Unit I Financial MGT & Corporate Governance

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MBA

Unit I

Financial Management & Corporate Financing

Corporate finance as managing financial activities involved in running a corporation. It involves


managing the required finances and its sources. The basic role of corporate finance is to maximize the
shareholders’ value in both short and long-term.

Corporate finance understands the financial problems of the organization beforehand and prevents
them. Capital investments become an important part of corporate financial decisions such as, if
dividends should be offered to shareholders or not, if the proposed investment option should be
rejected or accepted, managing short-term investment and liabilities.

Corporate finance includes, planning, raising, investing and monitoring of finance in order to achieve the
financial goals of the organization.

Nature of Corporate Finance

 Financial Planning: Corporate finance includes preparation, raising funds, investing plus tracking
each finance of organization. At short, it offers all financial aspects for the firm.
 Fund Raising: An important features of corporate finance is to raise funds for the company.
Finance can be accumulated through shares, bank loans, debentures, bonds, etc.
 Goal Oriented: The main goal of corporate finance are to maximize profits, giving good
dividends to shareholders, as well as creating fund reserves for future expansion activities.
 Investing Objective: The nature of corporate finance notes for every company is to optimize
investing needs for maximizing profits.
 Finance Options: There are two main options in the nature of corporate finance, i.e. working
capital and fixed capital.
 Connecting with Other Divisions
 Dynamic in Nature
 Business Management
 Legal Requirements
 Managing and Controlling

SCOPE OF CORPORATE FINANCE

 Estimating Financial Requirements: A primary task associated with financial manager is to


calculate long-term and short term financial requirements out of his business. To make certain
you’ve got sufficient money, it is crucial to calculate the financial requirements before beginning
a newer or expanding a current business.
 Deciding Capital Structure: The capital structure looks how a firm finances their general
operations, research and development by making use of various sources of funds.
 Choosing the Source of Finance: One efficient financial control calls concerning various type of
decision-making. A major significant move for any company should determine that sources of
funds.
 Proper Cash Management
 Selecting Pattern of Investment

KEY POINTS:

 Corporate finance is the process of obtaining and managing finances in order to optimize a
company’s growth and value for its shareholders.
 The concept focusses on investment, financing and dividend principle.
 The main functional areas are capital budgeting, capital structure, working capital management
and dividend decisions. For example, judging whether to invest in debt or equity as a medium to
raise funds for the business is the primary focus of capital structure decisions.
 Going over the risk-return aspect of investment alternatives, ensuring working capital
management, etc. are some aspects of this branch of finance.

WHAT IS CORPORATE GOVERNANCE?

Corporate governance is the system of rules, practices, and processes by which a firm is directed and
controlled. Corporate governance essentially involves balancing the interests of a company's many
stakeholders, such as shareholders, senior management executives, customers, suppliers, financiers, the
government, and the community.

Since corporate governance also provides the framework for attaining a company's objectives, it
encompasses practically every sphere of management, from action plans and internal controls to
performance measurement and corporate disclosure.

PRINCIPLE OF CORPORATE GOVERNANCE

 Accountability
 Transparency
 Freedom / Independence
 Fairness

BENEFITS OF CORPORATE GOVERNANCE

 Good corporate governance ensures corporate success and economic growth.


 Strong corporate governance maintains investors’ confidence, as a result of which, company can
raise capital efficiently and effectively.
 It lowers the capital cost.
 There is a positive impact on the share price.
 It provides proper inducement to the owners as well as managers to achieve objectives that are
in interests of the shareholders and the organization.
 Good corporate governance also minimizes wastages, corruption, risks and mismanagement.
 It helps in brand formation and development.
 It ensures organization in managed in a manner that fits the best interests of all.

KEY POINTS

 Corporate governance is the structure of rules, practices, and processes used to direct and
manage a company.
 A company's board of directors is the primary force influencing corporate governance.
 Bad corporate governance can cast doubt on a company's operations and its ultimate
profitability.
 Corporate governance entails the areas of environmental awareness, ethical behavior,
corporate strategy, compensation, and risk management.
 The basic principles of corporate governance are accountability, transparency, fairness, and
responsibility.

WHAT IS AN AGENCY PROBLEM?

