Unit 1: Introduction to Corporate Financial System

Financial Management
• Application of general managerial principles to the area of financial decision-
making
• Profit maximization vs. Wealth maximization
• Financial Management- Functions
1. Investment decisions- Capital budgeting (NPV, PI, PBP, IRR) & Liquidity
(WCM)
2. Financing decision- Optimum capital structure (Leverage)
3. Dividend decision- Optimum dividend policy
4. Financial control- Evaluation of financial performance (RoI, Budgetary,
Cost control, Ratio analysis)
5. Financial negotiations- Negotiations with FI
Corporate Financial Policy
• Financing is the process of organising the flow of funds
• It helps the business firm to meet its objectives and meet its obligations
• Financial policy provides clarity and guidelines for investment decisions, DE mix
decision, mode of financing, expenditure, hedging decision to achieve corporate
objectives such as wealth maximization
• CFP is concerned with procurement and deployment of funds
Scope of CFP/Role and function of Corporate Financial Manager
1. Estimating financial requirements
• Estimation of short term and long term requirements
2. Selecting a pattern of investment
• It’s related to the use of funds
• Decision regarding which assets to be purchased
3. Deciding capital structure
• Kind and proportion of different securities for raising funds
4. Selecting the source of finance
• After preparing capital structure, an appropriate source of finance is
selected
• It includes- share capital, debenture, banks, public deposits
5. Cash management
• Neither shortage nor idle
• Shortage of cash will damage creditworthiness of the firm
6. Implementing financial controls
• Necessitates the use of various control technique
a. Budgetary control
b. Break even analysis
c. Internal audit
d. Cost control
e. Ratio analysis
7. Proper use of surplus
• Judicious use of surplus is essential for expansion and diversification
• Retained earnings for expansion
Decisions- CFP
The Finance Functions of Corporate Financial Manager
1. Investment Decisions
• The way that the funds of a firm are to be invested into different assets, so that
the firm is able to earn highest possible return for the investors
• Assets includes long term (fixed) and short term (current) assets
• Long term investment decision- Capital budgeting
• Short term investment decision- Liquidity decision or WCM
2. Financing Decision
• Concerned with capital structure
• Refers to the proportion of debt capital and equity share capital
• Find out best financing mix
• Determine the proportion of Equity and Debt capital- Optimal capital structure
• Equity- owners capital
• Debt capital- borrowed funds that must be repaid at a later date
3. Dividend Decision
• Decision must be made whether the firm should distribute all profits or retain it
or distribute its part
• Concerned with the distribution of profits of a firm to the shareholders
• Decision will depend upon the preferences of the shareholders, investment
opportunities available within the firm and opportunity for future expansion
• Optimum dividend policy
Factors affecting formulating CFP
Internal:
1. Nature of business

• Different financial requirement for manufacturing and service firm

2. Size of operations
• The larger the organization, higher will be the capital requirement
• The growing companies will require more funds which will be met through
raising debt
3. Risk level
• Higher proportion of debt increases the financial risk of the company
4. Level of business activities
• If the business is expanding or diversification of business, the company needs
to raise additional funds
5. Retaining control
• The attitude of the management towards retaining control over the company
will have direct impact on the capital structure
• If the existing share holders wants to continue, they may not encourage the
issue of additional equity
6. Liquidity and Profitable Position
• Liquidity and profitability of the firms leads to easy payments of dividend
• If the firms have high liquidity, the firms can provide cash dividend otherwise,
they have to pay stock dividend
External Factors
1. Nature of Industry
• Services industry requires lesser capital than production
2. Legal Requirements
• SEBI guidelines to be followed to protect the investors
• Ex- Tolerance limit of D:E ratio
3. Requirement of investors
• Investors are cautious over the investments
• It will be appropriate for the companies to issue different sources of
securities to reduce the risk
4. Taxation policy

