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Chapter 1
Overview Of Corporate Finance
and Financial Modelling.
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Why should I care about Corporate
Finance and Financial Modeling?

 Prepare for the workplace of tomorrow.

 Broadening expectations of financial
knowledge and skills.
 Use and understand financial terminology
and concepts in team communication.
 Developing cross-functional capabilities.
 Critical thinking.

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After studying Chapter 1, you should
be able to explain the following:

 What is Corporate Finance

 The Goal of the Firm
 Corporate Governance
 Organization of the Financial
Management Function

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What is Corporate Finance?

Corporate finance is defined

generally as the activities
involved in managing cash
flows (money) in a business
environment
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The 5 Basic Corporate Finance Functions

Financing
(Raising Capital)

Financial Management

Capital Budgeting

Risk Management

Corporate Governance

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The 5 Basic Corporate Finance Functions
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Financing(Raising Capital)
Raising capital to support companies’ operations and investment programs.
Financial Management
Managing firms’ internal cash flows and its mix of debt and equity financing,
both to maximize the value of the debt and equity claims on firms’ and to ensure
that companies can pay off their obligations when they come due.
Capital Budgeting
Selecting the best projects in which to invest the resources of the firm, based on
each project’s perceived risk and expected return.
Risk Management
Managing firms ’exposures to all types of risk, both insurable and uninsurable,
in order to maintain optimum risk return trade-off s and thereby maximize
shareholder value.

Corporate Governance
Developing ownership and corporate governance structures for companies
that ensure that managers behave ethically and make decisions that
benefit shareholders.
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The three(3)
Investment Decisions
decisions in
Financial Financing Decisions
Management
Dividend Decisions

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Investment Decisions
Most important of the three decisions.
 What is the optimal firm size?
 What specific assets should be acquired?
 What assets (if any) should be reduced or eliminated?

 These are decisions that have to do with the firm

deciding on what investments it wishes to make. It
also includes determining what assets to invest in.
The decision making process involves selecting
viable projects by applying investment appraisal
techniques depending on the nature of business the
firm is involved in (e.g. mining, retail, manufacturing
or tourism

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Financing Decisions
 What is the best type of financing?
 What is the best financing mix?
 What is the best dividend policy (e.g., dividend-payout ratio)?
 How will the funds be physically acquired?
 These are decisions regarding, how the investment(s) selected
will be financed.
 Firms have three options regarding where they source finances.
They can source them internally by using retained earnings,
borrowing from the Debt capital market or Issuing stocks
(Ordinary Shares).
 The decision to use a specific source of finance is determined
by the period of investment (long-term or Short-term),use of
funds for either Capital investment or Working Capital
requirements and desired capital structure for a given firm. That
is, the balance between equity and debt used in financing the
assets of the firm.
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Dividend Decisions
 These decisions involve determining a dividend
policy for the firm which describes how the
returns from the investment are distributed to
shareholders as dividends. The policy describes
when and how much of the profits are distributed
as dividends including the mode of payment.
 As the finance manager performs these functions
the overriding goal is to ensure that the firm’s
value is maximized.

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What is the Goal of the Firm?
 Possible goals:
 Avoid bankruptcy and financial distress
 Minimize costs
 Maximize sales
 Maximize profits

 The best goal of a publicly traded firm:

Maximize share price (Maximization of Shareholder Wealth)
Wealth or value creation occurs when we maximize the
share price for current shareholders.
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Strengths of Shareholder Wealth
Maximization

 Takes account of: current and future

profits ; the timing, duration, and risk of
profits; dividend policy; and all other
relevant factors.
 Thus, share price serves as a barometer
for business performance.

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Shortcomings of Profit Maximization
(Maximizing earnings after taxes )

Problems
 Could increase current profits while
harming firm (e.g., defer maintenance)
 Ignores changes in the risk level of the
firm(Ignores risk)
 Does not fully consider cash flow timing

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The Modern Corporation

Modern Corporation

Shareholders Management

There exists a SEPARATION between

owners and managers.
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Role of Management

Management acts as an agent for

the owners (shareholders) of the
firm.
 An agent is an individual
authorized by another person,
called the principal, to act in the
latter’s behalf.

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The Agency Problem

 This is defined as a potential conflict of interest

between the principals (Shareholders) and the
agents (Managers).This is created when
managers act in contrast to the expectations of
the shareholders regarding the objective of
wealth maximization. It is necessary for
shareholders to put in place incentives to ensure
that managers maximize shareholder wealth.
 One agency problem is that managers can use
corporate funds for non-value maximizing
purposes.
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Managerial Incentives to maximize
shareholder wealth
To ensure that managers act in line with
shareholder expectation agency costs are
incurred by firms. These costs take several
forms:
 Expenditure to monitor managerial actions. e.g
external audits
 Expenditure to structure the organization so that
the possibility of undesirable managerial
behavior will be limited.

