Module code: AFU 07303

Module Name: CORPORATE FINANCE

Academic year 2018/2019

BBF2 & BTX2

Lecturer: Dr. Jumanne Basesa

jumannebasesa@gmail.com

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The Nature, Significance and Scope
of Corporate Finance
 Corporate Finance Mind Map

MARKETS
NPV
PORTFOLIO THEORY

COST OF CAPITAL

AGENCY THEORY
INVESTMENTS

DIVIDEND POLICY CAPITAL STRUCTURE

SHAREHOLDER VALUE
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 The nature, significance and scope of
Corporate Finance
 Every decision made in a business has financial implications,
and any decision that involves the use of money is a
corporate financial decision.

 Corporate finance is mainly concerned with

 procurement of fund, and
 Efficient utilization of funds.

 Corporate finance sometimes is referred to as Managerial

Finance, Business Finance or Financial Management.
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 The Role of the Financial Manager

 Every discipline has first principles that govern and

guide everything that gets done within it.
 All of corporate finance is built on three principles,
which are usually referred to as roles of the financial
manager necessary for financial decision-making:
 Investment decision,
 Financing decision and
 Dividend decision.

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 i) The Investment Decision

 Invest in assets and projects that yield a return

greater than the minimum acceptable hurdle rate.

 The hurdle rate should be higher for riskier projects

and should reflect the financing mix used - owners’
funds (equity) or borrowed money (debt).

 With regard to this type of decision, the financial

manager needs to identify the profitable investment
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opportunities. 19/11/2018 08:42
 ii) The Financing Decision

 Choose a financing mix (debt and equity) that

maximizes the value of the investments made and
match the financing to nature of the assets being
financed.

 financial manager is faced with challenges of

determining how the investments of the firm will
be financed.

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 iii)The Dividend Decision:

 If there are no profitable investments, return the

cash to the owners of the business. In the case of a
publicly traded firm, the form of the return -
dividends or stock buybacks - will depend upon
what stockholders prefer.

 The financial manager needs to take into

considerations the following questions in order to
formulate the dividend pay out decisions.
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 The Dividend Decision…
 Should the firm distribute high dividends and
finance the business growth through new issues
of equities or debt?
 Should the firm distribute low dividends and use
the retained earnings to finance the business
expansions? or
 Should the firm pay zero dividends and use the
whole earnings for profitable investment
opportunities?

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 The Objectives of The Firm
 Different organisations have different objectives to
accomplish depending upon the nature and situation
of the business. The following can be considered as
the objectives of the firm;
 Maximization of shareholders wealth
 Maximization of profits
 Maximization of sales
 Minimizing costs

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 Objectives …

 Survival of the firm

 Creating an ever expanding empire
 Maximization of managerial salaries
 Maximization of personal objectives
 Achieving the target market share, etc

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 Objectives …

 In practice, it is quite impossible for companies to

have all these objectives in place at once.
 The most widely accepted objective of the firm is to
maximize the wealth of owners (shareholders),
which is achieved by increasing the market value of share.
 The wealth of corporate owners is measured by the
share price of the stock, which in turn is based on the
timing of returns (cash flows), their magnitude, and
their risk.

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 Forms of Business Organization

 Three forms namely:

sole proprietorship,
partnership and
a company.

 Find details on the first two forms

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 Corporation
 A corporation (company) is a legal entity separate from
its owners:
 Corporations can borrow money and own property (acquire assets),
can sue and be sued by its own name, and can enter into contracts.
 A company is owned by shareholders but controlled or
managed by directors.
 A company pays taxes on its profits.
 The remaining profits are distributed to the
shareholders who pay personal income tax on this
income. This system is referred to as double taxation.
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 Concept Check
 You are a shareholder in ABC company. The company earns TZS10,000
per share before taxes. After it has paid taxes, it will distribute the rest
of its earnings to you as a dividend (we make this simplifying
assumption, but should note that most corporations retain some of their
earnings for reinvestment). The dividend is income to you, so you will
then pay taxes on these earnings. The corporate tax rate is 40% and your
tax rate on dividend income is 15%. How much of the earnings remains
after all taxes are paid?
 TZS10,000 per share * 0.40 = TZS4000 in taxes at the corporate level,
leaving $TZS10,000 – TZS4,000 = TZS6,000 in after corporate tax
earnings per share to distribute.
 You will pay TZS6,000 * 0.15 = TZS900 in taxes on that dividend,
leaving you with TZS5,100 from the original TZS10,000 after all taxes.
 Thus, your total effective tax rate is 400+900/10,000 = 49%.
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 Difference Between PLC vs. Ltd
 Companies are categorised as Public limited company (plc.)
or Private limited company (Ltd).
 PLC can quote shares in a stock exchange whereas the Ltd
Company cannot.
 Talking of shares, the government may hold a majority of
shares in a Public Limited Company. This does not happen in
a Ltd company as the majority of the shares will be with a
family or with private individuals.
 In a public Limited Company, the shares can be transferred
freely. This can not be done with the Ltd Company.

