Introduction

to
Corporate Finance
By
Dr. Gurendra Nath Bhardwaj
Associate Professor
IILM Graduate School of Management,
16 Knowledge Park - II, Greater Noida - 201 306,
Tel: 0120 - 3374335 (O), Mobile - 9910634497
Email: gurendra.bhardwaj@iilmgsm.ac.in, gurendrabhardwaj@gmail.com
 COURSE TOPICS
• Introduction, Fundamental Valuation
• Concepts & Overview of Risk & Return
• Cost of Capital
• Capital Budgeting
• Working Capital Management
• Capital Structure and Dividend Policy
The Process of Value Creation
 Financial Management
• Finance refers to the collection & best
utilization of funds.
• Financial Management is a managerial activity
which is concerned with planning &
controlling of the firm financial resources.
• It includes not only the collection & Utilization
of financial resources but also analytical part
of the financial decision making.

4
 Development of Financial
Management
• Traditional Phase
• Transitional Phase
• Modern Phase

5
 Traditional Phase
• Traditional phase lasted for about four decades.
• As its features, it referred to certain episodic
events in the life cycle of the firm particularly
about the formation of the company.
• It also focused on the issue of capital, its broad
expansion programme and highlighted on
mergers, reorganization & Liquidation.
• During this period the emphasis was on
accounting and preparation of final accounts and
making arrangements of money
6
 Transitional Phase
• Transitional phase began around forties and
continued up to fifties.
• This was more or less similar to the traditional
phase but with the current problematic views
of the managers of finance in the areas of
fund analysis, planning and control and proper
utilization of funds.
• It included the ratio analysis and preparation
of funds flow statement.

7
 Modern Phase
• The modern phase started in mid fifties and has
witnessed an accelerated pace of development.
• Economic theories have incorporated these
finance ideas and attempted to develop
quantitative techniques in explaining these ideas.
• Attempts are made to rationally match the funds
and their uses in the light of appropriate decision
criteria.

8
 Collection of Funds
• Owner’s Funds
– Equity Share
– Preference Share
– Retained Earnings
• Borrowed funds
– Debentures
– Loan & Advances from FIs
– Bank Overdrafts
– Trade Creditor & Other Short Term Borrowings.

9
 Application of Funds
• Long Term Assets
• Short Term Assets

10
Functions of Modern Financial
Management
– Long Term Asset Mix or Investment Decision.
– Capital Mix or Financing Decision.
– Profit Allocation or Dividend Decision
– Short Term Asset Mix or Liquidity Decision

11
 2- Functions of Modern
Financial Management
Equity & Dividend & Long Term Short term
Debt Retained Assets Assets
Earning

Capital mix Profit Long term Short term

or financing allocation or asset mix or asset mix or
decision dividend investment liquidity
decision decision decision

12
 Long Term Asset Mix or
Investment Decision
It involves capital expenditure (Capital
budgeting). It consists broadly following
investment decisions.
– New Projects
– Expansion Project
– Renewal/ Renewal Projects
– Exploration projects (Oil Well)
– Research & Development (R & D) Projects.
– Projects for compliance of certain statutory
requirement.

13
 Capital Budgeting
In investment decision we have to do following
two things.
– The evaluation of the prospective profitability of
new investments.
– The measurement of cut off rate against that the
prospective return of new investments could be
compared.

14
 Capital Mix or Financing
Decision
• It includes determination of appropriate
proportion of equity and debt.
• The mix of equity & debt is known as capital
structure. One has to decide the optimum
capital structure.
• When the shareholders return is maximized
with given risk, the market value per share will
be maximized & the firm’s capital structure
would be considered optimum.

15
 Profit Allocation or Dividend
Decision
• This type of problem arises with companies’
whether it should distribute all the profit as a
dividend or retain that or distribute a portion
of the profit & retain the balance.
• In this segment calculation of dividend payout
ratio & retention ratio is done.
• The optimum dividend policy is one that
maximizes the market value of the firm’s
share.

16
 Short Term Asset Mix or
Liquidity Decision
• It emphasis on short term assets mix decision,
that we term as liquidity decision.
• A conflict exists between profitability &
liquidity, while managing current assets.
• The profitability – liquidity trade off requires
that the financial management should
develop should techniques of managing
current assets.

17
 Objective of the Firm

Profit Maximization Vs. Wealth

Maximization
• What should be the Objective of the firm?
Whether it has should increase profit/ current
Income or source of that income.
• What one has to do to obtain the objective?

18
 Profit Maximization
• As we know profit means the amount of
difference between the value of sales or cost
of any product & services.
• So the increase in the profit indicates the
change in the value of sales price or cost of
production or both.

19
 Example
• Let us assume if the sale price of product X is
Rs. 100 & its cost is Rs. 80. So, the profit is Rs.
20. We can increase the profit of Rs. 20 up to
Rs. 30 through following way.
– By increasing the selling price by Rs. 10
– By decreasing the cost by Rs. 10
– By increasing the selling price by Rs. 5 & by
decreasing the cost by Rs. 5

20
 Profit Maximization
• Profit maximization implies that a firm either produces maximum
output from the constant input or uses minimum input for the
production of constant output.
• In both the condition it highlighted the increase in the efficiency.

