This document provides an introduction to the Corporate Finance II course. It discusses two key financial decisions that firms face: the investment decision and the financing decision. The investment decision involves what projects a firm should undertake, while the financing decision involves how the firm will pay for those investments. The overall goal of corporate financial management is to maximize shareholder wealth. The document then outlines some of the key topics that will be covered in the course, including the capital structure decision, theories of capital structure, and corporate valuation. It also discusses how an understanding of corporate finance relates to different career paths in finance.

1. CORPORATE
FINANCE - II
TERM 3, MBA 2022-24, IIMU
CF2, MBA1, TERM 3, IIMU

2. INTRODUCTION
CF2, MBA1, TERM 3, IIMU 2

3. CORPORATE FINANCE
 Brealey, Chapter 1:“Introduction to Corporate Finance”
 The financial manager faces two broad financial questions:
 First, what investments should the corporation make?The investment decision
involves spending money.
 Was the focus of CF1
 Second, how should it pay for those investments?The financing decision involves
raising it.
 Will form a substantial part of CF2
CF2, MBA1, TERM 3, IIMU 3

4. CORPORATE FINANCIAL MANAGEMENT
 Financial Decision Making: Strong logic, backed by numbers. Build
arguments, to defend/ question a position
 But to what end? What is the goal of corporate financial management?
 Brealey, Chapter 1: Introduction to Corporate Finance:“This book is about
how corporations make financial decisions.We start by explaining what these
decisions are and what they are intended to accomplish”
CF2, MBA1, TERM 3, IIMU 4
So, what is the
goal of the firm?

5. GOAL OF CORPORATE FINANCIAL MANAGEMENT
 Shareholder Wealth Maximization
 Brealey, Chapter 1: Introduction to Corporate Finance: “Thus, the secret of
success in financial management is to increase value”
 And why is this goal important in a larger, societal context?
CF2, MBA1, TERM 3, IIMU 5

6. THE FINANCIAL SYSTEM
CF2, MBA1, TERM 3, IIMU 6
Capital Markets (Primary)
Financial
Intermediaries (Banks/
Mutual Funds)
Funds
Funds
HOUSEHOLD/
FIRM SAVINGS
FIRMS/
GOVERNMENTS
Equity
Debt
Real
Assets
Real Assets
Financial
Assets
The Capital
Budgeting
Decision (CF1)

7. SHAREHOLDERWEALTH MAXIMIZATION
 We understand that value is created through asset side decisions
 Called the “Capital Budgeting Decision” (CF1)
 Can value also be created through liability side decisions?
 Called the “Capital Structure Decision” (CF2)
CF2, MBA1, TERM 3, IIMU 7

8. THE FIRM
CF2, MBA1, TERM 3, IIMU 8
FIRMS
Equity
Debt
Real Assets
- Dividends ffffffff
= Retained Earnings
Debt Investors
Equity Investors
Sales aaaaa
- Operating Costs bbbbb
- Interest cccccc
- Taxes ddddd
= PAT eeeee

9. FINANCIAL DECISIONS IN A FIRM
 Investment Decision (Capital Budgeting)
 Financing Decision (Capital Structuring)
 Payout Decision (Dividends & Buyback)
CF2, MBA1, TERM 3, IIMU 9

10. COURSE OUTLINE
 The Financing Decision
 Operating & Financial Risk
 Effects of Financial Risk on FirmValue
 Equity Financing
 Debt Financing
 Theories of Capital Structure
 The Payout Decision
 CorporateValuation
 Mergers & Acquisitions
CF2, MBA1, TERM 3, IIMU 10

11. RELEVANCE: CAREERS
 Roles, Jobs?
 Firms, Enterprises (Finance of Business)
 Markets, Intermediaries, Advisors (Business of Finance)
CF2, MBA1, TERM 3, IIMU 11

12. TYPES OF LONG-TERM FINANCE
 Equity
 Equity Capital
 Internal Accruals
 Debt
 Term Loans
 Bonds/ Debentures
 Hybrids
 Preference Capital
 Other hybrids
CF2, MBA1, TERM 3, IIMU 12

13. DEBTVS EQUITY
CF2, MBA1, TERM 3, IIMU 13
Hybrids
Equity
Debt
Contractual (but
with flexibility)
Residual
Contractual
Claim over cash
flows
Depends
No
Yes
Tax deductibility of
payouts
Depends
Perpetual
Finite
Life of instrument
Limited
High
Limited
Control
Intermediate
Residual
Priority
Claim in case of
liquidation

14. LEARNING OBJECTIVES: MODULE 1
At the end of Module 1 (Operating & Financial Risk) you should be able to:
 Explain and analyse the impact of debt financing on a business; and
 Evaluate alternatives and create a simple capital structure after taking into
consideration a business’s operating characteristics.
CF2, MBA1, TERM 3, IIMU 14

