MBA608 2_Review of _Corporate Finance-converted-converted

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MASTER OF BUSINESS ADMINISTRATION SEMESTER-II CORPORATE FINANCE MBA608 1 CU IDOL SELF LEARNING MATERIAL (SLM)

CHANDIGARH UNIVERSITY Institute of Distance and Online Learning Course Development Committee Prof. (Dr.) R.S.Bawa Pro Chancellor, Chandigarh University, Gharuan, Punjab Advisors Prof. (Dr.) Bharat Bhushan, Director – IGNOU Prof. (Dr.) Majulika Srivastava, Director – CIQA, IGNOU Programme Coordinators & Editing Team Master of Business Administration (MBA) Bachelor of Business Administration (BBA) Coordinator – Dr. Rupali Arora Coordinator – Dr. Simran Jewandah Master of Computer Applications (MCA) Bachelor of Computer Applications (BCA) Coordinator – Dr. Raju Kumar Coordinator – Dr. Manisha Malhotra Master of Commerce (M.Com.) Bachelor of Commerce (B.Com.) Coordinator – Dr. Aman Jindal Coordinator – Dr. Minakshi Garg Master of Arts (Psychology) Bachelor of Science (Travel &Tourism Management) Coordinator – Dr. Samerjeet Kaur Coordinator – Dr. Shikha Sharma Master of Arts (English) Bachelor of Arts (General) Coordinator – Dr. Ashita Chadha Coordinator – Ms. Neeraj Gohlan Academic and Administrative Management Prof. (Dr.) R. M. Bhagat Prof. (Dr.) S.S. Sehgal Executive Director – Sciences Registrar Prof. (Dr.) Manaswini Acharya Prof. (Dr.) Gurpreet Singh Executive Director – Liberal Arts Director – IDOL © No part of this publication should be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording and/or otherwise without the prior written permission of the authors and the publisher. SLM SPECIALLY PREPARED FOR CU IDOL STUDENTS Printed and Published by: TeamLease Edtech Limited www.teamleaseedtech.com CONTACT NO:- 01133002345 For: CHANDIGARH UNIVERSITY 2 Institute of Distance and Online Learning CU IDOL SELF LEARNING MATERIAL (SLM)

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First Published in 2020 All rights reserved. No Part of this book may be reproduced or transmitted, in any form or by any means, without permission in writing from Chandigarh University. Any person who does any unauthorized act in relation to this book may be liable to criminal prosecution and civil claims for damages. This book is meant for educational and learning purpose. The authors of the book has/have taken all reasonable care to ensure that the contents of the book do not violate any existing copyright or other intellectual property rights of any person in any manner whatsoever. In the even the Authors has/ have been unable to track any source and if any copyright has been inadvertently infringed, please notify the publisher in writing for corrective action. 5 CU IDOL SELF LEARNING MATERIAL (SLM)

CONTENT Unit -1 Corporate Finance Basic-I Unit -2 Corporate Finance Basic-II Unit -3 Financial Analysis, Profit Planning and Control Unit -4 Capital Budgeting Unit -5 Current Assets Management Unit -6 Financial Decisions- I Unit -7 Financial Decisions- II Unit -8 Dividend Decision Unit -9 Risk Management Unit -10 Financial Risk Management 6 CU IDOL SELF LEARNING MATERIAL (SLM)

UNIT 1 CORPORATE FINANCE BASIC-I 7 Structure Learning objectives Introduction Meaning of Corporate Finance Definition by Malcolm Evans Nature and scope of Corporate Finance Nature of Corporate Finance Scope of Corporate Finance Objectives and Functions of corporate finance Functions of Corporate Finance Objective of Corporate Finance The role of financial manager The Firm in Corporate Finance The Objective of the Firm Profit maximization Wealth maximization Time value of Money Understanding the Time Value of Money Time Value of Money Formula Summary Keywords Learning activity Unit end questions References LEARNING OBJECTIVES After studying this unit, you will be able to: • Explain about meaning, nature and scope of Corporate finance, CU IDOL SELF LEARNING MATERIAL (SLM)

• State about objectives and functions of Corporate finance, • List about the role of financial manager and the firm in corporate finance • Discuss the concept of time value money INTRODUCTION Every decision made in a business has financial implications, and any decision that involves the use of money is a corporate financial decision. Defined broadly, everything that a business does fits under the rubric of corporate finance. It is, in fact, unfortunate that we even call the subject corporate finance, because it suggests to many observers a focus on how large corporations make financial decisions and seems to exclude small and private businesses from its purview. A more appropriate title for this discipline would be Business Finance, because the basic principles remain the same, whether one looks at large, publicly traded firms or small, privately run businesses. All businesses have to invest their resources wisely, find the right kind and mix of financing to fund these investments, and return cash to the owners if there are not enough good investments. In this introduction, we will lay the foundation for this discussion by listing the three fundamental principles that underlie corporate finance—the investment, financing, and dividend principles—and the objective of firm value maximization that is at the heart of corporate financial theory. Corporate finance deals with the capital structure of a corporation, including its funding and the actions that management takes to increase the value of the company. Corporate finance also includes the tools and analysis utilized to prioritize and distribute financial resources. The ultimate purpose of corporate finance is to maximize the value of a business through planning and implementation of resources, while balancing risk and profitability. MEANING OF CORPORATE FINANCE Corporate finance is one of the most important subjects in the financial domain. It is deep rooted in our daily lives. All of us work in big or small corporations. These corporations raise capital and then deploy this capital for productive purposes. The financial calculations that go behind raising and successfully deploying capital is what forms the basis of corporate finance. Here is a short introduction: Separation of Ownership and Management The basis of corporate finance is the separation of ownership and management. Now, the firm is not restricted by capital which needs to be provided by an individual owner only. The 8 CU IDOL SELF LEARNING MATERIAL (SLM)

general public needs avenues for investing their excess savings. They are not content with putting all their money in risk free bank accounts. They wish to take a risk with some of their money. It is because of this reason that capital markets have emerged. They serve the dual need of providing corporations with access to source of financing while at the same time they provide the general public with a plethora of choices for investment. Liaison between Firms and Capital Markets The corporate finance domain is like a liaison between the firm and the capital markets. The purpose of the financial manager and other professionals in the corporate finance domain is twofold. Firstly, they need to ensure that the firm has adequate finances and that they are using the right sources of funds that have the minimum costs. Secondly, they have to ensure that the firm is putting the funds so raised to good use and generating maximum return for its owners. These two decisions are the basis of corporate finance and have been listed in greater detail below: Financing Decision As stated above the firm now has access to capital markets to fulfill its financing needs. However, the firm faces multiple choices when it comes to financing. The firm can firstly choose whether it wants to raise equity capital or debt capital. Even within the equity and debt capital the firm faces multiple choices. They can opt for a bank loan, corporate loans, public fixed deposits, debentures and amongst a wide variety of options to raise funds. With financial innovation and securitization, the range of instruments that the firm can use to raise capital has become very large. The job of a financial manager therefore is to ensure that the firm is well capitalized i.e. they have the right amount of capital and that the firm has the right capital structure i.e. they have the right mix of debt and equity and other financial instruments. Investment Decision Once the firm has gained access to capital, the financial manager faces the next big decision. This decision is to deploy the funds in a manner that it yields the maximum returns for its shareholders. For this decision, the firm must be aware of its cost of capital. Once they know their cost of capital, they can deploy their funds in a way that the returns that accrue are more than the cost of capital which the company has to pay. Finding such investments and deploying the funds successfully is the investing decision. It is also known as capital budgeting and is an integral part of corporate finance. 9 CU IDOL SELF LEARNING MATERIAL (SLM)

Capital budgeting has a theoretical assumption that the firm has access tounlimited financing as long as they have feasible projects. A variation of this decision is capital rationing. Here the assumption is that the firm has limited funds and must choose amongst competing projects even though all of them may be financially viable. The firm thus has to select only those projects that will provide the best return in the long term. Financing and investing decisions are like two sides of the same coin. The firm must raise finances only when it has suitable avenues to deploy them. The domain of corporate finance has various tools and techniques which allow managers to evaluate financing and investing decisions. It is thus essential for the financial wellbeing of a firm. 1.2.1 Definition by Malcolm Evans “Corporate Finance is the process of matching capital needs to the operations of a business.” It differs from accounting, which is the process of the historical recording of the activities of a business from a monetized point of view. Capital is money invested in a company to bring it into existence and to grow and sustain it. This differs from working capital which is money to underpin and sustain trade - the purchase of raw materials; the funding of stock; the funding of the credit required between production and the realization of profits from sales. Corporate Finance can begin with the tiniest round of Family and Friends money put into a nascent company to fund its very first steps into the commercial world. At the other end of the spectrum it is multi-layers of corporate debt within vast international corporations. Corporate Finance essentially revolves around two types of capital: equity and debt. Equity is shareholders' investment in a business which carries rights of ownership. Equity tends to sit within a company long-term, in the hope of creating a return on investment. This can come either through dividends, which are payments, usually on an annual basis, related to one's percentage of share ownership. Dividends only tend to accrue within very large, long-established corporations which are already carrying sufficient capital to more than adequately fund their plans. Younger, growing and less-profitable operations tend to be voracious consumers of all the capital they can access and thus do not tend to create surpluses from which dividends may be paid. In the case of younger and growing businesses, equity is often continually sought. In very young companies, the main sources of investment are often private individuals. After the already mentioned family and friends, high net worth individuals and experienced sector figures often invest in promising younger companies. These are the pre-start up and seed phases. 10 CU IDOL SELF LEARNING MATERIAL (SLM)

