Lecture notes on corporate finance

Topic one
MODULE OVERVIEW
Generally firms cannot think about their operations without thinking about finance. Virtually,
every aspect of the existence and operations of firms is tightly organized into an increasingly
complex web of financial sense.

The course is aimed at introducing you to fundamental corporate finance concepts. Corporate
finance departments are charged with governing and overseeing their firms' financial activities
and capital investment decisions. Such decisions include whether to pursue a proposed
investment and whether to pay for the investment with equity, debt, or both. They also include
whether shareholders should receive dividends, and if so, at what dividend yield. Additionally,
the finance department manages current assets, current liabilities, and inventory control.

Corporate finance tasks include making capital investments and deploying a company's long-
term capital. The capital investment decision process is primarily concerned with capital
budgeting. Through capital budgeting, a company identifies capital expenditures, estimates
future cash flows from proposed capital projects, compares planned investments with potential
proceeds, and decides which projects to include in its capital budget.

Corporate financing includes the activities involved with a corporation's financing, investment,
and capital budgeting decisions

Definition and Introduction:

Corporate finance is a branch of finance which deals with the financial activities of a corporation
starting from selection of the sources of fund to the capital structure of the corporation. The
primary objective of corporate finance is maximizing shareholder value by means of both long
and short-term planning and implementing different strategies. Corporate finance is essential for
any business whether big or small. In short, corporate finance helps a company in finding
sources of funds, expansion of business, planning the future course of actions, managing finance
and assuring healthy profitability and economic viability. The core of the corporate financial
theory is the goal of maximizing the corporation’s value as well as minimizing the risk.

Fundamentals of Corporate Finance:

The investment, financing and dividend principles are the three basic principles of corporate
finance.

Investment Principle:
The most efficient allocation of the business’s resources is the basic concept of the investment
principle. The investment decisions should result in revenue opportunities as well as save fund
for future. This principle also involves the working capital decisions like the allotment of credit
days to the customers etc. Corporate finance also ascertains the feasibility of the investment or
project by calculating the return on the investment decision and making a comparison of it with
the cost of capital.

Financing Principle:

Businesses are financed mostly with debt or equity or both. The financing principle ascertains
whether the debt-equity mix is right or not. The corporate-financier has to study conditions in
which the optimal financing mix minimizes the cost of capital and evaluate the effects on the
value of the company because of a change in capital structure. After the optimal financing mix
has been defined, the decision has to be made whether to take it on a long-term or short-term
basis. Then other factors like taxes, decisions regarding the structure of financing, the risk-return
trade-off, i.e. the riskier the asset, the higher the expected return, etc. are considered.

Dividend principle:

A business reaches a certain phase in its lifecycle in which it grows and the cash flows generated
exceeds the expected cost of capital. Then the business finds it necessary to ascertain the means
of paying back the owners with it. So here decision has to be taken whether the excess cash
should be paid to the owners/investors or should be kept in the business. A public limited
company has both the options, either paying off dividends or buying back shares.

Basic terminologies in Corporate Finance:

Corporate finance has a very wide area of discussion. It includes various concepts and
fundamentals. Among those, a few basic concepts are briefly discussed here.

Capital Budgeting:

The planning procedure of expenditures on such fixed assets, which will generate cash flows
more than one year, is called capital budgeting. Here, “capital” means long-term assets and
“budget” is a detailed plan of the projected cash flows (both in and out) over the specified future
period.

The basic approaches used during project selection are discussed below:

Net Present Value (NPV):

Under this method, all cash inflows and outflows are discounted at the cost of capital of the
project and then those cash flows are added. If NPV gives a positive value, the project will be
accepted.
NPV = Σ [CFt/ (1 + k) t]

Where CFt =expected cash flow at time, t,

CFT = expected cash flow at time t,

k = the project’s cost of capital.

Internal Rate of Return (IRR):

IRR is the discount rate which makes the value of NPV of a project zero.

NPV = Σ[CFt/(1 + IRR)t];

IRR = expected rate of return on a project. The NPV and IRR methods have the same accepting
or rejecting criteria.

Payback period:

Payback period is the number of years in which the original or initial investment will be
recovered. Cumulative net cash flows will be zero in payback period. The payback period should
be as short as possible. A company should set a standard payback period and should reject the
project when payback is greater than the standard.

Time Value of Money:

A certain unit of money today is worth more than the same unit of money tomorrow.

If a person has Le 1,000 today, s/he can earn interest on it and has more than Le 1,000 next year.
For example, Le 1,000 of today’s money invested for one year and earning 5% interest will be
worth Le 1,050 after one year.

Annuity

An Annuity is a series of regularly made equal payments or structured payments, such as paid
monthly or yearly.