• High corporate tax, higher tax on dividends, capital gain highly influences
capital structure of the company
5. Level of interest rate
 • The rate of interest will have a direct impact on the borrowed funds
• Low interest rate attracts debt form of capital
6. Government policy
• Company must consider government policy regarding the capital structure
Financial Modeling
• Financial Model is a numerical representation of a company's operations in the
past, present, and the forecasted future
• Process of creating a summary of a company's expenses and earnings that can be
used to calculate the impact of a decision
Objectives:
• To estimate the valuation of a business
• To raise capital
• For capital allocation
• For budgeting
• For divesting of assets
Financial Models of Corporate Analysis
Three-statement Model
• Basic financial model
• All three basic statements (Income Statement, Balance Sheet, Cash flow Statement are
dynamically linked with formulas in excel
• Based on the historical financial data this interconnected statements model helps
to predicts the future expected performance such as :
1. Revenue Growth rate
2. Profitability
3. Liquidity
Discounted Cash Flow Model
• Builds on the three-statement model to value a company based on NPV of future
cash flow
• It estimate the intrinsic value of the company
• Intrinsic value- Fundamental value of a company based on its ability to generate
future cash flows
• Model consider time value of money and helps to determine worth of the
company
 • Helps to understand if the company is undervalued or overvalued
• Used in Equity research
Comparable Company Analysis (Trading Comps Model)
• Relative valuation of a company compared with prevailing share prices of similar
or peer companies in the market
• Determine the value of the company compared with competitors
• Factors consider for analysis are
1. Revenue growth
2. Profitability
3. Liquidity
• Helps to understand the relative value and positioning of the company within the
industry
Merger Model (M&A)
1. Evaluates consequences of merging two companies
2. Model helps to determine the value of a company that they plan to acquire and
finances required for it
3. Model analyse factors of the company such as:
1. Projected growth
2. Cost involved in acquisition
4. Helps to determine expected EPS, Cash flow and Return on Investment post M&A
IPO Model
• IPO issued for fresh capital
• Model analyses the offer price and estimated capital to be raised
• Examine the dilution effect on existing shareholders
• Post IPO total value of the company is divided among a greater number of
shareholders, stock dilution can lower the value of existing shares

• Helps to examine the expected EPS post IPO

Leveraged Buyout Model
• Model used for equity and investment analysis
 • Model assess financial viability of an acquiring company using leverage/debt
• Potential return is estimated along with the risk involved
• Model analyse factors such as projected cash flows, capital structure, and cost of
debt
• Assess company’s ability to generate cash flows to serve the cost of debt
Sum of Parts Model
• Individual business units are valued separately based on its financials and future
growth potential
• Total value of the company is computed by adding value of individual business
units
• This model is suitable for conglomerates
Why do we need different financial models?
• DCF Model- Need to evaluate performance and future cash flow
• IPO Model- Company is looking for fresh capital, analyse offer price and
estimated capital to be raised
• LBO Model- You have to analyse when Debt is increasing
• M&A Model- Company is looking for expansion
• CCA Model- Competition exists in the market, examine the growth of peer companies
• SoP Model- Company has to analyze SBU
Debt Financing

• Debt financing occurs when a company raises money by selling debt instruments
such as bonds, bills, or notes to investors
• Debt financing may be procured as:
1. Issue of bonds/debentures
2. Term loans
• Debt financing is the opposite of equity financing
How it works? Elements
1. Principal
• The amount of the investment loan
• Must be paid back at a date in future
• Lenders have a higher claim on any liquidated assets in case of liquidation
2. Cost of Debt
• Interest payment to bondholders- coupon payments
• Interest rate paid on debt represents the cost of debt
Measurement of Debt Financing
• Measurement of debt financing is done through the debt-to-equity ratio
• Equity
• Equity share capital + Reserves + Surplus
• Debt
• Long Term Loans + Debentures + Public Deposits
Advantages of Debt Financing
• Provision for additional capital
• Less dependent of internal funds
• Source of funds for expansion
• Enhanced credit score
• No change in equity
• No dilution of ownership
• Less cost of capital
Disadvantages of Debt Financing Increased debt
• Repayment obligation
• Covenants- Legally binding clauses
• High cost during high interest rates
• Meet regulatory, legal requirement
• Loss of reputation on default of payment
Internal Financing
• Process of a firm using its retained profits or assets as a source of capital
• Cost of capital is less compared to external sources
• No transaction cost and no tax on paying dividend
• The pecking order theory states that a company should prefer to finance
internally through retained earnings
1. Retained Earnings
• Most common and prominent form of internal financing
• Retained earnings are the profits of a company that are not distributed to
shareholders in the form of dividends
• Financing through RE means company doesn't owe anyone anything
• Inexpensive form of financing
• Earnings actually belong to shareholders
• Loss of value for shareholders
• Financing through RE is beneficial only when the company produces +NPV
2. Sale of Asset/Asset monetisation
• Selling some or all of company assets (both tangible and intangible) in exchange
of money
• This is important when company is downsizing its operations
• By selling assets company may increase asset efficiency
• Short-term source: Sale of equipment which has become obsolete or outdated
• Long-term source: Sale of more substantial assets such as buildings, land
• Business may let its real estate, or equipment to lease for funding
Advantages of Internal Financing
• Easy Access of funds
 • No dilution of ownership
• Less cost of capital
• Flexible to use funds
• Control over operations
• No obligation of repayment
Disadvantages of Internal Financing
• Limited funds
• Depended on profit
• Opportunity cost
• Affects liquidity and credit rating
• Lack of funds for expansion
• May not reflect true financial position
The Role of Capital Market in explaining Corporate Performance
• Capital formation- Mobilise savings into capital
• Source of finance- IPO, QIP, FII
• Continuous flow of funds
• Dissemination of information
Problems on EPS and Point of Indifference (refer notes)

