Introduction to

Financial Products
Lecture 1
Introduction to Corporate Finance
By the end of the lecture, students will be able to :

● Understand financial market and instruments

● Discuss the concept of Financial management
● Classify Risk and uncertainty pertaining to investment
● Define Financial analysis
● Define the advantages and disadvantages of Profit and Wealth Maximization
Overview of Capital Market

Capital market is a market for financial investments that are direct or indirect claims to capital. It is a
market where savings and investments channel between suppliers and investors.

Capital markets are combination of primary and secondary markets. The most common capital
markets are the stock market and the bond market.

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Are capital market same as financial market?

Financial markets encompass the broad range of venues where people and organizations exchange
assets, securities and contracts with one another, and are often secondary markets. Capital markets
on the other hand are used primarily to raise funding usually for a firm, to be used in operations and
for growth.
What is financial management according to you?

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Financial management

Financial management is an integral part of overall management. It is a managerial activity

concerned with planning and controlling the firm’s financial resources.
Objectives of Financial Management

● Profit maximization: The main aim of any economic activity is earning profit. Profit maximization
aims at maximizes the gain of the concern.
● Wealth maximization: Wealth maximization is one of the modern approaches. Wealth
maximization is also known as value maximization or net present worth maximization.
Functions of Financial Market

1. Estimation of capital requirements: A finance manager has to estimate with regards to the
company's capital requirements. This will depend on expected costs, profits, and future
programs and policies of concern.
2. Determination of capital composition: The capital structure must decide, which involves
short-term and long-term debt-equity analysis. This will depend upon the proportion of equity
capital a company possesses and additional funds raised from outside parties.
3. Choice of sources of funds: For additional funds to be procured, a company has many choices
like-
● Issue of shares and debentures
● Loans to be taken from banks and financial institutions
● Public deposits to be drawn like in form of bonds.

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4. Investment of funds: The finance manager has to decide to allocate funds into profitable ventures
so that investment safety and regular returns are possible.

5. Disposal of surplus: The net profits decision have to be made by the finance manager. This can be
done in two ways:

● Dividend declaration - It includes identifying the rate of dividends and other benefits like bonus.
● Retained profits - The volume has to decide, which will depend upon the company's expansion,
innovational, diversification plans.

6. Financial controls: The finance manager has to plan, procure and utilize the funds, but he also
exercises control over finances. This can be done through ratio analysis, financial forecasting, cost
and profit control, etc.
3 Key Questions in Corporate Finance

1. What long term investment should the firm take?

Capital Budgeting Decision

1. What is the best way to finance these long term investments?

Capital Structure Decision

1. How should a firm manage its short term asset and liabilities?

Working Capital Management

Let’s learn the 3 types of Financial Decisions

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Types of Financial Decisions

Investment Decision (Capital Budgeting Decisions)

A financial decision concerned with how the funds invest in different assets is known as an
investment decision.

Key questions can be answered in investment decision

1. How much cash does the firm expect to receive?

2. When does the firm expect to receive it?
3. How likely is the firm to receive it?

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Factors Affecting Investment Decisions / Capital Budgeting
Decisions

● Cash flows of the project- The sequence of cash receipts and payments over the life of an
investment proposal should consider and analyze for selecting the best recommendation.
● Rate of return- The predicted returns from each proposal and the risk involved should be
considered to select the best recommendation.
● Investment criteria involved- The various investment proposals are evaluated based on capital
budgeting techniques, which involve calculating investment amount, interest rate, cash flows,
rate of return, etc.
Financing Decision (Capital structure decision)

A financial decision is concerned with the amount of finance to raise from various long-term sources
of funds like equity shares, preference shares, debentures, bank loans, etc.

Key questions can be answered in financing decision

1. How should the firm pay for its asset? Debt or equity?
2. How much the firm borrow?
3. What is the least expensive source of funds?
4. When and where to raise the money?

