Corporate Finance

1
Corporate Finance

• Capital Structure, Financial Planning, Financial
  Markets, Growth, Cost of Money

2
Business Organisation

• What is an Organisation ?
• Organisation is a social arrangement which
  pursues collective goals, which controls its own
  performance, and which has a boundary separating
  it from its environment.
• Types of Business Organisation
• Sole Proprietorships.
• Partnerships.
• Corporations.
• Limited Companies.
• Limited Liability Companies.
• Non-Profit Organisations.

3
Sole Proprietorship

• Easily and inexpensively formed.
• Corporate tax obligations are eliminated.
• Less prone to complex government regulations.
• Raising capital from the market is a tedious
  tasks.
• Full ownership of all liabilities associated with
  the organisation.
• In many cases, the life of the organisation is
  linked to the life of the individual who creates
  it. Complexities may arise in terms of transfer
  of ownerships and liabilities from previous
  owners.

4
Partnerships

• Partnerships may operate under different degrees
  of formality ranging from informal, oral
  understandings to formal agreements.
• Unlimited Liabilities.
• Limited life of an organisation and difficulty in
  transferring ownership.
• Difficulty in raising capital.
• Enjoys certain tax advantages similar to that of
  a sole proprietorships.
• Partners can potentially loose all of their
  assets in case of bankruptcy.
• All partners are deemed to have equal share in
  both growth and bankruptcy.

5
Corporations

• Corporations are legal entity created by the
  state and it is distinct and separate from its
  owners and managers.
• Unlimited life.
• Easy transferability of ownership interest.
  Ownership may come in the form of shares.
• Limited liability losses limited to the actual
  fund invested.
• Subject to comparatively higher taxation.
• Setting up a corporation is time consuming. It
  requires drawing up charters, articles of
  association and Memorandum of Association.

6
LLP, Limited Company, NPO

• In an LLP, also called Limited Liability Company,
  all partners enjoy limited liability with regards
  to the businesss liability. LLP combines the
  advantages of having limited liability to the tax
  advantages enjoyed by partnership.
• Non-Profit Organisations Government
  organisations, Non-Governmental organisations.
  More prone to organisations slacks. Profit
  maximisation is not seen an objective and they do
  not obviously work towards achieving it.

7
Capital Structure

• Capital Structure refers to the way a corporation
  finances its assets through some combination of
  equity, debt or hybrid securities.
• In other words, a firm capital structure is the
  composition or structure of its liabilities.
• Financing can be done from within its own
  resources i.e. cash at its disposal, through
  issue of equities or through debt financing i.e.
  tapping the money market.
• Firms can consider changing its capital structure
  through issue of further shares, converting
  existing convertible assets like bonds, rights
  issues, bonus issues, warrants etc.

8
Capital Structure

• Capital structure, therefore, forms an important
  aspect in assessing the companys value.
• In a perfect market, the value of the firm is not
  so affected by its capital structure.
• Example Proponents of the perfect market and
  classical tax system argue that there is
  deduction of taxes from interests on debt
  financing which makes external financing a lot
  more attractive and internal financing is of
  lesser value.
• In reality, however, we know that such perfect
  market and market norms is incorrect and that
  there is cost associated to its external
  financing structure.
• Bankruptcy costs, Agency Costs, Asymmetric
  Information all adds up to the risk associated
  with long term external financing.

9
Capital Structure

• Capital structure, in real world -
• Trade off theory - explains the fact that firms
  or corporations usually are financed partly with
  debt and partly with equity. There is an
  advantage to financing with debt - the Tax
  Benefit of Debt and the cost of financing with
  debt, the costs of financial distress including
  Bankruptcy Costs of debt and non-Bankruptcy costs
  such as employee attrition, suppliers demanding
  disadvantageous payment terms.
• The marginal benefit of further increases in debt
  declines as debt increases, while the marginal
  cost increases, so that a firm that is optimizing
  its overall value will focus on this trade-off
  when choosing how much debt and equity to use for
  financing.
• Bankruptcy Costs of Debt are the increased costs
  of financing with debt instead of equity that
  result from a higher probability of bankruptcy.

