Corporate Finance

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Corporate finance is an area of finance dealing with financial decisions business enterprises make and the tools and analysis used to make these decisions. The primary goal of corporate finance is to maximize corporate value while managing the firm's financial risks. Although it is in principle different from managerial finance which studies the financial decisions of all firms, rather than corporations alone, the main concepts in the study of corporate finance are applicable to the financial problems of all kinds of firms.
  • 1. CORPORATE FINANCE Module 1 Financial Management and Valuation Concepts & Securities Valuation
  • 2. Agenda  Definitions  Finance  Business Finance and  Financial Management (FM)  Meaning, Objectives and Scope of FM  Liquidity vs. Profitability  Time Value of Money  Valuation Concept  Valuation of  Assets  Debentures  Preference Shares and  Equity Shares
  • 3. Definitions
  • 4. Objectives of Financial Management  Maintenance of adequate liquid assets  To maintain a balance between liquidity and profitability  Profit Maximization  However this is under severe criticism as it is vague, ignores timing and overlooks quality aspects of future activities  Wealth Maximization  It is maximization of net present worth  Any financial action which creates wealth or which has a net present worth above zero should be undertaken  Fair return to shareholders  It can be termed as return on equity. It is a financial ratio that measures how effective a company is at generating income compared to the funding that shareholders have contributed  Ensuring maximum operational efficiency  By efficient and effective utilization of finances  Building up reserves for growth and expansion
  • 5. Scope of Financial Management The scope of financial management is the wise use of funds by looking at financial problems of an entity in an analytical way and by taking financial decisions with a target to achieve financial goals which an enterprise sets for itself The main contents of financial problems are:  What is the total volume of funds an enterprise should commit?  What specific assets should an enterprise acquire?  How should the funds required be financed? The above questions lead to four broad financial decision areas of FM:  Fund requirement decision- Capitalization An estimate has to be made about total funds required by the enterprise taking into account both the fixed and working capital requirements.  Financing decision- Capital Structure This involves identification of sources from which funds can be raised, amount that can be raised from each source and the cost involved.  Investment decision- Capital Budgeting & Working Capital Management This involves decisions relating to investment in capital and current assets. For investment in capital asset evaluate different capital investment proposals and select the best among them. The investment in current assets will depend on the credit and inventory policies pursued by the enterprise.  Dividend decision- Dividend Policy This involves the determination of the percentage of profits earned by the enterprise which is to be paid to the shareholders.
  • 6. Liquidity Vs. Profitability  Liquidity means that: 1) the firm has adequate cash to pay for its bills, 2) the firm has sufficient cash to make unexpected large purchases and, 3) the firm has sufficient cash to meet emergencies at all times.  Profitability on other hand requires that the funds of the firm are so used as to yield the highest return. Note :There is inverse relationship between the two. For ex, if higher inventories are kept in anticipation of increase in prices of raw materials, the profitability goal is approached but the liquidity of the firm is endangered Concept: Risk & Return Trade-Off There is a direct relationship between higher risk and higher return. Higher risk endangers liquidity of the firm while higher return increases profitability. Risk-return trade-off level has to be maintained i.e., the level where both return and risk are optimized. At this level market value of the company’s shares would be the maximum.
  • 7. Money has time value because of following-  Individuals prefer current consumption to future consumption.  An investor can profitably employ a rupee received today to give him a higher value to be received tomorrow.  In an inflationary economy the money received today has more purchasing power than the money to be received in the future. Thus, the concept behind the time value of money is that a sum of money received today is worth more than if the same is received after sometime. For example: If an individual won a prize of 20,000 rupees and have an option to receive it today or after a year he will prefer it now reasons being- no risk of getting money back that he already have today, higher purchasing power due to inflation and opportunity cost of interest if money will be invested. Time Value of Money
  • 8. Valuation In Finance, Valuation is the process of estimating the value or worth of a firm or securities etc. Wherein value depends on the required rate of return and the time period over which this return is expected to be received Valuation of Asset Asset is a tangible object or intangible right owned by an enterprise and carrying probable future benefits. Value of Asset is equivalent to the present value of the benefits associated with it. Symbolically: V= A * ADF where, V= Current value of an asset A= Annual cash inflow ADF= Annuity discount factor at an appropriate interest rate. For example, if an investor expects an annual return of Rs.1,000 for next 10 years from an asset, interest being 15%. Then, current value of asset = 1,000* 5.019 = Rs. 5,019