15. FINANCIAL LEVERAGE: NUMERICAL EXAMPLE
The next slide contains a numerical slide akin to the case we discussed in class
Two firms with similar base EBIT of 100 are presented.
The investment is Rs.700.The unlevered firm is fully funded through equity.The
levered firm employs Rs.500 of debt @ 10% interest and Rs.200 of equity.The tax rate
is 30%
Two scenarios are considered: one in which the EBIT goes up to 150 (+50% over the
base case) and the other where EBIT goes down to 50 (-50% below the base case).
While the PAT changes by +50% and -50% for the unlevered firm, It changes by +100%
and -100% for the levered firm, resulting from a DFL of 1 and 2 for the two firms,
respectively. Note that the change in EPS is also of the same order for the two firms.
CF2, MBA1, TERM 3, IIMU 15

16. FINANCIAL LEVERAGE
CF2, MBA1, TERM 3, IIMU 16
LEVERED FIRM
UNLEVERED FIRM
Down
Up
Base
Down
Up
Base
50
150
100
50
150
100
EBIT
50
50
50
0
0
0
Interest
0
100
50
50
150
100
EBT
0
30
15
15
45
30
Taxes @30%
0
70
35
35
105
70
PAT
-50%
+50%
-50%
+50%
Change in EBIT
-100%
+100%
-50%
+50%
Change in PAT
2.0
1.0
DFL
500
500
500
0
0
0
Debt
200
200
200
700
700
700
Equity invested
0.0%
35.0%
17.5%
5.0%
15.0%
10.0%
ROE
0.00
3.50
1.75
0.50
1.50
1.00
EPS

17. DRIVERS OF DEGREE OF FINANCIAL LEVERAGE
 DFL = EBIT / PBT
 DFL is a function of EBIT and interest
 EPS of firms with high interest more sensitive to changes in EBIT
 EPS of firms with low EBIT more vulnerable to changes in EBIT
CF2, MBA1, TERM 3, IIMU 17

18. ANOTHER NUMERICAL EXAMPLE
 What follows is another numerical example of the effect of the financing structure
on the nature of the EBIT-EPS relationship
 An all equity financed firm with existing equity of 10,000,000 (1,000,000 shares of
Rs.10 each), EBIT of 2,000,000 and EPS of Rs.1.4 is investing 10,000,000 in a new
project
 Two financing structures are analyzed; one where the project is financed through
further equity of 10,000,000 thus making the total equity 20,000,000 and the other
where the project is financed through debt of 10,000,000 at an interest rate of 12%
 For each structure, two scenarios are presented; one where the EBIT remains at
2,000,000 and the other where the EBIT doubles to 4,000,000
 Compute the indifference point on your own (the EBIT level at which the EPS will
be similar under both structures
CF2, MBA1, TERM 3, IIMU 18

19. EBIT-EPS ANALYSIS
CF2, PGP1, TERM 3, IIMU 19
As-Is New Project
Equity 10,000,000 Project Cost 10,000,000
No. of shares of Rs 10 each 1,000,000 Δ EBIT - Scenario 1 -
Debt - Δ EBIT - Scenario 2 2,000,000
EBIT 2,000,000
Interest -
EBT 2,000,000
Taxes @30% 600,000 Financing Options
PAT 1,400,000 1. Equity
EPS 1.40 2. Debt @ 12% p.a.
Rs

20. EBIT-EPS ANALYSIS
CF2, PGP1, TERM 3, IIMU 20
Scenario 1 Scenario 2 Scenario 1 Scenario 2
Equity 20,000,000 20,000,000 10,000,000 10,000,000
No. of shares of Rs 10 each 2,000,000 2,000,000 1,000,000 1,000,000
Debt - - 10,000,000 10,000,000
EBIT 2,000,000 4,000,000 2,000,000 4,000,000
Interest - - 1,200,000 1,200,000
EBT 2,000,000 4,000,000 800,000 2,800,000
Taxes @30% 600,000 1,200,000 240,000 840,000
PAT 1,400,000 2,800,000 560,000 1,960,000
EPS 0.70 1.40 0.56 1.96
Equity Financing Debt Financing
Rs

21. EBIT-EPS ANALYSIS
CF2, PGP1, TERM 3, IIMU 21
(1.5)
(1.0)
(0.5)
-
0.5
1.0
1.5
2.0
2.5
3.0
0.0 1.0 2.0 3.0 4.0 5.0
EPS
EBIT (million)
Debt
Equity

22. INDIFFERENCE POINT
CF2, MBA1, TERM 3, IIMU 22
And what is
the EPS
corresponding
to this?

23. EFFECT OF DEBT IN CAPITAL STRUCTURE
 EPS becomes more sensitive to changes in EBIT.
 So we wonder: what drives changes in EBIT?What impacts EBIT?
CF2, MBA1, TERM 3, IIMU