At the next stage, when there is at least some sense of a cohesive business, the main investors tend to be venture capital funds, which specialize in taking promising earlier stage companies through quick growth to a hopefully highly profitable sale, or a public offering of shares. The other main category of corporate finance related investment comes via debt. Many companies seek to avoid diluting their ownership through ongoing equity offerings and decide that they can create a higher rate of return from loans to their companies than these loans cost to service by way of interest payments. This process of gearing-up the equity and trade aspects of a business via debt is generally referred to as leverage. Whilst the risk of raising equity is that the original creators may become so diluted that they ultimately obtain precious little return for their efforts and success, the main risk of debt is a corporate one - the company must be careful that it does not become swamped and thus incapable of making its debt repayments. Corporate Finance is ultimately a juggling act. It must successfully balance ownership aspirations, potential, risk and returns, optimally considering an accommodation ofthe interests of both internal and external shareholders. NATURE AND SCOPE OF CORPORATE FINANCE Corporate finance as managing financial activities involved in running a corporation. It involves managing the required finances and its sources. The basic role of corporate finance is to maximize the shareholders’ value in both short and long-term. Corporate finance understands the financial problems of the organization beforehand and prevents them. Capital investments become an important part of corporate financial decisions such as, if dividends should be offered to shareholders or not, if the proposed investment option should be rejected or accepted, managing short-term investment and liabilities. 11 CU IDOL SELF LEARNING MATERIAL (SLM)

Figure 1.1 Corporate finance is different from business finance, while business finance refers to finance to all types of business such as partnership firms, joint stock companies, etc.., corporate finance includes, planning, raising, investing and monitoring of finance in order to achieve the financial goals of the organization. Nature of Corporate Finance Financing as well as investing choices are always termed as two sides of a same coin. That the firm must increase funds only when this has suitable ways in order to invest them. Features of corporate finance and characteristics of corporate finance offers different technology and also strategies what allow managers to evaluate financing and also investing choices. It’s therefore important for us to understand nature of corporate finance for well- being of a company. Here are some of the guidelines below discuss the characteristics, features and nature of corporate finance. 1. Financial Planning Corporate finance is a financial planning for a company. The characteristics of corporate finance includes preparation, raising funds, investing plus tracking each finance of organization. At short, it offers all financial aspects for the firm. This research, techniques and strategies are defined by each financial department lead through that finance supervisor. 2. Fund Raising An important feature of corporate finance is to raise funds for the company. Finance can be accumulated through shares, bank loans, debentures, bonds, etc. It’s most hard for newer service providers in order to collect finance as their investors do not have confident and vision towards new businesses. Nevertheless, it is quite easy for respected companies to gather finance considering goodwill, reputation in the market. 3. Goal Oriented One of the features of corporate finance is goal oriented. That means, it is important to regularly achieve each objectives associated with the company. The main goal of corporate finance are to maximize profits, giving good dividends to shareholders, as well as creating fund reserves for future expansion activities and so forth. 4. Investing Objective The nature of corporate finance notes for every company is to optimize investing needs for maximizing profits. Your finance can be used to quickly attain your investing objectives of the company. For example: it can be used to invest in machines or fixed assets. It’s can also be used for day to day company operations. That finance needs to be optimized forprofitably. 12 CU IDOL SELF LEARNING MATERIAL (SLM)

5. Finance Options There are two main options in the nature of corporate finance, i.e. working capital and fixed capital. Working-capital normally called as short-term finance. It’s mainly used to meet the short-term financial requirements for your business. For example: It can be used to cover your day-to-day expenses or operational cost of a company. Fixed capital normally called as long-term finance. It is always used to fulfil your very long-term financial requirements for your business. For example: buying a new manufacturing unit or fixed assets. 6. Legal Requirements There are definitely various legal criteria to corporate finance. The company need to take the appropriate permission, from the finance regulatory board of the country for the rising finance from public. For example: In India SEBI (Securities and Exchange Board of India) and SEC (Securities Exchange Commission) in United States also offers to follow all of the guidelines to a company. This features of corporate finance need to be taken utmost care when raising funds. 7. Managing and Controlling Financial management is excellent art considering that it needs individual skills, techniques, strategies as well as judgement. Nature of corporate finance requires ideal way for planning as well as control. Creating is needed in order to collect finance from the investors. It’s also necessary for investing their finance. Control is needed to find whether the finance are optimized and invested appropriately. If the finance is not been utilized properly then corrective steps should be taken and may also need to restructure the way finance is been utilized. 8. Business Management Corporate finance is plays a crucial and important role in business management. Characteristics of corporate finance is that it is a blood or life-line of a business. A nature of corporate finance is needed towards many business tasks. For example: It’s necessary for performing that business smoothly, its required for promoting business, for expansion, modernization, diversification, replacing old assets with new assets and more. Finance is also required for paying interest, dividend, taxes as well as for managing risks. 9. Dynamic in Nature A dynamic in nature of corporate finance is a distinct feature of finance. That it goes on changing based on the change in planning, environment, circumstances, times, project delays etc. Your finance supervisor must suggestions new and innovative ideas to utilize savings, invested money and corporate finance. He must be a creativity when doing his task. 10. Connecting with Other Divisions 13 CU IDOL SELF LEARNING MATERIAL (SLM)

A nature of corporate finance has a near relationship with different divisions within a company. For example: marketing and promotional department, manufacturing department, advertising division, accounting department, etc. That is mainly because all the divisions require finance to perform their operation constantly and smoothly. Scope of Corporate Finance 1. Estimating Financial Requirements A primary task associated with financial manager is to calculate long-term and short term financial requirements out of his business. To make certain you’ve got sufficient money, it is crucial to calculate the financial requirements before beginning a newer or expanding a current business. Firstly, figure out expenses, then divided into recurring expenses and one- time cost. According to the scope of corporate finance, management will create a current financial plan as well as forecast financial plan for future. For example: finance necessary for purchasing fixed assets, requirement of funds for working capital, etc. An essential factor to be considered when estimating financial requirements are repayment time, cost, liquidity, etc. 2. Deciding Capital Structure The capital structure looks how a firm finances their general operations, research and development by making use of various sources of funds. Financial debts appear in the form of bond issues or long-term bonds. While equity is classified as a preferred stock, retained earnings or common stock. Short-term debt including working capital fund as a scope of corporate finance for capital structure. Factors determining capital structure are trading on equity, flexibility of financial plan, degree of control, choice of investors, capital market condition, cost of financing, period of financing, sizes of a company, Stability of sales and more. 3. Choosing the Source of Finance One efficient financial control calls concerning various type of decision-making. A major significant move for any company should determine that sources of funds. Broadly, that the category of finance presented for any business is debt and also equity. Your proportion of funding will determine the capital structure of your company. When making that choice, you need to ensure that it fits your business conditions. An essential factor to be considered while selecting a source of finance are risk associated with source of finance, cost of finance, long term versus short term borrowing, dilution of control and management, flexibility in repayment, etc. 4. Selecting a Pattern of Investment Investment analysis actually broad term which encompasses a lot of different aspects to 14 CU IDOL SELF LEARNING MATERIAL (SLM)

investing. This include evaluating historical returns to make predictions about future returns, selecting a right type of investment vehicle which best suit for investors requirement or analyzing bonds / stocks for valuation and investor specificity. A factor used for selecting pattern of investments as a scope of corporate finance are choosing the right asset classes, balancing stocks and bonds, figuring out your timeline, projected profitability, favorable asset utilization, intrinsic value (rather than market value), conservative capital structure, earnings momentum and more. 5. Proper Cash Management Cash management relates to a diverse area of finance involving the collection, planning, handling and use of cash. This involves evaluating promote liquidity, assets / investments and cash flow. The objective of cash management should be to regulate the cash balances or cash liquidity rather than investing in inventories or fixed assets to avoid the risk of insolvency. Aspects checked being a role of cash management incorporate a company liquidity, short- term investing methods and techniques and cash balances. Factors to be considered as a scope of corporate finance when managing liquidity are right time to buys raw materials, when to transforms those raw materials into products, effective manufacturing process, when it sells products, when it pays their bills and more. 6. Implementing Financial Controls Financial controls are definitely processes, procedures and policies that are implemented in order to handle funds. They play a role in an organization’s financial goals to fulfilling commitments of corporate governance, due diligence and fiduciary duty. Financial controls are implemented with automation, accountability and responsibility. An essential factor in implementing financial controls are Accounting Standards, Financial Statements, Policies, Operating Metrics, Segregation of Duties, Reconciliation, Approvals, Responsibilities, Disbursement Policies, Audit Trail, Information Security and more. 7. Proper Usage of Surpluses Surplus is that levels of an amount or resource in which exceeds your section that is used. A surplus can be used towards explain countless excess assets plus income, profits, goods and capital. A surplus frequently occurs in financial budgets, even spending have always been below the earnings. Finance excess is associated with demand and supply needs. Your idea is to plan and make use of procedures to ensure this value creation works well and effectively. Therefore, things just like capital investment as well as investment banking are component concerning scope of corporate finance basics. Either the business is actually large or small; we probably have a committed person or even a division to oversee each financial strategy. They look after their corporate finance associated with company to ensure that business works effectively and appropriately. 15 CU IDOL SELF LEARNING MATERIAL (SLM)