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 Difference Between PLC vs. Ltd...
 The shares in a PLC can be bought and sold through the
stock exchange and there is no need to consult the owners
for selling and buying shares. On the other hand, the shares
of Ltd Company are normally sold to close friends and
others and that can only be done if all the shareholders
agree.
 While an Ltd company thinks more of profit from the
business, the Public Limited Company cares less of profit as
it is concerned with services and goods for the public.
 If something goes wrong with a Public Limited Company, it
has very adverse impact on the public.
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 The Agency Problem

 This constitutes:
o Agency problem
o Agency theory
o Agency costs
 Agency problems arise when there is a conflict between the
interests of the agent (e.g. the managers) and those of the
principal (e.g. shareholders).
 Agency costs are the costs associated with the agency problem
and arise mainly due to the conflict of interest between the
managers and the shareholders.

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 Agency Theory
 An agency relationship exists when one or more persons,
called principals (shareholders),
 hires one or more persons, called agents (directors), to
perform some service,
 And delegates decision-making authority to them.

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 Ways to reduce agency conflict:
 Mitigate agency problems through:
 Threat of firing or Sackings
 Threat of takeover and selling shares
 Granting share options to directors and senior
managers
 Maintaining good relationship
 Profit related pay
 Direct intervention by shareholders.

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 TIME VALUE OF MONEY

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 Time Value of Money
 Basic Problem:
 How to determine value today of cash flows that are
expected in the future?
 Time value of money refers to the fact that a dollar in
hand today is worth more than a dollar promised at some
time in the future
 Which would you rather have [TZS1,000,000 today or
TZS1,000,000 in 5 years]?
 Obviously, TZS1,000,000 today; why?

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 Time Value of Money…
 A dollar received today is worth more than a dollar received
tomorrow:
 This is because a dollar received today can be invested to earn interest
 Another reason behind this concept is that, future cash flows are not
only subject to risk but also inflation.
 Money received sooner rather than later allows one to use the
funds for investment or consumption purposes. This concept is
referred to as the Time value of money!!
 TIME allows one the opportunity to postpone consumption and
earn Interest.

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 Simple and Compound Interests

 Simple Interest
Is interest paid or earned only on the principal. The
Principal is the original amount of money you deposit or
borrow. Refer to MTU 07101.
 Compound Interest

Is interest earned not only on the principal, but also on the

interest that has already been earned, i.e. earning interest
on interest.
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 Types of TVM Calculations
 There are many types of TVM calculations
 The basic types that will be covered in this class include:
 Present value of a lump sum
 Future value of a lump sum
 Present and future value of cash flow streams
 Present and future value of annuities
 Keep in mind that these forms can, should, and will be
used in combination to solve more complex TVM
problems.

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 Compounding and Future value

 Compounding is the way to determine the future value of a

sum of money invested now:
 For example in a bank account, where interest is left in the
account after it has been paid.
 Interest is earned on re-invested interest in the future.
 Future value is calculated using the formula:

FVt  P0 (1  r ) t or FVt  P0  FVIFr ,t

Where: (1+r)n is called the compounding factor

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 Future Value of a Lump Sum
 Future value determines the amount that a sum of
money invested today will grow to in a given
period of time
 The process of finding a future value is called
“compounding” (hint: it gets larger)
Example
 How much money will you have in 3 years if you
invest TZS1million today at a 10% rate of return?