10
Capital Structure

• Pecking Order Theory - It states that companies
  prioritize their sources of financing (from
  internal financing to equity) according to the
  law of least effort, or of least resistance,
  preferring to raise equity as a financing means
  of last resort.
• Once internal funds have been used and on its
  depletion, debts are issued, and when it is not
  sensible to issue any more debt or once the
  marginal benefits coming from debt financing
  reduces, equity is issued.
• This theory maintains that businesses adhere to a
  hierarchy of financing sources and prefer
  internal financing when available, and debt is
  preferred over equity if external financing is
  required.

11
Financial Planning

• Financial planning is the process of solving
  financial problems and achieving financial goals
  by developing and implementing a corporate "game
  plan."
• Financial Planning do NOT focus on one aspect or
  process. It is a series of processes that
  culminates into end-results which are likely to
  be achieved in the long run. The process may
  require many adjustments as economic scenarios
  can change. Short run adjustment may be required
  to accommodate for the changes in the long run.
• In other words, most decisions pertaining to
  financial planning have a long lead times, which
  means that they take a long time to implement.

12
Financial Planning

• Various component that go into financial planning
  model
• Sales forecast all financial plans require near
  accurate sales forecast. Forecasting sales,
  however, cannot be predicted accurately and
  depends significantly on prevailing and future
  macroeconomic conditions.
• Pro-forma statement based on forecasted sales
  and costs (PL statements), and various balance
  sheet components, financial planning can be
  conducted and adjusted.
• Asset requirement the plan will describe
  projected capital spending. The use of net
  working capital can also be discussed.
• Feasibility different / alternative financial
  plans must fit into overall corporate objective
  of maximizing shareholders wealth.

13
Financial Planning

• Financial requirements and options provides the
  opportunity for the firm to work through various
  investment and financing options.
• Economic Assumption the plan must explicitly
  include the current state of economic affairs and
  the likely consequences from such economic
  indicators i.e. the prevailing and forecasted
  rate of interest
• See the sample example.
• Ross Westerfield Jaffe, Corporate Finance,
  Chap-3, Financial Planning and Growth, pg 48/49
  

14
Financial Planning Growth

• Growth In simple terms, growth refers to an
  increase in some quantity over some time. In
  economic terms, growth imply an increment in the
  monetary value of goods and services produced
  in the economy.
• Growth vs. Value Maximisation
• Rappaport in applying the shareholder value
  approach, growth should not be the goal in itself
  but rather a consequences of decisions that
  maximises shareholder value.
• Growth ideally should not be the principle goal
  but a secondary consequences that emerge out of
  value maximisation.
• Quality in Growth is paramount in value
  maximisation.
• A. Rappaport, Creating Shareholder Value The New
  Standard for Business Performance (New York Free
  Press, 1986)

15
Financial Planning Growth

• Recall from the example that the
• Firms assets will grow in proportion to the
  sales.
• Firm is reluctant to meet in financial
  requirement through external equities.
• Net Income is a constant proportion of the sales
  because cost of sales remains constant.
• Firm has given determined dividend-payout policy.
• Asset Debts Equities
• Therefore,
• Changes in Assets Changes in Debts Changes in
  Equity.

16
Financial Planning Growth

• Variables in determining growth rate
• T ratio of total assets/sales.
• p net profit margin (NP/Sales).
• d dividend payout ratio.
• L debt equity ratio.
• S0 current sales.
• S1 projected sales.
• ?S changes in sales (S1 S0).

17
Financial Planning Growth

• Donaldson suggests that most major industrial
  companies are very reluctant to use external
  equity as a major part of their financial
  planning. Supposing that the firm wants to
  achieve growth (sales) through increase sales,
  how can the firm increase sales and what could be
  used as source of funding ?
• To increase sales by ?S, the firms need to
  increase its assets by T?S. T?S can financed
  through
• Retained Earnings / Reserves and Surpluses which
  is a component in Equity Funding. Retained
  earnings is depended on the sales, dividend-pay
  out ratio.
• External Borrowings.

