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WHAT IS CORPORATE FINANCEThe division of a company that is concerned with the financial operation of the company. In most businesses, corporate finance focuses on raising money for various projects or ventures.For investment banks and similar corporations, corporate finance focuses on the analysis of corporate acquisitions and other decisionsThis is basically about money OBJECTIVES SAN LIO 1
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The primary goal of corporate finance is to Maximize corporate value while managing the firm’s financial risks SAN LIO 2
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ANALYSIS OF FINANCIAL STATEMENTSPrimary goal of financial management is to maximize the stock price, not accounting measures such as the bottom line or EPS.Evaluation of accounting statements helps management appreciate the company’s performance trends, as well as to forecast where the company is goingThe primary financial statements include: The statement of financial position The income statement SAN LIO 3
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The statement of retained earnings or called statement of changes in equity The cash flow statementOTHERS ARE Notes to the financial statements Accounting policies Statement of financial position-retrospective restatementRatios analysis-important SAN LIO 4
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RATIOSSolvency and financial strengthProfitability ratiosEarning value ratios (share value)Efficiency ratiosGearing/leverage ratios SAN LIO 5
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CONSIDER THESE OBJECTIVES OF FMProvide support for decision makingEnsure the availability of timely, relevant and reliable financial and non-financial informationManage risksUse resources efficiently, effectively and economicallyStrengthen accountabilityProvide a supportive control environmentComply with authorities and safeguard assets SAN LIO 6
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FINANCIAL PLANNING AND FORECASTINGWhat is a plan?-explain this to the studentsWhat is a forecast- explain this to the studentsThe optimal forecast becomes the budget SAN LIO 7
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CAPITAL BUDGETING TECHNIQUES Defined- This is the process of evaluating specific investment decisions. Capital investment decisions are important because: They involve huge sums of money Hard to discover alternative economic use Difficult to get out of the project once funds are committed Aim is to increase owners wealth and thus Control Capital used to mean operating assets used in production SAN LIO 8
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Budget is a plan (activities) that details projected cash flows during some future period.Thus capital budget is an outline of planned investments in operating assets while capital budgeting is the whole process of analysing projects and identifying the ones to include in the budget accordingly and these the ones that add to firm’s value SAN LIO 9
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PROJECT CLASSIFICATION KEY Categories which firms analyse include: Replacement: MAINTENANCE OF BUSINESS-worn-out or damaged equipments –depends on whether to continue the business or go into new ventures- no need of elaborate decision process Replacement: COST REDUCTION- detailed analysis Expansion of existing products or markets- higher level decisions within the firm Expansion into new products or markets- boards decision as a part of firm’s strategic plan SAN LIO 10
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Safety and/or environment projects- mandatory investments to comply with specific industry requirementsResearch and development- may use decision tree analysis rather than DCF techniquesLong-term contracts- to provide products or services to specific customers- DCF analysis necessary SAN LIO 11
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CAPITAL BUDGETING DECISION RULESThere are seven key methods namelyPaybackDiscounted paybackAccounting rate of returnNet present value (NVP)Internal rate of return ( IRR)Modified internal rate of return (MIRR)Profitability index SAN LIO 12
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PAYBACK PERIODExpected number of years required to cover the original investmentPayback = year before full recovery +unrecovered cost at start of yearCash flow during the yearEXAMPLETake two projects X and YX= -1000 Y1 500 Y2 400, Y3 300 Y4 100Y=-1000 Y1 100 Y2 300 Y3 400 Y4 600 SAN LIO 13
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EXAMPLE CONTRequired: find payback period and advise which project should be undertaken if both projects are mutually exclusiveSOLUTIONX= 2 + 100/300 = 2.33Y= 3+ 200/600= 3.33CONCLUSION X has the shortest pay back period thus accepted accordingly. SAN LIO 14
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DISCOUNTED PAYBACKHere the expected cash flows are discounted by the project’s cost of capitalDiscounted payback period defined as the number of years required to recover the investment from discounted net cash flowsEXAMPLE OF OUR PROJECTS X AND YDiscounting the cash inflows for both projects assuming a cost of capital of 10%Use tables accordingly SAN LIO 15