Perpetuity

A Perpetuity is an equal amount of annuity having an infinite number of cash flows. In other
words, it is a never-ending annuity.

Cost of Capital:

A necessary factor of production is capital which has a cost. The providers of capital want a
return on their investment. A company must clearly ensure that shareholders or the lenders of the
fund such as financial institutions, banks, receive the return that they want. The cost of capital is
the rate of return used when analyzing capital projects. The project will be acceptable when it
returns greater than the cost of the project.

Weighted Average Cost of Capital (WACC) is one of the common methods of calculating the
cost of capital which is the weighted average of the costs of debt, preferred stock, and equity or
common stock. It is also known as the marginal cost of capital (MCC).

Working Capital Management:

Working capital management includes the relationship between the short-term assets and short-
term liabilities of a company. The motive of working capital management is ensuring a
company’s continued operation by enabling it to pay short-term debt and future operational
expenses. Working capital management consists of managing cash, inventories, accounts
receivables, and payables.

Measures of Leverage:

A company has a certain amount of fixed costs which is known as leverage.

These fixed costs include fixed operating expenses like equipment or building leases; fixed
financing costs like interest paid on debt. Greater the leverage, greater will be the volatility of the
company’s operating earnings after tax and net income after tax.

Corporate finance is a vast area of finance. Here, the basic principles and only a few basic
concepts are discussed briefly. Business people should have a clear understanding of the basics
of Corporate Finance before accepting any business project and to maximize the business’s value
as well as minimizing the risk.

