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WHAT IS CORPORATE FINANCE

The division of a company that is concerned with the financial operation of the company. In most businesses, corporate finance focuses on raising money for various projects or ventures.

For investment banks and similar corporations, corporate finance focuses on the analysis of corporate acquisitions and other decisions

This is basically about money OBJECTIVES

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The primary goal of corporate finance is to Maximize corporate value while managing the firm’s financial risks

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ANALYSIS OF FINANCIAL STATEMENTS

Primary goal of financial management is to maximize the stock price, not accounting measures such as the bottom line or EPS.

Evaluation of accounting statements helps management appreciate the company’s performance trends, as well as to forecast where the company is going

The primary financial statements include:The statement of financial positionThe income statement

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The statement of retained earnings or called statement of changes in equity

The cash flow statementOTHERS ARENotes to the financial statementsAccounting policiesStatement of financial position-retrospective

restatementRatios analysis-important

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RATIOS

Solvency and financial strengthProfitability ratiosEarning value ratios (share value)Efficiency ratiosGearing/leverage ratios

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CONSIDER THESE OBJECTIVES OF FM

Provide support for decision makingEnsure the availability of timely, relevant and

reliable financial and non-financial informationManage risksUse resources efficiently, effectively and

economicallyStrengthen accountabilityProvide a supportive control environmentComply with authorities and safeguard assets

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FINANCIAL PLANNING AND FORECASTING

What is a plan?-explain this to the studentsWhat is a forecast- explain this to the studentsThe optimal forecast becomes the budget

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CAPITAL BUDGETING TECHNIQUES

Defined- This is the process of evaluating specific investment decisions.

Capital investment decisions are important because: They involve huge sums of money Hard to discover alternative economic use Difficult to get out of the project once funds are

committedAim is to increase owners wealth and thus Control Capital used to mean operating assets used in

production

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Budget is a plan (activities) that details projected cash flows during some future period.

Thus capital budget is an outline of planned investments in operating assets while capital budgeting is the whole process of analysing projects and identifying the ones to include in the budget accordingly and these the ones that add to firm’s value

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PROJECT CLASSIFICATIONKEY Categories which firms analyse include: Replacement: MAINTENANCE OF BUSINESS-worn-out or

damaged equipments –depends on whether to continue the business or go into new ventures- no need of elaborate decision process

Replacement: COST REDUCTION- detailed analysis Expansion of existing products or markets- higher level

decisions within the firm Expansion into new products or markets- boards decision

as a part of firm’s strategic plan

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Safety and/or environment projects- mandatory investments to comply with specific industry requirements

Research and development- may use decision tree analysis rather than DCF techniques

Long-term contracts- to provide products or services to specific customers- DCF analysis necessary

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CAPITAL BUDGETING DECISION RULES

There are seven key methods namelyPaybackDiscounted paybackAccounting rate of returnNet present value (NVP)Internal rate of return ( IRR)Modified internal rate of return (MIRR)Profitability index

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PAYBACK PERIOD

Expected number of years required to cover the original investment

Payback = year before full recovery + unrecovered cost at start of yearCash flow during the yearEXAMPLE Take two projects X and YX= -1000 Y1 500 Y2 400, Y3 300 Y4 100Y=-1000 Y1 100 Y2 300 Y3 400 Y4 600

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EXAMPLE CONT

Required: find payback period and advise which project should be undertaken if both projects are mutually exclusive

SOLUTIONX= 2 + 100/300 = 2.33Y= 3+ 200/600= 3.33CONCLUSION X has the shortest pay back period thus

accepted accordingly.

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DISCOUNTED PAYBACK

Here the expected cash flows are discounted by the project’s cost of capital

Discounted payback period defined as the number of years required to recover the investment from discounted net cash flows

EXAMPLE OF OUR PROJECTS X AND YDiscounting the cash inflows for both projects

assuming a cost of capital of 10%Use tables accordingly

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EXAMPLE CONT

Project X = 2 + 214/225= 2.95 yearsProject Y = 3 + 360/410= 3.88 years Project X is preferred accordingly Period discounting factor at 10%1 .90912 .82643 .75134 .68305 .6209

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PROJECT X

YEAR CASH FLOW DIS FAC PV BAL 0 -1000 1 -1000 -1000 1 500 .9091 455 -545 2 4OO .8264 331 -214 3 300 .7513 225 11 4 100 .6830 68 79