18
Financial Planning Growth

• Total Capital Spending (T?S) to achieve growth
• Equity Financing (S1 p) (1 d)
• External Borrowings (S1 p) (1 d) L
• Therefore,
• T?S (S1 p) (1 d) (S1 p) (1 d)
  L
• Given the above equation, we can now derive the
  sales growth

p (1 - d) (1 L)
?S

T p (1 d) (1 L)
S0
19
Financial Planning Growth

• T 1
• p 16.5
• d 72.4
• L 1
• Sustainable Growth Rate 0.165 (1 0.724)
  (1 1)
• 1 0.165 (1 0.724) (1
  1)
• 0.10 or 10 percent

20
Financial Planning Growth

• Can growth be achieved beyond the sustainable
  level ?
• In principle it can be done
• Sell news shares of stock.
• Increase its reliance on debts.
• Reduce its dividend pay out ratio.
• Increase profits margin.
• Decrease its asset-requirement ratio.

21
Financial Markets

• Physical asset markets are those that primarily
  deal in physical assets such as wheat, cars,
  automobile, machineries. Financial asset markets
  deal in stocks, bonds, notes, mortgages and other
  financial instruments.
• Types of market
• Spot, forwards and futures markets.
• Money markets those that deal in short and
  medium term highly liquid securities.
• Capital markets medium and long term debts and
  corporate stocks.
• Mortgage Market.
• IPO market, Primary markets and Secondary markets

22
Financial Markets
S Rate Hike
S1
Interest Rate
Interest Rate
S1
12
10
8
D1
D2 Recession Induced
D1
Low Risk Securities
High Risk Securities
23
Interest Rate and Determinants

• Quoted / Nominal Interest Rate refers to the
  rate of interest rate before adjusting for
  inflation.
• Real / Effective Interest Rate - effective rate
  is the interest rate on a loan or financial
  product restated from the nominal interest rate
  as an interest rate with annual compound
  interest.
• Consider Debt Security with a quoted/nominal
  interest rate of r.
• r r IP DRP LP MRP
• Nominal rate r is composed of
• r Risk-free interest rate.
  IP Inflation premium.
• DRP Default risk premium.
  LP Liquidity premium.
• MRP Maturity risk premium.

24
Interest Rate and Determinants

• Real Risk-Free Rate (r) interest rate on a
  risk-less security if no inflation exist. Risk
  free rate are never static and it is adjusted
  with changing economic circumstances.
• Therefore,
• Nominal Risk-Free Rate (rRF) risk free rate
  (r) plus premium for expected inflation.
  Securities that boast of offering such nominal
  interest rate tend to enjoy no risk of default,
  no maturity risk, no liquidity risk, no risk of
  loss if inflation rises.
• rRF r IP
• Inflation Premium is the average expected
  inflation rate over the life of the security.

25
Interest Rate and Determinants

• Inflation Premium Example
• Consider
• Investment Amount 1000.
• Market Interest Rate 5
• Investment Horizon 1 year
• TTM 1 year.
• Inflation Rate 10
• Investment Product Oil at 1 per gallon
• In the spot market
• 1000 gallons _at_ 1000.

Forward spot price of oil _at_ 10 inflation rate -
1.10 1000 _at_ 5 1050. NPV 955. Cost of
Oil 1 _at_ 10 1.10
26
Interest Rate and Determinants

• Default Risk Premium premium added to the
  interest rate for the risk that the borrower will
  default on a loan. In general, government
  securities do not have default risk premium as
  they are unlikely to default on interest
  payments.
• Liquidity Premium the risk of not being able to
  convert the underlying security into cash at a
  fair market value.
• Maturity Risk Premium premium added to the
  expected returns when the duration of an
  underlying securities is longer. Since longer
  duration leads to longer payment schedules, the
  risk of default is higher. Also the underlying
  security is more prone to changing interest
  rates.