Corporate Finance

Term III, Section A

Class Notes 1

Indian Institute of Management Calcutta

Prof Purusottam Sen

December 2018-March 2019
Overview of Corporate Finance
 Firm Ownership Structure

• Sole Proprietorship Unlimited Liability

Personal Tax on Profits
• Partnerships

Limited Liability
• Corporation Corporate Tax on Profits +
Personal Tax on Dividends*

* Most countries now avoid double taxation – i.e. taxation on distributed dividends and
taxation of dividends received by shareholders. In India additional income tax is payable @
10% by corporations of the dividend distributed. This dividend is exempt in the hands of the
shareholders.
 Firm Ownership Structure – A Comparison
Corporation Partnership

Liquidity Shares can be easily Subject to substantial

exchanged restrictions

Voting Rights Usually each share gets one General Partner is in charge;
vote limited partners may have
some voting rights

Taxation Double taxation in the past. Partners pay taxes on

Now only the corporation distributions
Reinvestment and Broad latitude All net cash flow is
dividend payout distributed to partners

Liability Limited liability General partners may have

unlimited liability; limited
partners enjoy limited
liability
Continuity Perpetual life Limited life
 The Firm and the Financial Markets

Firm Firm issues securities (A) Financial

markets
Invests
Retained
in assets cash flows (F)
(B) • Short-term
debt
• Current assets Cash flow Dividends and
from firm (C) debt payments (E) • Long-term
• Fixed assets
debt
• Equity shares
Taxes (D)

The cash flows from the firm

Ultimately, the firm must be
must exceed the cash flows
a cash generating activity. Government
from the financial markets.
 Financial Institutions

Company

Funds Obligations

Intermediaries
Banks, Insurance Companies
Brokerage Firms
 Financial Institutions

Intermediaries

Funds Obligations

Investors
Depositors, Policy Holders,
Investors
 Broad Areas of Finance
 Money & Capital Markets – deals with securities markets
and financial institutions

 Investments – deals with investment decisions by individual

and institutional investors as they choose securities for their
investment portfolios

 Financial Management /Corporate Finance – deals with

financial decisions within the firm

• What long-term investments should the firm choose?

(Investment Decision)
• How should the firm raise funds for the selected
investments? How should capital structure be
determined? (Financing Decision)
• What determines dividend policy? (Dividend Decision)
• How should short-term assets be managed and financed?
Interdependence of Financial Management Decisions

Investment Financing
Decisions Decisions
Maximise
Value

Dividend
Decisions
 Corporate Securities

• Debt is a promise by the borrowing firm to repay a fixed amount of

money by a certain date.

• The shareholder’s claim on firm value is the residual amount that

remains after the debt-holders are paid.

– If the value of the firm is less than the amount promised to the
debt-holders, the shareholders get nothing.

 Which is riskier?
 Which should attract a higher expected return?
 Financial Instruments

Common Stock – Ownership shares in a publicly held corporation.

Equity claims held by “residual owners” of the firm, who are last to
receive any distribution of earnings or assets
Bond– A long term debt of a firm. In common usage, the term
“bond” often refers to both secured and unsecured bonds
Preferred Stock – A type of stock whose holders are given certain
priority over common stockholders in the distribution of dividend.
Usually the dividend rate is fixed at the time of issue. Preferred
stock holders normally do not receive voting rights.
Option– A right –but not an obligation – to buy or sell underlying
assets at a fixed price during a specified time period.
 Capital Market and Some Definitions

Primary Market– Where new issues of securities are offered to

the public.
Initial Public Offering (IPO) – The original sale of a company’s
securities to the public. Also called an unseasoned new issue.
Seasoned New Issue – Anew issue of stock after the company’s
stock have previously been issued. A seasoned issue can be made
by using a cash offer or a rights offer.
Secondary Market – Market in which already issued securities
are traded by investors. Already-existing securities are bought and
sold on the exchange or in the over-the-counter market
 Some Concepts

• Principal Agent Relationships

o Principal hires an agent to represent his/her interest
o Stockholders (principals) hire managers (agents) to run the
company

• Information Asymmetry

Different Objectives?

