Final Copy_corporate Finance

8/11/2019 Final Copy_corporate Finance

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Chapter 1

INTRODUCTION

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COPORATE FINANCE

Corporate finance is an area of finance dealing with financial decisions business

enterprises make and the tools and analysis used to make these decisions. The primary goal of

corporate finance is to maximize corporate value while managing the firm's financial risks.

Although it is in principle different from managerial finance which studies the financial decisions

of all firms, rather than corporations alone, the main concepts in the study of corporate finance are

applicable to the financial problems of all kinds of firms.

The discipline can be divided into longterm and shortterm decisions and techni!ues.

"apital investment decisions are longterm choices about which pro#ects receive investment,

whether to finance that investment with e!uity or debt, and when or whether to pay dividends to

shareholders. $n the other hand, the short term decisions can be grouped under the heading

%&orking capital management. This sub#ect deals with the shortterm balance of current assets and

current liabilities the focus here is on managing cash, inventories, and shortterm borrowing and

lending.

The Corporate Firm

The firm is a way of organizing the econiomic activity of many individuals, and there are

many reasons why so much economic activity is carried out by firms and not by individuals. A

basic problem of the firm is how to raise cash. The corporate form of business, that is organizing

the firm as a corporation, is the standard method for solving problems encountered in raising large

amounts of cash. (owever, businesses can take other forms.

The Corporation

$f the many forms of business enterprises, the corporation is by far the most important. )t

is a legal distinctentity. A corporation can have a name and en#oy many of the legal powers of

natural persons. *or example, corporations can ac!uire and exchange property. "orporations can

enter in to contracts and may sue and be sued.

+tarting a corporation is more complicated then starting a proprietorship or partnership. The

incorporators must prepare articles of incorporation and a set of bylaws. The articles of

incorporation must include the following

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1. ame of the corporation.

2. )ntended life of the corporation.

3. /usiness purpose.

4. umber of shares of stock that the corporation is authorised to issue, with a statement

of limitations and rights of different classes of shares.

5. ature of the rights granted to shareholders.

. umber of members of the initial board of directors.

The bylaws are the rules to be used by the corporation to regulate its own existence, and they

concern its shareholders, directors, and officers. /ylaws range from the briefest posssible statement

of rules for the corporation's management to hundreds of pages of text.

)n its simplest form, the corporation comprises three sets of distinct interests the

shareholders, the directors, who inturn selects the top management. 0embers of hte top

management serve as corporate officers and manage the operation of the corporation in the best

interest of the shareholders. )n closely held corporations with few shareholders, there may be a

large overlap manong the shareholders, the directors, and the top management. (owever, in larger

corporationsx the shareholders, directors, and the top management are likely to be distinct groups.

The potential seperation of ownership from management gives the corporation several

advantages over proprietorships and partnerships

/ecause ownership in a corporation is represented by share of stock, ownership can be

redily transfered to new owners. /ecause the corporation exists independently of those who

own its shares, there is no limit to the transferability of shares as there is in partnerships.

The corporation has unlimited life. /ecause the corporation is a seperate from its owners,

the death or withdrawal of an owner does not affect its legal existence. The corporations

can continue on after the orginal owners have withdrawn.

The shareholders' liability is limited to the amount invested in the ownership shares. *or

example, if a shareholder purchased s.1222 in shares of a corporation, the potential loss

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would be s.1222. )n a partnership, a general partner with a s.1222 contribution could

lose the s.1222 plus any other indebtedness of the partnership.

4imited liability, ease of ownership transfer, and perpetual succession are the ma#or advantages of

the corporation form of business organisation. These give the corporation an enhanced ability to

raise cash.

There is however, one great disadvantage to incorporation. The federal government taxes

corporate income. This tax in addition to the personal income tax that shareholders pay on dividend

income they receive. This is double taxation for shareholders when compared to taxation on

proprietorships and partnerships.

!oa"# of the Corporate Firm

The 0anagers in a corporation make decisions for the stockholders because the stockholders

own and control the corporation. +o, the goals for the corporations is to

Add value for the stockholders

To maximize corporate value

0anage the firm5s financial risks

$a"ance %heet &o'e" of the Firm

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The assets of the firm are on the lefthand side of the balance sheet. These assets thought of

as current and fixed. *ixed assets are those that will last a long time, such as buildings. +ome fixed

assets are tangible, such as machinery and e!uipment. $ther fixed assets are intangibles such as

patents, trademarks, and the !uality of management. The other category of assets, current assets,

comprises those that have short lives, such as inventory. 7nless we have overproduced, they will

leave the firm shortly.

/efore an company can invest in an asset, it must obtain financing, which means that it

must raise the money to pay for the investment. The forms of financing are represented on the

ighthand side of the balance sheet. A firm will issue pieces of paper called debt or e!uity shares.

8ust as assets are classified as longlived or shortlived, so too are liabilities. A shortterm debt is

called as current liability. +hortterm debt represents loans and other obligations that must be

repaid within one year.4ong term debt that does not have to be repaid within one year.

+hareholders' e!uity represents the difference between the value of the assets and the debt of the

firm. )n this sense it is a residual claim on the firm's assets.

*rom the balance sheet model of the firm, it is easy to understand how finance is collected and

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utilized by the firm.

o "apital budgeting and capital expenditures are used to describe the process of making and

managing expenditures on long term assets.

o To raise cash re!uired for capital expenditure, c!apital structure represents the proportion

of the firm's financing fron current and longterm debt and e!uity.

o +hort term operating cash flows : there is often mismatch between the timing of cash

inflows and cash outflows during operating activities. The amount and timing of operating

cash flows are not known with certainity. The financial managers must attempt to manage

the gaps in cash flow from a balancesheet perspective, shortterm management of cash

flow is associated with a firm's net working capital. et working capital is defined ascurrent assets minus current liabilities.

C(APTER 2

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)ON! TER& * %(ORT TER& %OURCE% OF

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/usiness enterprises need funds to meet their different types of re!uirements. All the

financial needs of a business may be grouped into the following three categories

)on+ Term Financin+ Nee' #

The longterm decisions of a firm involve setting of the firm, expansion, diversification,

modernization and other similar capital expenditure decisions. All these decisions involve huge

investment, the benefits of which will be seen only in the long term and these decisions are also

irreversible in nature. /y the nature of these pro#ects, long term sources of funds become the best

suited means of financing. *unds re!uired to finance permanent or hard core working capital

should be procured from long term sources.

&e'i,m Term Financin+ Nee'#

+uch e!uirements refer to those funds which are re!uired for a prior exceeding one year

but not exceeding 9 years. *or example, if a company resorts to extensive publicity and

advertisement campaign then such type of expenses may be written off over a period of 3 to 9

years. These are called deferred revenue expenses and funds re!uired for them are classified in the

category of medium term financial needs. +ometimes long term re!uirements, for which long term

funds cannot be arranged immediately may be met from medium term sources and thus the demand

of medium term financial needs, are generated. As and when the desired long term funds are made

available, medium term loans taken earlier may be paid off.

%hort Term Financia" Nee'#

+uch type of financial needs arise to finance in current assets such as stock, debtors, cash

etc. investment in these assets is known as meeting of working capital re!uirements of the concern.