• On the other hand the sale price of product / or services is very

important in each case & every market.
• The increase in the profit also shows the shifting of resource form
non productive or less productive application to the productive or
highly productive application.
21
 Question of Welfare Economy

• But the million dollar question is whether the

price system or profit maximization concepts
can serve the concept of social welfare or
welfare economy?

22
 Arguments Against profit
maximization
• Profit maximization assumes the perfect competition.

• It is also an old concept which was developed in the age of early 19th
centaury.
• When the business structures were limited.

• The concept of unlimited liability of the owner was there as in the case of
sole trading & partnership.
• But now in the case of modern phase there is an age of corporate sector
in which owner has limited liabilities, the interest of owners & lenders has
been controlled & directed by the management or salary paid employees.

23
 Contd.
• Profit maximization also leads to increase in
inequality of income & wealth.
• Labour becomes the most exploited factor of
production.
• Profit maximization suffers from the following
limitations.
– Ambiguous definition of profit
– It ignores the concept of time value of money.
– It also ignores the risk factor.

24
Ambiguous definition of profit:
What does it mean by profit?
Does it mean-
• Long or Short Term Profit
• Gross Profit or Net Profit
• Profit before Tax or Profit after Tax
• Total Profit or Profit per Share
• Only operating profit or Total Profit

25
 It ignores the concept of time
value of money
• Time value of money is an individual’s
preference for the possession of a given
amount of money now, rather than the same
amount at some future time.
• The reasons for this preference may be as
follows.
– Risk
– Preference for consumption
– Investment opportunities

26
 Table No. 1
Yearly Company A Company B
Profit

I 15,000 35,000

II 25,000 25,000

III 35,000 15,000

Total 75,000 75,000

27
 Concept of Time Value of Money

Years PV of Rs. Actual Effective Actual Effective

1 @ 10% Profit of Profit of
A B
I .909 15,000 13635 35,000 31815

II .826 25,000 20650 25,000 20650

III .751 35,000 26285 15,000 11265

75000 60570 75000 63730

28
It also ignores the risk factor
Years Probability Actual Effective Actual Effective
Profit of Profit of Profit of Profit of
A Co. A Co. B Co. A Co.
I .80 15,000 12000 35,000 28000

II .60 25,000 15000 25,000 15000

III .90 35,000 31500 15,000 13500

75000 58500 75000 56500

29
Maximization of Profit Per share
Maximization of profit does not lead to
maximization of profit per share
Let us assume
Profit After tax = Rs. 1,00,000
No. of shares = 10,000
EPS = 1,00,000 / 10,000 = Rs. 10
Profit after Taxes = Rs. 1,50,000
No. of Shares = 20,000
EPS = 1,50,000/20,000 = Rs. 7.50

30
 Share Holder’s Wealth Maximization
• It means maximization of net present value of share holder’s wealth
or appreciation in the share holder’s wealth after considering the
concept of time value of money & Uncertainty of return.
• Net present Value of share holder’s wealth is the amount of difference
between present value of its benefits & present value of its costs.
• So, the investment proposals having positive NPV should be accepted
& proposals having negative NPV should be rejected. In case of
mutually exclusive projects, projects bearing highest NPV should be
accepted.

31
 Contd.
• In the net present value system the benefits are measured in terms
of cash flows not terms of accounting profit.
• This concept is based on the assumption that the financial
management should seek to maximize in making investment and
financing decision on behalf of share holders.
• From the shareholder’s point of view, the wealth created by a
company through its action is reflected in the market value of the
company’s shares.
• So, it implies the firm’s objective is to maximize the market value of
its shares.
32
 Examples
• “For creation of wealth for shareholders on a
sustainable and long-term basis and to
maximize total returns to shareholders.”
-Ranbaxy
• “Our mission is to maximize share-owner
value over time.”
-Coca-Cola Company
• “Creating value.”
-Tata Steel
 Issue for Discussion

Agent Principal Conflicts

 Concept
• The mangers perform on behalf of the
shareholders.
• The Agency theory suggests
– that managers who act as agents of the
shareholders , may act in their best interest.
– They may most interested in increasing their
personal wealth.
• Agency costs are additional costs incurred by
the principals (shareholders), when acting
through an agent.
• It arise due to-
– Managerial Rewards
– Information asymmetry
– Manager’s Risk preference
– Manger's short-termism
 Check your knowledge
• Key financial functions of firm include the
following except:
– Investment Decision
– Make or buy decision
– Dividend decision
– Financing decision
• Profit is maximized when:
– Cost is minimized
– Revenue is maximized
– Marginal revenue= Marginal cost
– None of the above
• Wealth maximization objective stands for
– Maximizing earning per share
– Maximizing value of debt instruments
– Maximizing market value of equity shares
– None of the above
• Agency theory suggests that managers
(agents) may:
– Not operate in the best interest of the firm
– Try to maximize their personal gains rather than
maximizing the wealth of share holders
– Operate in the best interest of the stakeholders
– None of the above
• Agency Cost does not include the following
– Bonus
– Higher pay packages
– Dearness allowance
– Stock options
 Answers
Question Right Answers
no.

1. Make or buy decision

2 Marginal revenue= Marginal cost

3 Maximizing market value of equity shares

4 Try to maximize their personal gains rather than

maximizing the wealth of share holders

5 Dearness allowance
Thanks