• Managers vs. Stockholders

• Top management vs. Operating management
• Stockholders vs. banks and lenders
 Some Concepts (contd.)

• Agency Costs
• Managers do not attempt to maximize firm value, instead
they
• Seek expensive perquisites
• Display survival instincts
• Need independence
• Place undue importance to growth & size of the firm
• Have risk attitudes different from shareholders
• Shareholders incur costs to monitor managers and influence
actions
 Some Concepts (contd.)

• Financial Signaling:

Shareholders can observe:

 Stock prices and return

 Issues of shares and other securities
 Dividends
 Financing

But not detailed internal information that is not always

reflected in the above information
What is the Goal of the Corporation?

– Maximize profit?

– Minimize costs?

– Maximize market share?

– Maximize shareholder wealth?

 Goal of the Corporation
Maximize Firm Value / Shareholder Wealth
Managers of the corporation should make efforts to maximize firm value
and thereby shareholder wealth.

 Principal Role of Managers : Maximize Value of Shareholders

 Firm value is a function of company performance in relation to expected

returns for the risks employed

 Firm value must lead to share price

 Therefore, Value = Share Price * Shares owned

Is this synonymous with Profit Maximization?

 Value & Profit Maximization
1. Risk
Profit

Company A Company B
State
Recession (Prob.: 1/3) 90 0
Of
Normal (Prob.: 1/3) 100 100
Economy
Boom (Prob.: 1/3) 110 200

2. Timing

Period 1 Period 2 Period 3

Company A 100 75 175

Company B 175 0 175

 Value & Profit Maximization
1. Risk
Profit

Company A Company B
State
Recession (Prob.: 1/3) 90 0
Of
Normal (Prob.: 1/3) 100 100
Economy
Boom (Prob.: 1/3) 110 200

Expected 100 100

Value
Dispersion 20 200

Assumption : Investor is Risk Averse

2. Timing

Period 1 Period 2 Period 3 Future Value

@ 10%
Company A 100 75 175 379

Company B 175 0 175 387

 Value & Profit Maximization (Contd.)
3. Accounting Issues
If we expect a certain profit in future is it possible to assess how much
is it worth today?
Subjectivity of accounting numbers :
• Computation of Profit
• Pay Dividend or Retain?
• Today’s Profit Vs Tomorrow’s Profit
4. Ethical Issues & Social Responsibility
• Firms with dissatisfied customers and a disgruntled work force are more
likely to have declining profits and low share price
• Reputation and trust
• Severe impact of dishonesty (eg Enron, Worldcom and more recently
Madoff fraud)
• Maximise value after ensuring meeting of ethical standards & social
responsibility?

5. Corporate Governance
 Present Value

Present Value
Value today of future cash
flow

Present Value arrived at by discounting a future cash

flow by an “appropriate” Discount Rate *

* Opportunity cost of capital/ cost of capital / required rate of return / Hurdle

rate
 Present Value

Present Value =PV

PV=discount factor x Ct

Present Value Cash flow at the end of year t

 Present Value

Discount Factor (DF) =PV of Rs.1

(for a given time period, t, and discount rate, r)

DF = 1/(1+r)t

Discount Factors can be used to compute the present

value of any cash flow
 Value & Timing

PV @
Period 1 Period 2 Period 3
10%

Company A 100 75 175 ₹284.37

Company B 175 0 175 ₹290.57
 Future or Terminal Values

FV  C (1  r )t
t 0
C  amount invested at the beginning
0
r  discount rate
 Compounding More Than Once A Year
The general formula for the future or terminal value at the end of year “n” where
interest is paid “m” times a year is

mt
FVt  C0 (1  r / m)
as m approaches   (infinity),
mt rt
the term (1  r/m) approaches  e
m
e  lim(1  1/m) as m  
 2.71828)

