CORPORATE FINANCE

UNIT 1
INTRODUCTION:
Corporate finance generally plays a crucial role in every business to maximize profits at minimum
costs. If you work in corporate finance, you usually handle an organization's day-to-day finances,
including budgeting, report preparation, loan payments, and investment decisions. Companies seek
to streamline their corporate financing arm for optimal wealth distribution and return generation. If
you want to know the significant value of corporate finance and its scope, you will need to gather
some essential details and manage your financial decisions perfectly

MEANING

Corporate finance is one of the best fields, focusing on businesses' financial activities. It primarily
aims to maximize shareholder value and encompasses various activities, from capital investment
decisions to financing strategies and risk management. It even helps you obtain funds from the
appropriate sources to help manage periodic and long-term financial activities. With this help, you
can plan how a company will help you use and manage capital to maximize value accordingly.

CORE CONCEPTS OF CORPORATE FINANCE:

 Capital Budgeting:

Capital budgeting identifies and evaluates potential major projects or investments, such as new
machinery, product development, or acquisitions. You can utilize the best techniques, such as the
internal rate of return, net present value, and payback period, which are commonly used to assess
the profitability and risk of these investments.

 Capital Structure:

Capital structure pertains to how a company manages its operations and growth using different
funds. The blend of debt and equity financing is crucial, and the goal is to find an optimal structure
that minimizes the cost of capital while maximizing shareholder value.

 Working Capital Management:

Working capital management generally focuses on managing the company's short-term assets and
liabilities to ensure sufficient liquidity to run its operations. Effective working capital management
involves optimizing inventory levels, managing receivables and payables, and ensuring adequate cash
flow to meet operational needs.

 Dividend Policy:

Decisions regarding distributing profits back to shareholders as dividends versus retaining earnings for
reinvestment in the business. The policy chosen can impact investor satisfaction and the firm's
reinvestment strategy.

 Risk Management:

When it comes to identifying, analyzing, and mitigating financial risks, it includes market, credit,
liquidity, and operational risks. To fix this risk management tissue, you must use the best tools, such
as derivatives, options, futures, and swaps, often used to hedge against these risks.

SCOPE OF CORPORATE FINANCE:

Corporate finance is a comprehensive field that includes various strategic financial activities to
achieve long-term growth and stability for a company. Corporate finance also involves several costs to
control a business's financial resources and attain its economic objectives, which you can read in
detail below.

 Financial Planning:

When it comes to financial planning for the business, the best financing combination and sources,
whether equity, debt, or hybrid instruments, are used to fund the company's operations and growth.
It is also associated with the significant management of debt levels and interest payments.

 Investment Decisions:

When you make a clear investment decision on capital allocation for long-term projects and
investments, assessing their viability, profitability, and alignment with the company's planning
objectives will be simple.

 Mergers and Acquisitions (M&A):

Evaluate potential merger or acquisition opportunities, which helps you conduct due diligence and
execute these transactions to achieve your business's planned market expansion or diversification.

 Financial Planning and Analysis:

It helps you to develop detailed financial plans and forecasts to guide the company's future activities,
including budgeting, forecasting, and scenario analysis.

 Dividend and Payout Decisions:

It is important to make strong policies on how much profit should be distributed to shareholders and
reinvested in the business to fund future growth.

 International Finance:

When managing financial operations and investments in different countries, you must focus on
exchange rates, international taxation, and cross-border regulations.

IMPORTANCE OF CORPORATE FINANCE

Corporate finance helps you identify and analyze investment opportunities to increase the company's
shareholder value. Hence, it allows you to make sound financial decisions, and organizations can
attract more investors, increasing their overall value accordingly. Corporate finance is vital to the
functioning and success of any business, and its importance can be seen in its impact on various
aspects of a company's operations and strategic initiatives.

 Enhance operational efficiency:

Corporate finance is always there to improve your company's operations and efficiency. It optimizes
the use of financial resources, and companies can reduce costs, improve profitability, and enhance
their competitive position in the market.

