Principles of
Corporate Finance
Session 1 & 2
Unit I: INTRODUCTION
Why study Managerial
Finance?
• Prepare for the workplace of tomorrow.
• Broadening expectations of financial
knowledge and skills.
• Use and understand financial
terminology and concepts in team
communication.
• Developing cross-functional
capabilities.
• Critical thinking.
Career Opportunities in Finance
Capital Budgeting Analyst
Project Finance Manager
Cash Manager
Banking & Financial Institutions
Personal Financial Planning
Investments
Pension Fund Manager
Real Estate
Insurance
Financial Analyst
What is Finance?
• Finance is the art and science of managing
money.
• Finance affects all individuals, businesses,
and governments in the process of the transfer
of money through institutions, markets, and
instruments.
Managerial Finance
• Managerial finance is concerned with the duties of the
financial manager in the business firm.
• The financial manager actively manages the financial
affairs of any type of business, whether private or
public, large or small, profit-seeking or not-forprofit.
• Increasing globalization has complicated the
financial management function.
• Changing economic and regulatory conditions also
complicate the financial management function.
Principles of
Corporate Finance
Session 3
Firm and its Legal forms
• A Firm is a transformation unit, which
transforms inputs ( 5 M’s) into Outputs
(Goods & Services)
Firm and its Legal forms
Four basic forms of business organization
(Firm):
• Sole Proprietorships
• Partnerships (general and limited)
• Corporations
• Limited liability companies
Sole Proprietorship
• A business form for which there is one
owner. This single owner has unlimited
liability for all debts of the firm.
• Oldest form of business organization.
Summary for
Sole Proprietorship
•
•
•
•
Advantages
Simplicity
Low setup cost
Quick setup
Single tax filing on
individual form
Disadvantages
• Unlimited liability
• Hard to raise
additional capital
• Transfer of
ownership
difficulties
Partnership
• A business form in which two or more
individuals act as owners.
• Types of Partnerships
– General Partnership – all partners have unlimited
liability and are liable for all obligations of the
partnership.
– Limited Partnership – limited partners have liability
limited to their capital contribution (investors only).
At least one general partner is required and all
general partners have unlimited liability.
Summary for Partnership
•
•
•
•
Advantages
Disadvantages
Can be simple
• Unlimited liability for
the general partner
Low setup cost, higher
than sole proprietorship • Difficult to raise
additional capital, but
Relatively quick setup
Limited liability for limited easier than sole
proprietorship
partners
• Transfer of ownership
difficulties
Corporation
• A business form legally separate from its
owners.
• An artificial entity that can own assets and
incur liabilities.
Summary for Corporation
•
•
•
•
Advantages
Limited liability
Easy transfer of
ownership
Unlimited life
Easier to raise large
quantities of capital
Disadvantages
• Double taxation
• More difficult to
establish
• More expensive to
set up and
maintain
Limited Liability Companies
• A business form that provides its owners
(called “members”) with corporate-style
limited personal liability and the federal-tax
treatment of a partnership.
Principles of
Corporate Finance
Session 4 & 5
The Managerial Finance Function
Relationship to Economics
• The primary economic principal used by financial
managers is marginal analysis which says that
financial decisions should be implemented only when
benefits exceed costs.
The Managerial Finance Function
Relationship to Accounting
• One major difference in perspective and
emphasis between finance and accounting is
that accountants generally use the accrual
method while in finance, the focus is on cash
flows.
• The significance of this difference can be
illustrated using the following simple
example.
The Managerial Finance Function
Relationship to Accounting
• The Zasloff Corporation experienced the following
activity last year:
Sales:
$100,000 (50% still uncollected)
Cost of Goods:
$ 60,000 (all paid in full under supplier terms)
Expenses:
$ 30,000 (all paid in full)
• Now contrast the differences in performance under the
accounting method versus the cash method.
The Managerial Finance Function
Relationship to Accounting
INCOME STATEMENT SUMMARY
Sales
-COGS
Gross Margin
-Expenses
Net Profit/(Loss)
ACCRUAL
$100,000
(60,000)
$ 40,000
(30,000)
$ 10,000
CASH
$ 50,000
(60,000)
$(10,000)
(30,000)
$(40,000)
Principles of
Corporate Finance
Session 6
Key Activities of the Financial Manager
Investment Decisions
Most important of the three
decisions.
• What is the optimal firm size?
• What specific assets should be
acquired?
• What assets (if any) should be reduced
or eliminated?
Financing Decisions
Determine how the assets (LHS of
balance sheet) will be financed (RHS of
balance sheet).
• What is the best type of financing?
• What is the best financing mix?
• What is the best dividend policy (e.g.,
dividend-payout ratio)?
• How will the funds be physically
acquired?
Asset Management
Decisions
• How do we manage existing assets
efficiently?
• Financial Manager has varying degrees of
operating responsibility over assets.
• Greater emphasis on current asset
management than fixed asset
management.
Principles of
Corporate Finance
Session 7
Goal of the Financial Manager
 Profit maximization (profit after tax)
Shareholder’s Wealth Maximization
Goal of the Financial Manager
Profit Maximization
• Maximizing the Rupee Income of Firm
– Resources are efficiently utilized
– Appropriate measure of firm performance
– Serves interest of society also
Goal of the Financial Manager
Objections to Profit Maximization
•
•
•
•
•
It is Vague
It Ignores the Timing of Returns
It Ignores Risk
Assumes Perfect Competition
In new business environment profit
maximization is regarded as
–
–
–
–
Unrealistic
Difficult
Inappropriate
Immoral.
Goal of the Financial Manager
• Why?
Maximize Shareholder Wealth!!!
• Because maximizing shareholder wealth properly
considers cash flows, the timing of these cash flows,
and the risk of these cash flows.
• This can be illustrated using the following simple
valuation equation:
Share Price = Future Dividends
Required Return
level & timing
of cash flows
risk of cash
flows
Goal of the Financial Manager
What About Other Stakeholders?
• Stakeholders include all groups of individuals who have
a direct economic link to the firm including:
– Employees
– Customers
– Suppliers
– Creditors
– Owners
• The "Stakeholder View" prescribes that the firm make a
conscious effort to avoid actions that could be
detrimental to the wealth position of its stakeholders.
• Such a view is considered to be "socially responsible."
Principles of
Corporate Finance
Session 8
Risk-return Trade-off
• Risk and expected return move in
tandem; the greater the risk, the greater
the expected return.
• Financial decisions of the firm are
guided by the risk-return trade-off.
• The return and risk relationship:
Return = Risk-free rate + Risk premium
• Risk-free rate is a compensation for
time and risk premium for risk.
The Agency Issue
The Problem
• Whenever a manager owns less than 100% of the
firm’s equity, a potential agency problem exists.
• In theory, managers would agree with shareholder
wealth maximization.
• However, managers are also concerned with their
personal wealth, job security, fringe benefits, and
lifestyle.
• This would cause managers to act in ways that do not
always benefit the firm shareholders.
The Agency Issue
Resolving the Problem
• Market Forces such as major shareholders and the
threat of a hostile takeover act to keep managers in
check.
• Agency Costs may be incurred to ensure management
acts in shareholders interests.
•Structure management compensation to make
shareholder interests their own