The re!uirement of working capital depends upon a number of factors which may differ from

industry to industry and from company to company in the same industry. The main characteristic of

short term financial needs is that they arise for a short period of time not exceeding the accounting

period i.e. one year.

)on+ Term %o,rce# of Finance

The main sources of longterm finance can broadly divided into

1= )nternal +ource and

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-= ?xternal +ource

Interna" %o,rce# inc",'e

a= +hare "apital @?!uity and preference shares=.

b= eserves and +urplus @etained ?arnings=.

c= ersonal loans of owners.

E-,it %hare Capita"

?!uity shareholders are the owners of the business. They en#oy the residual profits of the

company after having paid the preference shareholders and other creditors of the company and

their liability is restricted to the amount of share capital they contributed to the company. The

advantage of e!uity capital to the issuing firm is that without any fixed obligation for the payment

of dividends, it offers permanent capital with limited liability for repayment. (owever, the cost of

e!uity capital is higher than other capital. *irstly, since the e!uity dividends are not tax deductible

expenses and secondly, the high costs of issue. )n addition to this since the e!uity shareholders

en#oy voting rights, excess of e!uity in the firms capital structure will lead to dilution of effective

control.

&erit# of E-,it %hare#/

1. o fixed burden on company

-. )t is a life time source

3. )t does not have any charge against assets of the company

6. o risk of magnified losses during bad times

9. "an be easily marketed

Demerit# of E-,it %hare#

1. ?xpectations of shareholders are high and hence more costly.

-. "hances of losing control of the company.

3. ew share holders have e!ual voting rights.

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6. "ost of issuing is generally high.

9. Cividend not deductable for tax purpose.

Preference %hare Capita"

reference shares have some attributes similar to e!uity shares and some to debentures.

4ike in the case of e!uity shareholders, there are no obligatory payments to the preference

shareholders and the preference dividends are not tax deductable. (owever similar to the debenture

holders the preference holders earn a fixed rate of return for their investment. )n addition to this the

preference share holders have a preference over e!uity shareholders to the post tax earnings in the

form of dividends and assets in the event of li!uidation.

$ther features of the preference capital include the call feature wherein the issuing company

has the option to redeem the shares, prior to the maturity date, at a certain price. rior to the

"ompany5s Act, 1B9; companies could issue preference shares with voting rights. (owever, with

the commencement of "ompany5s Act, 1B9; the issue of preference rights with voting rights have

been restricted only to the following places

1. There are arrears in dividends for two or more years incase of cumulative preference

shares.

-. reference dividends is due for a period of two or more consecutive preceding years, or

3. )n the preceding six years including the immediately preceding financial year, if the

company has not paid the preference dividend for a period of three or more years.

reference capital represents a hybrid form of financing it takes some characteristics of e!uity

and some attributes of debentures.

It re#em0"e# e-,it in the fo""oin+ a#

1. reference dividend is payable only out of distributed profits

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-. reference dividend is not an obligatory payment

Preference capita" i# #imi"ar to 'e0ent,re# in #eera" a#

1. The dividend rate of preference capital is usually fixed

-. The claim of preference shareholders is prior to the claim of e!uity shareholders

3. reference shareholders do not normally en#oy the right to vote.

A'anta+e# of preference capita"

1. There is no legal obligation to pay preference dividend. A company does not face

bankruptcy or legal action if it skips preference dividend.

-. There is no redemption liability in the case of perpetual preference shares. ?ven in the case

of redeemable preference shares, financial distress may not be much because.

eriodic sinking fund payments are not re!uired.

edemption can be delayed without significance penalties.

3. reference capital is generally regarded as part of et worth. (ence it enhances the credit

worthiness of the firm.

6. reference shares do not, under normal circumstances, carry voting right. (ence there is no

dilution of control.

Preference Capita" hoeer #,ffer# from #erio,# #hortcomin+#

1. "ompared to debt capital, it is an expensive source of financing because the dividend paid

to preference shareholders is not, unlike debt interest, or tax deductable expense.

-. Though there is no legal obligation to pay preference dividends, skipping them can

adversely affect the image of the firm in the capital market.

3. "ompared to e!uity shareholders, preference shareholders have a prior claim on the assets

and earnings of the firm.

Retaine' Earnin+#

etained earnings represent the internal sources of finance available to the company. )t is

not a method of financing but it refers to accumulation of profits by the company to finance its

developmental activities or repay loans. Also called as D)nternal *inancing5 it is an important

source of long term financing for corporate enterprises.

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Eterna" %o,rce Inc",'e

1. Term loan from financial institution and international bodies like )nternational

0onetary *unds, &orld /ank, Asian Cevelopment /ank.

-. Cebentures.

3. 4ease *inancing.

6. (ire urchase.

9. (ypothecation.

Term )oan#

Term loans are directly from the banks and financial institutions in )ndia. Term loans are

generally obtained for financing large expansions, modernizations and diversification pro#ects.

Therefore, this method of financing is also called as pro#ect financing. Term loans have a maturity

of more than one year. *inancial institutions provide term loans for the period of six to ten years

and in some cases a grace period of one or two years is also granted. "ommercial banks advance

term loans for a period of three to five years.

De0ent,re#

Another way of raising the loan is to issue a financial instrument called EdebenturesF. A

debenture is a loan raised by the company from the capital market against which the assets of the

company are mortgaged with the trustees. Cebentures carry a fixed rate of interest. Cebenture

holders are the creditors of the company. There exists obligation on the part of the company

contractual interest as well as to repay the principal amount. Cebenture finance is also cheaper than

share capital. )t also commands a tax benefit as a debenture interest is allowed as deductible

business expenses.

Tpe# of De0ent,re#/

$earer De0ent,re#

They are registered and are payable to its bearers. They are negotiable instruments and are

transferable by delivery.

Re+i#tere' De0ent,re#

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They are payable to the registered holder whose name appears both on debentures and in

register of debenture holders maintained by the company. egistered debentures can be transferred

but have to be registered again. egistered debentures are not negotiable instruments.

%ec,re' De0ent,re#

Cebenture, which create a charge on the assets of the company which may be fixed or

floating are known as secured debentures.

Un#ec,re' or Nae' De0ent,re#

Cebentures, which are issued without any charge on assets, are unsecured or naked

debentures, the holders are like unsecured creditors and may sue the company for recovery of debt.

Re'eema0"e De0ent,re#

ormally debentures are issued on the condition that they shall be redeemed after a certain

period. They can however be reissued after redemption.

Perpet,a" De0ent,re#

&hen debentures are redeemable they are called perpetual.

Conerti0"e De0ent,re#

)f an option is given to convert debentures in to e!uity shares at stated rate of exchange

after a specified period the are called convertible debentures. )n our country convertible debentures

are very popular. $n conversion, the holders cease to be lenders and become owners.

Cebentures are usually issued in series with a pari passu@at the same rate= clause which

entitles them to discharge rate ably though issued at different times. ew series of debentures

cannot rank pari passu wit hold series unless the old series provides so. ew debt instruments

issued by public limited companies are participating debentures, convertible debentures with

options, third party convertible debentures, and convertible debentures redeemable at premium,

debt e!uity swaps and zero coupon convertible notes.

Participatin+ De0ent,re#

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&hen debentures are unsecured, corporate debt securities which participate in the profits of

the company. They might find investors id issued by existing dividend paying companies.