 Cost Management:

Corporate finance helps identify places where expenditures can be diminished without compromising
the quality or efficiency of your organization. This can include renegotiating supplier contracts,
facilitating processes, or investing in more efficient technologies.

 Performance Measurement:

If you are involved in financial analysis and performance metrics, you will be eligible to assess your
company's operations and identify areas for improvement. Performance management helps you set
benchmarks and targets for continuous improvement in your company.

 Resource Allocation:
Corporate finance ensures that resources are allocated to the most productive uses by prioritizing
projects and investments based on potential returns. Reviewing resource allocation generally
enhances your company's operation's overall efficiency and effectiveness.

 Ensure financial stability and sustainability

Financial stability is crucial for a company's long-term sustainability. Corporate finance assists in
maintaining this stability by managing financial risks, ensuring adequate liquidity, and planning for
future contingencies. It is also essential for supporting a company's well-planned growth ambitions,
such as mergers and acquisitions, new product development, and market expansion. This can help
you understand how vital corporate finance is.

ROLE OF FINANCIAL INSTITUTIONS

Meaning
Financial institutions are organizations that provide financial services to their clients. These include
banks, credit unions, insurance companies, brokerage firms, and asset management companies. They
play a crucial economic role by facilitating monetary transactions, lending, investment, and risk
management. Financial institutions act as intermediaries between savers and borrowers, mobilize
savings, and channel them into productive investments, thereby fostering economic growth and
financial stability.

Types of Financial Institutions

Financial institutions come in various forms, each serving distinct functions to support economic
activities and financial stability. Here are the main types of financial institutions:

Commercial Banks

A commercial bank is a financial institution that accepts money from individuals and businesses and
provides loans to those in need. It offers services such as loans, savings, certificates of deposits, bank
accounts, bank overdrafts, etc., to its customers. These organizations earn money by granting loans to
individuals and gaining interest on loans. Business loans, house loans, personal loans, car loans, and
education loans are the different types of loans offered by commercial banks.

Investment Banks
Investment banking helps individuals, organizations, governments, and other institutions raise capital
and provides financial consultancy advice. It doesn’t deal with customer deposits but rather assists
with financing through securities such as bonds and stocks.

They are a type of financial institution that provides services that specialize in facilitating business
operations, such as financing and offerings of capital expenditure and equity, mergers and
acquisitions, and new issues of initial public offerings (IPOs). They also commonly act as market
makers for trading exchanges, provide brokerage services for investors, and other corporate
restructurings.

Credit Unions

A credit union is a financial institution similar to a commercial bank. However, it is a non-profit

institution created, owned, and operated by its members. Credit unions provide
traditional banking services only to their members, such as account opening, issuing credit cards,
loans, etc. Credit unions charge interest and account fees just like a bank, but they reinvest those
profits into the products they offer; however, banks provide these profits to their shareholders.

Historically, credit unions only served a particular demographic according to their field of
membership, such as military members, teachers, etc. Nowadays, they have liberated the restrictions
on membership and provide their services to the general public.

Insurance Companies
Insurance companies are familiar kinds of non-bank financial institutions. They offer insurance
services to both individuals and organizations. The insurance can be related to the protection against
financial risk, life insurance, health, home, shop, company, products, vehicles, etc. These institutions
put the money from insurance premiums into a pool to fund the policy coverage. Insurance
companies can be necessary for the stability of financial systems mainly because they are significant
investors in financial markets. As a result of the growing links between insurers and banks, insurers
are insuring the risks of households and firms to guarantee their financial stability.

Brokerage Firms

A brokerage firm or company is a middleman who facilitates the transaction by connecting the buying
and selling parties. Brokers assist in the dealing of securities such as stocks, mutual funds, shares,
bonds, options, and other financial instruments. Once the transaction is completed, brokers receive
both parties’ brokerage (commission). Some brokerage companies also provide financial advice and
act as consultants.

Role of Financial Institutions

Financial institutions are vital to the economy, providing essential services such as lending,
investment, and risk management, facilitating economic growth and stability. Let's understand the
role of financial institutions in detail.