Thus under continuous compounding we can say that :

rt
FVt  C0 e
Present Value When Interest is Compounded More Than
Once a Year

The formula has to be modified in the similar way as is done for terminal
values. Assuming m is the number of times the interest is compounded in
an year,

Cn
PV 
(1  r / m) mt

For continuous compounding, this becomes,

PV  Cn e  rt
 Compound Interest

Interest Rate 6%
Maturity
(years) 1
Amount 1
Interest Annual Annual
Periods per per Percentage Value after Compounded
Year Period Rate (APR) 1 Year Rate of Interest
1 6.0000% 6% 1.06000 6.00000%
2 3.0000% 6% 1.06090 6.09000%
3 2.0000% 6% 1.06121 6.12080%
4 1.5000% 6% 1.06136 6.13636%
5 1.2000% 6% 1.06146 6.14574%
6 1.0000% 6% 1.06152 6.15202%
7 0.8571% 6% 1.06157 6.15651%
12 0.5000% 6% 1.06168 6.16778%
24 0.2500% 6% 1.06176 6.17570%
52 0.1154% 6% 1.06180 6.17998%
365 0.0164% 6% 1.06183 6.18313%
1000000 0.0000% 6% 1.06184 6.18365%

e= 2.71828
Annual Compounded Rate of Interest (Amount -
Amount * ert) 6.18365%
 Effective Annual Rate (EAR)

(1  EAR)  (1  [r / m]) m*1

EAR  (1  [r / m]) m*1  1

Rs.1 compounded @ 8% quarterly,

EAR = (1+[0.08/4]) 4– 1 = 0.08243  8.2 %

r= Stated Annual Interest Rate (SAIR)

m = number of ‘compoundings’ per year
 Present Value : Example

Cost of Capital or Discount Rate : 10 %

Cash Flows:
Year 1 : Rs.1
Year 2 : Rs.3
Year 3 : Rs.2

What is the maximum we should we pay for this cash flow?

 Present Value : Example
Cost of Capital or Discount Rate : 10 %
Cash Flows:
Year 1 : Rs.1
Year 2 : Rs.3
Year 3 : Rs.2

PV = 1 * 1/(1 + 0.10) + 3 * 1/ (1 + 0.10)2 + 2 * 1 / (1 + 0.10)3 =4.8910

.90909 .82645 .75131

Discount Factors
If we can pay 4.5 for the above cash flow, we produce a net additional value of :
0.3910 for the investor
 Valuing an Office Building

Step 1 : Forecast the cash flows

Cost of building= C0 = 350
Sale price in Year 1 =C1 =400

Step 2 : Estimated Opportunity Cost of Capital

If equally risky investments in the capital market offer return of
7 % , then Cost of Capital = r = 7 %
 Valuing an Office Building

Step 3: Discount future cash flows

PV = C1/(1+r) =400 / (1+0.07) = 374

Step 4: Go ahead if PV of payoff exceeds investment

NPV = -350 +374 = 24

NPV = PV – required investment

NPV = -C0 + C1/ (1+r)

 Risk and Present Value
• Higher risk projects require a higher rate of return
• Higher required rates of return cause lower PVs

PV of C1 (Rs.400) at 12% :
PV = 400 / (1+0.12) = 357

PV of C1 (Rs.400) at 7% :
PV = 400 / (1+0.07) = 374

If discount rate is 14.2857% then the PV of 400 that occurs a year later is exactly
350. If the discount rate is more than this, then the PV would be less than 350 and
hence create negative value. This rate - 14.2857% - is called the Internal Rate of
Return, or the IRR
 Decision Rules for Capital Investment

• Accept Investments that have positive Net Present value

• We can easily establish an alternate rule : Accept

investments that offer Internal rates of return in excess of
their cost of capital (or discount rate

Note : The above two rules may conflict when there are cash flows in more than
two periods
Valuation Concepts
 Types of Valuation

 Book Value

 Liquidation Value

 Market Value

 Intrinsic Value
 Conceptual Approach to Valuation

 Amount and Timing of cash flows

 Discounted by the required rate of return

 Determined after accounting for risks