Conerti0"e De0ent,re# ith option#They are a derivative of convertible debentures with embedded options, providing

flexibility to the issuer as well as the investor to exit from the terms of the issue. The coupon rate is

specified at the time of issue.

Thir' part conerti0"e De0ent,re#

They are debt with a warrant allowing the investor to subscribe to the e!uity of a third firm

at a preferential visGvis the market price interest rate on third party convertible debentures is

lower than pure debt on account of the conversion option.

Conerti0"e De0ent,re# re'eema0"e at a premi,m

"onvertible debentures are issued at a face value with an option entitling investors to later

sell the bond to the issuer at a premium. They are basically similar to convertible debentures but

embody less risk.

&erit# of De0ent,re#

1. The debentures are for specific periods and hence financial planning is easy.

-. o dilution of control.

3. "ompany can trade on e!uity.

6. )nterest is deductible for tax purpose.

Demerit# of De0ent,re#

1. )nterest has to be paid irrespective of performance : in case of failure to pay interest,

debenture holder can file winding up petition.

-. (as to be repaid on maturity.

)ea#e Financin+

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A lease is a form of financing employed to ac!uire the economies use of assets for a stated

period without owing them. ?very lease involves two parties, the lease and the leasor. 4easing is

the contractual arrangement between the lease and the leasor , where in companies can enter into a

lease in with the manufacturer of the instruments or through some intermediary. This deal will give

the company the right to use the assets till the maturity of the lease deal and can later retain the

assets or buy from the manufacturers. Curing the lease period the company will have to pay lease

rentals, which generally is at a negotiable rates and payable every month.

(ire P,rcha#e

*inance companies usually offer the facility of leasing as well as hire purchase to the clients.

The features of hire purchase are given as follows

1. The hirer purchases the assets and gives it on hire to hiree.

-. The hiree pays regularly the hire purchase installments covering interest as well as

repayment of the principal amount. &hen the hiree pays the last installment, the title of the

asset is transferred to hiree.

3. The hirer charges interest on a flat basis.

6. The total interest collected by the hirer is allotted over various years.

(pothecation

7nder this arrangement, the possession of goods is not given to the banker. The

commodities remain at the disposal and in the godown of the borrower. The banker is given access

to goods whenever he so desires. The borrowing business unit has to furnish periodical returns of

stock to the banker. The banker advances the money only to the borrower in whose integrity it has

full confidence.

%OURCE% OF FINANCE FRO& A$ROAD

American Depo#itor Receipt# 6ADR7

AC is an instrument similar to HC. )t is issued in the capital markets of 7+A alone.

Henerally far more stringent rules and regulations prevail for bringing out and AC issue.

AC is defined as a receipt or a certificate issued by the bank representing title to the

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specified number of share of a non 7+ company. The 7+ bank is the depository in this case. AC

is the evidence of ownership of underlying shares. AC is freely traded in the 7+ without actual

delivery of underlying non 7+ shares.

)n this case the issuing company actively promotes the company5s AC in 7+A. A single

depository bank is normally chosen and an AC is routed through this bank.

The organisation with ACs with securities exchange commission @+?"= is not

compulsory. Technically AC5s are different from HCs. The size of ACs can be expanded or

reduced. Henerally it depends upon demand as depositories bank can issue or withdraw

corresponding shares in the local market.

!"o0a" Depo#itor Receipt 6!DR7HC is a new financial instrument. 0ade its appearance in 1BB1 and became an instant

success. )t also started when company5s in countries like +outh Iorea and 0alaysia began

attracting investors from ?urope and 7+A. )nspite of the investor interest companies face

difficulties. A novel way was found and it works in this way.

A bank in ?urope ac!uires the shares of such a company and then issues its own receipts or

certificates to the investors. This bank is also called depository and such certificates are called

HC. These HCs can be traded on the ?uropean exchange or in private placement in 7+A. AHC is a dollar denominated instrument tradable on the stock exchange in ?urope or private

placement in 7+A. HC represents one or more shares of the issuing company.

eliance was the first company to issue HC in 0ay 1BB-, to raise 7+ J122 million. The

bookings were about 9 times the size of the issue and eliance retained 7+ J192 million.

Forei+n C,rrenc Conerti0"e $on'# 6FCC$#7

*""/s mean bonds which can be issued and subscribed by nonresidents of )ndia inforeign currency and convertible into ordinary shares of the issuing company in any manner, i.e. in

whole, or in part.

A foreign currency convertible bond is a foreign currency dominated bond issued by a

company generally in a ?uropean or 7+ markets. A convertible bond can be exchanged for e!uity

shares at some later date after the issue of bond. "onvertible bond generally have smaller coupon

rate than nonconvertible. The advantages of *""/ are that there is no immediate dilution of

earning.

These bonds are issued and subscribed under the E)ssue of *oreign "urrency "onvertible

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bonds and $rdinary +hares +chemeF initiated by "entral government of )ndia in 1BB3.

%o,rce# of %hortterm Finance

+hort term finance is concerned with decisions relating to current assets and current

liabilities and is also called as working capital finance. +hort term financial decisions typically

involve cash flows within a year or within the operating cycle of the firm. ormally short term

finance is for a period upto 3 years.

The main #o,rce# of %hort term finance are/

1. "ash credit

-. /ills discounting

3. 4etter of credit

6. )nter corporate deposits

9. "ommercial papers

;. *actoring

. /ridge finance

Ca#h Cre'it

"ash "redit is the arrangement under which a customer is allowed and advanced upto

certain limit against credit granted by the bank. 7nder this arrangement, a customer need not

borrow entire amount of advance at one go, he can only draw to the extent of his re!uirement and

deposit his surplus funds in his account. )nterest is charged not on the full amount of advance but

on the amount actually availed by him. Henerally cash credit limits are sanctioned against the

security of goods by way of pledge or hypothecation.

Oer'raft

$verdraft arrangement is similar to the cash credit arrangement. 7nder this arrangement,

the customer is permitted to overdraw upto a prefixed limit. )nterest is charged on the amount

overdrawn sub#ect to some charge as in the case of cash credit arrangements. $verdraft accounts

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operate against security in the form of pledging of share security, assignment of the 4)" policies

and sometimes even mortgage of fixed assets.

)etter of Cre'it

+uppliers, particularly the foreign supplier insists that the buyer should ensure that his bank

would make payment if he fails to honor its obligation. This is ensured through letter of credit @4"=

arrangement. A bank opens a 4" in favour of a customer to facilitate his purchase of goods. )f the

customer doesn5t pay to the supplier within the credit period, the bank makes the payment under

the 4" arrangements. This arrangement passes the risk of supplier to the bank. /ank charges the

amount for opening 4". )t will extend such facilities to the financially sound customers.

Inter corporate Depo#it#

A deposit made by one company with another, normally for a period upto six months, is

referred to as inter corporate deposit. +uch deposits are usually are 3 types

1. Ca"" Depo#it#/ A call deposit is withdrawable by the lender on giving a days notice. )n

practice, however the lender has to wait for at least three days. The interest on such deposit

may be around 1;K.

-. To month# 'epo#it#/ These are more popular in practice. These deposits are taken from

borrowers to tie over short term cash inade!uacy that may be caused by one or more of the

following factors disruption in production, excessive imports of raw materials, tax

payment, and delay in collection, dividend payment and unplanned capital expenditure. The

interest on such deposits is around 1>K per annum.