24. OPERATING LEVERAGE: NUMERICAL EXAMPLE
The next slide contains a numerical slide akin to the case we discussed in class
Two firms with similar base Sales of 100 are presented.
Firm A has variable costs of Rs. 75 and fixed costs of Rs,.0 in the base case. Firm B has
variable costs of Rs. 50 and fixed costs of Rs. 25in the base case.
Two scenarios are considered: one in which the Sales goes up to 150 (+50% over the
base case) and the other where Sales goes down to 50 (-50% below the base case).
While the EBIT changes by +50% and -50% for the firm with no fixed costs, It changes
by +100% and -100% for the firm with fixed costs, resulting from a DOL of 1 and 2 for
the two firms, respectively.
CF2, MBA1, TERM 3, IIMU 24

25. OPERATING LEVERAGE
CF2, MBA1, TERM 3, IIMU 25
Firm B
Firm A
Down
Up
Base
Down
Up
Base
50
150
100
50
150
100
Sales
25
75
50
37.5
112.5
75
VC
25
25
25
0
0
0
FC
0
50
25
12.5
37.5
25
EBIT
-50%
+50%
-50%
+50%
Change in Sales
-100%
+100%
-50%
+50%
Change in EBIT
2.0
1.0
DOL

26. RISK DRIVER 2: DEGREE OF OPERATING LEVERAGE
CF2, MBA1, TERM 3, IIMU
Sales
Transmission of
revenue
volatility to
EBIT volatility
EBIT
DOL

27. DRIVERS OF DEGREE OF OPERATING LEVERAGE
 DOL = Q(p-v) / (Q(p-v) - F)
 DOL is a function of Q and cost structure
 EBIT of firms with high fixed costs more vulnerable to changes in Q
 EBIT of firms with low Q more vulnerable to changes in Q
CF2, MBA1, TERM 3, IIMU

28. BUSINESS RISK
Firm B
Firm A
1.5
3
DOL
Volatile,
Very Unpredictable
Stable,
Very Predictable
Sales
CF2, MBA1, TERM 3, IIMU
Now, for which firm is EBIT more volatile?
σEBIT
= Business Risk
= f(Cyclicality, DOL)
And CEC?

29. RISK DRIVER 3: CYCLICALITY OF SALES
CF2, MBA1, TERM 3, IIMU
Sales
Economy
σSales =
f(Cyclicality)

30. BUSINESS RISK
CF2, MBA1, TERM 3, IIMU
Sales
Economy
σEBIT
= f(Cyclicality,
DOL) +
Noise
EBIT
Variability in Q
Noise
DOL f(Cost Structure, Q)

31. BUSINESS RISK
CF2, MBA1, TERM 3, IIMU
Sales
Economy
σEBIT
= f(Cyclicality,
DOL) +
Noise
EBIT
Cyclicality
Noise
Cost Structure

32. ASSET BETA
 The volatility in EBIT arises out of both systematic factors and unsystematic
factors
 The asset beta or the unlevered beta measures the systematic portion of the volatility
and is a function of cyclicality of sales and Degree of Operating Leverage
CF2, MBA1, TERM 3, IIMU

33. TOTAL RISK
CF2, MBA1, TERM 3, IIMU
Sales
Economy
EBIT
PAT
σPAT
= f(Cyclicality,
DOL, DFL)
Noise
Variability in Q
DOL f(Cost Structure, Q)
DFL f(Capital Structure, EBIT)

34. TOTAL RISK
CF2, MBA1, TERM 3, IIMU
Sales
Economy
EBIT
PAT
σPAT
= f(Cyclicality,
Cost Structure,
Capital Structue)
Noise
Cyclicality
Cost Structure
Capital Structure

35. EQUITY BETA
 “…the levered beta, which is also the beta for an equity investment in a firm or
the equity beta, is determined both by the riskiness of the business it operates in
and by the amount of financial leverage it has taken on.” (Aswath Damodaran).
 Levered or Equity Beta is a function of cyclicality of sales, degree of operating
leverage, and degree of financial leverage.
CF2, MBA1, TERM 3, IIMU

36. ROI-ROE ANALYSIS: NUMERICAL EXAMPLE
 The next slide has a numerical example demonstrating the sensitivity of ROE to
ROI under two different financing structures.
 r,The cost of debt is assumed to be 12%
 The two structures examined are an all equity financed structure (D/E = 0) and a
leveraged structure with D/E = 1
CF2, MBA1, TERM 3, IIMU

37. ROI-ROE ANALYSIS
CF2, PGP1, TERM 3, IIMU
37
-15%
-10%
-5%
0%
5%
10%
15%
20%
25%
30%
35%
40%
0% 5% 10% 15% 20% 25% 30%
ROE
ROI
Debt
Equity
Returns to equity-holders
are better with debt
financing if ROI exceeds
cost of debt, but the ROE
is more variable.
Scenario 1 Scenario 2 Scenario 1 Scenario 2
ROI 10.0% 20.0% 10.0% 20.0%
ROE 7.0% 14.0% 5.6% 19.6%
Equity Financing Debt Financing