SRM Institute of Science & Technology

MB18203 - Corporate Finance

Unit I: Introduction
Introduction to Financial Management:
Finance is the life blood of a business.
Definition: “Financial management is the process of procuring and judicious use of financial
resources with a view to maximizing the value of the firm thereby the value of the owners.”

Conventional or Traditional view of financial management:

 Arrangement of short term and long term funds from financial institutions.
 Mobilization of funds from financial instruments like Equity shares, preference shares,
bonds, etc.
 Orientation of finance functions with the accounting function and compliance of legal
provisions relating to funds procurement, use and distribution.

Modern Approach to Financial Management:

 Total funds requirement of the firm
 Assets to be acquired
 Pattern of financing the assets

Three types of decisions

a. Investment decisions (deployment of funds)
Investment decisions relate to the careful selection and allocation of funds of viable and
profitable investment proposals.
 Ascertainment of total volume of funds a firm can commit.
 Appraisal and selection of capital investment proposals
 Measurement of risk and uncertainty
 Prioritization of investment decisions
 Funds allocation and its rationing
 Determination of fixed assets to be acquired
 Determination of levels of investment in current assets
 Buy or lease decisions
 Asset replacement decisions
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  Restructuring, re-organizing, mergers and acquisitions
 Security analysis and portfolio management
b. Financing Decisions (Mobilization of funds)
Financing decisions are concerned about procurement of funds and working capital
requirements.
 Determination of financial pattern of long term and short term funds requirement
 Raising of funds through issue of financial instruments
 Arrangement of funds from banks and financial institutions
 Arrangements of funds for working capital requirements
 Consideration of interest burden
 Consideration of cost of capital
 Consideration of various modes of improving EPS and market price
 Optimization of financing mix
 Study the impact of stock market and economic conditions
 Consideration of impact of over and under capitalization
 Consideration of foreign exchange risk
 Balance between owners’ and outside capital
 Balance between long and short term funds
 Evaluation of alternative uses of funds
c. Dividend decisions
Dividend decisions are mainly concerned with decisions relating to the distribution of earnings
of the firm among its shareholders and the amount retained.
 Determination of dividend and retention policies of the firm
 Consideration of impact of dividend and retention on market value of the share
 Consideration of possible required funds for expansion and diversification
 Reconsideration of policies in boom and recession periods
d. Liquidity decisions

Finance Function – covers financial planning, forecasting of cash receipts and disbursements,
realizing of funds, use and allocation of funds and financial control.
Who takes care of finance function in a business?
Financial controller or treasurer – finance officer
Managing Director or Agent of company
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Committee of Board of Directors

Scope of Finance Function:

 What specific assets should a firm acquire?
 What total volume of funds should a firm commit?
 How should the funds required be raised?
 How large and how fast a company should grow?
 What should be the composition of its liabilities?
 In what specific forms should it hold its assets?

Key Activities of Financial Management:

Management of the Financial Analysis, Planning and control Management of the
firm’s asset Balance Sheet firm’s asset
structure Long term financing Fixed assets structure
Short term Current assets
financing

Risk-Return Tradeoff:
Relationship between key financial decisions, return, risk and market value

Capital budgeting
Return
decisions

Capital structure Market value

decisions of firm

Dividend decisions
Risk
Working Capital
decisions

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Organisation of Finance Function:

Chief Finance Officer

Treasurer Controller

Cash Manager Credit Manager Financial Cost

accounting accounting
Capital Fund Raising manager manager
Budgeting Manager
manager Tax Manager Data
Processing
Portfolio Manager
Manager
Internal Auditor

Important Functions of finance manager:

1. Provision of capital
2. investor relations – market for securities and liaison
3. Short term financing
4. Banking and custody
5. Credit and Collections – granting of credit and collection of accounts
6. Investments – pensions, trusts
7. Insurance
8. Planning for control of operations
9. Reporting and interpreting – compare performance and interpret results
10. Evaluating and consulting – effectiveness of policies
11. Tax administration
12. Government reporting – preparation of reports
13. Protection of assets – insurance, audit
14. Economic appraisal

Traditional Finance Manager:

 Raising as much as possible funds from banks and financial institutions

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  Scouting around for green field projects – expansion of capacities to maximize profits for
organic growth of the company
 Engrossed with how to manage the inventory and how to recover debts as fast as possible
 Not looking much towards the issuance of shares in stock market
These are functions – nowadays classified as “orthodox” activities. Due to the ever changing
world of liberalization, globalization and internationalization – more responsibilities have been
vested on the shoulders of the finance manager.

