Topics Covered What is Corporate Finance Key Concepts of Corporate Finance Compounding & Discounting Corporate Structure The Finance Function Role of The Financial Manager Separation of Ownership and Management Agency Theory and Corporate Governance
Corporate Finance is concerned with the efficient and effective management of the finances of an organization in order to achieve the objectives of that organization. This involves Planning & Controlling the provision of resources (where funds are raised from) Allocation of resources (where funds are deployed to) Control of resources (whether funds are being used effectively or not)
Diff. b/w Corporate Finance & Financial Accounting Corporate Finance is inherently forward-looking and based on cash flows. Financial Accounting is historic in nature and focuses on profit rather than cash.
Diff. b/w Corporate Finance & Management Accounting Corporate Finance is concerned with raising funds and providing a return to investors. Management Accounting is concerned with providing information to assist managers in making decisions within the company.
Two Key Concepts in Corporate Finance The fundamental concepts in helping managers to value alternative choices are Relationship between Risk and Return Time Value of Money
Relationship between Risk and Return This concept states that an investor or a company takes on more risk only if higher return is offered in compensation. Return refers to Financial rewards gained as a result of making an investment. The nature of return depends on the form of the investment. A company that invests in fixed assets & business operations expects return in the form of profit (measured on before-interest, before-tax & an after- tax basis)& in the form of increased cash flows.
Relationship between Risk and Return Risk refers to Possibility that actual return may be different from the expected return. When Actual Return > Expected Return This is a Welcome Occurrence. When Actual Return < Expected Return This is a Risky Investment. Investors, Companies & Financial Managers are more likely to be concerned with • Possibility that Actual Return < Expected Return Investors & Companies demand higher expected return • Possibility of actual return being different from expected return increases.
Time Value of Money Time value of money is relevant to both Companies Investors In wider context, Anyone expecting to pay or receive money over a period of time. Time value of money refers to the facts that Value of money changes over time.
Time Value of Money Imagine that your friend offers you either Rs.1000 today or Rs.1000 in one year’s time. Faced with this choice, you will (hopefully) prefer to take Rs.1000 today. The question is to ask that why do you prefer Rs.1000 today?
Time Value of MoneySolution: There are three major factors Time: If you have the money now, you can spend it now. It is human nature to want things now rather than wait for them. Alternatively, if you do not want to spend money now, you can invest it, so that in one year’s time you will have Rs.1000 plus any investment income earned. Inflation: Rs.1000 spent now will buy more goods & services that Rs.1000 spent in one year’s time because inflation undermines the purchasing power of your money. Risk: If you take Rs.1000 now you definitely have the money in your possession. The alternative of the promise of Rs.1000 in a year’s time carries the risk that the payment may be less that Rs.1000 or may not be paid at all.
Compounding is the way to determine the future value of a sum of money invested now. FV = C0(1+i)n Where: FV = Future Value C0 = Sum deposited now i = Interest Rate n = number of years until the cash flow occurs Example: Rs. 20 deposited for five years at an annual interest rate of 6% will have future value of: FV = 20 x (1+.06)5 = Rs.26.76 Compounding takes us forward from current value of an investment to its future value.
Discounting is the way to determine the present value of future cash flows. PV = FV / (1+i)n Where: FV = Future Value PV = Present Value i = Interest Rate n = number of years until the cash flow occurs Example: Investor choice between receiving Rs.1000 now & Rs.1200 in one year’s time. Annual Interest rate is 10%. PV = 1200 / (1 + 0.1)1 = Rs.1091 Alternatively, PV of Rs.1000 into a FV FV = 1000 x (1 + 0.1)1 = Rs.1110 Discounting takes us backward from future value of a cash flow to its present value.
Corporate Objectives The objective should be to make decisions that maximise the value of the company for its owners. Financial Objective of Corporate Finance is stated as “Maximisation of shareholder wealth”. Shareholder receive their wealth through increase in value of their shares, in the form of Dividends Capital Gains Shareholder wealth will be maximised by maximising the value of dividends and capital gains that shareholders receive over time.
