1 corporate finance introduction

7/28/2019 1 Corporate Finance Introduction

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Corporate Finance - Introduction

Some Recent Business News

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India Nippon shareholders approve 7:10 bonus issue

Reliance Industries declares 150% dividend


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What is Corporate Finance about?

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Financial Decisions made by Corporations.

Three broad areas of financial decision making:

Investment Decisions

Financing Decisions

Dividend Decisions

Investment Decisions Firms have scarce resources which must be allocated among

competing uses.

Resources may be used for :

While taking Investment Decisions, we measure the Benefits(Returns) from the proposed Investment projects and comparewith Minimum Acceptable Hurdle rate to decide acceptance orrejection.

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Revenue Generating Introduction of a New Product Line

Cost Saving Projects Replacing old equipment with new

equipment

Strategic Decisions Which markets to enter Acquisition of other companies


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Investment Decisions (Contd.)

Minimum Acceptable Hurdle rate should be set so as to reflect:

Risk profile of the project (Higher hurdle rate for riskierprojects), and

Financing mix of the project

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9%

Less Risky More Risky

Projects with different Risk Profiles

16%

Investment Decisions (Contd.)

Investment Decisions are concerned with:

Establish Minimum Acceptable Hurdle Rate appropriate to

the investment proposal

Measuring Benefits (Returns) from the investment proposals,

Comparing benefits with minimum acceptable hurdle rate in

order to accept (or reject) the project.

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Invest in assets that earn a return greater than the

minimum acceptable hurdle rate


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Financing Decisions How should firms raise Financial resources required?

Businesses can broadly raise funds either through:

Owners Fund (Equity)

Borrowed Funds (Debt)

Financing Decision involves :

Finding a mix between Debt & Equity (Capital Structure), and

Type of Instrument

Long Term Vs. Short Term,

Fixed Rate Vs. Floating Rate,

Straight Vs. Convertible,

Domestic Markets Vs. International Markets.

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Choose the financing mix that maximizes the value of the

projects taken and matches the assets being financed.

Dividend Decisions Dividend is any reward by the firm to its shareholders.

Firms have to decide about what to do with the surplus generated

by the firm i.e.:

Reinvest into the business (Plough back) , or

Distribute as Dividend (reward the shareholders)

Amount of Dividend (Dividend Payout)

Stability of Dividend (Trend)

Form

Cash

Share Repurchase

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Dividend Decisions (Contd.)

Trade-off between retention & distribution is to be made.

When the firm is small and has attractive investmentopportunities, profits are retained and reinvested.

At a later stage in a firms life cycle when the funds generated

is greater than the investment requirements, that the firm has

to decide about ways of returning excess cash to the owners.

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If there are not enough investments that earn the

hurdle rate, return the cash to the owners.

Objective of the Firm

How do we judge the correctness of these decisions?

Any decision (Investment, Financing, or Dividend) that increases

the value is considered good and which reduces the value is

considered as poor.

Thus the basic objective of Financial Management is:

Value of the firm is, therefore, dependent on Firms Investment,

Financing & Dividend Decisions.

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to maximise the value of the firm


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Linking Financial Decisions with Firms Objective

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Hurdle Rateshould reflect

the riskiness ofinvestment and

the mix of Debt& Equity used

to fund it.

Returnsshould reflect

the

magnitudeandtiming of

cash flows

along with the

side effects

The right kindof debt that

matches the

tenure ofassets

financed

How muchcash you can

return

depends upon

current &potential

investmentopportunities

How youchoose to

return cash to

the owners will

dependwhether they

prefer dividendsor buybacks

Optimal Mixof Debt &

Equity

maximizes thefirms value

Investment Decision

Invest in assets that earn a return

greater than the minimum

acceptable hurdle rate

Financing Decision

Choose the financing mix that

maximizes the value of theprojects taken , and matches the

assets being financed.

Dividend Decision

If there are not enough

investments that earn the hurdlerate, return the cash to the

owners.

Maximize the value of the Firm

What is Firm Value?

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Debt holders can

protect

themselves

contractually.

Stock price is anobservable & real

measure of

stockholder

wealth.