3. %i month# 'epo#it#/ ormally, lending companies do not extend deposits beyond this

time frame. +uch deposits usually made with first class borrowers. These deposits carry on

interest rate of around -2K pa.

Commercia" Paper

"ommercial paper represents short term unsecured promissory notes issued by firms, which

en#oy fairly high credit rating. Henerally, large firms with considerable financial strength are able

to issue commercial paper. The important features of commercial papers are as follows

1. The maturity period of commercial paper ranges from B2 to 1>2 days.

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-. "ommercial paper is sold at a discount from its face value and redeemed at its face value.

(ence, the implicit interest rate is a function of the size of the discount and the period of

maturity.

3. "ommercial paper is either directly placed with investor or sold through dealers.

6. )nvestors who intend holding it till its maturity usually by commercial paper. (ence, there

is no well developed secondary market for commercial paper.

Factorin+

)n factoring accounts receivable are generally sold to a financial institution @factor= that charges

commission and bears the credit risks associated with the accounts receivable purchased by it. The

company can enter into agreement with a factor working out a factoring arrangement according to

its re!uirement. The factor then takes responsibility of monitoring, follow up, collection and risk

taking and provision of advance. *actoring offers the following advantages which makes it !uite

attractive to many firms

1. The firm can convert accounts receivables into cash without bothering about repayment.

-. *actoring ensures a definite pattern of cash inflows.

3. "ontinuous factoring virtually eliminates the need for credit department.

6. 7nlike a unsecured loan, compensating balance is not re!uired to be kept with the financial

institution in this case.

9. *actoring relives the borrowing firm of substantial credit and collection costs and to a

degree a considerable part of cash management.

P,0"ic Depo#it#

ublic deposits are very important source of short term and medium term finances

particularly due to credit s!ueeze by the eserve /ank of )ndia. These deposits may be accepted

for a period of six months to three years. ublic deposits are unsecured loans taken from public

they should not be used for ac!uiring fixed assets since they are to be repaid within a period of 3

years. These are mainly used to finance working capital re!uirements.

$ri'+e Finance

/ridge finance refers to loans taken by a company normally from commercial banks for a

short period, pending disbursement of loans sanctioned by financial institutions.

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Chapter 3

DECI%ION% UNDER CORPORATE FINANCE

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The decisions can be divided into longterm and shortterm decisions and techni!ues.

)on+ Term Deci#ion#

"apital investment decisions are longterm choices about which pro#ects receiveinvestment, whether to finance that investment with e!uity or debt, and when or whether to pay

dividends to shareholders.The capital structure of a company refers to the proportion of Cebt and

?!uity or the mixing of long term finances used by the firm.

The capital structure includes *unds received from the owners of the business i.e the

+hareholders and therefore called as shareholders funds.

The capital structure also includes /orrowed *unds, which are further divided into

+ecured 4oans @/ank 4oans, debentures=

7nsecured )oans

The combination of the above constitutes the capital structure or the total "apital

?mployed. )t is the financial planning of the company.

%hort term 'eci#ion#$n the other hand, the short term decisions deals with the shortterm balance of current

assets and current liabilities the focus here is on managing cash, inventories, and shortterm

borrowing and lending @such as the terms on credit extended to customers=.

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Chapter 4

FUNCTION% OF FINANCIA) &ANA!ER

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There are three main functions of a financial manager. They are investment decision,

financing decision and dividend decision.

Capita" Ine#tment 'eci#ion#/

"apital investment decisions are longterm corporate finance decisions relating to fixed assets and

capital structure. Cecisions are based on several interrelated criteria.

o "orporate management seeks to maximize the value of the firm by investing in pro#ects

which yield a positive net present value when valued using an appropriate discount rate.

o These pro#ects must also be financed appropriately.

o )f no such opportunities exist, maximizing shareholder value dictates that management

must return excess cash to shareholders @i.e., distribution via dividends=. "apital investment

decisions thus comprise an investment decision, a financing decision, and a dividend

decision.

1. Ine#tment 'eci#ion# relates to the selection of assets in which funds will be invested

by a firm. The assets, which can be ac!uired, fall into two broad groups

4ong term assets which yield a return over a period of time in future@"apital /udgeting=.

+hort term or current assets, defined as those assets which in normal course of business are

convertible into cash without diminution in value, usually within a year@working capital

management=.

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Chapter5

CAPITA) $UD!ETIN!

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The first and the most important decision that any firm has to make is to define the business

that it wants to be in. This decision has a significant bearing on how capital is allocated in the firm.

A plan has to be deployed to invest in buildings, machineries, e!uipment, research and

development, brands and other longlived assets. This is capital budgeting process. "onsiderable

managerial time, attention, and energy are devoted to identify, evaluate and implement investment

pro#ects. *rom a financial point of view the magnitude, timing and the risk of cash flows associated

with the pro#ect have to be studied. "apital budgeting decisions involves evaluating each

investment with respect to the related benefits and returns and also the risks and uncertainties

associated with it.

Capita" 0,'+etin+@or investment appraisal= is the planning process used to determine whether

a firm's long term investments such as new machinery, replacement machinery, new plants, new

products, and research development pro#ects are worth pursuing. )t is budget for ma#or capital, or

investment, expenditures.

0any formal methods are used in capital budgeting, including the techni!ues such as

Accounting rate of return

et present value

rofitability index

)nternal rate of return

0odified internal rate of return

?!uivalent annuity

These methods use the incremental cash flows from each potential investment, or pro#ect

Techni!ues based on accounting earnings and accounting rules are sometimes used though

economists consider this to be improper such as the accounting rate of return, and %return on

investment.%

Net present value

?ach potential pro#ect's value should be estimated using a discounted cash flow @C"*=

valuation, to find its net present value @L=. This valuation re!uires estimating the size and

timing of all the incremental cash flows from the pro#ect. These future cash flows are then

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discounted to determine their present value. These present values are then summed, to get the L.

+ee also Time value of money. The L decision rule is to accept all positive L pro#ects in an

unconstrained environment, or if pro#ects are mutually exclusive, accept the one with the highest

L @H?=.

The L is greatly affected by the discount rate, so selecting the proper rate sometimes

called the hurdle rate is critical to making the right decision. The hurdle rate is the minimum

acceptable return on an investment. )t should reflect the riskiness of the investment, typically

measured by the volatility of cash flows, and must take into account the financing mix. 0anagers

may use models such as the "A0 or the AT to estimate a discount rate appropriate for each

particular pro#ect, and use the weighted average cost of capital @&A""= to reflect the financing

mix selected. A common practice in choosing a discount rate for a pro#ect is to apply a &A"" that

applies to the entire firm, but a higher discount rate may be more appropriate when a pro#ect's risk

is higher than the risk of the firm as a whole.

Internal rate of return

The interna" rate of ret,rn@)= is defined as the discount rate that gives a net present

value @L= of zero. )t is a commonly used measure of investment efficiency.

The ) method will result in the same decision as the L method for @nonmutually

exclusive= pro#ects in an unconstrained environment, in the usual cases where a negative cash flow

occurs at the start of the pro#ect, followed by all positive cash flows. )n most realistic cases, all

independent pro#ects that have an ) higher than the hurdle rate should be accepted.

evertheless, for mutually exclusive pro#ects, the decision rule of taking the pro#ect with the

highest ) which is often used may select a pro#ect with a lower L.