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 Future Value of a Lump Sum
Example

 Formula: FVt = P0 × (1+r)t

FV5 = $100 × (1+0.1)5
FV5 = $161.051
1. XYZ wants to know how large the deposit of TZS10million today will
become at a compound annual interest rate of 10% for 5 years.
2. If you invest $1,000 today at an interest rate of 10 percent, how much
will it grow to be after 5 years?
3. If you invest $11,000 in a mutual fund today, and it grows to be $50,000
after 8 years, what compounded, annualized rate of return did you earn?

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 Present Value of a Lump Sum

 Present value calculations determine what the value of a

cash flow received in the future would be worth today (time
0)
 The process of finding a present value is called “discounting”
(hint: it gets smaller)
 The interest rate used to discount cash flows is generally
called the discount rate
FVt
PV  PV  FVt  PVIFr ,t
(1  r ) t

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 Present Value of a Lump Sum
Example
 How much would $100 received five years from now be
worth today if the current interest rate is 10%?
PV = FVt / (1+r)t
PV = 100 / (1 + .1)5
PV = $62.09

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 Present Value of a Lump Sum
More Examples

1. Assume that you need to have exactly $4,000 saved 10

years from now. How much must you deposit today in
an account that pays 6% interest, compounded
annually, so that you reach your goal of $4,000?

2. Joann needs to know how large of a deposit to make

today so that the money will grow to $2,500 in 5 years.
Assume today’s deposit will grow at a compound rate of
4% annually

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 Present Value of a Cash Flow Stream

 A cash flow stream is a finite set of payments that an investor

will receive or invest over time.
 The PV of the cash flow stream is equal to the sum of the
present value of each of the individual cash flows in the
stream.
 The PV of a cash flow stream can also be found by taking the
FV of the cash flow stream and discounting the lump sum at
the appropriate discount rate for the appropriate number of
periods.

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 Example of PV of a Cash Flow Stream

 Joe made an investment that will pay $100 the first year,
$300 the second year, $500 the third year and $1000 the
fourth year. If the interest rate is ten percent, what is the
present value of this cash flow stream?
 You can use a timeline:

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 PV of a Cash Flow Stream
Example …

Draw a timeline:
100 300 500 1000

0 1 2 3 4
?
?
r = 10%
?
?
PV = $90.91 + $247.93 + $375.66 + $683.01
PV = $1397.51
PV= [FV1/(1+r)1]+[FV2/(1+r)2]+[FV3/(1+r)3]+[FV4/(1+r)4]
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 Future Value of a Cash Flow Stream

 The future value of a cash flow stream is equal to the sum of

the future values of the individual cash flows.
 With unequal periodic cash flows, treat each of the cash flows
as a lump sum and calculate its future value over the relevant
number of periods.
 Sum up the individual future values to get the future value of
the multiple payment streams.

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 FV of a Cash Flow Stream
Time Line

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 FV of a Cash Flow Stream

Example: Future Value of an Uneven Cash Flow

Stream
Jim deposits $3,000 today into an account that pays 10% per
year, and follows it up with 3 more deposits at the end of
each of the next three years. Each subsequent deposit is
$2,000 higher than the previous one. How much money will
Jim have accumulated in his account by the end of three
years?

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 FV of a Cash Flow Stream
Example…

FV of Cash Flow at T0 = $3,000 x (1.10)3 = $3,000 x 1.331= $3,993.00

FV of Cash Flow at T1 = $5,000 x (1.10)2 = $5,000 x 1.210 = $6,050.00
FV of Cash Flow at T2 = $7,000 x (1.10)1 = $7,000 x 1.100 = $7,700.00
FV of Cash Flow at T3 = $9,000 x (1.10)0 = $9,000 x 1.000 = $9,000.00
Total = $26,743.00
Note:
Be aware that some CFs occur at the beginning of each period
while others occur at the end of each period.

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 FV of a Cash Flow Stream
Exercise

 Joe made an investment that will pay $100 the first year,
$300 the second year, $500 the third year and $1000 the
fourth year. If the interest rate is ten percent, what is the
future value of this cash flow stream if each cash flow
occur
i. At the beginning of each period
ii. At the end of each period

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 Annuity Streams

 An annuity is a cash flow stream in which the cash flows are

all equal and occur at regular intervals.
 Annuity can be categorized as:
 Annuity Due: Payments or receipts occur at the
beginning of each period; e.g. house rent
 Ordinary Annuity: Payments or receipts occur at the
end of each period; e.g. salary.

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 Future Value of Ordinary Annuity

 Compounding and summing for each payment.