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EXAMPLE CONTProject X = 2 + 214/225= 2.95 yearsProject Y = 3 + 360/410= 3.88 yearsProject X is preferred accordinglyPeriod discounting factor at 10%1 .90912 .82643 .75134 .68305 .6209 SAN LIO 16
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PROJECT Y Pay back 3 + 360/410 = 3.88ADVANTAGES OF PAYBACK METHODEasy to understand and calculateProvides some assessment of risk in a business environment of rapid technological changes, new plant and machinery may need to be replaced sooner than in the past, so a quick payback on investment is essential SAN LIO 18
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The investment climate today in particular, demands that investors are rewarded with fast returns. Many profitable opportunities for long-term investment are overlooked because they involve a longer wait for revenues to flow SAN LIO 19
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DISADVANTAGESIgnores cash flows after the payback period. Cash flows are regarded as either pre-payback or post- payback, but the latter tend to be ignored.Does not measure profitability. Payback takes no account of the effect on business profitability. Its sole concern is cash flowIgnores time value of moneyIt lacks objectivity. Who decides the length of optimal payback time? No one does - it is decided by pitting one investment opportunity against another. SAN LIO 20
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NB/It is probably best to regard payback as one of the first methods you use to assess competing projects. It could be used as an initial screening tool, but it is inappropriate as a basis for sophisticated investment decisions SAN LIO 21
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ACCOUNTING RATE OF RETURN (ARR)Focuses on a project’s net income and not its cash flowIs the ratio of the project’s average annual expected net income to its average investmentFormulaARR = Average annual income * 100 Average investmentEXAMPLELets Assume the case of our TWO projects X and Y SAN LIO 22
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PROJECT XLets further assume that both projects will be depreciated using the straight line method- in their useful economic life of FOUR years and have a scrap value of zeroThe depreciation expense = 1000/4= 250 per yearAVERAGE ANNUAL INCOME= Average cash flow- Average annual depreciationThus: (500+400+300+100)/4=325-250=75 SAN LIO 23
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AVERAGE INVESTMENT =Cost + Scrap Value 2THUS: 1000 + 0/2 = 500THUSARR = 75/500*100= 15%Lets determine ARR for Project Y- EVERY BODY SAN LIO 24
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PROJECT Y1,400/4= 350-250= 1001000+0/2= 500THUSARR = 100/500*100= 20%CONCLUSIONThe ARR method ranks project Y over project X.If the firm accepts projects with say 18%, Then accordingly, project Y will be accepted and project X rejected. SAN LIO 25
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ADVANTAGES OF ARREasy to understand and calculateManagers familiar with the key conceptsBrings into consideration the income earned over the whole life of projectThe idea of return on capital employed is generally understood and this aids the comprehension of the accounting rate of returnThe minimum required rate of return can be set with reference to the cost of the finance used by the company plus the additional return it requires for its own profit. SAN LIO 26
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DISADVANTAGES OF ARRIgnores the time value of moneyThe timing of income arising from alternative projects is ignored SAN LIO 27
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WHATS MORE ?We note that the rankings under the ARR method are exactly the opposite of the ones based on the Payback methodWhats the problem here?This is an argument we can have right here!Is it worth?Probably NO- Because these two method ignore a very fundamental issue- THE TIME VALUE of money. SAN LIO 28
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CONCLUSION ON THE TWO METHODSThey both do not give us complete information on the projects contribution to the firm’s intrinsic value.DCF-Discounted Cash Flow techniques are therefore reliable because they address this problem SAN LIO 29
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NET PRESENT VALUE (NPV)Present value (PV) is an accounting term that measures how money needs to be invested today in order to finance business initiatives, projects, and obligations tomorrowIn order to determine the present value of future costs, accountants use formulas based on the time value of money. These formulas feature variables such as the length of time involved and the prevailing interest rate and/or inflationary rates SAN LIO 30
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In other words, the present value of an amount to be received in the future is the discounted face value considering the length of time the receipt is deferred and the required rate of return (or appropriate discount rate under the circumstances)Present value is the result of the time value of money concept, which works in recognition that todays Shilling is worth more than the same Shilling received at a future point in time. SAN LIO 31