Equivalent annuity method

The e!uivalent annuity method expresses the L as an annualized cash flow by dividing

it by the present value of the annuity factor. )t is often used when assessing only the costs of

specific pro#ects that have the same cash inflows. )n this form it is known as the e!uivalent annual

cost @?A"= method and is the cost per year of owning and operating an asset over its entire

lifespan.

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)t is often used when comparing investment pro#ects of une!ual lifespan. *or example if

pro#ect A has an expected lifetime of < years, and pro#ect / has an expected lifetime of 11 years it

would be improper to simply compare the net present values @Ls= of the two pro#ects, unless the

pro#ects could not be repeated.

Real options

eal options analysis has become important since the 1B


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Pro8ect a",ation

?ach pro#ect's value will be estimated using a discounted cash flow @C"*= valuation, and

the opportunity with the highest value, as measured by the resultant net present value @L= will

be selected .This re!uires estimating the size and timing of all of the incremental cash flows

resulting from the pro#ect. +uch future cash flows are then discounted to determine their present

value. These present values are then summed, and this sum net of the initial investment outlay is

the L.

Three tpe# of 9a",ation/

1. /usiness valuation

-. +tock valuation, and

3. *undamental analysis

$,#ine## a",ation

$,#ine## a",ation is a process and a set of procedures used to estimate the economic

value of an owner5s interest in a business. Laluation is used by financial market participants to

determine the price they are willing to pay or receive to consummate a sale of a business. )n

addition to estimating the selling price of a business, the same valuation tools are often used by

business appraisers to resolve disputes related to estate and gift taxation, divorce litigation, allocate

business purchase price among business assets, establish a formula for estimating the value of

partners' ownership interest for buysell agreements, and many other business and legal purposes.

Standard and premise of value

/efore the value of a business can be measured, the valuation assignment must specify the

reason for and circumstances surrounding the business valuation. These are formally known as the

business value standard and premise of value. The standard of value is the hypothetical conditions

under which the business will be valued. The premise of value relates to the assumptions, such as

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assuming that the business will continue forever in its current form @going concern=, or that the

value of the business lies in the proceeds from the sale of all of its assets minus the related debt

@sum of the parts or assemblage of business assets=.

/usiness valuation results can vary considerably depending upon the choice of both the

standard and premise of value. )n an actual business sale, it would be expected that the buyer and

seller, each with an incentive to achieve an optimal outcome, would determine the fair market

value of a business asset that would compete in the market for such an ac!uisition. )f the synergies

are specific to the company being valued, they may not be considered. *air value also does not

incorporate discounts for lack of control or marketability.

ote, however, that it is possible to achieve the fair market value for a business asset that is

being li!uidated in its secondary market. This underscores the difference between the standard and

premise of value.

These assumptions might not, and probably do not, reflect the actual conditions of the

market in which the sub#ect business might be sold. (owever, these conditions are assumed

because they yield a uniform standard of value, after applying generallyaccepted valuation

techni!ues, which allows meaningful comparison between businesses which are similarly situated.

Elements of business valuation

Economic con'ition#

A business valuation report generally begins with a description of national, regional and

local economic conditions existing as of the valuation date, as well as the conditions of the industry

in which the sub#ect business operates.

Financia" Ana"#i#

The financial statement analysis generally involves common size analysis, ratio analysis

@li!uidity, turnover, profitability, etc.=, trend analysis and industry comparative analysis. This

permits the valuation analyst to compare the sub#ect company to other businesses in the same or

similar industry, and to discover trends affecting the company andMor the industry over time. /y

comparing a company5s financial statements in different time periods, the valuation expert can

view growth or decline in revenues or expenses, changes in capital structure, or other financial

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trends. (ow the sub#ect company compares to the industry will help with the risk assessment and

ultimately help determine the discount rate and the selection of market multiples.

Norma"i:ation of financia" #tatement#

The most common normalization ad#ustments fall into the following four categories

"omparability Ad#ustments. The valuer may ad#ust the sub#ect company5s financial

statements to facilitate a comparison between the sub#ect company and other businesses in

the same industry or geographic location. These ad#ustments are intended to eliminatedifferences between the way that published industry data is presented and the way that the

sub#ect company5s data is presented in its financial statements.

onoperating Ad#ustments. )t is reasonable to assume that if a business were sold in a

hypothetical sales transaction @which is the underlying premise of the fair market value

standard=, the seller would retain any assets which were not related to the production of

earnings or price those nonoperating assets separately. *or this reason, nonoperating

assets @such as excess cash= are usually eliminated from the balance sheet.

onrecurring Ad#ustments. The sub#ect company5s financial statements may be affected by

events that are not expected to recur, such as the purchase or sale of assets, a lawsuit, or an

unusually large revenue or expense. These nonrecurring items are ad#usted so that the

financial statements will better reflect the management5s expectations of future

performance.

Ciscretionary Ad#ustments. The owners of private companies may be paid at variance from

the market level of compensation that similar executives in the industry might command. )n

order to determine fair market value, the owner5s compensation, benefits, per!uisites and

distributions must be ad#usted to industry standards. +imilarly, the rent paid by the sub#ect

business for the use of property owned by the company5s owners individually may be

scrutinized.

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Income; A##et an' &aret Approache#

Three different approaches are commonly used in business valuation the income approach,

the assetbased approach, and the market approach. &ithin each of these approaches, there arevarious techni!ues for determining the value of a business using the definition of value appropriate

for the appraisal assignment. Henerally, the income approaches determine value by calculating the

net present value of the benefit stream generated by the business @discounted cash flow= the asset

based approaches determine value by adding the sum of the parts of the business @net asset value=

and the market approaches determine value by comparing the sub#ect company to other companies

in the same industry, of the same size, andMor within the same region.

A number of business valuation models can be constructed that utilize various methods

under the three business valuation approaches.

)n determining which of these approaches to use, the valuation professional must exercise

discretion. ?ach techni!ue has advantages and drawbacks, which must be considered when

applying those techni!ues to a particular sub#ect company. 0ost treatises and court decisions

encourage the valuator to consider more than one techni!ue, which must be reconciled with each

other to arrive at a value conclusion. A measure of common sense and a good grasp of mathematicsis helpful.

Income approaches

The income approaches determine fair market value by multiplying the benefit stream

generated by the sub#ect or Target "ompany times a discount or capitalization rate. The discount or

capitalization rate converts the stream of benefits into present value. There are several different

income approaches, including capitalization of earnings or cash flows, discounted future cash

flows @EC"*F=, and the excess earnings method @which is a hybrid of asset and income

approaches=. 0ost of the income approaches look to the company5s ad#usted historical financial

data for a single period only C"* re!uires data for multiple future periods. The discount or

capitalization rate must be matched to the type of benefit stream to which it is applied. The result

of a value calculation under the income approach is generally the fair market value of a controlling,

marketable interest in the sub#ect company, since the entire benefit stream of the sub#ect company

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is most often valued, and the capitalization and discount rates are derived from statistics

concerning public companies.

Di#co,nt or capita"i:ation rate#

A discount rate or capitalization rate is used to determine the present value of the expected

returns of a business. The discount rate and capitalization rate are closely related to each other, but

distinguishable. Henerally speaking, the discount rate or capitalization rate may be defined as the

yield necessary to attract investors to a particular investment, given the risks associated with that

investment.