1. Economic Growth of the Nation

At the national level, financial institutions are subject to government regulation. They serve as
government agents and develop the country’s economy. For instance, following government
regulations, financial institutions may extend a selective credit line with lower interest rates to assist a
struggling industry in resolving its problems.

2. Capital Formation

Financial institutions offer financial services to investors who require external cash to raise their
capital stocks by accepting individual savings. Investors may want financial services to carry out
development plans by setting up new machinery, tools, and equipment, constructing a new facility,
and purchasing new transport vehicles, among other things. Financial institutions contribute to the
creation of capital in this way.

3. Regulate Monetary Supply

The financial institution assists in controlling the amount of money in the economy. These
organizations keep the money supply stable and manage inflation. The Federal Reserve Bank
regulates the nation’s liquidity in several ways, including adjusting repo rates, participating in open
markets, and setting cash reserve ratios. To control liquidity, financial institutions purchase and sell
government assets.

4. Banking Services
Commercial banks and other financial institutions assist their clients by offering savings and deposit
services. Additionally, they provide their clients with credit options, including overdraft facilities, to
meet their short-term funding needs. Additionally, commercial banks offer their clients loans such as
house loans, mortgages, personal loans, and loans for schooling.

5. Pension Fund Services

Financial institutions assist people in retirement planning through the different types of investment
plans they offer. A pension fund is one of these investing possibilities. Employers, banks, or other
institutions contribute to the investment pool on behalf of the individual, who then receives a lump
sum or monthly income upon retirement.

Functions of Financial Institution

Financial institutions perform several key functions essential to the economy and financial system.
Here are the primary functions of financial institutions:

Intermediation

Financial institutions act as intermediaries between savers and borrowers. They collect funds from
individuals and businesses as deposits and then lend them to borrowers who need capital for various
purposes, such as starting a business or purchasing a home.

Depository Services

Financial institutions provide depository services by accepting deposits from individuals and
businesses. They offer checking accounts, savings accounts, and other deposit products where
customers can securely store their money. These deposits may also earn interest.

Credit Provision

Financial institutions extend credit to individuals and businesses through loans and credit lines. They
evaluate the creditworthiness of borrowers, determine interest rates, and provide financial support
for various needs, such as personal loans, mortgages, business loans, and working capital.

Investment Services

Financial institutions offer investment services to help individuals and businesses manage and grow
wealth. They provide access to investment products such as stocks, bonds, mutual funds, and other
securities. They also offer advisory services to guide clients in making informed investment decisions.

Risk Management

Financial institutions assist individuals and businesses in managing financial risks. They provide
insurance products, such as life insurance, health insurance, property insurance, and liability
insurance, to protect against potential losses and unforeseen events.

Payment and Settlement Services

Financial institutions facilitate payment transactions between individuals and businesses. They
provide payment and settlement services such as processing electronic fund transfers, issuing credit
and debit cards, and managing payment systems to enable smooth and secure transactions.

Asset Management

Financial institutions offer asset management services, where they manage investment portfolios on
behalf of clients. They provide expertise in selecting investment options, diversifying portfolios, and
monitoring market conditions to optimize returns and meet clients’ financial goals.

Financial Advisory

Financial institutions provide financial advisory services to individuals and businesses. They offer
guidance on financial planning, retirement planning, tax planning, estate planning, and overall wealth
management. They assist clients in making informed financial decisions based on their goals and risk
tolerance.

TIME VALUE OF MONEY

The concept of TVM refers to the fact that the money received today is different in its worth from the
money receivable at some other time in future. In other words, the same principle can be stated as
that the money receivable in future is less valuable than the money received today. For example, if an
individual is given an option to receive Rs.1000 today or to receive the same amount after one year,
he will definitely choose to receive the amount today.
The obvious reason for this reference for receiving money today is that the rupee received today has
a higher value than the rupee receivable in future. This preference for current money as against
future money is known as the time preference for money or simply time value of money. Cash flows
can be either positive or negative; positive cash flows are called cash inflows and negative cash flows
are called cash outflows.