OBJECTIVES AND FUNCTIONS OF CORPORATE FINANCE Corporate finance is the field of finance dealing with financial decisions that business enterprise 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 long-term and short-term decisions and techniques. Capital investment decisions are long-term choices about which projects receive investment, whether to finance that investment with equity or debt, and when or whether to pay dividends to shareholders. On the other hand, short term decisions deal with the short-term balance of .current assets and current liabilities; the focus here is on managing cash, inventories, and short-term borrowing and lending. Corporate finance covers every decision a firm makes that may affect its finances which can be grouped into five areas for the conceptual understanding. • The first is the objective function, where we define what exactly the objective in decision making should be. • The second is the investment decision, where we look at how a business should allocate of resources across competing uses. • The third is the financing decision, where we examine the sources of financing and whether there is an optimal mix of financing. • The fourth is the dividend decision, which relates to how much a business should reinvest back into operations and how much should be returned to the owners. • Finally, there is valuation, where all of the decisions made by a firm are traced throughto a final value Functions of Corporate Finance 1. Acquisition of Resources: Acquisition of resource indicates fund generation at the lowest possible cost. Resource generation is possible through: (a) Equity: This includes proceeds received from retained earnings, stock selling, and investment returns. (b) Liability: This includes warranties of products, bank loans, and payable account. 2. Allocation of Resources: Allocation of resources is nothing but investment of funds for profit maximization. Investment can be categorized into 2 groups: 16 CU IDOL SELF LEARNING MATERIAL (SLM)

(a) Fixed Assets – Buildings, Land, Machinery etc. (b) Current Assets – cash, receivable accounts, inventory, etc. Broad Functions of Corporate • Finance are: • Raising of Capital or Financing • Budgeting of Capital • Corporate Governance • Financial management • Risk Management Objective of Corporate Finance It is essential for all the corporate organizations to have objectives of corporate financing to make optimum utilization of available finance for maximizing your business profit earnings, stock valuations, give best returns to investors or shareholders for their investors and more. Let us see some of the key primary objectives of corporate finance going further on this topic: 1. Income Margins: In case your product sales method comprises of offering in the best reduced pricing to generate higher volumes, you might set an excellent objective of corporate finance towards increasing your profit margins on each product. It might be done without having a price tag augment with enhancing your manufacturing undertaking, the use of a variety of contents or negotiating better agreements from suppliers. In case a person carryout market review, you may discover you can enhance on your price tag not greatly decreasing sales volume. Your objectives of corporate financing should be to negotiate with best contracts using wholesalers to retailers as their best deals always improve your income margins. 2. Sales and Promotions: Companies have a range of selling objectives that go increasing with growing sales. You might set increased on the internet sales as a part of objectives of corporate finance. Assuming on the web sales incorporate most of your income therefore you may consider increasing sales and promotions in those areas as well as retail outlets. This probably provide you with a much healthier opportunity of exponential, instead of incremental sale growth in volume. Different financial objectives of corporate financing might be used to improve purchases of the specified product or service, whereas other objectives of corporate financing may include increasing revenues starting a specific segment for the market. 3. Financial Reporting System: 17 CU IDOL SELF LEARNING MATERIAL (SLM)

Key financial objectives of corporate finance for many smaller business is creation of a great financial reporting system that provides management with a range of informational data to help planning the preparation of pricing, budgeting, goals setting, distribution channel and other objectives. These reports include a professional general ledger, budgeting reports, expenses plan, overhead to production computational report, accounts receivable aging, profit-loss statement, cash flow analysis and balance sheet. THE ROLE OF FINANCIAL MANAGER Financial managers perform data analysis and advise senior managers on profit-maximizing ideas. Financial managers are responsible for the financial health of an organization. They produce financial reports, direct investment activities, and develop strategies and plans for the long-term financial goals of their organization. Financial managers typically: • Prepare financial statements, business activity reports, and forecasts, • Monitor financial details to ensure that legal requirements are met, • Supervise employees who do financial reporting and budgeting, • Review company financial reports and seek ways to reduce costs, • Analyze market trends to find opportunities for expansion or for acquiring other companies, • Help management make financial decisions. The role of the financial manager, particularly in business, is changing in response to technological advances that have significantly reduced the amount of time it takes to produce financial reports. Financial managers’ main responsibility used to be monitoring a company’s finances, but they now do more data analysis and advise senior managers on ideas to maximize profits. They often work on teams, acting as business advisors to top executives. Financial managers also do tasks that are specific to their organization or industry. For example, government financial managers must be experts on government appropriations and budgeting processes, and healthcare financial managers must know about issues in healthcare finance. Moreover, financial managers must be aware of special tax laws and regulations that affect their industry. Capital Investment Decisions Capital investment decisions are long-term corporate finance decisions relating to fixed assets and capital structure. Decisions are based on several inter-related criteria. Corporate management seeks to maximize the value of the firm by investing in projects which yield a positive net present value when valued using an appropriate discount rate in consideration of 18 CU IDOL SELF LEARNING MATERIAL (SLM)

risk. These projects must also be financed appropriately. If no such opportunities exist, maximizing shareholder value dictates that management must return excess cash to shareholders (i.e., distribution via dividends). Capital investment decisions thus comprise an investment decision, a financing decision, and a dividend decision. Management must allocate limited resources between competing opportunities (projects) in a process known as capital budgeting. Making this investment decision requires estimating the value of each opportunity or project, which is a function of the size, timing and predictability of future cash flows. Achieving the goals of corporate finance requires that any corporate investment be financed appropriately. The sources of financing are, generically, capital self-generated by the firm and capital from external funders, obtained by issuing new debt or equity. Types of Financial Managers There are distinct types of financial managers, each focusing on a particular area of management. Controllers direct the preparation of financial reports that summarize and forecast the organization’s financial position, such as income statements, balance sheets, and analyses of future earnings or expenses. Controllers also are in charge of preparing special reports required by governmental agencies that regulate businesses. Often, controllers oversee the accounting, audit, and budget departments. Treasurers and finance officers direct their organization’s budgets to meet its financial goals and oversee the investment of funds. They carry out strategies to raise capital and also develop financial plans for mergers and acquisitions. Credit managers oversee the firm’s credit business. They set credit-rating criteria, determine credit ceilings, and monitor the collections of past-due accounts. Cash managers monitor and control the flow of cash that comes in and goes out of the company to meet the company’s business and investment needs. Risk managers control financial risk by using hedging and other strategies to limit or offset the probability of a financial loss or a company’s exposure to financial uncertainty. Insurance managers decide how best to limit a company’s losses by obtaining insurance against risks such as the need to make disability payments for an employee who gets hurt on the job or costs imposed by a lawsuit against the company. Important Skills for Financial Managers 19 CU IDOL SELF LEARNING MATERIAL (SLM)