Modern Finance Manager:

 Debt Restructuring activity – due to changing financial scenario of ‘softer interest
rates’ (raising low cost loans to swap high cost funds and improve profitability by
reducing costs). Example – Arvind Mills – after debt restructuring exercise – reduced
interest cost from Rs. 80 Crores to Rs. 40 Crores and enhanced profits by Rs. 160 Crores
per annum.
 Concerned not just with quantum of funds but the cost of funds – not in just domestic
markets but at the international level through ECBs – Euro Commercial Borrowings, or
GDRs – Global Depository Receipts or ADRs – American Depository Receipts.
 Save his company from any hostile takeover bid
 Concerned with buying back shares from market rather than issuing them
 Preparing the game plan to arrange huge funding for takeover bids – Brownfield
expansions or growth of the company (acquiring companies not only in India but also
across the frontiers).
 “Value creation” for its shareholders – must know the nitty gritty of EVA (Economic
Value Added), SVC (Shareholders Value Creation)
 Structuring appropriate ESOP to motivate employees – attractive for employees and not
be expensive for company.
 Must also see to fresh issue of rights shares or preferential allotment to existing
promoters, LBO (Leveraged Buyouts – raising for acquisition).

Financial Objectives of a firm:

Basic financial objective – to increase or maximize owners’ wealth
 Return on capital employed (or) ROI
 Value addition and profitability
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  Growth in EPS and Price Earnings ratio
 Growth in Market value of shares
 Growth in dividend
 Optimum level of leverage
 Survival and growth of firm
 Minimization of finance charges
 Efficient utilization of short, medium and long term finance

Goals of Financial Management: Profit versus Wealth

Profit Maximization – means maximizing the rupee (or any other currency) income of the firm.
Price system is the most important organ of a market economy indicating what goods and
services society wants.
Would the price system in a free market economy serve the interests of the society?
Adam Smith’s logic is that when individual firms pursue the interest of maximizing profits,
society’s resources are efficiently utilized.
Therefore, the underlying logic of profit maximization is efficiency.

Objections to Profit Maximization

Criticized in recent years. Apart from shareholders, the other interested parties are customers,
employees, government and society.
In modern business environment, profit maximization is regarded as unrealistic, difficult,
inappropriate and immoral.
It fails to serve as an operational criterion for maximizing owner’s economic welfare.
It suffers from following limitations:
 It is vague – definition of profit is ambiguous – short term or long term, before tax or
after tax.
 It ignores time value of money
 It ignores risk – earnings may fluctuate

Shareholders’ Wealth Maximization (SWM):

SWM means maximizing the net present value or wealth of a course of action to shareholders.

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The NPV of a course of action is the difference between the present value of its benefits and the
present value of its costs.
Positive NPV – creates wealth and therefore desirable
Negative NPV – would destroy wealth and so rejected.
SWM takes care of timing and risk of expected benefits. The benefits are measured in terms of
cash flows and not accounting profits.
SWM is in harmony with interests of various groups – owners, employees, creditors, customers
and society.

Corporate finance:
Corporate finance is the area of finance dealing with the sources of funding and the capital
of corporations and the actions that managers take to increase the value of the firm to the
shareholders, as well as the tools and analysis used to allocate financial resources.
Corporate finance is described 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 maximise the shareholders’ value in both short and long-term.
Corporate finance understands the financial problems of the organisation 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.

Nature and scope of Corporate finance

Capital investment decisions are an important part of corporate finance. These decisions include
 Deciding whether the dividends should be offered to shareholders or not
 Sanctioning or rejecting proposed investment. If the investment is approved, it is
also to be decided whether the company should pay with debt of equity or both.
 Managing of short term assets and liabilities, investments, inventory control and other
short term financial issues by the financial manager
 Corporate finance understands the financial problems of a company and prevents them
before hand. It also deals with the financial aspects, promotion and administration of new
enterprises.