Maximization of Value of the Firm

Maximization ofShareholders Value

Maximization of StockPrice of the Firm


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Corporate Form of Organisation

Level-I Management

Level-II Management

Level-V Management

Main Features

Separation of Ownership

& Management

Legal Person

Limited Liability of

shareholders

Shareholders are distinct

from the company

:

Owners (Shareholders)

Agents (Top Management)

Agency Problem

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Shareholders appoint agents (Management) to conduct thebusiness of the company.

As agents, the management should take decisions to maximizeshareholders wealth.

Shareholders delegate decision-making authority toManagement hoping that agents will act in shareholders bestinterests.

However, in actual practice, the objectives of the managementmay differ from those of the shareholders.

Managers may take decisions in their own interest rather thanin the interest of the shareholders.

This problem of management (agents) not acting in theinterests of their principals (shareholders) is called the AgencyProblem.


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Why Agency Problem?

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Divergence of ownership and control: Those who own the

company (shareholders) do not manage it, but appoint

agents (management) to run the company on their behalf.

Difference in Objectives of Management & Shareholders:

Managers are likely to maximize their own wealth rather

than the wealth of shareholders.

Asymmetry of information: Management, as a consequence

of running the company on a day-to-day basis, has access to

inside information while shareholders receive annual reports

which may themselves be manipulated by the management.

Resolving Agency Problem

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Jensen & Meckling (1976) suggested methods to deal with agencyproblem which encourage goal congruence betweenshareholders & managers.

Monitor the actions of the Management: Audit of Financialstatements by independent Auditors; Shadowing of SeniorManagers; Employment of External Analysts.

Incentives to Managers: Stock options; Bonus ; Perquisites &Punishments

Both methods involve costs- an inevitable result of theseparation of ownership and control of a company.

Lower the control, lower chances of managers behaviour beingconsistent with the shareholders, higher the Agency costs.

Agency costs-(a) when managers do not attempt to maximizesfirm value , and (b) shareholders incur cost to monitor managers.


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Financial System-An Overview

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Financial System : An Overview

In any economy there are two types of economic units:

Surplus Units, and

Deficit Units.

Surplus Units: Units whose Consumption and plannedInvestments are less than their Incomes. (C+I < Y)

Such units have surplus savings and look for avenues toinvest their surplus savings.

Deficit Units: Units whose Consumption and plannedInvestments are more than their Incomes. (C+I > Y)

Such units have negative savings and need to borrow funds.

A system through which the savings of Surplus Units aretransferred to Deficit Units is called the Financial System.


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Financial System

Suppliers

of Funds

Users

of Funds

Provide Funds Receive Funds

Issue SecuritiesBuy Securities

Financial System

Financial Markets

Financial Institutions

Financial Instruments

& Services

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Financial System (Contd.)

Financial System consists of the following three components,which facilitate the transfer of funds :

Financial Markets

Provides a mechanism through which funds flow fromsurplus units to deficit units

Centres that provide the facility of buying & selling offinancial claims

Financial Institutions

Organisations which channelise funds from Surplus Units toDeficit Units thereby act as mobilisers & depositories ofsavings, and creators of credit.

E.g.:Commercial Banks, Insurance Cos. Mutual Funds,Developmental Financial Institutions, NBFCs

Financial Instruments

Claims of the lenders of funds over the funds lent to theborrowers.


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Financial System - Defined

Financial system refers to a set of complex, inter-linked markets, institutions, instruments and

services in the economy which facilitate the

transfer and allocation of funds efficiently and

effectively.

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Classification of Financial Markets

Maturity of Claim Money Market

Capital Market

Seasoning of Claim Primary Market

Secondary Market

Nature of Claim Debt Market

Equity Market

Timing of Delivery Spot Market

Forward/Futures Market

Organisational

Structure

Exchange Traded Market

Over-the-Counter Market


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Financial Markets Capital & Money Markets

Money Markets:

Deal (trade) in debt securities of maturities of one year andless.

Economic entities with excess funds for short durations lend

(buy short-term instruments) to economic entities which face

shortage of funds for short duration (sell short-term

instruments).

Money Market Instruments: Treasury Bills (T-Bills)

Call/Notice Money

Repurchase Agreements (Repos)

Commercial Bills of Exchange

Commercial Papers (CPs) Certificates of Deposit (CDs)

No physical location, but an Over-the-Counter (OTC) Market;

trades are conducted via telephones, wire transfers, and

Computer trading.