Finance manager skills are those that help individuals in this role oversee all aspects of a company's financial transactions, including budget analysis and calculation of return on investment (ROI) as well as purchasing and staffing decisions. Finance managers provide accurate data analysis and strategic propositions to create profit and reduce loss. A finance manager's skills are built from a wide array of roles and responsibilities. 1. Understand and evaluate cash flow scenarios 2. Analyze financial data 3. Forecast future earnings and expenses 4. Understand and apply contract provisions 5. Oversee vendor or government contracts 6. Implement contract compliance policy 7. Secure financial management systems 8. Apply advanced mathematics 9. Use and understand statistical modeling software and spreadsheets. THE FIRM IN CORPORATE FINANCE The Firm: Structural Set-Up In corporate finance, we will use firm generically to refer to any business, large or small, manufacturing or service, private or public. Thus, a corner grocery store and Microsoft are both firms. The firms investments are generically termed assets. Although assets are often categorized by accountants into fixed assets, which are long-lived, and current assets, which are short-term, we prefer a different categorization. The assets that the firm has already invested in are called assets in place, whereas those assets that the firm is expected to invest in the future are called growth assets. Though it may seem strange that a firm can get value from investments it has not made yet, high-growth firms get the bulk of their value from these yet-to-be-made investments. To finance these assets, the firm can raise money from two sources. It can raise funds from investors or financial institutions by promising investors a fixed claim (interest payments) on the cash flows generated by the assets, with a limited or no role in the day-to-day running of the business. We categorize this type of financing to be debt. Alternatively, it can offer a residual claim on the cash flows (i.e., investors can get what is left over after the interest payments have been made) and a much greater role in the operation of the business. We call 20 CU IDOL SELF LEARNING MATERIAL (SLM)

this equity. Note that these definitions are general enough to cover both private firms, where debt may take the form of bank loans and equity is the owners own money, as well as publicly traded companies, where the firm may issue bonds (to raise debt) and common stock (to raise equity). Thus, at this stage, we can lay out the financial balance sheet of a firm as follows: Figure 1.2 Note the contrast between this balance sheet and a conventional accounting balance sheet. Figure 1.3 An accounting balance sheet is primarily a listing of assets in place, though there are some circumstances where growth assets may find their place in it; in an acquisition, what gets recorded as goodwill is a conglomeration of growth assets in the target firm, synergies and overpayment. The Objective of the Firm No discipline can develop cohesively over time without a unifying objective. The growth of corporate financial theory can be traced to its choice of a single objective and the development of models built around this objective. The objective in conventional corporate financial theory when making decisions is to maximize the value of the business or firm. Consequently, any decision (investment, financial, or dividend) that increases the value of a business is considered good one, whereas one that reduces firm value is considered a poor one. Although the choice of a singular objective has provided corporate finance with a unifying theme and internal consistency, it comes at a cost. To the degree that one buys into 21 CU IDOL SELF LEARNING MATERIAL (SLM)

this objective, much of what corporate financial theory suggests makes sense. To the degree that this objective is flawed, however, it can be argued that the theory built on it is flawed as well. Many of the disagreements between corporate financial theorists and others (academics as well as practitioners) can be traced to fundamentally different views about the correct objective for a business. For instance, there are some critics of corporate finance who argue that firms should have multiple objectives where a variety of interests (stockholders, labor, customers) are met, and there are others who would have firms focus on what they view as simpler and more direct objectives, such as market share or profitability. Given the significance of this objective for both the development and the applicability of corporate financial theory, it is important that we examine it much more carefully and address some of the very real concerns and criticisms it has garnered: It assumes that what stockholders do in their own self-interest is also in the best interests of the firm, it is sometimes dependent on the existence of efficient markets, and it is often blind to the social costs associated with value maximization. Profit maximization • An assumption in classical economics is that firms seek to maximize profits. • Profit = Total Revenue (TR) – Total Costs (TC). • Therefore, profit maximization occurs at the biggest gap between total revenue and total costs. • A firm can maximize profits if it produces at an output where marginal revenue (MR) = marginal cost (MC) Diagram of Profit Maximization 22 CU IDOL SELF LEARNING MATERIAL (SLM)

Figure 1.4 To understand this principle, look at the above diagram. • If the firm produces less than Output of 5, MR is greater than MC. Therefore, for this extra output, the firm is gaining more revenue than it is paying in costs, and total profit will increase. • At an output of 4, MR is only just greater than MC; therefore, there is only a small increase in profit, but profit is still rising. • However, after the output of 5, the marginal cost of the output is greater than the marginal revenue. This means the firm will see a fall in its profit level because the cost of these extra units is greater than revenue. Profit maximization for a monopoly 23 CU IDOL SELF LEARNING MATERIAL (SLM)

Figure 1.5 • In this diagram, the monopoly maximizes profit where MR=MC – at Qm. This enables the firm to make supernormal profits (green area). Note, the firm could produce more and still make normal profit. But, to maximize profit, it involves setting a higher price and lower quantity than a competitive market. • Note, the firm could produce more and still make a normal profit. But, to maximize profit, it involves setting a higher price and lower quantity than a competitive market. • Therefore, in a monopoly profit maximization involves selling a lower quantity and at a higher price. see also: Diagram of monopoly Profit Maximization in Perfect Competition 24 CU IDOL SELF LEARNING MATERIAL (SLM)

Figure 1.6 In perfect competition, the same rule for profit maximization still applies. The firm maximizes profit where MR=MC (at Q1). For a firm in perfect competition, demand is perfectly elastic, therefore MR=AR=D. This gives a firm normal profit because at Q1, AR=AC. Profit Maximization in the Real World Limitations of Profit Maximization • In the real world, it is not so easy to know exactly your marginal revenue and the marginal cost of last goods sold. For example, it is difficult for firms to know the price elasticity of demand for their good – which determines the MR. • It also depends on how other firms react. If they increase the price, and other firms follow, demand may be inelastic. But, if they are the only firm to increase the price, demand will be elastic (see: kinked demand curve and game theory. • However, firms can make a best estimation. Many firms may have to seek profit maximization through trial and error. e.g. if they see increasing price leads to a smaller % fall in demand they will tryto increase price as much as theycan before demand becomes elastic • It is difficult to isolate the effect of changing the price on demand. Demand may change due to many other factors apart from price. • Firms may also have other objectives and considerations. For example, increasing the price to maximize profits in the short run could encourage more firms to enter the market; therefore, firms may decide to make less than maximum profits and pursue a higher market share. • Firms may also have other social objectives such as running the firm like a cooperative – 25 CU IDOL SELF LEARNING MATERIAL (SLM)

to maximize the welfare of stakeholders (consumers, workers, suppliers) and not just the profit of owners. • Profit satisficing. This occurs when there is a separation of ownership and control and where managers do enough to keep owners happy but then maximize other objectives such as enjoying work. Wealth maximization Wealth maximization is the concept of increasing the value of a business in order to increase the value of the shares held by its stockholders. The concept requires a company's management team to continually search for the highest possible returns on funds invested in the business, while mitigating any associated risk of loss. This calls for a detailed analysis of the cash flows associated with each prospective investment, as well as constant attention to the strategic direction of the organization. The most direct evidence of wealth maximization is changes in the price of a company's shares. For example, if a company spends funds to develop valuable new intellectual property, the investment community is likely to recognize the future positive cash flows associated with this new property by bidding up the price of the company's shares. Similar reactions may occur if a business reports continuing increases in cash flow or profits. The concept of wealth maximization has been criticized, since it tends to drive a company to take actions that are not always in the best interests of its stakeholders, such as suppliers, employees, and local communities. For example: A company may minimize its investment in safety equipment in order to save cash, thereby putting workers at risk. A company may continually pit suppliers against each other in the unmitigated pursuit of the lowest possible parts prices, resulting in some suppliers going out of business. A company may only invest minimal amounts in pollution controls, resulting in environmental damage to the surrounding area. Because of these types of issues, senior management may find it necessary to back away from the sole pursuit of wealth maximization, and instead pay attention to other issues, as well. The result is likely to be a modest reduction in shareholder wealth. Given the issues noted here, wealth maximization should be considered just one of the goals that a company must attend to, rather than its only goal. 26 CU IDOL SELF LEARNING MATERIAL (SLM)

Figure 1.7 TIME VALUE OF MONEY The time value of money (TVM) is the concept that money you have now is worth more than the identical sum in the future due to its potential earning capacity. This core principle of finance holds that provided money can earn interest, any amount of money is worth more the sooner it is received. TVM is also sometimes referred to as present discounted value. Understanding the Time Value of Money The time value of money draws from the idea that rational investors prefer to receive money today rather than the same amount of money in the future because of money's potential to grow in value over a given period of time. For example, money deposited into a savings account earns a certain interest rate and is therefore said to be compounding in value. 27 CU IDOL SELF LEARNING MATERIAL (SLM)