THUS: 2 + 214/225 = 2.95

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PROJECT Y

Pay back 3 + 360/410 = 3.88

ADVANTAGES OF PAYBACK METHODEasy to understand and calculateProvides some assessment of risk in a business environment of rapid technological

changes, new plant and machinery may need to be replaced sooner than in the past, so a quick payback on investment is essential

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The investment climate today in particular, demands that investors are rewarded with fast returns. Many profitable opportunities for long-term investment are overlooked because they involve a longer wait for revenues to flow

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DISADVANTAGES

Ignores cash flows after the payback period. Cash flows are regarded as either pre-payback or post-payback, but the latter tend to be ignored.

Does not measure profitability. Payback takes no account of the effect on business profitability. Its sole concern is cash flow

Ignores time value of moneyIt lacks objectivity. Who decides the length of optimal

payback time? No one does - it is decided by pitting one investment opportunity against another.

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NB/It is probably best to regard payback as one of the first methods you use to assess competing projects. It could be used as an initial screening tool, but it is inappropriate as a basis for sophisticated investment decisions

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ACCOUNTING RATE OF RETURN (ARR)

Focuses on a project’s net income and not its cash flow

Is the ratio of the project’s average annual expected net income to its average investment

FormulaARR = Average annual income * 100 Average investmentEXAMPLELets Assume the case of our TWO projects X and Y

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PROJECT X

Lets further assume that both projects will be depreciated using the straight line method- in their useful economic life of FOUR years and have a scrap value of zero

The depreciation expense = 1000/4= 250 per year

AVERAGE ANNUAL INCOME= Average cash flow- Average annual depreciation

Thus: (500+400+300+100)/4=325-250=75

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AVERAGE INVESTMENT =Cost + Scrap Value 2THUS: 1000 + 0/2 = 500THUSARR = 75/500*100= 15%Lets determine ARR for Project Y- EVERY BODY

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PROJECT Y

1,400/4= 350-250= 1001000+0/2= 500THUS ARR = 100/500*100= 20%CONCLUSIONThe ARR method ranks project Y over project X. If the firm accepts projects with say 18%, Then

accordingly, project Y will be accepted and project X rejected.

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ADVANTAGES OF ARR

Easy to understand and calculateManagers familiar with the key conceptsBrings into consideration the income earned over the

whole life of projectThe idea of return on capital employed is generally

understood and this aids the comprehension of the accounting rate of return

The minimum required rate of return can be set with reference to the cost of the finance used by the company plus the additional return it requires for its own profit.

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DISADVANTAGES OF ARR

Ignores the time value of moneyThe timing of income arising from alternative

projects is ignored

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WHATS MORE ?

We note that the rankings under the ARR method are exactly the opposite of the ones based on the Payback method

What's the problem here?This is an argument we can have right here!Is it worth?Probably NO- Because these two method ignore

a very fundamental issue- THE TIME VALUE of money.

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CONCLUSION ON THE TWO METHODS

They both do not give us complete information on the projects contribution to the firm’s intrinsic value.

DCF-Discounted Cash Flow techniques are therefore reliable because they address this problem

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NET PRESENT VALUE (NPV)

Present value (PV) is an accounting term that measures how money needs to be invested today in order to finance business initiatives, projects, and obligations tomorrow

In order to determine the present value of future costs, accountants use formulas based on the time value of money. These formulas feature variables such as the length of time involved and the prevailing interest rate and/or inflationary rates

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In other words, the present value of an amount to be received in the future is the discounted face value considering the length of time the receipt is deferred and the required rate of return (or appropriate discount rate under the circumstances)

Present value is the result of the time value of money concept, which works in recognition that today's Shilling is worth more than the same Shilling received at a future point in time.

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NPV PROCEDURE

Find the present value of each cash flow, including all inflows and outflows, discounted at the project’s cost of capital

Sum these discounted cash flows; this particular sum is called the project’s NVP

If the NPV is positive, the project is accepted but rejected if the NPV is negative

If two projects with positive NPV are mutually exclusive, the one with the higher NPV is selected

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THE FORMULA

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The formula (We know it!) WHERECFt= the expected net cash flow at period tr= the projects cost of capitaln= the projects lifeCF0= a negative number being the cash outflowsNOTEWe can also use the tables of discounted factors

accordingly

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EXAMPLES

Lets compute NPV Of both our projects X and Y

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NPV RATIONALE

A NPV of zero signifies that the project’s cash flows are exactly sufficient to repay the invested capital and provide the required rate of return on that capital.