  • 9. Valuation of Debentures Debenture is a formal document constituting acknowledgement of a debt by an enterprise usually given under its common seal. Debenture holder is entitled to receive: 1) Interest at a fixed rate till maturity, 2) The principal amount of the debenture on its maturity. V= I(ADFI) + F(DFF) where, V= Current value of bond or debenture I= Interest payable on the bond ADFI= annuity discount factor applicable to interest F= Face value DFF= appropriate discount factor applicable to face value. For example, debenture of Rs.100 with interest at 15% will become due for repayment after 5 years. Required rate of interest being 10%. Now debentures current value will be = (15*3.791)+(100*0.621)= approx Rs.119 Valuation of perpetual debentures These are the debentures which will never mature. V= A/ I where, V= value of debentures A= Annual interest I= Expected rate of interest For example, A debenture holder is to receive an annual interest of Rs.100 for perpetuity on his debenture of Rs.1,000. Required rate of return is 15%. Thus, value of debenture= 100/ 0.15 = Rs. 667
  • 10. Valuation of Debentures (Cont..) Valuation of redeemable debentures These are the debentures which are redeemable after a fixed period. Yield on debentures in such cases will be: Y=A + (F-P)/n (F+P)/2 where, Y= Yield till maturity A= Annual interest payment F= Face value of the debenture P= Present value of the debenture n= period of debenture to maturity For example, the current market price of a debenture of X Ltd is Rs.800 having a face value of Rs.1,000. The debentures will be redeemed after 5 years. The debenture carries an interest rate of 12% p.a. Now, yield to maturity on debenture will be- Y= 120 + (1,000- 800)/5 (1,000+ 800)/2 = 0.17 or 17% Valuation of Preference Shares Preference shares carry a fixed dividend rate. Thus, their valuation can be done on the same basis as that of debentured or bonds. For example, Face value of preference share Rs.100 Dividend rate 10% Current market price 15% Maturity 10 years therefore, value of preference share = (10* 5.19) + (100*0.247) = Rs.74.89
  • 11. Equity shares do not carry a fixed dividend or interest rate. Equity shareholders may or may not get dividends. Following are the two methods of valuation of equity shares- 1) Dividend capitalization approach According to this approach the value of an equity share is equivalent to the present value of future dividends plus the present value of the price expected to be realized on its resale 2) Earning capitalization approach According to this approach the value of an equity share can simply be determined by capitalizing the expected earnings Dividend capitalization approach This approach is bases on following assumptions: i) Dividends are paid annually ii) The dividend is received after the expiry of a year of purchase of equity share. Two valuation models used for this purpose: 1)Single period valuation method 2)Multi period valuation method Valuation of Equity Shares
  • 12. 1) Single period valuation method- It is presumed that investor expects to hold the equity for one year only. P= D1+ P1 . (1+ Ke) where, P= Current price of the equity share D1= Dividend per share expected at the end of first year P1= Expected market price of the share at the end of first year Ke= The required rate of return or capitalization rate. For example, An individual holds an equity share giving him an annual dividend of Rs.20. He expects to sell the share at the end of the year for Rs.180. Required rate of return is 12% Now the value of share will be = (20+180)/(1+0.12)= Rs.178.57 2) Multi period valuation method- In this equity share have no maturity period. P= De Ke where, P= Current value of equity share De= Expected annual dividend per equity share ke= Capitalization rate For example, A Ltd. is expected to pay dividend of Rs.40 per share each year. Capitalization rate is 15%. Now the present value of equity share will be= 40/0.15= Rs.267 Growth in Dividend: So far we have presumed that dividend per share remains constant year after year. However this is unrealistic. Earnings and dividends of most companies grow over time at least because of retention policies Growth in Dividend may be constant or variable year after year Valuation of Equity Shares (Cont..)
  • 13. Growth in dividends= retained earnings* rate of return For example, A company has a share capital of Rs.5,00,000. the company retains 60% of its earning. Rate of return of the company is 10%. Now the growth in dividends will be= 0.6*0.1= 0.06 or 6%. In case of constant growth in dividends, P= D1 (Ke- g) where, P= Current market price of an equity share D1= Dividend at the end of the year Ke= capitalization rate g= Growth rate in dividends For example, X Ltd is expected to pay a dividend at Rs.40 per share. Dividends are expected to grow perpetually at 10%. Capitalization rate is 15% Now value of equity share= 40/ (0.15- 0.10) = Rs.800 Earning capitalization approach- In this approach the value of equity share can simply be determined by capitalizing the expected earnings. P= E1 Ke where, P= Current value of an equity share E1= Expected earning per share. This will be same as D1, since the entire earnings are distributed as dividends. Ke= Capitalization rate For example, Earning per share of X Ltd is Rs.10. Capitalization rate is 20% and retained earning is ‘nil’ thus, value of equity share= 10/ 0.20= Rs.50. Valuation of Equity Shares Cont.
  • 14. Now its your turn: Questions Q1. Face value of debenture Rs.2,000 Annual interest rate 15% Expected interest rate 15% Maturity period 5 years Calculate the value of debentures. Ans: Rs.2,000 Q2. Annual interest for perpetuity Rs.1,000 Rate of return 8% Calculate the value of debentures. Ans: Rs.12,500 Q3. Expected dividend at year end Rs.10 Expected market price of share at year end Rs.90 Required rate of return 12% Calculate the current price of equity share. Ans: Rs.89.29
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