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Factors Affecting Financing Decision:

● Cost- The cost of raising funds from different sources is different. The cost of equity is more
than the cost of debts. The cheapest source should be selected prudently.
● Risk- The risk associated with different sources is different. More risk is associated with
borrowed funds than the owner’s fund as interest is paid on it, and it is also repaid after a fixed
period of time or on the expiry of its tenure.
● Flotation cost- Flotation cost involves issuing securities such as broker’s commission,
underwriter’s fees, expenses on the prospectus, etc. Higher the flotation cost, less attractive is
the source of finance.
● Cash flow position of the business- In case the cash flow position of a company is good enough
then it can easily use borrowed funds.
Dividend Decision (Working capital management)
A financial decision concerned with deciding how much of the profit earned by the company
should be distributed among shareholders (dividend) and how much should retain for the future
contingencies (retained earnings) is called a dividend decision.

Key questions can be answered in dividend decision

1. How should the firm manage the receipt and disbursement of cash - current assets and current
liabilities?
2. What is the best way to manage day to day short term assets like inventory?
3. How should the firm obtain short term financing?
4. Should the firm sell or purchase on credit? On what terms?

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 Factors Affecting Dividend Decision:
● Earning: A company having high and stable earnings could declare a high rate of dividends as
dividends are paid out of the current and past earnings.
● Stability of dividends: Companies generally follow the policy of stable dividends. The dividend
per share is not altered if earning changes by a small proportion or an increase in earnings is
temporary.
● Growth prospects: In case there are growth prospects for the company in the near future then,
it will retain its earnings and thus, no or less dividend will be declared.
Factors Affecting Dividend Decision:

● Cash flow positions: Dividends involve an outflow of cash and thus, availability of adequate cash
is foremost requirement for declaration of dividends.
● Preference of shareholders: When deciding about dividends, shareholders' preference is taken
into account. In case of shareholders desire for dividend, then the company may go for declaring
the same. In such a case, the dividend amount depends upon the degree of shareholders'
expectations.
Investment under risk and uncertainty
Risk and uncertainty are inherent in decisions regarding capital budgeting. This is because
investment decisions and capital budgeting are today's actions that will bear unexpected fruit in the
future.

● Technological advances raise the level of risk and uncertainty by making the plants or
machinery outdated and the product redundant.
● Inflation and deflation are expected to affect potential investment decision making the degree
of uncertainty more extreme and expanding the risk spectrum.
● Seasonal fluctuations and market cycles can significantly affect cash inflows and expected
outflows for various project proposals. The cost of capital providing cut-off rates can often be
inflated or deflated under the business cycle conditions.

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How to Turn Uncertainty into an Advantage

● Forecasting is essential: Companies that rely on annual budgets are finding themselves in
shallow waters because the figures may no longer be applicable even before a specific financial
year is over.
● Shift to automation: Manual collection of data takes up more time than actually analyzing it, so
it is often too late when problems are identified.
● Efficient reporting of finances: Automation also contributes to achieving financial reports that
are efficient and accurate.
● Self-service is key: Stakeholders are an important component of an organization, which is why
providing self-service apps is helpful.

For example, users can use a specific app to open their accounts and evaluate the data by
themselves. This not only gives them the freedom to do so anytime it is convenient for them, but it
also frees up work for the organization’s IT team, letting them concentrate on more critical processes.
Financial Analysis

Financial analysis is the process of evaluating businesses, projects, budgets, and other finance-related
transactions to determine their performance and suitability.

● It is used to analyze whether an entity is stable, solvent, liquid, or profitable enough to warrant a
monetary investment.
● Financial analysis is used to evaluate economic trends, set financial policy, build long-term plans
for business activity.
● One of the most common ways to analyze financial data is to calculate ratios from the data in the
financial statements to compare against those of other companies or the company's historical
performance.

For example, return on assets (ROA) is a common ratio used to determine how efficient a company is at
using its assets and as a measure of profitability.

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Corporate Financial Analysis

In corporate finance, the accounting department conducts the analysis internally and shares it with
management to improve business decision-making.

● This type of internal analysis may include ratios such as net present value (NPV) and internal
rate of return (IRR) to find projects worth executing.
● A key area of corporate financial analysis involves extrapolating a company's past performance,
such as net earnings or profit margin, into an estimate of the company's future performance.

For example, retailers may see a drastic upswing in sales in the few months leading up to Christmas.
This allows the business to forecast budgets and make decisions, such as necessary minimum
inventory levels, based on past trends.
Quiz :

Which of these is not a factor affecting dividend decision ?