Nature or Principles of Corporate Finance

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Corporate finance is based on the following three principles:

The Investment Principle

According to this principle, the funds of an organization should be invested in such a way
to derive maximum return on investment. This investment should be made at acceptable
and minimum hurdle rate which depends on the project’s debt and equity. The riskier the
project is, the higher will be the hurdle rate.
The Financing Principle
According to this principle, one should choose the ratio of debts and equity in such a way
so as to attain maximum return on investment and to match the assets’ financial nature.
The corporate finance manager has to analyze how to attain the optimum financial
mix of debt and equity for the organization.
The Dividend Principle
According to this principle, when a business reaches a saturation point where cash flow
surpasses the required fund, the corporate finance manager needs to search for alternative
sources like dividends, stocks and assets to maintain a balance between the cash flow and
required funds.

Importance of corporate finance

The importance of corporate finance can be classified as follows:
Decision Making: There are several decisions that have to be done on the basis of
available capital and limited resources. If an organization has to start a new project,
then it has to consider whether it would be financially viable and if it would yield
profits. So while investing in a new project or a new venture, a company has to consider
several things like availability of finances, the time taken for its completion, etc. and
then makes decisions accordingly.
Research and Development: In order to survive in a volatile market for a long
duration, a business organization needs to continuously research the market and develop
new products to appeal the consumers. It may even have to upgrade its old products to
compete with new vendors in the market. Some companies employ people to conduct
market surveys on a large scale; prepare questionnaire for consumers; do market
analysis, while other may outsource this work to others. All these activities would
require financial support.
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Fulfilling Long Term and Short Term Goals: Every organization has several long
term goals in order to survive in the market. The short term goals may include paying
the salaries of employees, managing the short term assets, acquiring corporate finances
like bank drafts, trade credit from suppliers, purchase of raw materials for production
etc. Some long term goals would include acquiring bank loans and paying them off;
increasing the customer base for the company etc.
Depreciation of Assets: When you invest in a new software or a new equipment, you
would require to keep aside some amount to maintain it and upgrade it in the long run.
Only then you could be assured that it would yield good results over a period of time. In
the fast changing times of today, if this is not done, you might end up losing business if
you do not have finances for it.
Minimizing Cost of Production: Corporate finance helps in minimizing the cost of
production. With the rising cost of prices of raw materials and labor, the management
has to come up with innovative measures to minimize the cost of production. In many
organizations that spend a lot of money on large scale production, deploy professionals
for this purpose. These people tend to buy quality products from vendors who offer it at
lowest possible rates. For example, a products based software company might buy
software from a vendor that sells it at a lower rate than an internationally acclaimed
company selling the same thing.
Raising capital: When an organization has to invest in a new venture, it is very
important that it has to raise capital. This cab be done by selling bonds and debentures,
stocks of the company taking loans from the banks etc. All this can be done only by
managing corporate finances in a proper manner.
Optimum Utilization of Resources: The resources available to organizations may be
limited. But if they are utilized efficiently, they can yield good results. For example, a
business organization needs to know the amount of money it can spend on its employees
and how much hike should be given to them. The proper management of corporate
finance would also help in utilizing its profits in such a manner that would help in
increasing them; for example, investing in government bonds, keeping up with the latest
technology trends to increase efficiency.
Efficient Functioning: A smooth flow of corporate finance would enable businesses to
function in a proper manner. The salaries of employees would be paid on time, loans

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would be cleared in time, purchase raw materials can be done when required, sales and
promotion for existing products and launch of new products, etc.
Expansion and Diversification: Before an organization decides to expand or diversify
in to a new arena, it has to consider various aspects like the capital available, risks
involved, the amount to be invested for purchase of new equipment etc. All this can be
done by experts and this would be very beneficial for the organization.
Meeting Contingencies: Running a business involves taking several risks. Not all risks
can be foreseen. Although some risks can be transferred to third parties by buying an
insurance policy, not every contingency can be covered by the insurer. Some amount
would have to be kept aside to tide over these situations.

