CORPORATE FINANCE(As per the New Syllabus of Mumbai University for S.Y. BMS, Semester III)

Pawan JhabakP.G.D.Ed.M., M.Com. (Finance)

Ex. Vice Principal,Rustomjee Business School, Dahisar (West),

Mumbai – 68.

MUMBAI NEW DELHI NAGPUR BENGALURU HYDERABAD CHENNAI PUNE LUCKNOW AHMEDABAD ERNAKULAM BHUBANESWAR INDORE KOLKATA GUWAHATI

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PREFACE

“Genius is the ability to reduce the complicated to the simple”…

Albert Einstien

I earnestly hope that the book will make complicated Subject ‘Corporate Finance’ simple tounderstand and score high marks in Exams. The book has maximum number and variety of problemswith solution.

I look forward for constructive suggestion from the reader.

I am thankful to one and all who have contributed directly or indirectly to make this bookpossible.

This book is user-friendly and different. As one goes through the book, one will feel thedifference, and this will help to master finance in an enjoyable manner, with lifetime utility.

This is strictly as per S.Y. BMS Semester III Syllabus prescribed by Mumbai University.

Best Wishes!!

Million Thanks.

PAWAN JHABAK

scorejhabak@gmail.com

scoreeducation.co.in

SYLLABUS[60 lectures: 3 Credit]

Learning Objectives:

1. The objectives is to develop a conceptual framework of finance function and to acquaint theparticipants with the tools, techniques and process of financial management in the realm offinancial decision making.

2. The course aims at explaining the core concepts of corporate finance and its importance inmanaging a business.

3. It also aims at understanding of nature, importance, structure of corporate finance relatedareas and to impart knowledge regarding source of finance for a business.

Unit Name of the Topic No. ofLectures

Unit 1 Introduction to Corporate Finance: Meaning, Principles of CorporateFinance, Significance of Corporate Finance, Amount of Capitalisation, OverCapitalisation and Under Capitalisation, Fixed Capital and Working Capitalfunds.Introduction to Ownership Securities: Ordinary Shares, Reference Shares,Creditorship Securities, Debtors and Bonds, Convertible Debentures, Conceptof Private Placement of Securities.

14

Unit 2 Capital Structure and LeverageIntroduction to Capital Structure Theories, EBIT EPS Analysis for CapitalStructure Decision, Cost of Capital, Cost of Debt, Cost of Preference Shares,Cost of Equity Shares and Cost of Retained Earnings, Calculation of WeightedCost of Capital.Introduction to Concept of Leverage — Operating Leverage, FinancialLeverage and Combined Leverage.

16

Unit 3 Time Value of MoneyIntroduction to Time Value of Money — Compounding and DiscountingIntroduction to Basics of Capital Budgeting (Time Value of Money Basedmethods) NPV and IRR (Net Present Value and Internal Rate of Return)Importance of Risk and Return Analysis in Corporate Finance.

15

Unit 4 Mobilisation of FundsPublic Deposits and RBI Regulations, Company Deposits and SEBIRegulations, Protection of Depositors, RBI and Public Deposits with NBFCs,Foreign Capital and collaborations, Foreign direct Investment (FDI) Emergingtrends in FDI, Global Depository Receipts, Policy Development, Capital Flowsand Equity Debt.Brief Introduction and Sources of Short-term Finance, Bank Overdraft, CashCredit, Factoring.

15

PAPER PATTERN

Maximum Marks: 75Time: 2.5 Hours

Note: 1. All questions are compulsory subject to internal choice.

2. Figures to right indicate full marks.

Q.1. Attempt any 2 Questions (15 Marks)(a) (7.5 Marks)(b) (7.5 Marks)(c) (7.5 Marks)

Q.2. Attempt any 2 Questions (15 Marks)(a) (7.5 Marks)(b) (7.5 Marks)(c) (7.5 Marks)

Q.3. Attempt any 2 Questions (15 Marks)(a) (7.5 Marks)(b) (7.5 Marks)(c) (7.5 Marks)

Q.4. Attempt any 2 Questions (15 Marks)(a) (7.5 Marks)(b) (7.5 Marks)(c) (7.5 Marks)

Q.5. Case Study (15 Marks)