)n C"* valuations, the discount rate, often an estimate of the cost of capital for the business

is used to calculate the net present value of a series of pro#ected cash flows.

$n the other hand, a capitalization rate is applied in methods of business valuation that are

based on business data for a single period of time. *or example, in real estate valuations for

properties that generate cash flows, a capitalization rate may be applied to the net operating

income @$)= @i.e., income before depreciation and interest expenses= of the property for

the trailing twelve months.

There are several different methods of determining the appropriate discount rates. The discount

rate is composed of two elements

@1= The riskfree rate, which is the return that an investor would expect from a secure,

practically riskfree investment, such as a high !uality government bond plus

@-= A risk premium that compensates an investor for the relative level of risk associated

with a particular investment in excess of the riskfree rate. 0ost importantly, the selected

discount or capitalization rate must be consistent with stream of benefits to which it is to be

applied.

Capita" A##et Pricin+ &o'e" 6CAP&7

The "apital Asset ricing 0odel @"A0= is one method of determining the appropriate

discount rate in business valuations. The "A0 method originated from the obel rize winningstudies of (arry 0arkowitz, 8ames Tobin and &illiam +harpe. The "A0 method derives the

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discount rate by adding a risk premium to the riskfree rate. )n this instance, however, the risk

premium is derived by multiplying the e!uity risk premium times Ebeta,F which is a measure of

stock price volatility. /eta is published by various sources for particular industries and companies.

/eta is associated with the systematic risks of an investment.

$ne of the criticisms of the "A0 method is that beta is derived from the volatility of

prices of publiclytraded companies, which are likely to differ from private companies in their

capital structures, diversification of products and markets, access to credit markets, size,

management depth, and many other respects. &here private companies can be shown to be

sufficiently similar to public companies, however, the "A0 method may be appropriate.


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sset!based approaches

The value of assetbased analysis of a business is e!ual to the sum of its parts. That is the

theory underlying the assetbased approaches to business valuation. The asset approach to businessvaluation is based on the principle of substitution no rational investor will pay more for the

business assets than the cost of procuring assets of similar economic utility. )n contrast to the

incomebased approaches, which re!uire the valuation professional to make sub#ective #udgments

about capitalization or discount rates, the ad#usted net book value method is relatively ob#ective.

ursuant to accounting convention, most assets are reported on the books of the sub#ect company

at their ac!uisition value, net of depreciation where applicable. These values must be ad#usted to

fair market value wherever possible. The value of a company5s intangible assets, such as goodwill,

is generally impossible to determine apart from the company5s overall enterprise value. *or this

reason, the assetbased approach is not the most probative method of determining the value of

going business concerns. )n these cases, the assetbased approach yields a result that is probably

lesser than the fair market value of the business. )n considering an assetbased approach, the

valuation professional must consider whether the shareholder whose interest is being valued would

have any authority to access the value of the assets directly. +hareholders own shares in a

corporation, but not its assets, which are owned by the corporation. A controlling shareholder may

have the authority to direct the corporation to sell all or part of the assets it owns and to distribute

the proceeds to the shareholders. The noncontrolling shareholder, however, lacks this authority

and cannot access the value of the assets. As a result, the value of a corporation's assets is rarely the

most relevant indicator of value to a shareholder who cannot avail himself of that value. Ad#usted

net book value may be the most relevant standard of value where li!uidation is imminent or

ongoing where a company earnings or cash flow are nominal, negative or worth less than its

assets or where net book value is standard in the industry in which the company operates. one of

these situations applies to the "ompany which is the sub#ect of this valuation report. (owever, the

ad#usted net book value may be used as a Esanity checkF when compared to other methods of

valuation, such as the income and market approaches.

"arket approaches

The market approach to business valuation is rooted in the economic principle of

competition that in a free market the supply and demand forces will drive the price of business

assets to certain e!uilibrium. /uyers would not pay more for the business, and the sellers will not

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accept less, than the price of a comparable business enterprise. )t is similar in many respects to the

Ecomparable salesF method that is commonly used in real estate appraisal. The market price of the

stocks of publicly traded companies engaged in the same or a similar line of business, whose

shares are actively traded in a free and open market, can be a valid indicator of value when the

transactions in which stocks are traded are sufficiently similar to permit meaningful comparison.

The difficulty lies in identifying public companies that are sufficiently comparable to the

sub#ect company for this purpose. Also, as for a private company, the e!uity is less li!uid @in other

words its stocks are less easy to buy or sell= than for a public company, its value is considered to be

slightly lower than such a marketbased valuation would give.

%toc a",ation

)n financial markets, #toc a",ationis the method of calculating theoretical values of

companies and their stocks. The main use of these methods is to predict future market prices, or

more generally potential market prices, and thus to profit from price movement : stocks that are

#udged undervalued @with respect to their theoretical value= are bought, while stocks that are

#udged overvalued are sold, in the expectation that undervalued stocks will, on the whole, rise in

value, while overvalued stocks will, on the whole, fall.

)n the view of fundamental analysis, stock valuation based on fundamentals aims to give an

estimate of their intrinsic value of the stock, based on predictions of the future cash flows and

profitability of the business.

%toc 9a",ation &etho'#

+tocks have two types of valuations. $ne is a value created using some type of cash flow,

sales or fundamental earnings analysis. The other value is dictated by how much an investor is

willing to pay for a particular share of stock and by how much other investors are willing to sell a

stock for @in other words, by supply and demand=. /oth of these values change over time as

investors change the way they analyze stocks and as they become more or less confident in the

future of stocks. 4et me discuss both types of valuations.

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*irst, the fundamental valuation. This is the valuation that people use to #ustify stock prices.

The most common example of this type of valuation methodology is M? ratio, which stands for

rice to ?arnings atio. This form of valuation is based on historic ratios and statistics and aims to

assign value to a stock based on measurable attributes. This form of valuation is typically what

drives longterm stock prices.

The other way stocks are valued is based on supply and demand. The more people that

want to buy the stock, the higher its price will be. And conversely, the more people that want to sell

the stock, the lower the price will be. This form of valuation is very hard to understand or predict,

and it often drives the shortterm stock market trends.

)n short, there are many different ways to value stocks. ) will list several of them here. The

key is to take each approach into account while formulating an overall opinion of the stock. 4ook

at each valuation techni!ue and ask yourself why the stock is valued this way. )f it is lower or

higher than other similar stocks, then try to determine why. And remember, a great company is not

always a great investment. (ere are the basic valuation techni!ues

Earnin+# Per %hare 6EP%7 Nou've heard the term many times, but do you really know what it

means. ?+ is the total net income of the company divided by the number of shares outstanding. )t

sounds simple but unfortunately it gets !uite a bit more complicated. "ompanies usually report

many ?+ numbers.

Price to Earnin+# 6P=E 7 M?s are probably the single most important valuation method because

they reflect the future growth of the company into the figure. And all stocks are priced based on

their future earnings, not on their past earnings. (owever, past earnings are sometimes a good

indicator for future earnings. M?s are computed by taking the current stock price divided by the

sum of the ?+ estimates for the next four !uarters, or for the ?+ estimate for next calendar of

fiscal year or two.