Topic two
CAPITAL BUDGETING

The capital budgeting is the process of identifying and evaluating capital projects, that is,
projects where the cash flow to the firm will be received over a period longer than a year. Any
corporate decisions with an impact on future earnings can be examined using this framework.
Decisions about whether to buy a new machine, expand business in another geographic area,
move the corporate headquarters, or replace a delivery truck, to name a few, can be examined
with a capital budgeting analysis.
For a number of good reasons, capital budgeting may be the most important responsibility that a
financial manager has. First, because a capital budgeting decision often involves the purchase of
costly long-term assets with lives of many years, the decisions made may determine the future
success of the firm. Second, the principles underlying the capital budgeting process also apply to
other corporate decisions, such as working capital management and making strategic mergers
and acquisitions. Finally, making good capital budgeting decisions is consistent with
management's primary goal of maximizing shareholder value.
The capital budgeting process has four administrative steps:
Step 1 idea generation: The most important step in the capital budgeting process is generating
good project ideas. Ideas can come from a number of sources including senior management,
functional divisions, employees, or sources outside the company.
Step 2 analyzing project proposals. Because the decision to accept or reject a capital project is
based on the project's expected future cash flows, a cash flow forecast must be made for each
product to determine its expected profitability.
Step 3: Creating the firm-wide Capital budget. Firms must prioritize: profitable projects
according to the timing of the project's cash flows, available company resources and the
company's overall strategic plan. Many projects that are attractive individually may not make
sense strategically.
Step 4: Monitoring decisions and conducting a post-audit. It is important to follow up on all
capital budgeting decisions. An analyst should compare the actual results to the projected results,
and project managers should explain why projections did or did not match actual performance.
Because the capital budgeting process is only as good as the estimates of the inputs into the
model used to forecast cash flows, a post-audit should be used to identify systematic errors in the
forecasting process and improve company operations.
Categories of Capital Budgeting Projects
Capital budge ring projects may be divided into the following categories:
• Replacement projects to maintain the business are normally made without detailed analysis.
The only issues arc whether the existing operations should continue and, if so, whether existing
procedures or processes should be maintained.
• Replacement projects for cost reduction determine whether equipment that is obsolete, but still
usable, should be replaced. A fairly detailed analysis is necessary in this case.
• Expansion projects are taken on to grow the business and involve a complex decision-making
process because they require an explicit forecast of future demand. A very detailed analysis is
required.
• New product or market development also entails a complex decision-making process that will
require a detailed analysis due to the large amount of uncertainty involved.
• Mandatory projects may be required by a governmental agency or insurance company and
typically involve safety-related or environmental concerns. These projects typically generate
little to no revenue, but they accompany new revenue producing projects undertaken by the
company.
• Other projects. Some projects are not easily analyzed through the capital budgeting process.
Such projects may include a pet project of senior management [e.g. Corporate perks) or a high-
risk endeavor that is difficult to analyze with typical capital budgeting assessment methods (e.g.
research and development projects).
Principles of capital budgeting process
The capital budgeting process involves five key principles:
1. Decisions are based on cash flows, not accounting income. The relevant cash flows to
consider as part of the capital budgeting process are incremental cash flows, the changes in cash
flows that will occur if the project is undertaken.
Sunk costs are costs that cannot be avoided, even if the project is not undertaken.
Because these costs are not affected by the accept/reject decision, they should not be included in
the analysis. An example of a sunk cost is a consulting fee. Paid to a marketing research firm to
estimate demand for a new product prior to a decision on the project,
Externalities are the effects the acceptance of a project may have on other firm cash flows. The
primary one is a negative externality called cannibalization, which occurs when a new project
takes sales from an existing product. When considering externalities, the full implication of the
new project (loss in sales of existing product) should be taken into account. An example of
cannibalization is when a soft drink company introduces a diet version of an existing beverage.
The analyst should subtract the lost sales of the existing beverage from the expected new sales of
the diet version when estimated incremental project cash flows. A positive externality exists
when doing the project would have a positive effect on sales of a firm's other product lines.
A project has a conventional cash flow pattern if the sign on the cash flows changes only once,
with one or more cash outflows followed by one or more cash inflows. An unconventional cash
Row pattern has more than one sign change.
For example, a project might have an initial investment outflow, a series of cash inflows, and a
cash outflow for asset retirement costs at the end of the project's life.
2. Cash flows are based on opportunity cost. Opportunity costs are cash flows that a firm will
lose by undertaking the project under analysis. These are cash flows generated by an asset the
firm already owns that would be forgone if the project under consideration is undertaken;
Opportunity costs should be included in project costs. For example, when building a plant, even
if the firm already owns the land, the cost of the land should be charged to the project because it
could be sold if not used.
3. The timing of cash flow is important. Capital budgeting decisions account for the time value
of money, which means that cash flows received earlier are worth more than cash flows to b.
received later.
4. Cash flows are analyzed on an after-tax basis. The impact of taxes must be considered when
analyzing all capital budgeting projects. Firm value is based on cash flows they get to keep, not
those they send to the government.
5. Financing Costs are reflected in the projects required rate of return. Do not consider
financing cost specific to the project when estimating Incremental cash flows. The discount rate
used in the capital budgeting analysis takes account of the firm's cost of capital. Only projects
that are expected to return more than the cost of the capital needed to fund them will increase the
value of the firm.
How to evaluate and select capital projects
Independent VS Mutually Exclusive Projects
Independent projects arc projects that are unrelated to each other and allow for each project to be
evaluated based on its own profitability. For example, if projects A and B are independent, and
both projects are profitable, then the firm could accept both projects. Mutually exclusive means
that only one project in a set of possible projects can be accepted and that the projects compete
with each other. If projects A and B were mutually exclusive, the firm could accept either Project
A or Project B. but not both. A capital budgeting decision between two different stamping
machines with different costs and output would be an example of choosing between two
mutually exclusive projects.
Project Sequencing
Some projects must be undertaken in a certain order, or sequence, so that investing in a project
today creates the opportunity to invest in other projects in the future. For example, if a project
undertaken today is profitable, that may create the opportunity to invest in a second project a
year from now. However, if the project undertaken today turns out to be unprofitable, the firm
will not invest in the second project.
Unlimited Funds vs. Capital Rationing
If a firm has unlimited access to capital, the firm can undertake all projects with expected returns
that exceed the Cost of capital. Many firms have constraints on the amount of capital they can
raise and must use capital rationing. If a firm's profitable project opportunities exceed the
amount of funds available, the firm must ration, or prioritize, its capital expenditures with the
goal of achieving the maximum increase in value for shareholders given its available capital.
BASIC INVESTMENT APPRAISAL TECHNIQUES
THE PAYBACK PERIOD
The payback period (PBP) is the number of years it takes to recover the initial cost of an
investment.
The objective is to determine the period that it takes to recover the initial investment.
BENEFITS:
 Simple to compute
 Provides some information on the risk of the investment
 Provide a crude measure of liquidity
LIMITATIONS
 No concrete decision criteria to indicate whether an investment increases the firm’s value
 Ignores cash flows beyond the payback period
 Ignores the time value of money
 Ignores the risk of future cash flow
DISCOUNTED PAYBACK PERIOD
The discounted payback period uses the present values of the project's estimated cash flows. It is
the number of years it takes a project to recover its initial investment in present value terms and,
therefore, must be greater than the payback period without discounting.
The discounted payback period addresses one of the drawbacks of the payback period by
discounting cash flows at the project's required rate of return. However, the discounted payback
period still does not consider any cash flows beyond the payback period, which means that it is a
poor measure of profitability. Again, its use is primarily as a measure of liquidity.
BENEFITS
 It considers time value of money
 Considers the riskiness of the project’s cash flows (through the cost of capital)
LIMITATIONS
 No concrete decision criteria to indicate whether an investment increases the firm’s value
 Ignores cash flows beyond the discounted payback period
 It requires an estimate of the cost of capital in order to calculate the payback
PROFITABILITY INDEX (PI)
The profitability index (PI) is the present value of a project's future cash flows divided by the
initial cash outlay:
present value net present value+initial out lay
PI = ∨
initial outlay initial outlay
The profitability index is related closely to net present value. The NPV is the difference between
the present value of future cash flows and the initial cash outlay, and the PI is the ratio of the
present value of future cash flows to the initial cash outlay.
If the NPV of a project is positive, the PI will be greater than one. If the NPV is negative, the PI
will be less than one. It follows that the decision rule for the PI is:

If PI > 1.0, accept the project.