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Financial Markets Capital & Money Markets

Capital Markets

Deal in long-term securities (equity and debt) havingmaturities of more than one year.

Capital Market instruments include:

Equity Shares

Bonds/Debentures issued by Corporates, Public SectorUndertakings, Governments,

Units of closed ended schemes of Mutual Funds


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Financial Markets - Primary & Secondary Markets

Primary Markets:

Markets in which Users of funds raise resources through issueof new financial instruments.

Also called New Issues Market.

Fund users have new projects but do not have sufficient funds

internally, hence they issue new securities in the Primary

Market to raise additional funds.

Intermediary between the user (Issuer) and the suppliers

(Investors) which helps raise funds from the Primary Market

Investment Banker (Merchant Banker).

Funds may be raised thru Initial Public Offering (IPOs); Private

Placements; Secondary Public Offerings/Follow-on Public

Issue(FPO); Rights Issue (Seasoned Offerings).

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Financial Markets - Primary & Secondary Markets

Secondary Markets:

Once the financial instruments have been issued in thePrimary Market, they are traded (bought and sold) in theSecondary Market.

Deals in existing financial claims (securities).

Provides a centralised marketplace for buyers and sellers totrade efficiently (save on search costs).

Trade takes place through a stock/securities broker.

E.g.: National Stock Exchange (NSE); Bombay Stock Exchange(BSE); NYSE, LSE.

Advantages:

Investors can trade at market values (an indicator of companys performance)

An active secondary market boosts the primary market.


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Functions of Financial System

Payment System: Banks play a pivotal role in the smooth

functioning of the payments systems.

Pooling of Funds: Businesses requires huge investments beyond

the means of any one individual. Through the Financial System,

the savings are mobilized and used to finance business

enterprises.

Transfer of Resources: A well-developed Financial System helps in

the efficient allocation of resources into the most productive use

in the business sector.

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Functions of Financial System (Contd.)

Risk Management: Financial System provides various

instruments for pooling, pricing & sharing of risks by way of:

Hedging (Forward Cover);

Diversification (Mutual Funds- pooling & sub-division of risks)

Insurance (the Insured retains the economic benefit of

ownership while laying off the possible losses).

Price Information for Decentralised Decision-making: Interest

rates and security prices help in Investment decisions by each

individual unit Surplus Units would want to the Highest returns

while the Deficit Units would want the Lowest Costs.


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Indian Financial System

An Overview

Regulatory Authorities Financial Markets

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Ministry ofFinance

(GOI)

Securities &ExchangeBoard of

India

InsuranceRegulatory &Development

Authority

Pension FundRegulatory &Development

Authority

Reserve Bankof India

Forward

Markets

Commission


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Reserve Bank of India (RBI)

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Developmental

Financial

Institutions (DFIs)

All India:

-IFCI

-IIBI

-TFCI-IDFC

-PFC

-IRFC

Commercial

Banks

Public Sector:

-SBI Group

-Nationalised

Private Sector:-Indian

-Foreign

-NABARD

-EXIM Bank

-SIDBI

-NHB

Other

Apex FIs NBFCs

State Level:

-SFCs

-SIDCs

RRBs/

Co-op. Banks

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Central monetary authority in India

Set up on April 1, 1935; became state-owned in 1949

Main Functions:

Note Issuing Authority

Banker to the Government

Bankers Bank(Lender of last resort)

Regulator of Money & Credit

Supervising Authority Exchange Control Authority

Promotional Activities

Governor:

Dr.D.Subbarao

www.rbi.org.in


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Other Apex (Refinancing) & Regulatory FIs

NABARD 1982 National Bank for Agriculture & Rural Development

-Regulatory & Refinancing authority for RRBs.

EXIM Bank 1982 Export Import Bank of India

-Refinancing authority for Exports/Imports.

SIDBI 1988 Small Industries Development Bank of India

-Refinancing authority for SMEs.