 The formula for calculating the future value of an
annuity stream is as follows:

(1  r )  1
n
FV A  A[ ] FVA  A  FVIFAr ,n
r

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 FV of Ordinary Annuity
example

Example: Future Value of an Ordinary Annuity Stream

Jill has been faithfully depositing $2,000 at the end of each year
for 10 years into an account that pays 8% per year. How much
money will she have accumulated in the account?

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 FV of Ordinary Annuity
 solution
Future Value of Payment One = $2,000 x 1.089 = $3,998.01
Future Value of Payment Two = $2,000 x 1.088 = $3,701.86
Future Value of Payment Three = $2,000 x 1.087 = $3,427.65
Future Value of Payment Four = $2,000 x 1.086 = $3,173.75
Future Value of Payment Five = $2,000 x 1.085 = $2,938.66
Future Value of Payment Six = $2,000 x 1.084 = $2,720.98
Future Value of Payment Seven = $2,000 x 1.083 = $2,519.42
Future Value of Payment Eight = $2,000 x 1.082 = $2,332.80
Future Value of Payment Nine = $2,000 x 1.081 = $2,160.00
Future Value of Payment Ten = $2,000 x 1.080 = $2,000.00
Total Value of Account at the end of 10 years $28,973.13

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 FV of Ordinary Annuity
solution using formula
 Using the formula

(1  0.08)  1
10
FV A  2,000[ ]
0.08
 $2,000 14.4866
 $28,973.1250

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 FV of Ordinary Annuity
Exercise
 Suppose you want to accumulate $500,000 at the end of
30 years as your retirement money. The interest rate you
can make annual deposits is 8%. How much should you
deposit each year, so that you will have $500,000 at the
end of 30 years?
 Assume that Sally owns an investment that will pay her
$100 each year for 20 years. The current interest rate is
15%. What is the FV of this annuity?

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 Present Value of Ordinary Annuity
 Discounting and summing for each payment.
 The generalized formula is

n
1  (1  r )
PV A  A[ ] PVA  A  PVIFA
r

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 PV of Ordinary Annuity
time line at r = 8%

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 PV of Ordinary Annuity
example
Example: Present Value of an Annuity.
John wants to make sure that he has saved up enough
money prior to the year in which his daughter begins
college. Based on current estimates, he figures that
college expenses will amount to $40,000 per year for 4
years (ignoring any inflation or tuition increases during
the 4 years of college). How much money will John need
to have accumulated in an account that earns 7% per
year, just prior to the year that his daughter starts
college?

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 PV of Ordinary Annuity
solution

 For; r = 7% and n = 4, PVIFA =3.3872

PVA = A*PVIFA = 40,000 × 3.3872
= $135,488

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 Annuity Due

 A cash flow stream such as rent, lease, and insurance

payments, which involves equal periodic cash flows that
begin right away or at the beginning of each time interval, is
known as an annuity due.
 An annuity due is calculated in reference to an ordinary
annuity. In other words, to calculate either the present value
(PV) or future value (FV) of an annuity-due:
Annuity Due = Ordinary annuity x (1 + r)

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 Annuity Due
example

Example: Annuity Due versus Ordinary Annuity

Let’s say that you are saving up for retirement and decide to
deposit $3,000 each year for the next 20 years into an
account that pays a rate of interest of 8% per year. By how
much will your accumulated nest egg vary if you make each of
the 20 deposits at the beginning of the year, starting right
away, rather than at the end of each of the next twenty years?

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 Annuity Due
solution

 FV ordinary annuity = $3,000 × [((1.08)20 - 1)/.08]

= $3,000 × 45.76196
= $137,285.89
 FV of annuity due = FV of ordinary annuity × (1+r)
 FV of annuity due = $137,285.89 × (1.08)
= $148,268.76

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 Evaluating Perpetuities

 A series of constant cash flows expected to occur at the

end of each year for ever and ever into the future is
known as a perpetuity.

C
PV A 
r

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 Perpetuity
Example
Example 5: PV of a Perpetuity
If you are considering the purchase of a consol that pays
$60 per year forever, and the rate of interest you want to
earn is 10% per year, how much money should you pay
for the consol?
Answer:
r=10%, A = $60, and PV = ($60/0.1) = $600.
So $600 is the most you should pay for the consol.

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 THANK YOU FOR LISTENING

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