If PI < 1.0, reject the project.
BENEFITS
 It provides you with information about how an investment changes the value of a firm.

 It will take into consideration all cash flows from a project.

 It will take the time value of money into consideration in the calculation.

 It considers the risks which are involved with future cash flows.

 It will give you information about ranking projects while still rationing capital.

 It is an investment tool that is easy to understand.

LIMITATIONS

 The information generated is based on estimates instead of facts.

 It may not provide correct decision-making criteria for certain projects.

 The tool ignores what is called the “sunk cost.”

 It can be difficult to estimate opportunity costs.

 The profitability index often relies on optimism.

INTERNAL RATE OF RETURN
For a normal project, the internal rate of return (IRR) is the discount rate that makes the present
value of the expected incremental after-tax cash inflows just equal to the initial cost of the
project. More generally, the IRR is the discount rate that makes the present values of a project's
estimated cash inflows equal to the present value of the projects estimated cash outflows. That is,
IRR is the discount rate that makes the following relationship hold:
To calculate the IRR, you may use the trial-and-error method. That is, just keep guessing IRRs
until you get the right one or you may use a financial calculator.
Decision rule: First, determine the required rate of return for a given project. This is usually the
firm's cost of capital. Note that the required rate of return may be higher or lower than the firm's
cost of capital to adjust for differences between project risk and the firm's average project risk.
If IRR > the required rate of return, accept the project.
If IRR < the required rate of return, reject the project.

Internal rate of return= A% (B-A) %

Where:
A= lower cost of capital
B= higher cost of capital
a= NPV of A
b= NPV of B
BENEFITS
Tells whether the investment will increase the firm’s value
Considers all the cash flows of the project
Considers the time value of money
Considers the risk of future cash flows (through the cost of capital in the decision rule)
LIMITATIONS
Requires an estimate of the cost of capital in order to make a decision
May not give the value-maximizing decision when used to compare mutually exclusive
projects
May not give the value-maximizing decision when used to choose projects when there is
capital rationing
NET PRESENT VALUE
The NPV is the sum of the present values of all the expected incremental cash flows if a project
is undertaken. The discount rate used is the firm's cost of capital, adjusted for the risk level of the
project. For a normal project, with an initial cash outflow followed by a series of expected after-
tax cash inflows, the NPV is the present value of the expected inflows minus the initial cost of
the project.
A positive NPV project is expected to increase shareholder wealth, a negative NPV project is
expected to decrease shareholder wealth, and a zero NPV project has no expected effect on
shareholder wealth.
For independent projects, the NPV decision rule is simply to accept any project with a positive
NPV and to reject any project with a negative NPV.
BENEFITS
Tells whether the investment will increase the firm’s value
Considers all the cash flows
Considers the time value of money
Considers the risk of future cash flows (through the cost of capital)
LIMITATIONS
Requires an estimate of the cost of capital in order to calculate the net present value
It is an absolute measure expressed in whole figures and not as a percentage
ACCOUNTING RATE OF RETURN (ARR)
This is the percentage rate of return expected on an investment or an asset as compared to the
initial investment cost.
Decision rule: if the ARR is equal to or greater than the required rate of return, the project is
acceptable. If it is less than the desired rate, it should be rejected. When comparing investments,
the higher the ARR, the more attractive the investment.

Using the formula , 100

Where: (i) Average Annual Accounting Profit Cash Flows depreciation

(ii) Average investment = initial outlay + scrap proceed/2
BENEFITS
It considers the total profits or savings over the entire period of economic life of the
project
Recognises the concept of net earnings. i.e. earnings after tax and depreciation, which is a
vital factor in the appraisal of an investment proposal
Facilitates the comparison of new product project with that of cost reducing project
It gives a clear picture of the profitability of a project
It is a useful method in measuring current performance of a firm
LIMITATIONS
It ignores time factor, it ignores the time value of funds in selecting alternative uses of
funds
It does not take into account cash flows which are important than accounting profits
It does not consider the external factors which are also affecting the profitability of the
project
It cannot determine a fair rate of return; it is the discretion of the management.