CORPORATE FINANCE

Overview of financial markets Session 1

Surplus sectors: economic agents who have more than enough for their
current consumption requirements.
Deficit sectors: those who can put to productive use funds in excess of
what they have currently available.
Primary market: companies which issue new shares, or governments
which issue new bonds.
Secondary market: financial assets bought and sold among market.

Product market: goods and services are distributed to their end-users.

Factor markets: two inputs into the production process – labour and
capital – are bought and sold.

Ordinary shares: single type of security.

Limited liability: downside risk of shares.

Internal risk factors: early termination (takeover bid, financial

difficulties, change of business)

External risk factors: the issuer may be unable to pay the contracted
amounts of interest and principal in full and on time (unexpected
deterioration in its profitability), profits may have been accumulated in
a foreign country which imposes restrictions on the repatriation of
earning, investors realise their investments early by selling them on to
other investors on the secondary market.

Market benefits
- Reduction in search costs (stock exchange)
- Reduction in transaction costs
- Price discovery and market efficiency
- Settlement guarantee
- Protection and monitoring
- Liquidity
- Transformation (of maturity, of risk, of size

Users and their Information Needs Session 2

The principal classes of users of financial statements are
DECISION MAKING
- present and potential investors
- employees
- lenders
- suppliers and other trade creditors
- customers
- governments and their agencies
- the general public

Cannot provide all information:

- Financial statements show the financial effects of past events and
transactions, whereas the decisions that most users of financial
statements have to make relate to the future
- Financial statements provide only a limited amount of the non-
financial information needed by users of financial statements.

The objective of financial statements is to provide information about

- the financial position
- the performance and
- changes in financial position

The financial position of an enterprise is affected by BALANCE

SHEET
- the economic resources it controls
- its financial structure
- its liquidity and solvency, and
- its capacity to adapt to changes in the environment in which it
operates

BALANCE SHEET: assets, liabilities, equity

Performance INCOME
STATEMENT
- Performance is the ability of an enterprise to earn a profit on the
resources that have been invested in it.

INCOME STATEMENT: income, expenses

Changes in financial position CASH FLOW

STATEMENT
- Performance is the ability of an enterprise to earn a profit on the
resources that have been invested in it.

CASH FLOW STATEMENT: asset, liabilities, equity, income, expenses

Underlying assumptions
- Accrual basis: The effects of transactions and other events are
recognised when they occur, rather than when cash or its
equivalent is received or paid
- Going concern: The financial statements presume that an enterprise
will continue in operation indefinitely
Qualitative Characteristics of Financial Statements
- Understandability
- Relevance
- Reliability
- Comparability

Using ratios to assess company performance Session 3

Overall performance
- Profitability: how much profit the company makes per unit of sales
- Operating efficiency: how much sales the company makes per unit
of assets
- Financial structure: how much assets the company has per unit of
equity

Core ratios
Return on equity = Net profit after tax / equity

Return on equity = Operating efficiency × Financial structure ×

Profitability
Return on equity = Asset turnover × Asset leverage × Return on sales

Asset turnover = sales / total assets reflects technology of

the sector
Asset leverage = total assets / equity

Profitability = net profit after tax / sales

Cash Flow Statement from Income Statement & Balance Sheet

Session 2&3
Income statement: this is an historical account of the reporting firm’s
financial performance over a specific period.
Balance sheet: this is a statement of the firm’s financial position at a
specific point in time.
Cash flow statement: shows the cash inflows and outflows for the
period.

Step 1: computing raw changes in balance sheet values

- - fixed assets – inventory – receivables + payables + long term debt
+ retained earnings = change in cash
Step 2: Analysing the Income Statement
- operating profit – interest – tax – dividends – retained earnings = 0
Step 3: Identifying any non-cash transactions
- depreciation – fixed assets = 0
Step 4: Calculating the net cash flows
- add all together = 31
Step 5: Compiling the Cash Flow Statement
Operating cash flow,
consisting of::
Operating profit
Add back: Depreciation
Taxes paid
Adjust for changes in:
Inventories
Receivables
Payables

Capital expenditure:

Financing cash flows,

consisting of:
Interest paid
Dividends paid
Increase in long-term debt

Change in cash

The Time Value of Money

Interest rate = discount rate, cost of capital, opportunity cost of
capital, required return

PV = FV / (1 + r)t  r = (FV / PV)1/t – 1  t = ln(FV /

PV) / ln(1 + r)

Interest rates
Annual Percentage Rate (APR):
- APR = period rate × the number of periods per year

Effective Annual Rate (EAR)

- This is the actual rate paid (or received) after accounting for
compounding that occurs during the year.

as interest rates increase present values decrease

as interest rates increase, bond prices decrease

If YTM = coupon rate, then par value = bond value

If YTM > coupon rate, then par value > bond value
If YTM < coupon rate, then par value < bond value

Interest rate risk = price risk, reinvestment rate risk

Current Yield = annual coupon / price

Yield to maturity = current yield + capital gains yield

Equity
- Ownership interest
- Common stockholders vote for the board of directors and other
issues
- Dividends are not considered a cost of doing business and are not
tax deductible
- Dividends are not a liability of the firm and stockholders have no
legal recourse if dividends are not paid
- An all equity firm can not go bankrupt merely due to debt since it
has no debt

Zero-coupon bonds: make no periodic interest payments

Floating-rate bonds: coupon rate floats depending on some index value

Clean price: quoted price

Dirty price: price actually paid (quoted price plus accrued interest)
Real rate of interest – change in purchasing power
Nominal rate of interest – quoted rate of interest, change in purchasing
power and inflation

Capital markets are the markets where investment securities like

bonds and equities and other financial instruments are traded

Total dollar return = income from investment + capital gain (loss) due
to change in price

Percentage returns
- Income yield = income / beginning price
- Capital gains yield = (ending price – beginning price) / beginning
price
- Total percentage return = dividend yield + capital gains yield

IRR is the return that makes the NPV = 0

Accept the project if the IRR > return

Mutually exclusive project: if you choose one, you can’t choose the
other.

Net present value

- Difference between market value and cost
- Take the project if the NPV is positive
- Has no serious problems
- Preferred decision criterion
Internal rate of return
- Discount rate that makes NPV = 0
- Take the project if the IRR is greater than the required return
- Same decision as NPV with conventional cash flows
- IRR is unreliable with non-conventional cash flows or mutually
exclusive projects
Profitability Index
- Benefit-cost ratio
- Take investment if PI > 1
- Cannot be used to rank mutually exclusive projects
- May be used to rank projects in the presence of capital rationing

Common types of cash flows

Sunk costs – costs that have accrued in the past
Opportunity costs – costs of lost options
Side effects
- Positive side effects – benefits to other projects
- Negative side effects – costs to other projects
Changes in net working capital
Financing costs
Taxes