Figure 1.8 This chapter is a practical approach to the time value of money. We fully understand that today's technology provides multiple calculators and applications to help you derive both present value and future value of money. If you do not take the time to comprehend how these calculations are derived, you may make critical financial decisions using inaccurate data (because you may not be able to recognize whether the answers are correct or incorrect). There are five (5) variables that you need to know: Present value (PV) - This is your current starting amount. It is the money you have in your hand at the present time, your initial investment for your future. Future value (FV) - This is your ending amount at a point in time in the future. It should be worth more than the present value, provided it is earning interest and growing over time. The number of periods (N) - This is the timeline for your investment (or debts). It is usually measured in years, but it could be any scale of time such as quarterly, monthly, or even daily. Interest rate (I) - This is the growth rate of your money over the lifetime of the investment. It is stated in a percentage value, such as 8% or .08. Payment amount (PMT) - These are a series of equal, evenly-spaced cash flows. Further illustrating the rational investor's preference, assume you have the option to choose 28 CU IDOL SELF LEARNING MATERIAL (SLM)

between receiving $10,000 now versus $10,000 in two years. It's reasonable to assume most people would choose the first option. Despite the equal value at the time of disbursement, receiving the $10,000 today has more value and utility to the beneficiary than receiving it in the future due to the opportunity costs associated with the wait. Such opportunity costs could include the potential gain on interest were that money received today and held in a savings account for two years. Time Value of Money Formula Depending on the exact situation in question, the time value of money formula may change slightly. For example, in the case of annuity or perpetuity payments, the generalized formula has additional or less factors. But in general, the most fundamental TVM formula takes into account the following variables: FV = Future value of money PV = Present value of money i = interest rate n = number of compounding periods per year t = number of years Based on these variables, the formula for TVM is: FV = PV x [ 1 + (i / n)] (n x t) Time Value of Money Examples Assume a sum of $10,000 is invested for one year at 10% interest. The future value of that money is: FV = $10,000 x [1 + (10% / 1)] ^ (1 x 1) = $11,000 The formula can also be rearranged to find the value of the future sum in present day dollars. For example, the value of $5,000 one year from today, compounded at 7% interest, is: PV = $5,000 / [1 + (7% / 1)] ^ (1 x 1) = $4,673 Effect of Compounding Periods on Future Value 29 CU IDOL SELF LEARNING MATERIAL (SLM)

The number of compounding periods can have a drastic effect on the TVM calculations. Taking the $10,000 example above, if the number of compounding periods is increased to quarterly, monthly, or daily, the ending future value calculations are: Quarterly Compounding: FV = $10,000 x [1 + (10% / 4)] ^ (4 x 1) = $11,038 Monthly Compounding: FV = $10,000 x [1 + (10% / 12)] ^ (12 x 1) = $11,047 Daily Compounding: FV = $10,000 x [1 + (10% / 365)] ^ (365 x 1) = $11,052 This shows TVM depends not only on interest rate and time horizon, but also on how many times the compounding calculations are computed each year. You can calculate the fifth variable if you are given any four of the five (all) variables listed above. A simple example of this would be: If you invest one dollar (PV) for one year (N) at 6% (I), you will receive $1.06 (FV). This would be the same as saying the present value of $1.06 you expect to receive in one year, is only $1.00 (PV). SUMMARY Corporate finance is the area of finance that deals with sources of funding, the capital structure of corporations, the actions that managers take to increase the value of the firm to the shareholders, and the tools and analysis used to allocate financial resources. The primary goal of corporate finance is to maximize or increase shareholder value. Correspondingly, corporate finance comprises two main sub-disciplines. Capital budgeting is concerned with the setting of criteria about which value-adding projects should receive investment funding, and whether to finance that investment with equity or debt capital. Working capital management is the management of the company's monetary funds that deal with the short-term operating balance of current assets and current liabilities; the focus here is on managing cash, inventories, and short-term borrowing and lending (such as the terms on credit extended to customers). In any ways your important primary objectives of corporate finance should be to increasing the trust and giving good returns to investors and shareholders. Once your basic objective of corporate financing is achieved all rest of the task to be perform will have a smoother road ahead. Hope you enjoyed reading this article. KEYWORDS • Capital Budget – a company’s plan for capital expenditures (acquisition of fixed assets). • Capital Expenditures – money used to acquire or improve fixed assets. • Quick Ratio – a calculation of a company’s financial strength and liquidity – determined by subtracting inventories from total current assets and dividing by current liabilities. 30 CU IDOL SELF LEARNING MATERIAL (SLM)

• Restrictive Covenant - an agreement placing constraints on the operations of a borrower. • Retained Earnings – earnings retained by a company for reinvestment in its operations LEARNING ACTIVITY 1. What are Financial Statements of a company and what do they tell about a company? 2. How do managing the Corporate Finance helps in managing time value for money? UNIT END QUESTIONS A. Short Descriptive Question 1. Explain what do you understand by corporate finance? 2. Explain the functions of corporate finance. What is the role of firm in corporate finance? 3. Discuss, what is time value of money? Explain it with the help of formula. 4. Discuss, what are the objectives of corporate finance? What is the role of manager in corporate finance? Long questions 1. Explain, what the nature and scope of corporate finance? 2. If you wish to accumulate $140,000 in 13 years, how much must you deposit today in an account that pays an annual interest rate of 14%? 3. If you wish to accumulate $197,000 in 5 years, how much must you deposit today in an account that pays a quoted annual interest rate of 13% with semi-annual compounding of interest? 4. How many years will it take for $197,000 to grow to be $554,000 if it is invested in an account with a quoted annual interest rate of 8% with monthly compounding of interest? B. Multiple Choice Questions (MCQs) 1. The time value of money (TVM) is the concept that money you have now is worth more than the identical sum in the future due to its potential……… . 31 CU IDOL SELF LEARNING MATERIAL (SLM)

a. earning capacity b. spending capacity c. financial transactions d. saving capacity 2. The ………in conventional corporate financial theory when making decisions is to maximize the value of the business or firm. a. Decision b. Nature c. Scope d. Objective 3. The assets that the firm has already invested in are called ………. a. Assets in growth b. Assets in place c. Assets in save d. Asset in subject 4. Financial management is excellent art considering that it needs individual skills, techniques, strategies as well as …………. . a. Judgement b. Techniques c. Nature d. Technology 5. Financial controls are definitely processes, procedures and policies that areimplemented in order to handle ………… a. Funds b. Savings c. Money 32 CU IDOL SELF LEARNING MATERIAL (SLM)

d. None of these 6. The Short Holder bank pays 5.60%, compounded daily (based on 360 days), on a 9-month certificate of deposit. If you deposit $20,000 you would expect to earn around in interest. a. $840 b. $858 c. $1,032 d. $1,121 7. With continuous compounding at 8 percent for 20 years, what is the approximate future value of a $20,000 initial investment? a. $52,000 b. $93,219 c. $99,061 d. $915,240 8. In 2 years you are to receive $10,000. If the interest rate were to suddenly decrease, the present value of that future amount to you would . a. falls b. rises c. remains unchanged d. The correct answer cannot be determined without more information. 9. Assume that the interest rate is greater than zero. Which of the following cash-inflow streams totaling $1,500 would you prefer? The cash flows are listed in order for Year 1, Year 2, and Year 3 respectively. a. $700 $500 $300 b. $300 $500 $700 c. $500 $500 $500 d. Any of the above, since they each sum to $1,500. 33 CU IDOL SELF LEARNING MATERIAL (SLM)

10. You are considering investing in a zero-coupon bond that sells for $500. At maturity in 8 years, it will be redeemed for $1,000. During the life of the bond NO interest coupons will be paid. Using the Rule of 72, what approximate a. 8 percent. b. 9 percent. c. 12 percent. d. 25 percent. Answers 1. a 2. d 3. b 4. a 5. A 6.b 7.c 8.b 9.a 10. b REFERENCES • Joel M. Stern, ed. (2003). The Revolution in Corporate Finance (4th ed.). Wiley- Blackwell. ISBN 9781405107815. • Jean Tirole (2006). The Theory of Corporate Finance. Princeton University Press. ISBN 0691125562. • Ivo Welch (2014). Corporate Finance (3rd ed.). ISBN 978-0-9840049-1-1. • Damodaran, A. (2007). Corporate Finance–Theory & Practice, Hoboken, New Jersey: John Wiley and Sons, Inc. • M Y Khan, P K Jain. (2018). Financial Management, New Delhi: Tata Mc Graw Hill. • Pandey, I.M. (2016). Financial Management. New Delhi: Vikas Publication House Pvt. Ltd. • Richard A Brealey, Stewart C myers, Franklin Allen, Pitabas Mohanty. (2018). Principles of Corporate Finance. New Delhi: Tata Mc Graw Hill. 34 CU IDOL SELF LEARNING MATERIAL (SLM)