!roth Rate Laluations rely very heavily on the expected growth rate of a company. *or

starters, you can look at the historical growth rate of both sales and income to get a feeling for

what type of future growth that you can expect. (owever, companies are constantly changing, as

well as the economy, so don't rely on historical growth rates to predict the future, but instead use

them as a guideline for what future growth could look like if similar circumstances are encountered

by the company.

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PE! RatioThis valuation techni!ue has really become popular over the past decade or so. )t is

better than #ust looking at a M? because it takes three factors into account the price, earnings, and

earnings growth rates. To compute the ?H ratio @a.k.a. rice ?arnings to Hrowth ratio= divide the

*orward M? by the expected earnings growth rate @you can also use historical M? and historical

growth rate to see where it's traded in the past=. This will yield a ratio that is usually expressed as a

percentage. The theory goes that as the percentage rises over 122K the stock becomes more and

more overvalued, and as the ?H ratio falls below 122K the stock becomes more and more

undervalued. The theory is based on a belief that M? ratios should approximate the longterm

growth rate of a company's earnings. &hether or not this is true will never be proven and the

theory is therefore #ust a rule of thumb to use in the overall valuation process.

Ret,rn on Ine#te' Capita" 6ROIC7: This valuation techni!ue measures how much money the

company makes each year per dollar of invested capital. )nvested "apital is the amount of money

invested in the company by both stockholders and debtors. The ratio is expressed as a percent and

you should look for a percent that approximates the level of growth that you expect. )n its simplest

definition, this ratio measures the investment return that management is able to get for its capital.

The higher the number, the better the return.

Ret,rn on A##et# 6ROA7 +imilar to $)", $A, expressed as a percent, measures the

company's ability to make money from its assets. To measure the $A, take the pro forma net

income divided by the total assets. (owever, because of very common irregularities in balance

sheets @due to things like Hoodwill, writeoffs, discontinuations, etc.= this ratio is not always a

good indicator of the company's potential. )f the ratio is higher or lower than you expected, be sure

to look closely at the assets to see what could be over or understating the figure.

Price to %a"e# 6P=%7This figure is useful because it compares the current stock price to the annual

sales. )n other words, it tells you how much the stock costs per dollar of sales earned. To compute

it, take the current stock price divided by the annual sales per share. The annual sales per share

should be calculated by taking the net sales for the last four !uarters divided by the fully diluted

shares outstanding. The price to sales ratio is useful, but it does not take into account any debt the

company has. *or example, if a company is heavily financed by debt instead of e!uity, then the

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sales per share will seem high @the M+ will be lower=. All things e!ual, a lower M+ ratio is better.

(owever, this ratio is best looked at when comparing more than one company.

&aret Cap0arket "ap, which is short for 0arket "apitalization, is the value of all of the

company's stock. To measure it, multiply the current stock price by the fully diluted shares

outstanding. emember, the market cap is only the value of the stock. To get a more complete

picture, you'll want to look at the ?nterprise Lalue.

Enterpri#e 9a",e 6E97: ?nterprise Lalue is e!ual to the total value of the company, as it is

trading for on the stock market. To compute it, add the market cap @see above= and the total net

debt of the company. The total net debt is e!ual to total long and short term debt plus accounts

payable, minus accounts receivable, minus cash. The ?nterprise Lalue is the best approximation of

what a company is worth at any point in time because it takes into account the actual stock price

instead of balance sheet prices. &hen analysts say that a company is a %billion dollar% company,

they are often referring to its total enterprise value. ?nterprise Lalue fluctuates rapidly based on

stock price changes.

E9 to %a"e#This ratio measures the total company value as compared to its annual sales. A high

ratio means that the company's value is much more than its sales. To compute it, divide the ?L by

the net sales for the last four !uarters. This ratio is especially useful when valuing companies that

do not have earnings, or that are going through unusually rough times. *or example, if a company

is facing restructuring and it is currently losing money, then the M? ratio would be irrelevant.

(owever, by applying a ?L to +ales ratio, you could compute what that company could trade for

when its restructuring is over and its earnings are back to normal.

E$ITDA?/)TCA stands for earnings before interest, taxes, depreciation and amortization. )t is

one of the best measures of a company's cash flow and is used for valuing both public and private

companies. To compute ?/)TCA, use a companies income statement, take the net income and then

add back interest, taxes, depreciation, amortization and any other noncash or onetime charges.

This leaves you with a number that approximates how much cash the company is producing.

?/)TCA is a very popular figure because it can easily be compared across companies, even if all

of the companies are not profitable.

E9 to E$ITDAThis is perhaps one of the best measurements of whether or not a company is

cheap or expensive. To compute, divide the ?L by ?/)TCA. The higher the number, the more

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expensive the company is. (owever, remember that more expensive companies are often valued

higher because they are growing faster or because they are a higher !uality company. &ith that

said, the best way to use ?LM?/)TCA is to compare it to that of other similar companies.

F,n'amenta" A na"#i#

F,n'amenta" ana"#i#of a business involves analyzing its financial statements and health,

its management and competitive advantages, and its competitors and markets. &hen applied to

futures and forex, it focuses on the overall state of the economy, interest rates, production,

earnings, and management. &hen analyzing a stock, futures contract, or currency using

fundamental analysis there are two basic approaches one can use bottom up analysis and top down

analysis. The term is used to distinguish such analysis from other types of investment analysis,

such as !uantitative analysis and technical analysis.

*undamental analysis is performed on historical and present data, but with the goal of making

financial forecasts. There are several possible ob#ectives

to conduct a company stock valuation and predict its probable price evolution,

to make a pro#ection on its business performance,

to evaluate its management and make internal business decisions,

to calculate its credit risk.

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Chapter

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IN! CAPITA) &ANA!E&ENT

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&orking "apital 0anagement refers to investment in working capital @current assets

current liabilities=.The finance manager has to properly manage current assets such as cash,

inventory and account receivables. (e has to ensure trade off between li!uidity and profitability.

Ade!uate level of current assets is necessary to maintain the re!uired level of li!uiditu of funds.

$n the other hand, if the funds are idle the profitability may be low. "urrent assets are to be fully

and efficiently utilized to attain these twin ob#ectives i.e. 4i!uidity and profitability.


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term debt and upcoming operational expenses. )n so doing, firm value is enhanced when, and if,

the return on capital exceeds the cost of capital

Deci#ion criteria

&orking capital is the amount of capital which is readily available to an organization. That

is, working capital is the difference between resources in cash or readily convertible into cash

@"urrent Assets=, and cash re!uirements @"urrent 4iabilities=. As a result, the decisions relating to

working capital are always current, i.e. short term, decisions.

)n addition to time horizon, working capital decisions differ from capital investment

decisions in terms of discounting and profitability considerations they are also reversible to some

extent.

&orking capital management decisions are therefore not taken on the same basis as long

term decisions, and working capital management applies different criteria in decision making the

main considerations are @1= cash flow M li!uidity and @-= profitability M return on capital @of which

cash flow is probably the more important=.

The most widely used measure of cash flow is the net operating cycle, or cash conversion

cycle. This represents the time difference between cash payment for raw materials and cash

collection for sales. The cash conversion cycle indicates the firm's ability to convert its

resources into cash. /ecause this number effectively corresponds to the time that the firm's

cash is tied up in operations and unavailable for other activities, management generally

aims at a low net count. Another measure is gross operating cycle which is the same as net

operating cycle except that it does not take into account the creditors deferral period.