A positive NPV means the project is generating more cash than needed to service the debt and to provide the required return to shareholders; and that this excess cash accrues solely to the entities stockholders

Positive NPV means the wealth of the stockholders increases

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We may at this stage compare our two projects, X and Y, and see by how much each of them increases the shareholders wealth.

NOTE: there is a direct relationship between NPV and EVA (Economic Value Added- which is the estimate of a business’s true economic profit for the year- and represents the residual income that remains after the cost of all capital, including equity capital. Quite different from accounting profit which does not include a charge for equity capital)

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NPV is equal to the present value of the project’s future EVAs.

Thus accepting a project with positive NPV results in a positive EVA and a positive MVA (Market Value Added- being the excess of a firm’s market value over its book value).

Since entities should in fact reward managers for producing positive EVA-MVA; then NPV becomes a better method for making capital budgeting decisions accordingly.

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ACCOUNTING OR ECONOMIC PROFIT

Economic profit = (explicit and implicit revenue) Minus (explicit and implicit cost)

Accounting Profit = TR (Total Revenue= Price * Quantity) - (Cost of land) - (cost of labor) – (cost of capital)

Economic profit = accounting profit – cost of equity capital

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ADVANTAGES OF NPV

Links capital budgeting decisions to EVA-MVARecognizes the time value of moneyCorrect ranking of mutually exclusive projectsDependent on forecast cash flows and

opportunity cost of capital, instead of arbitrary guess work by management

No arbitrary guess work

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DISADVANTAGES

Possible errors in forecastingHard to determine the minimum rate of

return of a projectOther factors which may affect a project’s

structure of cash flows e.g. government grants, taxation etc

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THE INTERNAL RATE OF RETURN

Defined as the discount rate that equates the present value of a project’s expected cash inflows to the present value of the project’s costs.

This means:PV (Inflows) = PV (Investment costs)Further, this means IRR is simply the rate of return that

forces the NPV to equal to ZeroFormula : CF0 + CFI + CF2 + CFn =0 (1+irr)0 (1+irr)1 (1+irr)2 (1+irr)nCan use the calculator to solve the equation

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ALTERNATIVE FORMULAR TO IRR

IRR = X + x * (Y-X) x + y

WhereX = Discount rate for positive NPVY= Discount rate for negative NPVx= positive NPV found using Xy= negative NPV found using Y Ignore negative signs

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EXAMPLE-OUR PROJECT X AND Y

NOTE- this is a trial and error process- whereby a higher rate of return (than the provided cost of capital) is used- until the result is a negative NPV

Lets use 18% as cost of capitalDiscount factors are: YEAR1 .8475, Y2.7182,

Y3.6086,Y4.5158,Y5.4371Then solve IRR for both projects. Lets all do it

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SOLVED-X

10 + 78.82 (18-10) 78.82+54= 14.75 SOLVED Y10+ 49.18 (18-10) 49.18+ 148=11.99

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DECISION MAKING

Both projects have a cost of capital ( hurdle rate) of 10%

IRR rule indicates that if the projects are independent of each other, then the both are accepted since they earn more than the cost of capital needed to finance them

If the two projects are mutually exclusive, the project X ranks higher and should be selected and Y rejected

If the cost of capital is above 14.75, both projects will be rejected

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NOTE

Both NPV and IRR will always lead to the same decision (accept or reject) for INDEPENDENT projects (mathematical reasons)

This so because if NPV is positive, IRR must exceed r (the cost of capital in NPV)

This scenario is however not true for projects that are mutually exclusive

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IRR RATIONALE

This particular rate is critical because:The IRR on a project is the expected rate of return

If the IRR exceeds the cost of capital (funds used to finance the project), then a surplus will remain after paying for the capital. This surplus

will accrue to the entity’s stockholders This means a project whose IRR exceeds its cost of

capital increases shareholders wealth. If the IRR is less than the cost of capital, then that

particular project will impose a cost on stockholders

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NOTE: This break-even quality of IRR makes it fairly useful in evaluating capital projects

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NPV VERSUS IRR

NPV is better than IRR in many aspects. IRR however can not be ignored- popular with many

managers and seriously entrenched into the business industry

Important to understand why a project with a lower IRR may be more attractive to a mutually exclusive one with a higher IRR