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NPV PROCEDUREFind the present value of each cash flow, including all inflows and outflows, discounted at the project’s cost of capitalSum these discounted cash flows; this particular sum is called the project’s NVPIf the NPV is positive, the project is accepted but rejected if the NPV is negativeIf two projects with positive NPV are mutually exclusive, the one with the higher NPV is selected SAN LIO 32
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The formula (We know it!)WHERE CFt= the expected net cash flow at period t r= the projects cost of capital n= the projects life CF0= a negative number being the cash outflowsNOTEWe can also use the tables of discounted factors accordingly SAN LIO 34
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EXAMPLESLets compute NPV Of both our projects X and Y SAN LIO 35
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NPV RATIONALEA NPV of zero signifies that the project’s cash flows are exactly sufficient to repay the invested capital and provide the required rate of return on that capital.A positive NPV means the project is generating more cash than needed to service the debt and to provide the required return to shareholders; and that this excess cash accrues solely to the entities stockholdersPositive NPV means the wealth of the stockholders increases SAN LIO 36
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We may at this stage compare our two projects, X and Y, and see by how much each of them increases the shareholders wealth.NOTE: there is a direct relationship between NPV and EVA (Economic Value Added- which is the estimate of a business’s true economic profit for the year- and represents the residual income that remains after the cost of all capital, including equity capital. Quite different from accounting profit which does not include a charge for equity capital) SAN LIO 37
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NPV is equal to the present value of the project’s future EVAs.Thus accepting a project with positive NPV results in a positive EVA and a positive MVA (Market Value Added- being the excess of a firm’s market value over its book value).Since entities should in fact reward managers for producing positive EVA-MVA; then NPV becomes a better method for making capital budgeting decisions accordingly. SAN LIO 38
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ACCOUNTING OR ECONOMIC PROFITEconomic profit = (explicit and implicit revenue) Minus (explicit and implicit cost)Accounting Profit = TR (Total Revenue= Price * Quantity) - (Cost of land) - (cost of labor) – (cost of capital)Economic profit = accounting profit – cost of equity capital SAN LIO 39
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ADVANTAGES OF NPVLinks capital budgeting decisions to EVA-MVARecognizes the time value of moneyCorrect ranking of mutually exclusive projectsDependent on forecast cash flows and opportunity cost of capital, instead of arbitrary guess work by managementNo arbitrary guess work SAN LIO 40
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DISADVANTAGESPossible errors in forecastingHard to determine the minimum rate of return of a projectOther factors which may affect a project’s structure of cash flows e.g. government grants, taxation etc SAN LIO 41
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THE INTERNAL RATE OF RETURNDefined as the discount rate that equates the present value of a project’s expected cash inflows to the present value of the project’s costs.This means:PV (Inflows) = PV (Investment costs)Further, this means IRR is simply the rate of return that forces the NPV to equal to ZeroFormula : CF0 + CFI + CF2 + CFn =0 (1+irr)0 (1+irr)1 (1+irr)2 (1+irr)nCan use the calculator to solve the equation SAN LIO 42
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ALTERNATIVE FORMULAR TO IRRIRR = X + x * (Y-X) x+yWhere X = Discount rate for positive NPV Y= Discount rate for negative NPV x= positive NPV found using X y= negative NPV found using Y Ignore negative signs SAN LIO 43
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EXAMPLE-OUR PROJECT X AND YNOTE- this is a trial and error process- whereby a higher rate of return (than the provided cost of capital) is used- until the result is a negative NPVLets use 18% as cost of capitalDiscount factors are: YEAR1 .8475, Y2.7182, Y3.6086,Y4.5158,Y5.4371Then solve IRR for both projects.Lets all do it SAN LIO 44
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DECISION MAKINGBoth projects have a cost of capital ( hurdle rate) of 10%IRR rule indicates that if the projects are independent of each other, then the both are accepted since they earn more than the cost of capital needed to finance themIf the two projects are mutually exclusive, the project X ranks higher and should be selected and Y rejectedIf the cost of capital is above 14.75, both projects will be rejected SAN LIO 46
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NOTEBoth NPV and IRR will always lead to the same decision (accept or reject) for INDEPENDENT projects (mathematical reasons)This so because if NPV is positive, IRR must exceed r (the cost of capital in NPV)This scenario is however not true for projects that are mutually exclusive SAN LIO 47
