1. The document discusses different types of business entities including sole proprietorships, partnerships, and corporations. It notes key characteristics of each like ownership, liability, taxation, and life of the business. 2. It then covers topics relevant to corporate finance including the roles of financial managers, the goal of maximizing shareholder wealth, and investment and financing decisions. 3. The document also discusses concepts such as the balance sheet, time value of money, net present value, and discounted cash flow analysis which are important tools used in financial management.

1. Lecture 1
Introduction
Financial Management(N12403)
Lecturer:
Farzad Javidanrad (Autumn 2014-2015)

2. Some Preliminaries
• Types of Firms:
1. Sole Trader (sole proprietorship): Small business entity (unit) run by an
individual who gets all profits with total responsibility about all debts.
Most common and cheapest type of business structure in the world. Not many
regulations applied in its establishment.
The owner has unlimited liability (legal responsibility) for business debts &
obligations. In the case of bankruptcy (liquidation) the owner’s assets can be
treated as the business asset in order to clear the debt.
 Tax is calculated based on the owner’s income tax.
The life of this type of firm is limited by the life of the owner.

3. Some Preliminaries
2. Partnership: Small/Medium business entity with two or more owners who
equally responsible (in case of General Partnership) for all debts of the business.
Two types of partnerships
The liability of the limited partner(s) is limited to the contribution of each partner.
They are taxed based on their personal income.
The life of the business is terminated if the general partner(s) dies or quits.
General Partnerships: All partners are liable for the debts.
Limited Partnerships: At least one partner is considered as
the general manager and have unlimited liability.

4. Some Preliminaries
3. Corporations: Large company (or a group of companies) authorised by law
to act as a single legal entity run by a set of directors elected by shareholders
(owners) with limited liability which means they are not totally responsible
for the amount debt of the company when it fails. (e.g. BP, Tesco, British
Airways and etc.)
 The ownership belongs to the shareholders but the management of the
corporation is with the Chief Executive Officer (CEO), which is the most
senior manager of the corporation and has maximum responsibility in the
company.
The CEO manages several subordinate executives, including the Chief
Financial Officer (CFO), also known as Finance Director in the UK, who is
responsible for financial planning (investment decisions and financial
decisions) and risk assessment.

5. Role of a Financial Manager in a Corporation
Adopted from Hillier’s PPT , The McGraw-Hill Companies, 2012

6. The Goal of Financial Management
Adopted from Hillier’s PPT , The McGraw-Hill Companies, 2012

7. Types of Firms
Sole Proprietorship
• Owned and Managed by
one person
• Very easy to form
• Profits taxed as personal
income
• Unlimited liability
• Life of company linked to
life of owner
• Amount of funding is
limited by owner’s
personal wealth
Partnership
• Easy to form
• Requires a partnership
agreement
• Limited and unlimited
partners
• Partnership is terminated
when a partner dies or
leaves the firm
• Difficult to raise cash
• Profits taxed as personal
income
• Controlled by general
partners – sometimes
votes are required on
major business decisions
Limited Corporation
• Articles and
Memorandum of
Incorporation Required
• Limited Liability
• Profits taxed at corporate
tax rate
• Board of Directors
• Life of company
hypothetically unlimited
Adopted from Hillier’s PPT , The McGraw-Hill Companies, 2012

8. Some Preliminaries
The separation of ownership and management gives a chance of permanent
life to a corporation. Shareholders can transfer their shares to others and
CEOs can be replaced by the owners but the corporation can continue as long
as it is profitable for the owners.
Shareholders have limited liabilities based on their participation in
investment in the company (number of shares). Their shares represent partial
or fractional ownership of the company.
By issuing bonds and shares corporations are able to finance their investment
projects. Bond holders are lenders (creditors) and shareholders (or
stockholders) are investors. In case of bankruptcy, lenders have higher
priority on claiming the assets, compare to investors, i.e., they will be paid
first from selling the assets. If the liabilities are more than assets,
shareholders’ equity (residual value) will be negative.