A) Earning
B) Cashflow positions
C) Growth Prospects
D) Cost
What is Corporate Finance ?
● Corporate finance refers to the financial decisions that an organisation makes in its daily business
operations. It aims to utilise the capital, which the organisation has, to make more money while
simultaneously reducing the risks of certain decisions.
● Business decisions that involve the decision pertaining to the identification of sources of capital for
funding corporations are known as corporate financial decisions.
Role of a Finance Manager :

● He aims to effectively allocate and use the resources of an organisation

● He is responsible for procuring funds from the market to reduce risks and cost
● His functions include forecasting, planning, determining the capital structure, raising sufficient fund,
designing investment policy, financial negotiation and planning dividend decision
Few Career Opportunities in Corporate Finance :
Real Estate Manager
Corporate accountant
Benefits Manager
Financial Analyst
Treasurer
Cost Analyst
Investor Relations Manager
Auditor
Objectives of Corporate Finance
Let us have a look at the major objectives of Corporate Finance
Objectives :
1) Profit Maximization

● Profit maximisation is used as a standard of financing decisions

● With this approach, a firm should undertake all those activities which add to its profits and
eliminate all others activities which reduce its profits
● In totality,the objective highlights the fact that all the decisions—financing, dividend and
investment, should result in profit maximisation.
2) Wealth Maximization

● The Wealth maximisation approach is known for the evaluation of performance of a

business undertaking
● It is also known as value maximisation or maximisation of net present worth. According to
this approach, financial management should take decisions which increase the net present
value of the firm
3)Value Maximization

● Value maximization may be defined as the managerial function involved in the appreciation
of the long-term market value of an organization
● The total value of an organization is comprised of all the financial assets, such as equity,
debt, preference shares, and warrants
● The total value of an organization increases when the value of its shares increases in the
market
Profit Maximization
Favorable Arguments for Profit Maximization:

● Everyone is working to get reward and the reward of the entrepreneur is profit so the main
aim of the entrepreneur should be to earn maximum profits
● Profit is the barometer of the business operation efficiency.profit maximization is justified on
the grounds of rationality
● Profit reduces risk of the business concern. A business will be able to survive in an
unfavorable situation, only if it has some past earnings to rely upon
● Profit is the main source of finance for the growth and development of business concern
● Firms which tend to earn continuous profit in the long run make up their products according
to the demand of the consumers
Unfavorable Arguments for Profit Maximization:
● It leads to exploiting the consumers by charging high prices to get more profits
● For achieving the Profit maximization objective sometimes businessmen uses immoral
practices such as corrupt practice, unfair trade practice, etc
● Profit maximization objectives lead to increase in the inequalities in the society
● It leads to exploitation of the workers also by creating pressure on them for more production
to earn more profit
Limitations of Profit Maximization
● It is vague
● It ignores the time value of money
● It ignores risk
● It ignores the society
● It is incomplete concept
Wealth Maximization
Favorable Arguments for Wealth Maximization:
● It considers the time value of money
● It considers the risk of the business concern
● It provides efficient allocation of resources
● It ensures the economic interest of the society
● It considers maximizing the stockholder wealth instead of profit of the firm
Limitations of Wealth Maximization :
● Useful for Large Organizations Only
● Does not distribute dividend regularly
Comparative Analysis of Profit Maximization and Wealth
maximization
Profit Maximization
● It is only for short term
● It emphasis on profit only
● It ignores society
● It has a narrow scope
● It is a traditional approach
● It ignores the risk factor
● It ignores the time value of money
● It is a secondary objective
Wealth Maximization
● It is for long term
● It emphasis on shareholders wealth
● It considers society
● It has a wider scope
● It is a modern approach
● It considers the risk factor
● It considers time value of money
● It is primary objective
Activity :

Match the following :

i)Total value of an organization increases
i) Profit Maximization
when the value of its shares increases
ii) Wealth maximization ii) Financing, dividend and investment,
should result in profit maximisation.
iii) Value Maximization
iii) Increasing the net present value of the
firm
Activity :

Match the following :

i)Total value of an organization increases
i) Profit Maximization
when the value of its shares increases
ii) Wealth maximization ii) Financing, dividend and investment,
should result in profit maximisation.
iii) Value Maximization
iii) Increasing the net present value of the
firm
Worksheet 1