Look at the NVP Profile curve SLIDE 56- simply plots a projects NPV and cost of capital- And if a project has its cash flows coming in the early year;

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Then its NPV will not decline very much if the cost of capital increases but a project with cash flows which come later will be severely penalized by high capital costs. –Y in our case and it has a steeper slope

NOTE NPV profiles decline as the cost of capital increases

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EVALUATING INDEPENDENT PROJECTS

Both the NPV and IRR criteria always lead to the same accept/reject decision

EVALUATING MUTUALLY EXCLUSIVE PROJECTSIf we assume that our projects X and Y are

mutually exclusiveThis means we can either choose X or Y or

reject both BUT cannot accept both

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A conflict exists where the cost of capital is less than the crossover rate- NPV will choose X whereas IRR will choose Y

If r is greater than cross point-both NPV and RRR take XThis conflict is resolved by asking the question- how useful

is it to generate cash flows sooner rather than laterThis really depends on how on the return we can earn from

those cash flows ie the rate at which we can reinvest them.The NPV assumes that the rate at which cash flows can be

reinvested is the cost of capital

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IRR assumes that the firm can reinvest at the IRR rate

In this particular case, NPV prevails as a better method since it is better to reinvest at the cost of capital rather than at IRR rate

Thus where the conflict exist, NPV is used accordingly

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• NPV• 400 • 300 Ys NPV profile• Xs NPV profile

• IRR

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MULTIPLE IRRsThis exists if a project is regarded as having nonnormal cash

flows. Nonnormal cash flows occur when there is more than one

change in the sign e.g. a project starts with negative cash flows and switch to positive cash flows and switch again to negative cash flows

These kinds of projects can have two or more IRRsILLUSTRATIONImagine a firm is considering the expenditure of Ksh 1.6 million

to develop an equipment to manufacture balls. The balls will produce a cash flow of Ksh 10 million at the end of year 1.

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At the end of year 2, additional Ksh 10 million must be utilised to expand this project due to increasing demand due to the upcoming world cup championship

REQUIREDIRR of the projectSOLUTIONNPV=Ksh 1.6 + Ksh 10 + -Ksh10 = 0 (1+IRR)0 (1+IRR)1 (1+IRR)2=Ksh 1.6 +Ksh 10 + -Ksh10 = 0 (1+IRR)1 (1+IRR)2

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1.6 (1+IRR)2 = 10(1+IRR) -101.6(1+IRR)2= 10 + 10IRR -101.6IRR2 + 3.2IRR + 1.6= 10IRR1.6IRR2 -6.8IRR +1.6 = 04IRR2 -17IRR +4 =0 SOLVING EQUATIONIRR = 25% OR 400%MULTIPLE IRRs MEANING

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1. If NPV were used, then there would be no dilema in making the decision

2. if the r were between 25% and 400%, the NPV would be positive

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MODOFIED IRR

NPV prevails over IRR in times of conflict but IRR continues to be popular and many executives prefer IRR to NPV because it is apparently easy to work with a percentage

The idea here is to device a percentage evaluator that is better than IRR

This is basically done by modifying the IRR rate and make it a better indicator of relative profitability and therefore better for use in capital budgeting

This is called MIRR

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Formula : PV OF COSTS= TERMINAL VALUE (1+MIRR)n

- COF= Cash outflows (negative numbers)- CIF = cash inflows (positive numbers)- r= the cost of capital- The compounded future value of the cash inflows is called the TERMINAL

VALUE (TV)- The discount rate that makes PV of TV equal to the PV of the costs is the

MIRRASSIGNMENTLets attempt the MIRR for projects X and Y

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PROJECT X1000= 1579.50 (1 +irr)4Irr= 12.1%

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IRR ADVANTAGES

The rate of return measured is familiar with managers

incorporates the time value of money

DISADVANTAGESNonnormal cash flows produces multiple IRRsFor mutually exclusive projects, there is conflict

with NPV- although this problem is solved by MIRR

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PROFITABILITY INDEX

Computed as PI = PV of future cash flows Initial costEXAMPLE PROJECT XPIX = 1,078.82/1000= 1.079A project is accepted if its PI is greater than 1The higher the PI the higher the project’s rankingSSIGNMENTWhich project would be selected between X and Y