9. Partnership VS Corporation
Adopted from Hillier’s PPT , The McGraw-Hill Companies, 2012

10. Partnership VS Corporation
Adopted from Hillier’s PPT , The McGraw-Hill Companies, 2012

11. Corporate Governance & Corporate Finance
• Corporate Governance: It refers to a set of rules, practices and mechanisms
by which a corporation is directed and controlled. These rules and practices
should guarantee keeping the balance between different and sometimes
conflicting rights of stakeholders including shareholders, creditors,
managers, customers, government and local or international communities.
• Corporate Finance: It is the part of finance that deals with the financial
activities necessary for running a corporation and maximising the value of the
company in favour of the shareholders (owners).

12. Corporations
• Corporations invest in variety of assets to increase their flow of returns
and consequently to maximise the market value of their shares and in
order to finance these investments they either use their own resources
(re-investment) or outside resources (borrowing / selling shares).
• Assets: An economic (tangible or intangible) resources with a price
(subject to fluctuations) which is owned /controlled by individual(s) or
companies with a capability of producing future returns. E.g. machines,
inventories, buildings, lands, cash, vehicles, patents and etc.

13. Real & Financial Assets
• Assets can be divided into real or financial:
Real assets are physical or tangible assets such as
commodities, machineries, buildings, precious
metals/stones, arts, equipment and etc.
Financial assets are non-physical or intangible
assets such as bank accounts, bonds, shares and
etc. Financial assets are more liquid than real
assets, which means they can be converted to
money quickly. Money is the most liquid asset as it
can be used for purchasing goods and services or
for meeting the obligations and offsetting the
claims.
Adopted from http://www.batr.org/totalitariancollectivism/100911.html

14. Financial Assets & Securities
• If corporations borrow from individuals or financial institutions, in
fact, they sell claims (promises) on their existing assets or their future
cash flow to the lenders. It means lenders can claim them based on
their contract.
• If the claims are not transferable or tradable they are just financial
assets (such as bank deposits, bank loans) but if they are tradable in
the financial markets they are special financial assets which are
called securities (such as bonds, shares).

15. • Balance Sheet: A financial statement that reviews a company's assets, liabilities and
shareholders' equity at a specific time such as the end of financial year.
• This statement shows how a company deals with its assets and debts and it is a
measure for investors (shareholders) and creditors (bondholders) to assess the
companies value.
• In any balance sheet there should be a balance between asset side and the liability
side at the end of financial year, i.e.:
Assets= Liabilities + Shareholder’s Equity
Balance Sheet
The logic behind the formula is clear:
A company should purchase its assets either
through investors (shareholders) or creditors.

16. Balance Sheet
• Here is an example of a simple
balance sheet.
• The difference between current
assets (short-term assets) and
current liabilities (short-term
liabilities) is called Net Working
Capital.
• Non-current items refer to the long-
term elements in the balance sheet.
Adopted from http://www.accounting-tutorial.com/definition-balance-sheet-components

17. Balance Sheet of Inmarsat plc in 2009 & 2010
Adopted from Hillier’s PPT , The McGraw-Hill Companies, 2012

18. Investment & Financing Decisions
• Two important and broad questions that a financial manager (CFO) in
any corporation should face with:
a) What investments should be made? and how to manage the new &
existing assets? What is the risk of acquiring the new assets and what
is the risk or/and opportunity of keeping existing assets?
b) How should the new investments be financed? and how the
obligations to investors or lenders should be met? Is the re-
investment option is doable? What is the payout policy?
Investment Decision
Financing Decision

19. Capital Structure
• Corporations can borrow from lenders (in exchange for a promise to
pay back the debt plus a fixed/variable rate of interest) or they can issue
shares to attract equity investors (share holders) in the stock market
(in exchange for sharing profit and/or cash flow through dividend).
• The decision to go for debt or equity financing is called the capital
structure decision.
• In some ways financing decisions are less important than investment
decisions. Financial managers say that “value comes mainly from the
asset side of the balance sheet.” In fact the most successful corporations
sometimes have the simplest financing strategies. (Principle of Corp. p. 4)