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Mechanism applied to force managers to act in the
shareholders best interest include

 The threat of being fired.

 The threat of take over which takes the form of a hostile
takeover. When a new firm takes over another company,
managers are usually replaced by those appointed by the
new board. Management would want to avoid a takeover for
fear of losing their jobs due to competition.
 Structured Managerial Incentives, which include executive
share options, where executives, are given an opportunity to
buy shares in the future at some discounted price and
performance shares awarded on the basis of performance
using some criteria.

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Corporate Social Responsibility

 Wealth maximization does not

preclude the firm from being socially
responsible at the corporate level.
 Assume we view the firm as producing
both private and social goods.
 Then shareholder wealth maximization
remains the appropriate goal in
governing the firm.
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What is Corporate Social
Responsibility?
 Describe the actions of a private, commercial organisation
assuming a responsible view of its wider obligations to society.

 Defined as: “fulfilling a role wider than your strict economic

role” or: “acting as a corporate citizen”

 Prime objective management will set financial objectives,

including: profit levels, sales and profit growth, margin
improvement, cost releasing efficiency savings, and EPS growth

 Management will also set non-financial objectives, which

should complement and support the financial objectives. These
may include: brand awareness levels, research & development
successes, new product development, new markets entered,
customer satisfaction levels, employee motivation levels
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Such objectives may also include the following:

 providing for the welfare of employees and

management
 upholding responsibilities to customers and
suppliers
 provision of a service.
 contributing to the welfare of society as a
whole
 environmental protection,
Which is what is loosely described as acting in a
social responsible manner.
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Arguments in favour of CSR include that
it;

 creates positive Public Relations for the

organisation, or, as a minimum avoids
bad P.R.
 helps attract new and repeat custom
 improves staff recruitment, motivation
and retention
 helps keep your organisation within the
law
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Arguments against CSR are that:

 market capitalism is the most equitable

form of society that has ever appeared
 the ethics of doing business are not those
of wider society
 governments are responsible for the well
being of society
 an organization’s maximum requirement is
to remain within the law, no more than this
is required.
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Corporate Governance
 Corporate governance involves regulatory and
market mechanisms, and the roles and
relationships between a company’s management,
its board, its shareholders and other stakeholders,
and the goals for which the corporation is governed
(wiki definition)

 Corporate governance: represents the system by which

corporations are managed and controlled. It includes
shareholders, board of directors, and senior
management.

 Then shareholder wealth maximization remains the

appropriate goal in governing the firm.
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Board of Directors

 Typical responsibilities:
• Set company-wide policy;
• Advise the CEO (Chief Executive Officer) and
other senior executives;
• Hire, fire, and set the compensation of the CEO;
• Review and approve strategy, significant
investments, and acquisitions; and
• Oversee operating plans, capital budgets, and
financial reports to common shareholders.

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Forms of Business
Organizations

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The three basic forms of business

organization:
 Sole Proprietorships
 Partnerships (general and limited)
 Corporations

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Environment
Sole Proprietorship – A business form
for which there is one owner. This
single owner has unlimited liability
for all debts of the firm.
 Oldest form of business organization.
 Business income is accounted for on
your personal income tax form.
form
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Sole Proprietorship

Advantages Disadvantages
Easiest to start • Unlimited liability
Least regulated • Hard to raise
Single owner additional capital
keeps all the • Transfer of
profits ownership
Single tax filing difficulties
on individual • Limited to life of
form owner

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Partnership – A business form in

which two or more individuals act
as owners.

 Business income is accounted for on

each partner’s personal income tax
form.
form

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Types of Partnerships

1. General Partnership – all partners have unlimited liability and are liable for all
obligations of the partnership.

2. Limited Partnership – Partners have liability limited to their capital contribution

(investment only). The chief characteristics of a limited partnership are as follows:
There must be at least one partner with unlimited liability. The liability of the
remaining partners is limited to their capitals in the firm. Thus, a limited
partnership consists of two types of partners, general partner and limited partner.
The limited partner cannot take part in the management of the firm. He has no
implied authority to represent and bind the firm. However, he is allowed to inspect
the books of accounts of the firm.
The limited or special partner cannot assign his share to an outsider without the
consent of the general partner.
The limited partner cannot withdraw any part of his capital.

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Partnership

Advantages Disadvantages
 Can be simple  Unlimited liability for
 Low setup cost, higher the general partner
than sole  Difficult to raise
proprietorship additional capital, but
 Relatively quick setup easier than sole
 Limited liability for proprietorship
limited partners  Transfer of ownership
difficulties
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Corporation – A business form

legally separate from its owners.
 An artificial entity that can own assets
and incur liabilities.
 Business income is accounted for on
the income tax form of the corporation.
corporation

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Corporation

Advantages Disadvantages
 Limited liability  Double taxation
 Easy transfer of  More difficult to
ownership establish
 Unlimited life  More expensive
 Easier to raise large to set up and
quantities of capital maintain

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