The most useful measure of profitability is eturn on capital @$"=. The result is shown as

a percentage, determined by dividing relevant income for the 1- months by capital

employed eturn on e!uity @$?= shows this result for the firm's shareholders. As above,

firm value is enhanced when, and if, the return on capital, exceeds the cost of capital. $"

measures are therefore useful as a management tool, in that they link shortterm policy with

longterm decision making.

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&ana+ement of orin+ capita"

Huided by the above criteria, management will use a combination of policies and

techni!ues for the management of working capital. These policies aim at managing the currentassets @generally cash and cash e!uivalents, inventories and debtors= and the short term financing,

such that cash flows and returns are acceptable.

Ca#h mana+ement. )dentify the cash balance which allows for the business to meet day to

day expenses, but reduces cash holding costs.

Inentor mana+ement. )dentify the level of inventory which allows for uninterrupted

production but reduces the investment in raw materials and minimizes reordering costs

and hence increases cash flow

De0tor# mana+ement. )dentify the appropriate credit policy, i.e. credit terms which will

attract customers, such that any impact on cash flows and the cash conversion cycle will be

offset by increased revenue and hence eturn on "apital @or vice versa= see Ciscounts and

allowances.

%hort term financin+. )dentify the appropriate source of financing, given the cash

conversion cycle the inventory is ideally financed by credit granted by the supplier

however, it may be necessary to utilize a bank loan @or overdraft=, or to convert debtors to

cash through factoring.

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Chapter?

FINANCIN! DECI%ION

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The decision to finance the operations of the business enterprise, has to be made by the

finance manager. This decision is referred to as financingmix or capital structure or leverage.

"apital structure refers to the proportion of debt@fixed interest sources of financing= and e!uity

capital @variable dividend securitites=. The financing decision of a firm relates to the choice of

proportion of these sources to finance the investment re!uirements.

Achieving the goals of corporate finance re!uires that any corporate investment be financed

appropriately. As above, since both hurdle rate and cash flows will be affected, the financing mix

can impact the valuation. 0anagement must therefore identify the optimal mix of financingQthe

capital structures that result in maximum value.

The sources of financing will, generically, comprise some combination of debt and e!uity

financing. *inancing a pro#ect through debt results in a liability or obligation that must be serviced

thus entailing cash flow implications independent of the pro#ect's degree of success. ?!uity

financing is less risky with respect to cash flow commitments, but results in a dilution of

ownership, control and earnings. The cost of e!uity is also typically higher than the cost of debt

and so e!uity financing may result in an increased hurdle rate which may offset any reduction in

cash flow risk.

0anagement must also attempt to match the financing mix to the asset being financed as

closely as possible, in terms of both timing and cash flows.

$ne of the main theories of how firms make their financing decisions suggests that firms

avoid external financing while they have internal financing available and avoid new e!uity

financing while they can engage in new debt financing at reasonably low interest rates. Another

ma#or theory is the Trade$ff Theory in which firms are assumed to tradeoff the tax benefits of

debt with the bankruptcy costs of debt when making their decisions. An emerging area in finance

theory is rightfinancing whereby investment banks and corporations can enhance investment

return and company value over time by determining the right investment ob#ectives, policy

framework, institutional structure, source of financing @debt or e!uity= and expenditure framework

within a given economy and under given market conditions. $ne last theory about this decision is

the 0arket timing hypothesis which states that firms look for the cheaper type of financing

regardless of their current levels of internal resources, debt and e!uity.

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Chapter@

DI9IDEND PO)IC DECI%ION

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The third ma#or decision of financial management is the decision relating to the dividend

policy. Two alternatives are available in dealing with the profits of the firm they can be distributed

to the shareholders in the form of dividends or they can be retained in the business itself. The

decision as to whic hsystem should be followed forms the basis for dividend decision. *urther the

preference of the shareholders and the investment opportunities available to the firm influence the

dividend policy of the firm.

The Dii'en' Deci#ion, in "orporate finance, is a decision made by the directors of a company. )t

relates to the amount and timing of any cash payments made to the company's stockholders. The

decision is an important one for the firm as it may influence its capital structure and stock price. )n

addition, the decision may determine the amount of taxation that stockholders pay.

There are three main factors that may influence a firm's dividend decision

*reecash flow

Cividend clienteles

&hether to issue dividends, and what amount, is calculated mainly on the basis of the

company's inappropriate profit and its earning prospects for the coming year. )f there are no L

positive opportunities, i.e. pro#ects where returns exceed the hurdle rate, then management must

return excess cash to investors. These free cash flows comprise cash remaining after all business

expenses have been met.

This is the general case, however there are exceptions. *or example, investors in a Hrowth

stock, expect that the company will, almost by definition, retain earnings so as to fund growth

internally. )n other cases, even though an opportunity is currently L negative, management may

consider investment flexibility M potential payoffs and decide to retain cash flows.

0anagement must also decide on the form of the dividend distribution, generally as cash

dividends or via a share buyback. Larious factors may be taken into consideration where

shareholders must pay tax on dividends, firms may elect to retain earnings or to perform a stock

buyback, in both cases increasing the value of shares outstanding. Alternatively, some companies

will pay %dividends% from stock rather than in cash.

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Chapter B

%U$%IDIAR FUNCTION

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Apart from the above primary functions, a finance manager also undertakes the following

subsidiary function

1. Ca#h mana+ement The finance manager has to ensure that all sections i.e branches,

factories, departments and units of the organisation are supplied with ade!uate funds.

+ections whic hhave excess of funds have to contribute to the central pool for the use in

other sections ehich need funds. An ade!uate supply of cash at all points of time is

absolutely essential for the smooth flow of business operations.

-. Ea",atin+ financia" performance 0anagement control systems are often based upon

financial analysis. $ne prominent example is the $) @return on investment= system of

divisional control . A finance manager has to constantly review the financial performance

of the various units of the organisation.

3. Financia" ne+otiation# A ma#or portion of the time of the finance manager is utilized in

carrying out negotiations with the financial institutions, banks and public depositors. (e

has to furnish a lot of information to these institutions and persons and has to ensure that

raising of funds is within the statues like companies Act, etc. egotiations for outside

fnancing re!uire specialised skills.

6. Ieeping touch with stock exchange !uotations and behaviour of share prices. This involvesanalyzing ma#or trends in the stock market and #udging their impact on the prices of the

shares of the company.

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Chapter 1

FINANCIA) RI%> &ANA!E&ENT

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Financia" ri# mana+ement

isk management is the process of measuring risk and then developing and implementing

strategies to manage that risk. *inancial risk management focuses on risks that can be managed or

hedged using traded financial instruments typically changes in commodity prices, interest rates,

foreign exchange rates and stock prices. *inancial risk management will also play an important

role in cash management.

This area is related to corporate finance in two ways. *irstly, firm exposure to business risk

is a direct result of previous )nvestment and *inancing decisions. +econdly, both disciplines share

the goal of enhancing, or preserving, firm value. All large corporations have risk management

teams, and small firms practice informal, if not formal, risk management. There is a fundamental

debate on the value of isk 0anagement and shareholder value that !uestions a shareholder's

desire to optimize risk versus taking exp

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