20. Microsoft Example
• Microsoft as an example:
Price of shares (at the end of 2011)=$26
Number of shares =8.4 billion
So,
Market Capitalisation =26 × 8.4 = $218 𝑏𝑖𝑙𝑙𝑖𝑜𝑛
Not by going to debt, just by re-investment of cash flow

21. Separation of Ownership & Control
• Some corporations are known as public companies which means their
shares are traded in the market (New York, London, Tokyo and other
Stock Exchange markets) and any one can buy their shares (e.g.
Microsoft, Facebook, …).
• The owners are dispersed around the globe and none of them has the
main power to control the company. This means there is a separation
of ownership and control, which gives the corporations a permanence
characteristic.

22. Principal-Agent Problems
• Separation of ownership and control generates Principal-Agent Problems. It
happens in business and even in politics (between politicians and voters). The
problem arises when the directors/managers pursue their own interests rather
than those of the owners.
• In other words, it concerns about the problem of encouraging the agent (here; the
managers/directors) to work in the best interests of the principal (here; the
shareholders=owners) rather than their own interests.
• e.g. going for short-term projects when long-term strategies are more beneficial
or going for risky projects with high returns in an unstable economic
atmosphere).
• Lack of attention to this problem may bring the value of the company down
which has a direct impact of the wealth of the shareholders.

23. Principal-Agent Problems
• It might arise as the result of conflicting interests and the presence of asymmetric
information, as one party has more information than another.
• How to attack the problem?
a) Shareholders (principles) can offer some considerable incentives for the
managers and directors who work hard to increase the value of the company
(increase the wealth of the shareholders)
b) They can increase their monitoring on the decisions of the agents
c) They can increase their control over very important decisions.
• But all of them are costly and create, what is called as agency cost for the
principals.

24. Hurdle Rate & Opportunity Cost
• Shareholders expect to have a return from a new investments (offered
by the financial manager of the corporation) above the return they can
get by investing their money in other
projects (with the similar level of risk
taking).
This expected minimum return is called
hurdle rate which can be interpreted
here as an opportunity cost of the
shareholder’s capital.
http://catngeek.files.wordpress.com/2013/02/pause-dc3a9jeuner-culture-05.jpg

25. Opportunity Cost of Capital
• Opportunity Cost is the cost of losing a return from the best
alternative action (policy/investment) that has occurred because of
choosing a specific action (policy/investment).
• In case you are able to choose between several mutually exclusive
options (opportunities) the cost of losing the return (foregone return)
from the best alternative option (opportunity) is your opportunity
cost.
• What is your opportunity cost as being a student?

26. Time Value of Money
• A £100 today or a £100 next year; which one would you accept?
• In some cases, such as Germany in 1923, we need to change the time
horizon from “year” to “day”.

27. Compound Rate of Interest
• The difference between £100 today and £100 next year is caused by
interest rate (r) or/and inflation.
• If 𝑟 = 7% and £100 is invested, the future value of that £100 after a year
will be:
£100 + £100 × 0.07 = £100 1 + 0.07 = £107
And if the investment is going on for more years we will have:
£100 × 1.07 = £107
£107 × 1.07 = £100 × 1.072
= £114.49
£114.49 × 1.07 = £100 × 1.073
= £122.50
Your investment increases at a compound rate as you have a interest on both
the original value and its interests. (compound interest)
1st year
2nd year
3rd year

28. Future Value & Present Value
• In general, for any interest rate 𝑟 the future value (FV) of 𝐶0 after 𝑡 years will be:
𝐹𝑉 = 𝐶0 × (1 + 𝑟) 𝑡
• Now, imagine the question is reversed: How much do we need to invest today to
generate £114.49 after two years if the compound rate of interest is 7%?
• Obviously,
£114.49
(1.07)2
= £100
• It means the present value of £114.49, which can be obtained after two years, is
£100.