CONTENTS

Particulars Pg. No

Unit – I

Chapter 1: Introduction to Corporate Financial Management

Chapter 2: Introduction to Ownership Securities

1 – 9

10 – 17

Unit – II

Chapter 3: Capital Structure

Chapter 4: Cost of Capital

Chapter 5: Leverage

18 – 43

44 – 76

77 – 115

Unit – III

Chapter 6: Time Value of Money

Chapter 7: Capital Budgeting

Chapter 8: Risk and Return

116 – 132

133 – 161

162 – 192

Unit – IVChapter 9: Mobilisatin of Funds

Chapter 10: Foreign Capital

Chapter 11: Short Term Sources of Finance

193 – 202

203 – 210

211 – 213

UNIT – I

INTRODUCTION:

The concept of disclosure has grown and expanded considerably in response to the evolution ofcorporate form of business organisation. There are statutory requirements to prevent fraud andmanipulations and to protect the interest of shareholders. Accountancy has emerged as a recognizedprofession. Financial Reporting includes not only financial statement to be prepared by theaccountants but also other means of communicating information that relates directly or indirectly tothe information provided by the accounting system, that is information about resources, obligationsand earnings of a company. The management of a company may communicate information to theexternal users by means of financial reporting other than formal financial statements either becausethe information is required to be disclosed by authoritative pronouncement, regulatory rule customor because the management considers it useful for those outside the company and discloses itvoluntarily. Financial statements are audited by the auditors for the purpose of enhancingconfidence in their reliability.

Section I: Meaning of Corporate Financial ManagementCorporate Financial management is broadly concerned with the mobilization and deployment of

funds by a business organization. For efficient operation of business, it is necessary to obtain andutilize the funds effectively. This job is done by Corporate Financial Management.

According to ‘Warren Buffet’ “Finance is simply the art & science of managing money.” Basically,Corporate Financial management centers around fund raising for Business in the most economicalway and investing these funds in optimum way so that maximum returns can be obtained for theshareholders. Practically all Business decision have financial implication. Hence, Corporate FinancialManagement is interlinked with all other functions of business.

Section II: Scope of Corporate Financial ManagementScope of Corporate Financial Management

Forecasting Financing Coordination& control

Costing Decisionmaking

Others

Introduction to CorporateFinancial Management

Chapter 1

Analysis ofEconomic Trends

AcquiringFunds

FinancialAdjustment

Measuringcost ofcapital

FinancialDecision

TaxManagement

Analysis ofIndustries Trends

Allocationof funds

Accounting Preparingcost sheet

InvestmentDecision

Fixed Assetsmanagement

ForecastingFinancialrequirement

Investmentof funds

Budgeting Marginalcosting

Managementof income

Inventory /Receivablemanagement

Profit planning Ensuringavailabilityof funds

Reporting Dividenddecision

CorporateGovernance

Estimating ROI Meetingcontingentliability

EmployeeBenefits

ROT – Return on Investment

Corporate Financial management is one of the important parts of overall management, which isdirectly related with various functional departments like personnel, marketing and production.Corporate Financial management covers wide area with multidimensional approaches.

The following includes important scope of Corporate Financial Management.

1. Corporate Financial management and Economics: Economic concepts like micro andmacro economics are directly applied with the Corporate Financial management approaches.Investment decisions, micro and macro environmental factors are closely associated with thefunctions of financial manager. Corporate Financial management also uses the economicequations like money value discount factor, economic order quantity etc. Financialeconomics is one of the emerging area which provides immense opportunities to financeeconomical areas.

2. Corporate Financial management and Accounting: Accounting records includes thefinancial information of the business concern. Hence, we can easily understand therelationship between the Corporate Financial management and accounting. In the oldenperiods, both Corporate Financial management and accounting were treated as a disciplineand then it was merged as Management Accounting because this part is very much helpfulfor finance manager to take decisions.

3. Corporate Financial management and Mathematics: Modern approaches of the CorporateFinancial management applied large number of mathematical and statistical tools andtechniques. They are also called as econometrics. Economic order quantity, discount factor,time value of money, present value of money, cost of capital, capital structure theories,dividend theories, ratio analysis and working capital analysis are used as mathematical andstatistical tools and techniques in the field of Corporate Financial management.

4. Corporate Financial management and Production Management: Production managementis the operational part of the business concern, which helps to multiply the money into profit.Profit of the concern depends upon the production performance. Production performanceneeds finance production department requires finance for raw material, machinery, wages,operating expenses, etc.

5. Corporate Financial management and Marketing: Produced goods are sold in the marketwith innovative and modern approaches. For this, the marketing department needs finance tomeet their requirements. The financial manager or finance department is responsible toallocate adequate finance to the marketing department.