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IRR RATIONALE This particular rate is critical because:The IRR on a project is the expected rate of return If the IRR exceeds the cost of capital (funds used to finance the project), then a surplus will remain after paying for the capital. This surplus will accrue to the entity’s stockholders This means a project whose IRR exceeds its cost of capital increases shareholders wealth. If the IRR is less than the cost of capital, then that particular project will impose a cost on stockholders SAN LIO 48
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NOTE: This break-even quality of IRR makes it fairly useful in evaluating capital projects SAN LIO 49
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NPV VERSUS IRRNPV is better than IRR in many aspects.IRR however can not be ignored- popular with many managers and seriously entrenched into the business industryImportant to understand why a project with a lower IRR may be more attractive to a mutually exclusive one with a higher IRRLook at the NVP Profile curve SLIDE 56- simply plots a projects NPV and cost of capital- And if a project has its cash flows coming in the early year; SAN LIO 50
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Then its NPV will not decline very much if the cost of capital increases but a project with cash flows which come later will be severely penalized by high capital costs. –Y in our case and it has a steeper slopeNOTE NPV profiles decline as the cost of capital increases SAN LIO 51
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EVALUATING INDEPENDENT PROJECTSBoth the NPV and IRR criteria always lead to the same accept/reject decisionEVALUATING MUTUALLY EXCLUSIVE PROJECTSIf we assume that our projects X and Y are mutually exclusiveThis means we can either choose X or Y or reject both BUT cannot accept both SAN LIO 52
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A conflict exists where the cost of capital is less than the crossover rate- NPV will choose X whereas IRR will choose Y If r is greater than cross point-both NPV and RRR take X This conflict is resolved by asking the question- how useful is it to generate cash flows sooner rather than later This really depends on how on the return we can earn from those cash flows ie the rate at which we can reinvest them. The NPV assumes that the rate at which cash flows can be reinvested is the cost of capital SAN LIO 53
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IRR assumes that the firm can reinvest at the IRR rateIn this particular case, NPV prevails as a better method since it is better to reinvest at the cost of capital rather than at IRR rateThus where the conflict exist, NPV is used accordingly SAN LIO 54
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MULTIPLE IRRs This exists if a project is regarded as having nonnormal cash flows. Nonnormal cash flows occur when there is more than one change in the sign e.g. a project starts with negative cash flows and switch to positive cash flows and switch again to negative cash flows These kinds of projects can have two or more IRRsILLUSTRATIONImagine a firm is considering the expenditure of Ksh 1.6 million to develop an equipment to manufacture balls. The balls will produce a cash flow of Ksh 10 million at the end of year 1. SAN LIO 56
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At the end of year 2, additional Ksh 10 million must be utilised to expand this project due to increasing demand due to the upcoming world cup championshipREQUIREDIRR of the projectSOLUTIONNPV=Ksh 1.6 + Ksh 10 + -Ksh10 = 0 (1+IRR)0 (1+IRR)1 (1+IRR)2=Ksh 1.6 +Ksh 10 + -Ksh10 = 0 (1+IRR)1 (1+IRR)2 SAN LIO 57
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1. If NPV were used, then there would be no dilema in making the decision2. if the r were between 25% and 400%, the NPV would be positive SAN LIO 59
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MODOFIED IRRNPV prevails over IRR in times of conflict but IRR continues to be popular and many executives prefer IRR to NPV because it is apparently easy to work with a percentageThe idea here is to device a percentage evaluator that is better than IRRThis is basically done by modifying the IRR rate and make it a better indicator of relative profitability and therefore better for use in capital budgetingThis is called MIRR SAN LIO 60
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Formula : PV OF COSTS= TERMINAL VALUE (1+MIRR)n- COF= Cash outflows (negative numbers)- CIF = cash inflows (positive numbers)- r= the cost of capital- The compounded future value of the cash inflows is called the TERMINAL VALUE (TV)- The discount rate that makes PV of TV equal to the PV of the costs is the MIRRASSIGNMENTLets attempt the MIRR for projects X and Y SAN LIO 61
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PROJECT X1000= 1579.50 (1 +irr)4Irr= 12.1% SAN LIO 62
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IRR ADVANTAGESThe rate of return measured is familiar with managers incorporates the time value of moneyDISADVANTAGESNonnormal cash flows produces multiple IRRsFor mutually exclusive projects, there is conflict with NPV- although this problem is solved by MIRR SAN LIO 63
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PROFITABILITY INDEXComputed asPI = PV of future cash flows Initial costEXAMPLE PROJECT XPIX = 1,078.82/1000= 1.079A project is accepted if its PI is greater than 1The higher the PI the higher the project’s rankingSSIGNMENTWhich project would be selected between X and Y SAN LIO 64
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