Indian Financial System

Components of the Formal Financial System
 Financial Instruments
 Financial Markets
 Financial Institutions
 Financial Services
A financial institution is basically an establishment that conducts financial transactions such as
investments, loans and deposits.
The primary role of financial institutions is to provide liquidity to the economy and permit a
higher level of economic activity than would otherwise be possible.

History of financial institutions in India

The journey of Indian Banking system can be segregated into 3 different phases:
i. Early phase from 1786 to 1969 of Indian banks.
ii. Nationalisation of Indian Banks and up to 1991 prior to Indian banking sector reforms
iii. New phase of Indian Banking System with the advent of Indian financial and banking
sector reforms after 1991

Classification of Financial Institutions

1. Banking and Non-Banking
 Banks provide transactions services
 Create deposits or credit
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  Subject to legal reserve requirements
 Can advance credit by creating claims against themselves
 Other institutions can lend only out of resources put at their disposal by the savers.
 Examples of non-banking financial institutions are Life Insurance Corporation (LIC),
Mutual Fund Institutions (MFIs), and other Non-Banking Financial Companies (NBFCs).
 According to Sayers, banks are ‘creators’ of credit, and non-banking institutions are
‘purveyors’ of credit.
2. Intermediaries versus Non-Intermediaries
 Intermediaries intermediate between savers and investors;
 They lend money as well as mobilize savings
 Their liabilities are towards the ultimate savers, while their assets are from the investors
or borrowers
 All banking institutions are intermediaries and LIC and GIC are some of the of the non-
banking financial intermediaries (NBFI)
 Non-intermediary institutions do the loan business but their resources are not directly
obtained from the savers. Example: IFC, NABARD, etc.

Role of financial institutions in India

1. One of the more recent microeconomic approaches to economic growth is the promotion
of entrepreneurial activities.
2. Entrepreneurial efforts have been found to generate a wide range of economic benefits,
including new businesses, new jobs, innovative products and services.
3. Financing the small scale sector: Credit is the prime input for sustained growth of small
scale sector and its availability is thus a matter of great importance.
4. Micro Finance Credit: Providing loans to unemployed or low income individuals or
groups who would otherwise have no other means of gaining financial services.
5. State level institutions: Several financial institutions have been set up at the State level
which supplement the financial assistance provided by the All India institutions.
6. Insurance and Financial Services: The institutions are supporting a broad range of
financial services to help expand local capital markets and develop local financial
infrastructure.

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Concepts of value and Return
Most financial decisions affect a firm’s cash flows (CFs) in different time periods. Example: If
an asset is purchased, immediate cash outlay and receive CFs during many future periods. If a
firm borrows from bank – receives cash now and pays interest and principal in future. The CFs
which differ in time and risk cannot be logically comparable – if compared, becomes a wrong
decision.

Time Value of Money / Time Preference for money:

A rational individual prefers to possess a given amount of cash now, rather than same amount at
some future time.
Reasons:
 Risk
 Preference for consumption
 Investment opportunities

Time Preference Rate and Required rate of return

Required rate of return or Opportunity cost of capital = Risk-free rate + Risk premium
I. Compound Value or Future Value:
Compound interest – Interest earned on principal plus interest not withdrawn
Compounding – is the process of finding future value of a payment or a series of payment
Example: If a person requires 10% interest rate for Re. 1 invested today for 1 year, Future Value
will be Re. 1.10.
II. Present Value:
Present value is the amount of current cash that is of equivalent value to the decision maker.
Discounting – is the process of determining present value of a future payment or series of
payments.
Discount rate – is the compound interest rate used for discounting CFs.
Annuity – is a fixed payment each year for a specified number of years.
i. PV of an uneven periodic sum: (refer to PV of Re. 1 table)
PV = F1 + F2 + F3 + ------ + Fn
(1+r)1 (1+r)2 (1+r)3 (1+r)n
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ii. PV of an Annuity: (refer to PV of an Annuity table)
PV = A + A + A + ------ + A
(1+r)1 (1+r)2 (1+r)3 (1+r)n
Or
PV = A x PVIFA (Present Value Interest Factor Annuity)

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