UNIT 2 CORPORATE FINANCE BASIC-II Structure Learning objectives Introduction Financial decisions Investment Decision Factors Affecting Investment Decisions / Capital Budgeting Decisions: Financing Decision Factors Affecting Financing Decision: Dividend Decision Factors affecting Dividend Decision: Working Capital Management Decision Risk-Return Trade-Off: Corporate Financial Decisions, Firm Value, and Equity Value Some Fundamental Propositions about Corporate Finance Summary Keywords Learning activity Unit end questions References LEARNING OBJECTIVES After studying this unit, you will be able to: • List financial decision, • State the factors affecting various financial decisions • Explain the working capital management concept • State about fundamental propositions and firm value INTRODUCTION Corporate finance is the area of finance dealing with monetary decisions that business 35 CU IDOL SELF LEARNING MATERIAL (SLM)

enterprises make and the tools and analysis used to make those decisions. The primary goal of corporate finance is to maximize shareholder value. 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 financial problems of all kinds of firms. The discipline can be divided into long-term and short-term decisions and techniques. Capital investment decisions are long-term choices about which projects receive investment, whether to finance that investment with equity or debt, and when or whether to pay dividends to shareholders. On the other hand, short-term decisions deal with the short-term balance of current assets and current liabilities; the focus here is on managing cash, inventories, short- term borrowing, and lending (such as the terms on credit extended to customers). The terms corporate finance and corporate financier are also associated with investment banking. The typical role of an investment bank is to evaluate the company’s financial needs and raise the appropriate type of capital that best fits those needs. Thus, the terms “corporate finance” and “corporate financier” may be associated with transactions in which capital is raised in order to create, develop, grow, or acquire businesses. FINANCIAL DECISIONS Everything you need to know about the types of financial decisions taken by a company. The key aspects of financial decision-making relate to financing, investment, dividends and working capital management. Decision making helps to utilize the available resources for achieving the objectives of the organization, unless minimum financial performance levels are achieved, it is impossible for a business enterprise to survive over time. Therefore financial management basically provides a conceptual and analytical framework for financial decision making. The types of financial decisions can be classified under: - 1. Long-Term Finance Decisions 2. Short-Term Finance Decisions. There are four main financial decisions: - 1. Capital Budgeting or Long term Investment Decision 2. Capital Structure or Financing Decision 3. Dividend Decision 4. Working Capital Management Decision. INVESTMENT DECISION It is the decision for creation of assets to earn income. Selec•tion of assets in which 36 CU IDOL SELF LEARNING MATERIAL (SLM)

investment is to be made is the invest•ment decision. It has to be decided how the funds realized will be utilized on various investments. Generally, the assets of a company are of two types — those which yield income spread•ing over a year or so and assets which are easily convertible into cash within a short time. The first type of investment deci•sion is capital budgeting and the second one is the working cap•ital management. Capital budgeting is the allocation of funds on a new asset or reallocation of capital when an old asset becomes non-profitable. The worthiness of different investment proposals forms a vital part of capital budgeting exercise. Risks of investment are there, so the management has to consider it with sufficient cau•tion and prudence. Capital budgeting decision has another im•portant aspect. It is to determine the norm or standard against which benefits are to be judged. This is known as cut-off rate, hurdle rate, minimum rate of return etc. This is actually cost ofcapital. Working capital management relates to management of the cur•rent assets. To meet current obligations, sufficient working cap•ital may be necessary. This can be termed as liquidity. In case proper amount of working capital cannot be estimated, there may revenue lying idle or there may be dearth of capital. Nei•ther is desirable. In case working capital remains in excess which could otherwise be utilized in the long term productive assets, profit earning would suffer a setback. The very significant point here to note is that in working capital management there is the trade-off between liquidity and profit•ability. A financial decision which is concerned with how the firm’s funds are invested in different assets is known as investment decision. Investment decision can be long-term or short-term. A long term investment decision is called capital budgeting decisions which involve huge amounts of long term investments and are irreversible except at a huge cost. Short-term investment decisions are called working capital decisions, which affect day to day working of a business. It includes the decisions about the levels of cash, inventory and receivables. A bad capital budgeting decision normally has the capacity to severely damage the financial fortune of a business. A bad working capital decision affects the liquidity and profitability of a business. Factors Affecting Investment Decisions / Capital Budgeting Decisions: 1. Cash flows of the project- The series of cash receipts and payments over the life of an investment proposal should be considered and analyzed for selecting the bestproposal. 2. Rate of return- The expected returns from each proposal and risk involved in them should be taken into account to select the best proposal. 37 CU IDOL SELF LEARNING MATERIAL (SLM)

3. Investment criteria involved- The various investment proposals are evaluated on the basis of capital budgeting techniques. Which involve calculation regarding investment amount, interest rate, cash flows, rate of return etc. It is to be considered which technique to use for evaluation of projects. It is more important than the other two decisions. It begins with a determination of the total amount of assets needed to be held by the firm. In other words, investment decision relates to the selection of assets, on which a firm will invest funds. The required assets fall into two groups: (i) Long-term Assets (fixed assets – plant & machinery land & buildings, etc.,) which involve huge investment and yield a return over a period of time in future. Investment in long-term assets is popularly known as “capital budgeting”. It may be defined as the firm’s decision to invest its current funds most efficiently in fixed assets with an expected flow of benefits over a series of years. (ii) Short-term Assets (current assets – raw materials, work-in-process, finished goods, debtors, cash, etc.,) that can be converted into cash within a financial year without diminution in value. Investment in current assets is popularly termed as “working capital management”. It relates to the management of current assets. It is an important decision of a firm, as short-survival is the prerequisite for long-term success. Firm should not maintain more or less assets. More assets reduce return and there will be no risk, but having less assets is more risky and more profitable. Hence, the main aspects of working capital management are the trade-off between risk and return. Management of working capital involves two aspects. One determination of the amount required for running of business and second financing these assets. Firms have scarce resources that must be allocated among competing needs. The first and foremost function of corporate financial theory is to provide a framework for firms to make this decision wisely. Accordingly, we define investment decisions to include not only those that create revenues and profits (such as introducing a new product line or expanding into a new market) but also those that save money (such as building a new and more efficient distribution system). Furthermore, we argue that decisions about how much and what inventory to maintain and whether and how much credit to grant to customers that are traditionally categorized as working capital decisions, are ultimately investment decisions as well. At the other end of the spectrum, broad strategic decisions regarding which markets to enter and the acquisitions of other companies can also be considered investment decisions. Corporate finance attempts to measure the return on a proposed investment decision and compare it to a minimum acceptable hurdle rate to decide whether the project is acceptable. The hurdle rate has to be set higher for riskier projects and has to reflect the financing mix used, i.e., the owners funds (equity) or borrowed money (debt). In the discussion of risk and 38 CU IDOL SELF LEARNING MATERIAL (SLM)

return, we begin this process by defining risk and developing a procedure for measuring risk. In risk and return models, we go about converting this risk measure into a hurdle rate, i.e., a minimum acceptable rate of return, both for entire businesses and for individual investments. Having established the hurdle rate, we turn our attention to measuring the returns on an investment. In analyzing projects, we evaluate three alternative ways of measuring returns— conventional accounting earnings, cash flows, and time-weighted cash flows (where we consider both how large the cash flows are and when they are anticipated to come in). In extensions of this analysis, we consider some of the potential side costs that might not be captured in any of these measures, including costs that may be created for existing investments by taking a new investment, and side benefits, such as options to enter new markets and to expand product lines that may be embedded in new investments, and synergies, especially when the new investment is the acquisition of another firm. FINANCING DECISION This decision relates to how, when and where funds are to be acquired to meet investment needs. It is related to the capital structure or financial leverage. This is debt-equity ratio. If more recourse is taken to debt capital, shareholders’ risk is lessened and the prospects of their dividend earning are reduced. So, in financing decision, the crucial point is the trade-off between returned risks. The financing decision— unlike investment de•cision— relates to the determination of the capital structure — the proper balance between debt and equity. Financing deci•sion has two important dimensions: (1) Is there an optimum capital structure, and (2) In what proportion should funds be raised to maximize the return to the shareholders? Once the best debt-equity mix is determined, the finance manager will be on the lookout for appropriate sources for raising loans and selling shares. A financial decision which is concerned with the amount of finance to be raised from various long term sources of funds like, equity shares, preference shares, debentures, bank loans etc. Is called financing decision. In other words, it is a decision on the ‘capital structure’ of the company. Capital Structure Owner’s Fund + Borrowed Fund The risk of default on payment of periodical interest and repayment of capital on ‘borrowed funds’ is called financial risk. Factors Affecting Financing Decision: 1. Cost- The cost of raising funds from different sources is different. The cost of equity is 39 CU IDOL SELF LEARNING MATERIAL (SLM)