The Finance Function Chief Financial OfficerTreasurer Comptroller
Role of The Financial Manager (1) Firms Financial Financialoperations manager markets (1) Cash raised from investors
Role of The Financial Manager (2) (1) Firms Financial Financialoperations manager markets (1) Cash raised from investors (2) Cash invested in firm
Role of The Financial Manager (2) (1) Firms Financial Financialoperations manager markets (3) (1) Cash raised from investors (2) Cash invested in firm (3) Cash generated by operations
Role of The Financial Manager (2) (1) Firms Financial Financial (4a)operations manager markets (3) (1) Cash raised from investors (2) Cash invested in firm (3) Cash generated by operations (4a) Cash reinvested
Role of The Financial Manager (2) (1) Firms Financial Financial (4a)operations manager markets (3) (4b) (1) Cash raised from investors (2) Cash invested in firm (3) Cash generated by operations (4a) Cash reinvested (4b) Cash returned to investors
Aim of Financial Manager While accountancy plays an important role within corporate finance, the fundamental problem addressed by corporate finance is economic, i.e. how best to allocate the scarce resource of capital. Aim of Financial Manager is the optimal allocation of the scarce resources available to them.
Role of The Financial Manager Financial managers are responsible for making decisions about raising funds (the financing decision), allocating funds (the investment decision) and how much to distribute to shareholders (the dividend decision).
Role of The Financial Manager The high level of interdependence existing between these decision areas should be appreciated by financial managers when making decisions Can you think how these decisions may be inter-related?
Interrelationship b/w Investment, Financing & Dividend DecisionsInvestment: Finance: Dividends:Company decides to Company will need to If finance is not available fromtake on a large number raise finance in order to external sources, dividends mayof attractive new take up projects need to be cut in order toinvestment projects increase internal financing.Dividends: Finance: Investment:Company decides to pay Lower level of retained If finance is not available fromhigher levels of dividend earnings available for external sources than companyto its shareholders investment means may have to postpone future company may have to investment projects. find finance from external sources.Finance: Investment: Dividends:Company finances itself Due to a higher cost of The company’s ability to payusing more expensive capital the number of dividends in the future will besources, resulting in a projects attractive to the adversely affected.higher cost of capital. company decreases.
Role of The Financial Manager Maximisation of a company’s ordinary share price is used as a surrogate objective to that of maximisation of shareholder wealth.
Ownership vs. ManagementDifference in Information Different Objectives Stock prices and returns Managers vs. Issues of shares and stockholders other securities Top mgmt vs. operating Dividends mgmt Financing Stockholders vs. banks and lenders
Agency & Corporate Governance Managers do not always act in the best interest of their shareholders, giving rise to what is called the ‘agency’ problem.
Agency & Corporate Governance Shareholders including institutions and Creditors private individuals including banks, suppliers and bond holders THE COMPANY Management Employees Customers Diagram showing the agency relationships that exist between the various stakeholders of a company
Agency & Corporate Governance Agency is most likely to be a problem when there is a divergence of ownership and control, when the goals of management differ from those of shareholders and when asymmetry of information exists.
Agency & Corporate Governance An example of how the agency problem can manifest itself within a company is where managers diversify to reduce the overall risk of the company, thereby safeguarding their job prospects. Shareholders could achieve this themselves by diversification.
Agency & Corporate Governance Monitoring and performance-related benefits are two potential ways to optimise managerial behavior and encourage ‘goal congruence’.
Agency & Corporate Governance Due to difficulties associated with monitoring, incentives such as performance- related pay and executive share options can be a more practical way of encouraging goal congruence.
Agency & Corporate Governance Institutional shareholders now own approximately 60 per cent of all UK ordinary share capital. Recently, they have brought pressure to bear on companies who do not comply with corporate governance standards.
Agency & Corporate Governance The problem of corporate governance has received a lot of attention following a number of high profile corporate collapses and a plethora of self-serving executive remuneration packages. In the UK, we have the example of Transport and Banking
Agency & Corporate Governance UK corporate governance systems have traditionally stressed internal controls and financial reporting rather than external legislation.
Agency & Corporate Governance Corporate governance in the UK was addressed by the 1992 Cadbury Report and its Code of Best Practice, and the 1995 Greenbury Report.
Agency & Corporate Governance A financial manager can maximise a company’s market value by making good investment, financing and dividend decisions.