6. Corporate Financial management and Human Resource: Corporate Financialmanagement is also related with human resource department which provides manpower toall the functional areas of the management

7. Corporate Financial management and Ethics: With growing number of SCAMS, ethicsplays increasingly very important role in various Corporate Financial management decisions(corporate Governance )

Section III: Function of Corporate Financial ManagementFunction/Role of Corporate Financial management/Manager and how have they changed in

recent years.

Ans:

Role of Corporate Financial Management / Manager

Sources / Mobilisation of funds(Financial decision )

Application / Deployment of funds

( Investment decisions )

Proprietors Funds

Share capital

Fixed Assets

(Capital Budgeting)

Reserve & surplus

2. Borrowed Fund 2. Investments

(Treasury Management)(Capital Structure) (leverage)

(Cost of Capital) (Sources of Finance) 3. Net current Assets

(Working capital management)

(Cash & Receivable Mgmt.)

(Dividend policy)

The twin aspects of procurement & effective utilization of funds are the crucial tasks faced byfinancial manager. The financial manager is required to look into financial implication of any decisionin a firm. The finance manager has to manage funds in such a way as to make their optimumutilization & to ensure that their procurement is in a manner so that the risk, cost & controlconsiderations are properly balanced under a given situation.

“ Rule No. 1 : Never Loose Money

Rule No. 2 : Never Forget Rule No. 1”

… Warren Buffet

FUNCTIONS OF FINANCE MANAGER

Estimating the requirement of fund. Decision regarding capital structure. Investment decision. Dividend decision. Working capital management/liquidity function. Maintaining financial procedures & system etc

(1) Estimating The Requirement of Funds: In a business the requirements of funds have to becarefully estimated. Certain funds are required for long term purpose i.e. investments infixed assets etc. certain funds are required for short term purpose i.e. Working Capital. Acareful estimation of such funds & the timing of requirement is required to be made.Forecasting the requirements of funds involves the use of technique of budgetary control.Estimates of requirements of fund can be made only if all physical activities of theorganization have been forecasted.

(2) Decisions Regarding Capital Structure: Once the requirements of funds have beenestimated, decisions regarding various sources form where these funds would be raised haveto be taken. Finance manager has to carefully look into existing capital structure and seehow the various proposals of raising funds will affect it. Maintain a proper balance betweenlong-term funds and short-term funds. Long-term funds raised from outsiders have to be in acertain proportion with the funds contributed by the owner. Capitalization of company issuch that company is able to procure funds in future also. All such decisions are called‘financing decisions. The Finance manager should avoid Over Capitalisation as well asUnder Capitalisation since both can adversely affect functioning of Company.

(3) Investment Decision: Funds procured from different sources have to be invested in variouskinds of assets. Investments of funds in a project have to be made after careful assessment ofthe various projects through capital budgeting. A part of long-term funds is also to be keptfor financing working capital requirement. The production manager & finance managerkeeping in view the requirement of production, future price estimates of raw material &availability of funds would determine inventory policy. Investment Decisions are also calledCapital Budgeting Decisions and includes Planning for Fixed Capital reqirement.

(4) Dividend Decision: Finance manager is concerned with the decision to pay or declaredividend. He has to assist management in deciding as to what amount of profit should be

retained in business & this depends on whether the company can make a more profitable useof funds. But in practice the finance manager needs to consider trend of earning, sharemarket prices; requirement of funds for future growth, cash flow situation and expectation ofshareholders while deciding dividend.

(5) Working Capital Management/Liquidity Function: The financial manager has to properlymanage current assets such as cash, inventory and Accounts Receivable. He has to ensure atradeoff between liquidity and profitability, efficient utilization of every current assets andalso overall working capital involved in current assets. Adequate level of current assets isnecessary to maintain required level of liquidity of funds. On the other hand if the funds arekept idle i.e Excess Working Capital, the profitability will be low. Therefore the financialmanager has to maintain a proper balance between liquidity and profitability. It includescash management & receivable management.

Questions about working capital that must be answered are (1) How much cash and inventoryshould we keep on hand? (2) Should we sell on credit? If so, what terms will we offer, andto whom will we extend them? (3) How will we obtain short-term financing? Will wepurchase on credit or borrow in the short term and pay cash? If we borrow in the short term,how and where should we do it? These are just a sample of the issues that arise in managinga firm’s working capital.

(6) Maintaining Financial Procedures & Systems: This includes procedures established for theeffective execution of the other functions. Budgetary accounting, record keeping andmanagement information system (MIS) & Corporate Governance are integral part of anyorganization.

In the recent past, the complexion of the economic and financial environment has altered inmany ways.