Time Preference for Money

If an individual behaves rationally, he or she would not value the opportunity to receive a specific
amount of money now, equally with the opportunity to have the same amount at some future date.
Most individuals value the opportunity to receive money now higher than waiting for one or more
periods to receive the same amount.

Time Preference of Money or Time Value of Money (TVM) is an individual’s preference for possession
of a given amount of money now, rather than the same amount at some future time.

Three reasons may be attributed to the individual’s time preference for money.

 Risk

 Preference for consumption

 Investment opportunities

FUTURE VALUE
Let us assume that an investor requires 10 percent interest rate to make him different to cash flows
one year apart. The question is how should he arrive at comparative values of cash flows that are
separated by two, three or any number of years?

Once the investor has determined his interest rate, say, 10 percent, he would like to receive at least
Rs.1.10 after one year or 110 percent of the original investment of Re 1 today. A two year period is
two successive one-year periods. When the investor invested Re1 for one year, he must have received
Rs.1.10 back at the end of that year in exchange for the original Re1. If the total amount so receive
(Rs.1.10) were reinvested, the investor would expect 1.10 percent of that amount, or rs.1.21 = Re1 *
1.10 * 1.10 at the end of the second year.
Notice that for any time after the first year, he will insist on receiving interest on the first year‟s
interest as well as interest on the original amount (principal)

Compound Interest is the interest that is received on the original amount (principal) as well as on any
interest earned but not withdrawn during earlier periods. Compounding is the process of finding the
future values of cash flows by applying the concept of compound interest.

Simple Interest is the interest that is calculated only on the original amount (principal) and thus, no
compounding of interest takes place.

Future Value of a Single Cash Flow

Suppose your father gave you Rs.100 on your eighteenth birthday. You deposited this amount in a
bank at 10 percent rate of interest for one year. How much future sum would you receive after one
year? You would receive Rs.110:

Fn = P (1 +i) n
Future sum = Principal + Interest
= 100 + (0.10 *100)
= 100 * (1.10) = Rs.110
What would be the future sum if you deposited Rs.100 for two years? You would now receive interest
on interest earned after one year:

Future sum = 100 * 1.10 * 1.10 = Rs.121

You could similarly calculate future sum for any number of years. We can express this procedure of
calculating compound or future value in formal terms.

Future Value of an Annuity

Annuity is a fixed payment (or receipt) each year for a specified number of years. If you rent a flat and
promise to make a series of payment over an agreed period, you have created an annuity. The equal-
installment loans from the house financing companies or employers are common examples of
annuities. The compound value of an annuity cannot be computed directly from the previous
equation as shown above. The computations can be expressed as follows:

F = A(1+i) 3 +A(1+i)2 + A(1+i) + A

4

For example, a constant sum of Re1 is deposited in a savings account at the end of each year for four
years at 6 percent interest. This implies that Re1 deposited at the end of the first year grow for 3
years, Re1 at the end of second year for 2 years, Re1 at the end of the third year for 1 year and Re1 at
the end of the fourth year will not yield any interest.

Using the concept of the compound value of a lump sum, we can compute the value of annuity. The
compound value of

Re1 deposited in the first year will be: 1*1.063 = 1.191

Re1 deposited in the second year will be: 1*1.062 = 1.124
Re1 deposited in the third year will be: 1*1.061 = 1.060
Re1 deposited at the end of fourth year will be: 1 = 1.000
Total = 4.375
PRESENT VALUE
However, it is a common practice to translate future cash flows into their present values. Present
value of a future cash flow (inflow or outflow) is the amount of current cash that is of equivalent
value to the decision maker. Discounting is the process of determining present values of a series of
future cash flows. The compound interest rate used for discounting cash flows is also called the
discount rate.

Present Value of a Single Cash Flow

As we have seen earlier that an investor with an interest rate i, of say, 10 percent per year, would
remain indifferent between Re1 now and Re1*1.101 = Rs1.10 one year from now and Re1*1.102 =
Rs1.21 after two years and Re1*1.103 = Rs1.33 after 3 years.