An agency problem is a conflict of interest inherent in any relationship where one party is expected to
act in another's best interests. In corporate finance, an agency problem usually refers to a conflict of
interest between a company's management and the company's stockholders. The manager, acting as
the agent for the shareholders, or principals, is supposed to make decisions that will maximize
shareholder wealth even though it is in the manager’s best interest to maximize their own wealth.

UNDERSTANDING AGENCY PROBLEMS

The agency problem does not exist without a relationship between a principal and an agent. In this
situation, the agent performs a task on behalf of the principal. Agents are commonly engaged by
principals due to different skill levels, different employment positions, or restrictions on time and access.

For example, a principal will hire a plumber—the agent—to fix plumbing issues. Although the plumber‘s
best interest is to collect as much income as possible, they are given the responsibility to perform in
whatever situation results in the most benefit to the principal.

The agency problem arises due to an issue with incentives and the presence of discretion in task
completion. An agent may be motivated to act in a manner that is not favorable for the principal if the
agent is presented with an incentive to act in this way.
For example, in the plumbing example, the plumber may make three times as much money by
recommending a service the agent does not need. An incentive (three times the pay) is present, causing
the agency problem to arise.

SOLUTIONS TO THE AGENCY PROBLEM:

 Contract Design /Incentive Plans


 Performance evaluation & Compensation
 Shareholders Voting Rights
 Threat of Takeover

A Corporate valuation is a general process of determining the economic value of a whole business or
company unit. Corporate valuation can be used to determine the fair value of a business for a variety of
reasons, including sale value, establishing partner ownership, taxation, and even divorce proceedings.
Owners will often turn to professional business evaluators for an objective estimate of the value of the
business.

Need of Corporate Valuation

 Information to Stakeholders
 Comparision with similar entities
 Public listing
 In case of events like Merge, Demerger, Acquisition
 Corporate Valuation Model

Asset-Based Valuation:

Asset-based valuation is a form of valuation in business that focuses on the value of a company’s assets
or the fair market value of its total assets after deducting liabilities.

Net Asset Value = Total Assets - Total Liabilities

Assets are evaluated, and the fair market value is obtained.


For example, landowners may collaborate with appraisers to work out a property’s market worth. Over
time, property values increase, and a proprietor may realize a piece of property is worth more today
than it was five years ago. The new value is quoted and is used in the asset-based approach. On the
other hand, liabilities often occur at true market value.

Earning Based Valuation Model

Earnings-based business valuation methods value your company by its ability to be profitable in the
future. It is best to use earnings-based valuation methods for a company that is stable and profitable.

Advantages of Earning/Income Based Valuation Model

1) This is a well acknowledged and a popular approach of valuation;

2) Due to its flexibility, it is capable of resolving a varieties of issues faced by


companies at various stages; and

3) It acts as a catalyst to boost market price, even in a scenario of inactive market.

CASH FLOW BASE VALUATION MODEL


A cash flow model is a detailed picture of a client's assets, investments, debts, income and
expenditure which is projected forward, year by year, using assumed rates of growth, income,
inflation, wage rises and interest rates.

An important feature of these methods is the possibility to adapt to the available information,
allowing a more detailed or simplified analysis depending on the quantity and quality of data
available to the appraiser.

Methods to Calculate Cash Flow base valuation:

Dividend Discounted Model – DDM.


Discounted Cash Flow – DCF:
Enterprise Value Added – EVA.
Adjusted Present Value – APV.

WHAT IS CAPM?

The Capital Asset Pricing Model (CAPM) describes the relationship between systematic risk and
expected return for assets, particularly stocks.

CAPM is widely used throughout finance for pricing risky securities and generating expected returns for
assets given the risk of those assets and cost of capital.
FORMULA

E(Ri) = Rf+bi(E(Rm)-Rf)

E(Ri) = Capital asset expected return

Rf = Risk-free rate of interest

bi = Sensitivity

E(Rm) = Expected return of the market

ASSUMPTION:

 Risk Taker
 Purchase & Sale of assets
 No taxes No transaction Cost
 Perfect competition
 Investors should be rational
 Availablity of information
 Liquidity
 Funds are available at risk rate

ADVANTAGES:

 Eliminate unsytemetic risk.


 Investment Appraisal
 Ease of use

LIMITATION OF CAPM:

 Too many assumptions.


