Dividends paid put by a firm less net new equity raised.
Dividends paid 103
- Net new equity raised 40
Cash flow to shareholders 63
Cash flow from assets = 87 = 24 + 63