We can say that, given 10 percent interest rate, the present value of Rs.1.10 after one year is Re1; of
Rs.1.21 after two years is Re.1 and so on.

Assuming a 10 percent interest rate, we know that an amount sacrificed in the beginning of the year
will grow to 110 percent or 1.10 after a year. Thus the amount to be sacrificed today would be: 1/1.10
= Rs.0.909. In other words, at a 10 percent rate, Re.1 to be received after a year is 110 percent of
Re.0.909 sacrificed now. Stated differently, Re.0.909 deposited now at 10 percent rate of interest will
grow to Re.1 after one year. If Re.1 is received after two years, then the amount needed to be
sacrificed today would be 1/1.102 = Rs.0.826.

How can we express the present value calculations formally? Let I represent the interest rate per
period, n the number of periods, F the future value (or cash flow) and P the present value (cash flow).
We know the future value after one year, F1 (viz., present value (principal) plus interest), will be: F1 =
P(1+i)

The present value, P will be = P = F1/ (1+i)1

The future value after two years is = F = P(1+i)2
2
The present value, P will be = P = F2 / (1+i)2

The present values can be worked out for any combination number of years and interest rate. The
following general formula can be employed to calculate the present value of a lump sum to be
received after some future periods:
P = Fn/ (1+i)n = Fn [(1+i)−n]
P = Fn/ (1+i)n

The term in parentheses is the discount factor or present value factor (PVF) and it is always less than
1.0 for positive I, indicating that a future amount has a smaller present value. We can rewrite
Equation as follows:

Present value = Future value*Present value factor of Re1 PV

= Fn* PVFni

PVFni is he present value factor for n periods at i rate of interest. When we want to calculate the
present value factor, we can use a scientific calculator. Alternatively we can use of a table of pre-
calculated present value factors. Simply, to find out the present value of future amount, find out the
present value factor (PVF) for given n and I from the calculated table and multiply by the future
amount.
For example, an investor wants to find out the present value of Rs.50000 to be received after 15
years. The interest rate is 9 percent. First, we will find out the present value factor from the calculated
table as 0.275 and multiply by Rs.50000; we obtain Rs.13750 as the present value.

PV = 50000*PVF15 = 50000*0.275 = Rs.13750

Present Value of Annuity

An investor may have an opportunity of receiving an annuity – a constant periodic amount – for a
certain specified number of years. We will have to find out the present value of the annual amount
every year and will have to aggregate all the present values to get the total present value of the
annuity.

For example, an investor, who has a required interest rate as 10 percent per year, may have an
opportunity to receive an annuity of Rs.1 for four years.

The present value of Rs.1 received after one year is, P = 1/(1.10) = Rs.0.909,

After two years, P = 1/(1.10)2 = Rs.0.826, after 3 years, P = 1/(1.10)3 = Rs.0.751 and After four years, P
= 1/(1.10)4 = Rs.0.683.

Thus the total present value of an annuity of Rs.1 for four years is Rs.3.169 as shown below.

P = [1/(1.10) + 1/(1.10)2 +1/(1.10)3 +1/(1.10)4]

= [0.909 + 0.826 + 0.751 + 0.683 = Rs.3.169

The computation of the present value of an annuity can be written in the following general form:

P = A[1/i − 1/i (1+i)n]

The term within parentheses of above equation is the present value factor of an annuityof Rs.1,
which we would call PVFA and it is a sum of single-payment present value factors.

For example, assume that a person receives an annuity of Rs.5000 for four years. If the rate of interest
is 10 percent, the present value of Rs.5000 annuity is calculated as follows:

P = A[1/i − 1/i (1+i)n]

P = 5000 [1/0.10 − 1/0.10 (1.10)4]
= 5000 * (10
− 6.830) = 5000 * 3.170 = Rs.15,850
It can be realized that the present value calculations of an annuity for a long period would be extremely
cumbersome without a scientific calculator. We can use the table of pre-calculated present values of
an annuity of given present value of annuity of Rs.1 for numerous combinations of time periods and
rates of interest.