Unit 2: Cost of Capital

Types of capital
Fixed capital
• Durable capital used for production
Working capital
• Capital for day to day expenses
Financial capital
• Any economic resource measured in terms of money used by
businesses to buy what they need to make their products and
services
Sunk capital
• Capital used to produce only one type of G & S
 • Ex- Ice factory
Floating capital
• Floating capital includes all such items which can be put to
alternate uses
• Ex- Electricity
Real capital
• Capital goods other than money, Ex- machine
Money capital
• Liquid capital required to acquire asset
Physical capital
• Tangible form of capital
Private capital
• The umbrella term for investment, typically through funds, in
assets not available on public markets
Financing Decision
• Financing decision is concerned with capital structure of the firm
• Finance manager must decide the mode of raising the funds
• Capital structure refers to the proportion of debt capital and equity share capital
• Find out best financing mix for the firm
• Determine the proportion of Equity and Debt capital- Optimal capital structure
✓ Equity- owners capital
✓ Debt capital- borrowed funds that must be repaid at a later date
Capital Structure
• Proportion of each source of capital
• What amount from E:P:D
• The proportion is to be determine in such a manner that EPS of the company
should be maximum and overall cost of capital should be minimum
• Mix of debts and equities make up the finances used for a business's operations
and growth
✓ Ex- capital structure of a ABC Ltd is 40% Debentures, 10% preferred
stock, and 50% Equity
Cost of Capital
 • The cost of capital is the cost of a company's funds (both debt and equity) or
service cost
• Capital structure of a ABC Ltd is 40% Debentures, 10% preferred stock and 50%
Equity

• Here ABC has raised funds from E:P:D in the proportion 50:10:40
• That means ABC has raised funds from these three sources and they have the
obligation to pay dividend and interest as per proportion
• There is a cost is known as service cost or cost of capital
• The objective is to minimise cost of capital to maximise the profit
• Investment decisions for new project should always generate a return that
exceeds the firm's cost of capital
• A co. with a high cost of capital can expect lower proceeds in the long run
Cost
• Cost of capital = Capital x 100

Significance of Cost of Capital

1. Maximisation of the value of the firm
• Minimum cost of capital = Maximum value
• Judicious mix of debt and equity in the capital structure brings less
financial risk
2. Capital Budgeting Decisions:
• Cost of Capital is one of the important parameter in project decision
• Cost of capital is also referred to as cut off rate for project selection
3. Dividend Policy
• Decision regarding whether the profit should be distributed or not as
dividend is largely depends of cost of capital
4. Capital Structure Decision:
• Reduction in overall cost of capital (Ko) increase the value of the firm
5. Financial Health:
 • Cost of capital can be used to evaluate the financial performance and
efficiency
6. Working Capital Decision:
• Cost of capital may be used to calculate the cost of carrying investment in
receivables
Computation of Cost of Capital
• Cost of capital is measured for different sources of capital structure such as
1. Cost of Debt (Kd)
2. Cost of Equity (Ke)
3. Cost of Preference Shares (Kp)
4. Cost of Retained Earnings (Kr)
5. Weighted Average Cost of Capital (WACC)
Cost of Debt
• Cost of Irredeemable Debt
• Cost of debt issued at par
• Cost of debt issued at Premium and Discount
Cost of Preference Share Capital
• Cost of Irredeemable Preference Shares
• Cost of Redeemable Preference Shares
Cost of Equity Share Capital
• 4 Models
• Earnings Price Model
• Dividend Price Model
• Dividend Growth Model
• CAPM
Cost of Retained Earnings
Weighted Average Cost of Capital
Problems (refer notes)