 Ability to borrow at risk free rate
 Determination of project proxy beta
 Ignorance of important factors (inflation, dividend payout etc)
 Lack of validity
 The model assume that the expected return investors will invest in lower risk securities to higher
risk security
 The model considers that the investors gets all the information about the security and will bear
the risk and will also expect return on the asset.

WHAT IS THE ARBITRAGE PRICING THEORY?

The Arbitrage Pricing Theory (APT) is a theory of asset pricing that holds that an asset’s returns can be
forecasted with the linear relationship of an asset’s expected returns and the macroeconomic factors
that affect the asset’s risk.

The theory was created in 1976 by American economist, Stephen Ross. The APT offers analysts and
investors a multi-factor pricing model for securities based on the relationship between a financial asset’s
expected return and its risks.

Mathematical Model of the APT

The Arbitrage Pricing Theory can be expressed as a mathematical model:

Arbitrage Pricing Theory - Formula

Where:

ER(x) – Expected return on asset

Rf – Riskless rate of return

βn (Beta) – The asset’s price sensitivity to factor

RPn – The risk premium associated with factor

ASSUMPTION:

 All market participants trade with the intention of profit maximization


 No existence of arbitrage and if it occirs participants will enaged to benefit out of it and bring
back the market to equilibrium market.
 Frictionless markets
BENEFITS:

 Consideration of various factors


 high profitability of goods (ROR)
 Emphasizes on vovariance between assets returns and exogenous factors
 Works better in multi period cases
 Can be applied to cost of capital &Capital budgeting decisions

 No assumption as to empirical distribution

CONSTRAINT

 Short listing of factors is a difficult task


 Nature of factor may not be easily available
 Calculating sensitives can be an arduous task and impractical too.
 Difficulty in monitoring and maintaining stock price and sensitives

WHAT IS ECONOMIC VALUE ADDED?

Economic Value Added (EVA) or Economic Profit is a measure based on the Residual Income technique
that serves as an indicator of the profitability of projects undertaken.

Its underlying premise consists of the idea that real profitability occurs when additional wealth is
created for shareholders and that projects should create returns above their cost of capital.

Formula of EVA

EVA = NOPAT – (WACC * capital invested)

Where NOPAT = Net Operating Profits After Tax

WACC = Weighted Average Cost of Capital

Capital invested = Equity + long-term debt at the beginning of the period

and (WACC* capital invested) is also known as finance charge

ADVANTAGES OF EVA

 EVA facilitates the identification of various problem areas prevailing in a company.


 It reveals a true image of a company’s performance
 It recognising the best performer of the company or the most suitable individual who run the
company in proficient and effective manner.

Limitations
 EVA and similar other metrics encourages managers of a company to have a short-sighted
approach, inasmuch as they are more inclined to focus on immediate benefits
 Calculation is complicated
 it is relates to “result orientation”, which implies that it is not a supportive tool to “point
towards the root causes of operational inefficiencies”.

TIME VALUE OF MONEY

The time value of money (TVM) is the concept that a sum of money is worth more now than the same
sum will be at a future date due to its earnings potential in the interim.

This is a core principle of finance. A sum of money in the hand has greater value than the same sum to
be paid in the future.

KEY POINTS

 Time value of money means that a sum of money is worth more now than the same sum of
money in the future.
 This is because money can grow only through investing. An investment delayed is an
opportunity lost.
 The formula for computing the time value of money considers the amount of money, its future
value, the amount it can earn, and the time frame.
 For savings accounts, the number of compounding periods is an important determinant as well.

REASONS

 Risk involve
 Inflation
 Investment opportunities
 Personal Consumption Preference

Formula for TVM:

FV = PV x [ 1 + (i / n) ] ^(n x t)

Where

FV=Futurevalueofmoney

PV=Presentvalueofmoney

i=interestrate

n=numberofcompoundingperiodsperyear

t=numberofyears
TIME VALUE OF MONEY EXAMPLES

Assume a sum of 10,000 is invested for one year at 10% interest compounded annually. The future value
of that money is:

FV = 10,000 x [1 + (10% / 1)] ^ (1 x 1) = 11,000

EFFECT OF COMPOUNDING PERIODS ON FUTURE VALUE

The number of compounding periods has a dramatic effect on the TVM calculations. Taking the 10,000
example above, if the number of compounding periods is increased to quarterly, monthly, or daily, the
ending future value calculations are:

Quarterly Compounding: FV = 10,000 x [1 + (10% / 4)] ^ (4 x 1) = 11,038

Monthly Compounding: FV = 10,000 x [1 + (10% / 12)] ^ (12 x 1) = 11,047

Daily Compounding: FV = 10,000 x [1 + (10% / 365)] ^ (365 x 1) = 11,052

PRESENT VALUE OF FUTURE MONEY FORMULA

PV = FV / (1 + (i / n) ^ ( n x t)

CALCULATING PRESENT AND FUTURE VALUE OF ANNUITIES

DEFINING ANNUITY

Annuity = series of cash flows of the same value occurring at equal intervals

TYPES OF ANNUITY

Ordinary annuity = cash flows occur at the end of each period

Annuity due = cash flows occur at the beginning of each period

Perpetuity = never-ending sequence of cash flows = cash flows occur at the end of each period
indefinitely

EXAMPLE OF PRESENT VALUE OF AN ANNUITY

The formula for the present value of an ordinary annuity, as opposed to an annuity due, is below.
Calculating the Future Value of an Ordinary Annuity

let's assume that you invest $1,000 every year for the next five years, at 5% interest.

Using the example above, here's how it would work

Calculating the Present Value of an Ordinary Annuity

In contrast to the future value calculation, a present value (PV) calculation tells you how much money
would be required now to produce a series of payments in the future, again assuming a set interest rate.

Calculating the Future Value of an Annuity Due

An annuity due, you may recall, differs from an ordinary annuity in that the annuity due's payments are
made at the beginning, rather than the end, of each period.

To account for payments occurring at the beginning of each period, it requires a slight modification to
the formula used to calculate the future value of an ordinary annuity and results in higher values, as
shown below.

The reason the values are higher is that payments made at the beginning of the period have more time
to earn interest. For example, if the $1,000 was invested on January 1 rather than January 31 it would
have an additional month to grow.
KEY Points

 Recurring payments, such as the rent on an apartment or interest on a bond, are sometimes
referred to as "annuities."
 In ordinary annuities, payments are made at the end of each period. With annuities due, they're
made at the beginning of the period.
 The future value of an annuity is the total value of payments at a specific point in time.
 The present value is how much money would be required now to produce those future
payments.

START-UP FINANCING (beginning of activity phase). In this stage the investor finances the production
activity even if the commercial success or flop of the product/service is not yet known. The level of
financial contributions and risk is high. Early stage financing (first development phase).

SOURCES OF FINANCE

 A Personal Investment

 When it comes to sources of finance, this one may be obvious. When starting a business, you
can choose to make a personal investment. This may include your savings or other assets you
have.

 Family and Friends

 You can ask for a loan from your friends, parents, spouse, or other family members. Bankers call
this “patient capital.” It is money that is repaid once your business becomes profitable.

 Small Business Association Microloans

 When it comes to sources of finance for small and startup companies, turning to the Small
Business Association (SBA) is a popular option. The SBA microloan program partners with
intermediary, nonprofit, and community-based lenders to provide borrowers.

 Angel Investors

 An angel investor is a wealthy person or retired company executive who wants to make a direct
investment in a small firm or startup company.

 Usually, angel investors are considered leaders or experts in a specific niche or field.

 Incubators

 An incubator is an organisation, company, or university that will provide you with resources for
your startup company. The resources may include cash, consulting, marketing, laboratories,
office space, or anything else you may require for operations.

 Government Subsidies and Grants

 Some government agencies offer financing, such as subsidies and grants that your business may
qualify for.
 Equipment Financing

 If you require startup funding to buy equipment, consider equipment financing as a funding
option. One of the benefits of this is the self-secured nature that it offers.

 Crowdfunding

 crowdfunding is when you get funding from crowds, which means the general public. Usually, an
entrepreneur will use this option if they develop a product that is needed by people and not
available anywhere else.

 Bank Loans

 Bank loans are another source of financing you may want to consider. These offer several
benefits and customised repayment schedules. It is a good idea to shop around and find the
right lender in this situation.

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