We can also calculate the present value factor of an annuity of Rs.1 for n periods at i rate of interest,
by the formula and using the table (factor) value as shown below:

PV = 5000 * (PVFA4,0.10) = 5000 * 3.170 = Rs.15,850

Present Value of an Uneven Cash Flow

Investments made by a firm do not frequently yield constant periodic cash flows (annuity). In most
instances the firm receives a stream of even cash flows. Thus the present value factors for an annuity,
as given in the calculated table cannot be used. The procedure is to calculate the present value of each
cash flow (using the calculated table) and aggregate all present values.
Problem: Consider than an investor has an opportunity of receiving Rs.1000, Rs.1500, Rs.800, Rs.1100
and Rs.400 respectively at the end of one through five years. Find out the present value of this stream
of uneven cash flows. If the investor‟s required interest is 8 percent, what will be the present cash
flow?

Solution:The present value is calculated as follows:

Present value = 1000+ 1500 + 800 + 1100 + 400

(1.08) (1.08) (1.08)3(1.08)4(1.08)5
2

The complication of solving this equation can be resolved by using the calculated table. We can find
out the appropriate present value factors (PVFs) either from the calculated table or by using calculator
land multiplying them by respective amount. The present value calculation will be as follows:

PV =1000 * PVF1.08 + 1500 * PVF2.08 + 800 * PVF3.08 + 1100 * PVF4.08 + 400

* PVF5.08

= 1000*0.926 + 1500*0.857 + 800*0.794 + 1100*0.735 + 400*0.681

= Rs.3,927.60

MULTI-PERIOD COMPOUNDING
In practice, cash flows could occur more than once a year. For example, banks may pay interest on
savings account quarterly. On bonds or debentures and public deposits, companies may pay interest
semi-annually. Similarly, financial institutions may require corporate borrowers to pay interest
quarterly or half-yearly.

The interest rate is usually specified on an annual basis, in a long agreement or security (such as bonds)
and is known as the nominal rate of interest. If compounding is done more than once a year, the actual
annualized rate of interest would be higher than the nominal interest rate and it is called the effective
interest rate.

Problem:

You can get an annual rate of interest of 13 percent on a public deposit with a company. What is the
effective rate of interest if the compounding is done (a) half-yearly, (b) quarterly, (c) monthly and (d)
weekly? Calculate EIR.

Solution:
The general formula for calculating EIR can be written in the following general form:

EIR = [1+i/m] nm – 1 where „i‟ is the annual nominal rate of interest,

„n‟ the number of years and
„m‟ the number of compounding per year.

In annual compounding, m = 1, in monthly compounding, m = 12 and in

weekly compounding m = 52.

Effective Interest Rate (EIR)

(a) EIR = [1+0.13/2]1*2 – 1 = (1.065)2 – 1 = 1.1342 – 1 = 0.1342
or 13.42%
(b) EIR = [1+0.13/4] 1*4 – 1 = (1.0325)4 – 1 = 1.1365 – 1 = 0.1365
or 13.65%
(c) EIR = [1+0.13/12] 1*12 – 1= (1.01083) 12 – 1 = 1.1380 – 1 = 0.1380
or 13.80%
(d) EIR = [1+0.13/52]1*52 – 1= (1.0025)52 – 1 = 1.1386 – 1 = 0.1386
or 13.86%
______________________________________
Problem: (Multi-period Compounding)
Find out the compound value of Rs.1000, interest rate being 12 percent per annum if
compounded annually, semi-annually, quarterly and monthly for 2 years.

Annual compounding
F = 1000[1+0.12/1]2*1 = 1000(1.12)2 = 1000*1.254 = Rs.1254
n

Half-yearly compounding
F = 1000[1+0.12/2] 2*2 = 1000(1.06)4 = 1000*1.262 = Rs.1262
n

Quarterly compounding
F = 1000[1+0.12/4] 2*4 = 1000(1.03)8 = 1000*1.267 = Rs.1267
n

Monthly compounding
F n = 1000[1+0.12/12]2*12 = 1000(1.01)24 = 1000*1.270 = Rs.1270