NHB 1988 National Housing Bank

-Regulatory & Refinancing authority for Housing Finance

Companies

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Specialised FIs

IIBI 1997 Industrial Investment Bank of India

formerly IRBI: Industrial Reconstruction Bank of

India(1971)

TFCI 1989 Tourism Finance Corporation of India

PFC 1990 Power Finance Corporation Ltd

IRFC 1986 Indian Railway Finance Corporation Ltd

IDFC 1997 Infrastructure Development Finance Corporation


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Securities & Exchange Board of India (SEBI)

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Securities & Exchange

Board of India (SEBI)

Mutual Funds

Public Sector:

-UTI, SBI &

Others

Private Sector:

-Indian

-Foreign

-Stock Exchanges

-Merchant Bankers

-Underwriters

-Stock Brokers

-Custodians

-Depositories/DP-FIIs

-Investors

Venture

Capital

Funds

Capital MarketsForeign

Institutional

Investors

(FIIs)

Credit

Rating

Agencies

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Securities & Exchange Board of India (SEBI)

Regulatory Authority to oversee &

regulate the functioning of the Capital

Markets in India.

Set up in 1988 through an

administrative order but became a

statutory organization in 1992.

Objective : to protect the interest of the

investors & promote the development,

regulate the securities market.

Chairman:

Mr. UK Sinha

www.sebi.gov.in


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Insurance Regulatory & Development Authority (IRDA)

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Insurance Regulatory

& Development Authority

(IRDA)

Life Insurance

Public Sector

-LIC

Private Sector

Non-Life Insurance

Public Sector

-GIC

Private Sector

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Insurance Regulatory & Development Authority (IRDA)

Regulatory authority to oversee &

regulate the functioning of the

Insurance sector in India.

Set up in 1999.

Objective : To protect the interests of

the policyholders, to regulate, promote

and ensure orderly growth of the

insurance industry and for matters

connected therewith or incidental

thereto.

Chairman

Mr.J. Hari Narayan

www.irda.gov.in


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Pension Fund Regulatory

& Development Authority (PFRDA)

Established by the Government of India

on 23rd August 2003

Objective: to promote old age income

security by establishing, developing and

regulating pension funds, to protect the

interests of subscribers to schemes of

pension funds and for matters connected

therewith or incidental thereto

Chairman : Mr. Yogesh Agarwal

www.pfrda.gov.in

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Forward Markets Commission (FMC)

FMC is a regulatory authority for commodityfutures market in India.

Works under the administrative control ofMinistryof Consumer Affairs, Food and Public Distribution,Government of India

Chairman: Mr Ramesh Abhishek

www.fmc.gov.in

Regional Exchanges

1 BikanerCommodity Exchange Ltd.,Bikaner

2 Bombay Commodity Exchange Ltd., Vashi

3 Chamber Of Commerce,Hapur

4 Central India Commercial Exchange Ltd.,Gwalior

5 Cotton Association of India , Mumbai

6 East India Jute & Hessian Exchange Ltd., Kolkata

7 First Commodities Exchange of India Ltd., Kochi

8 Haryana Commodities Ltd.,Sirsa9 IndiaPepper & Spice Trade Association., Kochi

10 MeerutAgro Commodities Exchange Co. Ltd., Meerut

11 National Board of Trade, Indore

12 Rajkot Commodity Exchange Ltd.,Rajkot

13 Rajdhani Oils & Oilseeds Exchange Ltd., Delhi

14 SurendranagarCotton Oil & Oilseeds Association Ltd.,

Surendranagar

15 Spices and Oilseeds Exchange Ltd. Sangli

16 VijayBeopar Chamber Ltd.,Muzaffarnagar

National Exchanges

1 MultiCommodity Exchange of India Ltd. (MCX)

2 National Commodity & Derivatives Exchange Ltd. (NCDEX)

3 National Multi-Commodity Exchange of India Ltd. (NMCE)

4 Indian Commodity ExchangeLtd. (ICEX)

5 Ace Commodities & DerivativesExchange Ltd.


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Role of a Finance Manager

Tangible Assets:Plant & Equipments

Building

Intangible Assets:Patents

Financial Markets Investors holding

Financial assets

Finance

Manager

Funds raised

by selling

Financial

assets

Funds raised

invested in

firms Real

assets

Funds

generated

by firms

operations

Funds

returned to

investors

Funds

reinvested

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