more than the cost of debts. The cheapest source should be selected prudently. 2. Risk- The risk associated with different sources is different. More risk is associated with borrowed funds as compared to owner’s fund as interest is paid on it and it is also repaid after a fixed period of time or on expiry of its tenure. 3. Flotation cost- The cost involved in issuing securities such as broker’s commission, underwriter’s fees, expenses on prospectus etc. Is called flotation cost. Higher the flotation cost, less attractive is the source of finance. 4. Cash flow position of the business- In case the cash flow position of a company is good enough then it can easily use borrowed funds. 5. Control considerations- In case the existing shareholders want to retain the complete control of business then finance can be raised through borrowed funds but when they are ready for dilution of control over business, equity shares can be used for raising finance. 6. State of capital markets- During boom period, finance can easily be raised by issuing shares but during depression period, raising finance by means of debt is easy. After estimation of the amount required and the selection of assets required to be purchased, the next financing decision comes into the picture. Financial manager is concerned with makeup of the right hand side of the balance sheet. It is related to the financing mix or capital structure or leverage. Financial manager has to determine the proportion of debt and equity in capital structure. It should be on optimum finance mix, which maximizes shareholders’ wealth. A proper balance will have to be struck between risk and return. Debt involves fixed cost (interest), which may help in increasing the return on equity but also increases risk. Raising of funds by issue of equity shares is one permanent source, but the shareholders will expect higher rates of earnings. The two aspects of capital structure are- One capital structure theories and two determination of optimum capital structure. Every business, no matter how large and complex, is ultimately funded with a mix of borrowed money (debt) and owners funds (equity). With a publicly trade firm, debt may take the form of bonds and equity is usually common stock. In a private business, debt is more likely to be bank loans and an owner’s savings represent equity. Though we consider the existing mix of debt and equity and its implications for the minimum acceptable hurdle rate as part of the investment principle, we throw open the question of whether the existing mix is the right one in the financing principle section. There might be regulatory and other real- world constraints on the financing mix that a business can use, but there is ample room for flexibility within these constraints. We begin the discussion of financing methods, by looking at the range of choices that exist for both private businesses and publicly traded firms 40 CU IDOL SELF LEARNING MATERIAL (SLM)

between debt and equity. We then turn to the question of whether the existing mix of financing used by a business is optimal, given the objective function of maximizing firm value. Although the trade-off between the benefits and costs of borrowing are established in qualitative terms first, we also look at two quantitative approaches to arriving at the optimal mix. In the first approach, we examine the specific conditions under which the optimal financing mix is the one that minimizes the minimum acceptable hurdle rate. In the second approach, we look at the effects on firm value of changing the financing mix. When the optimal financing mix is different from the existing one, we map out the best ways of getting from where we are (the current mix) to where we would like to be (the optimal), keeping in mind the investment opportunities that the firm has and the need for timely responses, either because the firm is a takeover target or under threat of bankruptcy. Having outlined the optimal financing mix, we turn our attention to the type of financing a business should use, such as whether it should be long-term or short-term, whether the payments on the financing should be fixed or variable, and if variable, what it should be a function of. Using a basic proposition that a firm will minimize its risk from financing and maximize its capacity to use borrowed funds if it can match up the cash flows on the debt to the cash flows on the assets being financed, we design the perfect financing instrument for a firm. We then add additional considerations relating to taxes and external monitors (equity research analysts and ratings agencies) and arrive at strong conclusions about the design of the financing. DIVIDEND DECISION The profit of a company can be dealt with in two alternative ways — to distribute them as dividends to shareholders or to retain them in the business. If sufficient dividend is not paid, shareholders will not be satisfied, the market value of shares will come down and there may be financial crisis. If the profits, on the other hand, are distrib•uted to the maximum extent, the company will lose on impor•tant source of self-financing. So a judicious decision is a must. There should be a good combination of distribution and reten•tion. The dividend decision boils down to the determination of net profits to be paid out to shareholders as dividends. Here the management is to consider two major factors — preference of the shareholders and the investment opportunities in the com•pany. The functions of financial management can be discussed from different angles but the fact remains that finance plays the piv•otal role in the whole organization. Whatever has to be done needs money and that money procurement is the financial man­ager’s function. How to use the money, how much to use and where to use are also matters of consultation with the finance management. Even the top management personnel cannot by•pass the financial management to decide matters relating to fi•nance which is so vital to keep the 41 CU IDOL SELF LEARNING MATERIAL (SLM)

organization in sound health. Financial planning, investment of funds procured, financial con•trol and the future financial policy — all are within the preview of financial management. A financial decision which is concerned with deciding how much of the profit earned by the company should be distributed among shareholders (dividend) and how much should be retained for the future contingencies (retained earnings) is called dividend decision. Dividend refers to that part of the profit which is distributed to shareholders. The decision regarding dividend should be taken keeping in view the overall objective of maximizing shareholder s wealth. Factors affecting Dividend Decision: 1. Earnings- Company having high and stable earnings could declare high rate of dividends as dividends are paid out of current and past earnings. 2. Stability of dividends- Companies generally follow the policy of stable dividend. The dividend per share is not altered in case earning changes by small proportion or increase in earnings is temporary in nature. 3. Growth prospects- In case there are growth prospects for the company in the near future then, it will retain its earnings and thus, no or less dividend will be declared. 4. Cash flow positions- Dividends involve an outflow of cash and thus, availability of adequate cash is foremost requirement for declaration of dividends. 5. Preference of shareholders- While deciding about dividend the preference ofshareholders is also taken into account. In case shareholders desire for dividend then company may go for declaring the same. In such case the amount of dividend depends upon the degree of expectations of shareholders. 6. Taxation policy- A company is required to pay tax on dividend declared by it. If tax on dividend is higher, company will prefer to pay less by way of dividends whereas if tax rates are lower, then more dividends can be declared by the company. This is the third financial decision, which relates to dividend policy. Dividend is a part of profits, which are available for distribution to equity shareholders. Payment of dividends should be analyzed in relation to the financial decision of a firm. There are two options available in dealing with net profits of a firm, viz., distribution of profits as dividends to the ordinary shareholders where there is no need of retention of earnings or they can be retained in the firm itself if they are required for financing of any business activity. But distribution of dividends or retaining should be determined in terms of its impact on the shareholders’ wealth. Financial manager should determine the optimum dividend policy, which maximizes market value of the share thereby market value of the firm. Considering the 42 CU IDOL SELF LEARNING MATERIAL (SLM)

factors to be considered while determining dividends is another aspect of dividend policy. Most businesses would undoubtedly like to have unlimited investment opportunities that yield returns exceeding their hurdle rates, but all businesses grow and mature. As a consequence, every business that thrives reaches a stage in its life when the cash flows generated by existing investments is greater than the funds needed to take on good investments. At that point, this business has to figure out ways to return the excess cash to owners. In private businesses, this may just involve the owner withdrawing a portion of hisor her funds from the business. In a publicly traded corporation, this will involve either paying dividends or buying back stock. The discussion of dividend policy, we introduce the basic trade-off that determines whether cash should be left in a business or taken out of it. For stockholders in publicly traded firms, we note that this decision is fundamentally one of whether they trust the managers of the firms with their cash, and much of this trust is based on how well these managers have invested funds in the past. Finally, we consider the options available to a firm to return assets to its owners—dividends, stock buybacks and spin-offs— and investigate how to pick between these options. WORKING CAPITAL MANAGEMENT DECISION Working capital management is a business strategy designed to ensure that a company operates efficiently by monitoring and using its current assets and liabilities to the best effect. The primary purpose of working capital management is to enable the company to maintain sufficient cash flow to meet its short-term operating costs and short-term debt obligations. A company's working capital is made up of its current assets minus its current liabilities. Current assets include anything that can be easily converted into cash within 12 months. These are the company's highly liquid assets. Some current assets include cash, accounts receivable, inventory, and short-term investments. Current liabilities are any obligations due within the following 12 months. These include operating expenses and long-term debt payments. Working capital management can improve a company's earnings and profitability through efficient use of its resources. Management of working capital includes inventory management as well as management of accounts receivables and accounts payables. The objectives of working capital management, in addition to ensuring that the company has enough cash to cover its expenses and debt, are minimizing the cost of money spent on working capital, and maximizing the return on asset investments. Working capital management is concerned with management of a firm’s short-term or current assets, such as inventory, cash, receivables and short-term or current liabilities, such as creditors, bills payable. Assets and Liabilities which mature within the operating cycle of 43 CU IDOL SELF LEARNING MATERIAL (SLM)

business or within one year are termed as current assets and current liabilities respectively. Working capital management involves following issues: (1) What are the possible sources of raising short term funds? (2) In what proportion should the funds be raised from different short term sources? (3) What should be the optimum levels of cash and inventory? (4) What should be the firm’s credit policy while selling to customers? Risk-Return Trade-Off: Working capital management also involves risk-re- turn trade off as it affects liquidity and profitability of a firm. Liquidity is inversely related to profitability, i.e., increase in liquidity results in decrease in profitability and vice versa. Higher liquidity would mean having more of current assets. This reduces risk of default in meeting short term obliga•tions. But current assets provide lower return than fixed assets and hence reduce profitability as funds that could earn higher return via investment in fixed assets are blocked in current assets. Thus higher liquidity would mean lower risk but also lower profits and lower liquidity would mean more risk but more returns. Therefore the finance manager should have optimal level of working capital. Inter-Relationships between Financial Decisions: All the four financial management decisions explained above are not inde•pendent but related with each other’s. Capital budgeting decision requires calculation of present values of cost and benefits for which we need some appropriate discount rate. Cost of capital which is the result of capital structure decision of a firm is generally used as the discount rate in capital budgeting decision. Hence investment and financing decisions are inter•related. When operating risk of a business is high due to huge investment in long term assets (i.e. capital budgeting decision) then companies should have low debt capital and less financial risk. Dividend decision depends upon the operating profitability of a firm which in turn depends on the capital budgeting decision. Sometimes firms use retained earnings for financing their investment projects and if some amount of profit is left, that amount is distributed as dividend. Hence there is a relationship between dividends and capital budgeting on one hand and dividends and financing decision on the other. 44 CU IDOL SELF LEARNING MATERIAL (SLM)