29. Future Value & Present Value
• In general, at any interest rate 𝑟, the present value (PV) of 𝐶𝑡, which is
obtained after 𝑡 years, can be calculated by:
𝑃𝑉 =
𝐶𝑡
(1 + 𝑟) 𝑡
Where
1
(1+𝑟) 𝑡 is called the discount factor and 𝐶𝑡 is the future value.
• To value of an investment opportunity a financial manager should pay
attention to:
1. The present value of the expected cash flow from the investment project
2. The total cost (or even expected cost, if it continues for several years)
3. The opportunity cost of the investment project.

30. About Cash Flow
The most important
item to take from
financial statements
(see Table 3.4 Hillier, p. 69)
Cash Flow is NOT the
same as Net Working
Capital
Cash Flows from
Assets = Cash Flows
to Creditors and
Equity Investors
Total Cash Flow
comes from operating
activities, investing
activities, and
financing activities
AdoptedfromHillier’sPPT,TheMcGraw-HillCompanies,2012

31. The Present Value of a Multiple Cash Inflows
• If an investment project has a series of expected cash flows 𝐶1, 𝐶2, ⋯ , 𝐶𝑡 extending
over 𝑡 years and if we also assume that the interest (or discount) rate 𝑟 has no
significant change in this period, the present value of all expected returns will be
calculated by :
𝑃𝑉 =
𝐶1
(1 + 𝑟)
+
𝐶2
(1 + 𝑟)2
+ ⋯ +
𝐶𝑡
1 + 𝑟 𝑡
=
𝑖=1
𝑡
𝐶𝑖
1 + 𝑟 𝑖
• This is sometimes called the discounted cash flow (DCF), where ∑ is the symbol
of summation for the series.
• DCF can only be used if a financial manager is certain about the expected future
cash flows. This means, risk is not considered in this calculation. Using DCF when
risk is involved leads us to a wrong calculation.

32. The Net Present Value
• If the cost of a project is paid in the beginning, so, there will be only one cash
outflow (a negative value) but if there is a series of cash outflows the present
value of them can be calculated by the same formula.
• In both cases, the net present value (NPV) of an investment project is:
𝑁𝑃𝑉 = 𝑃𝑉 − 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 > 0
Case 1: Just one investment (𝐼0) in the beginning:
𝑁𝑃𝑉 =
𝑖=1
𝑡
𝐶𝑖
1 + 𝑟 𝑖
− 𝐼0 > 0
Case 2: Series of investment during the life time of the project:
𝑁𝑃𝑉 =
𝑖=1
𝑡
𝐶𝑖
1 + 𝑟 𝑖
−
𝑗=0
𝑚
𝐼𝑗
1 + 𝑟 𝑗
> 0 (𝑚 ≤ 𝑡)

33. The NPV & Rate of Return Rules
• When the returns (cash inflows) are on-time (without any delay) and also no risk
is involved, The NPV can be used as a rule to accept or reject an investment
project. Among all possible projects the one with the highest NPV might be the
best project to invest on.
• Rate of Return is another rule that financial managers might consider to decide
whether or not to invest on a project.
• Rate of return of a project shows the share of profit in the investment. In other
word, it represents what proportion of the investment is the profit, so;
𝑅𝑎𝑡𝑒 𝑜𝑓 𝑟𝑒𝑡𝑢𝑟𝑛 =
𝑃𝑟𝑜𝑓𝑖𝑡
𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡

34. The NPV & Rate of Return Rules
• Suppose we know a project is as risky as investing money in the stock market and
suppose we know the rate of interest paid in the stock market for such investment
is 𝛼% ; if the rate of return (as a percentage) resulting from investing in the project
is bigger than 𝛼, we can consider the project as a profitable project.
• So, the second rule for a financial manager to accept an investment project is:
𝑅𝑎𝑡𝑒 𝑜𝑓 𝑟𝑒𝑡𝑢𝑟𝑛 > 𝛼
• In case, the financial manager decides to invest in the project (instead of investing
in the stock market) the opportunity cost of the decision is losing 𝛼% of the total
investment.