Therefore the role of finance manager has changed from Mobilisation and deployment of fundsto profit planning, maximizing shareholder wealth, understanding capital markets and goodCorporate Governance.

The above changes have made the job of the Corporate finance manager more important,complex and demanding as shown in table 1.1 Function of Financial Manager.

Department-I

Forecasting Funds

FinanceManager

Investing Funds

Department-II

Fig. 1.1: Functions of Financial Manager

Section IV:- Objectives of Corporate FinancialManagement

Wealth maximization and shareholder value maximization as objectives of Corporate Financialmanagement. Corporate houses today are increasingly moving towards wealth maximization, or theobjective of Corporate Financial management is ‘wealth maximisation & not profit maximisation’.Comment

Fig. 1.2: Objectives of Corporate Financial management

Clear objectives are required for wise decision-making. Objectives provide a framework foroptimum financial decision-making. Two of the most widely discussed approaches are:

Profit maximization approach Wealth maximization approach

Profit Maximization Decision Criteria:

Under this approach, actions that increase profits should be undertaken and those thatdecrease profits are to be avoided. In specific operational terms, the profit maximization criterionimplies that the investment, financing and dividend policy decisions of a firm should be orientedtowards the maximization of profits. The rationable behind profit maximization acts as a guide tofinancial decision making, due to following reasons.

Profit is a test of economic efficiency. It provides the yardstick by which economicperformance can be judged.

It leads to efficient allocation of resources since funds tend to be directed for uses, which interms of profitability are the most desirable.

It ensures maximum social welfare. This is so to because the quest for value drives scarceresources to their most productive uses and their most efficient users. The more effectivelyresources are deployed, the more robust will be the economic growth and the rate of growthin the standard of living.

The profit maximization criterion however has been questioned and criticized on severalgrounds. It suffers from the following limitations:

Profit in absolute terms is not a proper guide to decision making. It has no precise connotation.It can be expressed either on a per share basis or in relation to investment. Also, profit canbe long term or short term, before tax or after tax, it may be the return on total capitalemployed or total assets or shareholders equity and so on. If profit maximization is taken tobe the objective which of these variants of profit should a firm try to maximize? Therefore, aloose term like profit object cannot from the basis of operational criterion for CorporateFinancial management.

It leaves considerations of timing and duration undefined. There is no guide for comparingprofit now with profit in future or for comparing profit streams of different durations.

It ignores Risk Factor. It cannot, for example, discriminate between an investment project,which generates a certain profit of ` 50 Lakhs and an investment project, which has avariable/uncertain profit outcome of ` 50 Lakhs.

Wealth Maximization Decision Criterion:

This is also known as value maximization or net present worth maximization. The focus ofCorporate Financial management is on the value to the owners or suppliers of equity capital. Thewealth of the owners is reflected in the market value of the shares. So wealth maximization impliesthe maximization of the market price of shares. It has been universally accepted as an appropriateoperational decision criterion for Corporate Financial management decisions as it removes thetechnical limitations, which characterise the earlier profit maximization criterion. Its operationalfeatures satisfy all the three requirements of a suitable operational objective of financial courses ofaction, namely exactness, quality of benefits and the time value of money. Maximization of thewealth of shareholders (as reflected in the market value of equity) appears to be the mostappropriate goal for financial decision-making.

Wider than profit maximization is the principle of corporate governance. The fundamentalobjective of corporate governance is the “the enhancement of the long-term shareholder value whileat the same time protecting the interests of stakeholders.” As such, this definition emphasizes theneed for a company to strike a balance at all times between the need to enhance shareholders”wealth and protecting the interest of other stakeholders in the company such as suppliers, customers,creditors, bankers, employees of the company, government and society at large.

If these factors are ignored, a company cannot survive for long. Profit maximization at the costof social and moral obligations is a short-sighted policy.

Hence, it is commonly agreed that the objective of a firm is to maximize its value or wealth.Value is represented by the market price of the company’s common stock. The market price of afirm’s stock represents the judgment of all market participants as to what the value of the particularfirm is. The market price serves as a performance index of the firm’s progress; it indicates how wellmanagement is doing on behalf of shareholders.

An increasingly popular measure of wealth is EVA (Economic Value Added).

Economic Value Added (EVA) can be defined as the net operating profit that a company earnsabove its cost’s of capital. It is a trademark of Stern Stewart & Co.