CORPORATE FINANCIAL DECISIONS, FIRM VALUE, AND EQUITY VALUE If the objective function in corporate finance is to maximize firm value, it follows that firm value must be linked to the three corporate finance decisions outlined—investment, financing, and dividend decisions. The link between these decisions and firm value can be made by recognizing that the value of a firm is the present value of its expected cash flows, discounted back at a rate that reflects both the riskiness of the projects of the firm and the financing mix used to finance them. Investors form expectations about future cash flows based on observed current cash flows and expected future growth, which in turn depend on the quality of the firms projects (its investment decisions) and the amount reinvested back into the business (its dividend decisions). The financing decisions affect the value of a firm through both the discount rate and potentially through the expected cash flows. This neat formulation of value is put to the test by the interactions among the investment, financing, and dividend decisions and the conflicts of interest that arise between stockholders and lenders to the firm, on one hand, and stockholders and managers, on the other. We introduce the basic models available to value a firm and its equity, and relate them back to management decisions on investment, financial, and dividend policy. In the process, we examine the determinants of value and how firms can increase their value. SOME FUNDAMENTAL PROPOSITIONS ABOUT CORPORATE FINANCE There are several fundamental arguments we will make repeatedly in this discussion: 1. Corporate finance has an internal consistency that flows from its choice of maximizing firm value as the only objective function and its dependence on a few bedrock principles: Risk has to be rewarded, cash flows matter more than accounting income, markets are not easily fooled, and every decision a firm makes has an effect on its value.2. Corporatefinance must be viewed as an integrated whole, rather than a collection of decisions. Investment decisions generally affect financing decisions and vice versa; financing decisions often influence dividend decisions and vice versa. Although there are circumstances under which these decisions may be independent of each other, this is seldom the case in practice. Accordingly, it is unlikely that firms that deal with their problems on a piecemeal basis will ever resolve these problems. For instance, a firm that takes poor investments may soon find itself with a dividend problem (with insufficient funds to pay dividends) and a financing problem (because the drop in earnings may make it difficult for them to meet interest expenses). 2. Corporate finance matters to everybody. There is a corporate financial aspect to almost every decision made by a business; though not everyone will find a use for all the 45 CU IDOL SELF LEARNING MATERIAL (SLM)

components of corporate finance, everyone will find a use for at least some part of it. Marketing managers, corporate strategists, human resource managers, and information technology managers all make corporate finance decisions every day and often don’t realize it. An understanding of corporate finance will help them make better decisions. 3. Corporate finance is fun. This may seem to be the tallest claim of all. After all, most people associate corporate finance with numbers, accounting statements, and hardheaded analyses. Although corporate finance is quantitative in its focus, there is a significant component of creative thinking involved in coming up with solutions to the financial problem’s businesses do encounter. It is no coincidence that financial markets remain breeding grounds for innovation and change. 4. The best way to learn corporate finance is by applying its models and theories to real- world problems. Although the theory that has been developed over the past few decades is impressive, the ultimate test of any theory is application. As we will argue, much (if not all) of the theory can be applied to real companies and not just to abstract examples, though we have to compromise and make assumptions in the process. SUMMARY Every decision made in a business has financial implications, and any decision that involves the use of money is a corporate financial decision. Defined broadly, everything that a business does fits under the rubric of corporate finance. It is, in fact, unfortunate that we even call the subject corporate finance, because it suggests to many observers a focus on how large corporations make financial decisions and seems to exclude small and private businesses from its purview. A more appropriate title for this discipline would be Business Finance, because the basic principles remain the same, whether one looks at large, publicly traded firms or small, privately run businesses. All businesses have to invest their resources wisely, find the right kind and mix of financing to fund these investments, and return cash to the owners if there are not enough good investments. In this introduction, we will lay the foundation for this discussion by listing the three fundamental principles that underlie corporate finance—the investment, financing, and dividend principles—and the objective of firm value maximization that is at the heart of corporate financial theory. This introduction establishes the first principles that govern corporate finance. The investment principle specifies that businesses invest only in projects that yield a return that exceeds the hurdle rate. The financing principle suggests that the right financing mix for a firm is one that maximizes the value of the investments made. The dividend principle requires that cash generated in excess of good project needs be returned to the owners. These principles are the core for corporate finance. 46 CU IDOL SELF LEARNING MATERIAL (SLM)

KEYWORDS • Dividends: Dividends are payments made by a corporation to its shareholder members. It is the portion of corporate profits paid out to stockholders • Corporation:Legal entities which is separate and distinct from its owners, and can own assets, incur liabilities, and issue stock. • Coverage Ratio – a formula used to assess the adequacy of cash flow generated through earnings for the purposes of meeting debt and lease obligations. • Depreciation: the charge to amortize the cost of long-term assets over the useful life ofthe assets. • Long-Term Debt: a debt with a maturity of more than one year. LEARNING ACTIVITY 1. Dividend policy is often described as \"sticky. What is meant by this description? What might explain the sticky nature of dividends? 2. As a financial advisor of a company what are major investment decision you will take or suggest in company. UNIT END QUESTIONS A. Descriptive Question 1. Explain what do you understand by financial decisions? What are the fundamental propositions about corporate finance? 2. Discuss the Investment decisions? What are the factors affecting investment decision? 3. Discuss the financing decisions? What are the factor affecting this decision? 4. Explain the Dividend decisions? What are the factors affecting this decisions? 5. Discuss what do you understand by Working capital management decision? Explain corporate financial decision and firm value. Long Descriptive questions 1. Following are the details regarding three companies X Ltd., Y Ltd. and Z Ltd. X Ltd. Y Ltd. Z Ltd. r = 15% r = 15% r = 10% Ke = 10% Ke = 10% Ke = 10% E = ` 8 E = ` 8 E = `.8 47 CU IDOL SELF LEARNING MATERIAL (SLM)

Calculate the value of equity share of each of the company applying Walter’s model, when dividend payout ratio is: (a) 50%, (b) 75% and (c) 25%. You are required to offer your comments on the result. 2. X Ltd. has an investment of ` 5,00,000 in assets and 50,000 shares outstanding at ` 10 each. It earns a rate of 15% on its investment and has a policy of retaining 50% of the earnings. If the appropriate discount rate is 10%, determine the price of company’s share using Gordon’s Growth Model. What will be the share price if the company has a payout of 80% or 40%? 3. Ruchi Soya Ltd. is an established company having its shares quoted in the stock market. The company has distributed dividend at 20% p.a. The paid-up capital of the company was` 50 lakh shares of ` 10 each. Annual growth rate in dividend expected is 3%. The expected rate of return on its equity capital is 15%. Calculate the value of shares of Ruchi Soya Ltd. based on Gordon’s dividend growth model. B. Multiple Choice Questions (MCQs) 1. In a private business, debt is more likely to be bank loans and an owner’s savings represent ………. . a. Equity b. Equivalent c. Finance d. Investment 2. When the optimal ................ mix is different from the existing one, we map out the best ways of getting from where we are (the current mix) to where we would like to be (the optimal), keeping in mind the investment opportunities that the firm has and the need for timely responses, either because the firm is a takeover target or under threat of bankruptcy. a. Investing b. Financing c. Dividend d. Working capital 3. Corporate finance attempts to measure the return on a proposed .................. decision and compare it to a minimum acceptable hurdle rate to decide whether the project is acceptable. 48 CU IDOL SELF LEARNING MATERIAL (SLM)

a. Financing b. Dividend c. Working capital d. Investment 4. If there are not enough investments that earn the hurdle rate, return the cash tothe owners of the business a. Dividend Principle b. Financing c. Investment d. Work capital 5. The growth of corporate...........theory can be traced to its choice of a single objective and the development of models built around this objective. a. Financial b. Investment c. Decision d. None of these 6. Capital budgeting actually the process of making investment decisions in a. Sales Planning b. Production process and style c. Fixed Assets d. Current Assets 7. Which is helpful in evaluation of financial efficiency of top management? 49 a. Brand b. Cost of capital c. Capital structure d. Product quality CU IDOL SELF LEARNING MATERIAL (SLM)