EVA can be calculated as follows:

EVA = Net Operating Profit After Taxes – {Weighted average cost of capital X Capital}

= NOPAT – (WACC x Capital )

Conceptually, EVA is superior as a measure of value creation because it recognizes the cost ofcapital and, hence, the riskiness of a firm’s operations. There is a strong correlation between EVA andthe market price of a company’s stock. Maximizing any accounting profit or accounting rate of returnas a way of increasing shareholder’s wealth often leads to an undesired outcome.

Therefore, wealth maximisation should be the objective of Corporate Financial managementsince it:

Considers risk. Uses Cash flows and not profits. Considers Time value of money. Implies taking care of Interest of both shareholders and other stakeholders (Corporate

governance).

Agency Problem’ in Achievement of Objectives of Corporate Financial ManagementA characteristic feature of corporate enterprise is the separation between ownership and

management as a corollary of which the latter enjoys substantial autonomy in regard to the affairs ofthe firm. With widely diffused ownership, scattered and ill-organised shareholders hardly exerciseany control/influence on management, which may be inclined to act in its own interests rather thanthose of the non promoter owners. However shareholders as owners of the enterprise have the rightto change the management. Due to the threat of being dislodged for poor performance, themanagement will have a natural inclination to achieve a minimum acceptable level of performanceto satisfy the shareholders requirements/goals, while focussing primarily on their own personal goals.Thus in furtherance of their objective of survival, management would aim at satisfying instead ofmaximising shareholders’ wealth. (Anil Agarwal (Vedanta), Mukesh Ambani (Reliance), Anil Ambani(Reliance) etc., are example of ‘Agency Problem’).

However, the conflicting goals of management objective of survival and maximizing ownersvalue/wealth can be harmonised by.

1. Incentives To Management: The incentive to management is of various types. Some of themare follows: Stock options: Confer on management the right to acquire shares of the enterprise at a

special / concessional price. Performance shares are given based on the performance of the management. Cash bonus linked to specified performance targets

2. Monitoring of Managers: Auditing financial statements and limiting decision making by the management.

The Audit Control procedures and limiting managerial decisions are intended to ensurethat the actions of management sub serve the interests of shareholders.

Shareholder activism, specially of financial institutions to safeguard interest of nonpromoter shareholders.

Rotation of Audit Partners. Overview by CAG, PAC, SEBI, I.T. department etc., is also required to overcome agency

problem.

Section V: Accounting PrinciplesEven though a financial manager is not an accountant, he must be familiar with various

accounting principles (GAAPs) to make good decisions:

Monetary Measurement: Accountants do not account for items unless they can be quantified inmonetary terms. Items that are not accounted for include items like market leadership, brandrecognition, goodwill etc.

Entity: This convention seeks to ensure that private transactions and matters relating to theowners of a business are segregated from transactions that related to the business. Eventransactions of owners with business are recorded in books of company.

Materiality: The preparation of accounts involves a high degree of judgement. Where decisionsare required about the appropriateness of a particular accounting judgement, the “materiality”convention suggests that this should only be an issue if the judgement is “significant” or “material” toa user of the accounts. The concept of “materiality” is an important issue for auditors of financialaccounts.

Going Concern: Accountants assume, unless there is evidence to the contrary, that a companywill continue operations in the foreseeable future. This has important implications for the valuationof assets and liabilities.

Consistency: Transactions and valuation methods are treated the same way from year to year,or period to period. Users of accounts can, therefore, make more meaningful comparisons offinancial performance from year to year. Where accounting policies are changed, companies arerequired to disclose this fact and explain the impact of any change in notes to Accounts.

Prudence/Conservatism: Profits are not recognised until a sale has been completed. In addition,a cautious view is taken for future problems and cost of business (they are “provided for” in theaccounts” as soon as their is a reasonable chance that such costs will be incurred in the future. Eg.Depreciation, provision for bad debts) Future probable Loss is to be provided in Current period butfuture probable Income should not be recorded in current period, according to principle ofconservatism.

Matching/Accruals: Income should be properly “matched” with the expenses of a givenaccounting period, to ascertain profitability. It also implies long term asset should be funded throughlong term source of finance & short term asset through short term sources of finance.

Practise Case Study

M/s Sona Chandi Heera Ltd. is a Stock Exchange listed Company making good profits every year.However the Board of Directors are very conservative and have declared dividend at fixed rate of ` 2per share, when EPS is always above ` 25 for last five years. The last bonus issue was made six yearsago. The salary packages are also not attractive. As a result there is a high turnover of employees andlow volume of company’s shares on bourses. The young members of the Directors family wish tomake the company more dynamic, employee friendly and darling of sharesholders so as to make it:most valued one. What steps you would suggest to achieve these objectives?