Thursday, 26 March 2020

Corporate Finance Notes

Corporate Finance Definition

To start a firm you need to make an investment in assets such as inventory, machinery, land and labor. This is called investment decision. And, you can finance your investment by borrowing and selling some shares of the firm. This is called financing decision. And, when your firm begins operation, it will generate cash. This is the basis of value creation. The purpose of the firm is to create value for the owner.
Definition
Corporate Finance is the study of investment and financing decision making, and how should a firm manage its short-term operating cash flows in order to increase the value of the firm to the owner.

Business Structures

Business can take many forms. But, the three basic forms are:
  1. The Sole Proprietorship
  2. The Partnership, and
  3. The Corporation
The Sole Proprietorship
A sole proprietorship is a business owned by one person. The person, owner, is liable for all business debts and obligations. And, the profits of the business are taxed as individual income.
The Partnership
When two or more people get together to carry out business, they form a partnership. The partners (except limited partners who have limited liability) are liable for all business debts and obligations. The profits of the business are taxed as personal income to the partners.
The two main advantages of the sole proprietorship and the partnership are that it is easy to start with limited budget and have to pay taxes only on personal incomes. But, it is difficult for large business to exist as a sole proprietorship or a partnership, because of:
  • Unlimited liabilities to the sole proprietors and the partners
  • Limited life of the business, as it depends on the life, mood and the circumstances of the sole proprietors or the partners
  • Difficulty of transferring ownership, and
  • Limited budget and difficulty in raising cash

Corporation

What is a corporation? How it is formed and what are its main functions? Who own the corporation and who run a corporation?
How corporations are formed?
Suppose you decide to start a firm to make some goods. To do this you hire managers to buy raw material, and you assemble a work force that will produce and sell finished goods. You can finance your investment by borrowing and selling some shares of the firm. A large corporation may have hundreds of thousands of shareholders, who become owners of the fraction of the firm by their fraction of investment. And your business set-up is called a “corporation”.
What is a corporation?
A corporation is a legal entity owned by its shareholders and run by its managers. According to the law, it is a legal person that is owned by its shareholders. As a legal person, a corporation can have a name and enjoy many of the legal powers of natural persons. The corporation can make contracts, carry on a business, borrow or lend money, and sue or be sued. One corporation can make a takeover bid for another and then merge the two businesses. Corporations pay taxes but cannot vote!
Functions of a corporation
Corporations invest in real assets, which generate cash inflows and income. The shareholders, who own the corporation, wants its managers, who run the corporation, to maximize its overall value and the current price of its shares.
To maximize the value for the owners, corporations face two principal decisions:
  1. Investment decision: what investments should the corporation make?
  2. Financing decision: how should it pay for the investments?Investment decision: what investments should the corporation make?

Corporation Investment Decision


The investment decision is one of the two principal decisions a corporation has to take. The investment decisions of a corporation are of two types:
1. Smaller Investment Decisions
Corporations make thousands of smaller and simpler investment decisions every year. These investments decisions are for example purchase of a vehicle, machine tools or any other regular running equipment. Usually managers themselves take these decisions.
2. Larger Investment Decisions
Larger investment decisions are also called capital budgeting or capital expenditure (CAPEX) because usually these investments list in a company’s annual budget. Managers do not take these decisions by themselves only. These decisions are taken after intensive research, in consultation with engineering, manufacturing and marketing department, and with the approval of board of governance.

Corporation Financing Decision


The investment decision is the first principal decision a corporation has to take. The second is Financing decision which means how to raise money for this investment. A corporation can raise money from:
A. Lenders, and
B. Shareholders
A. Borrowing Money from Lenders
A corporation can borrow money from:
1. Banks
A corporation can borrow money from a bank, where the corporation has to repay the cash back plus a fixed rate of interest for the use of capital.
2. Issuing Bonds
A corporation can also borrow by issuing bonds. In this case, the corporation also has to repay the cash back plus a fixed rate of interest for the use of capital.
The corporations often pay interest rate to bond holders less than the interest rate they have to pay to the banks. However, it is very difficult for young corporations to sell their bonds. So, usually they have to rely on bank loans.
B. Shareholders
Corporations can raise money either by:
1. Reinvesting the cash flow in the shape profits. In this case the corporation is investing on behalf of existing shareholders.
2. Issuing new shares. The investors who buy new shares contribute cash in exchange for a fraction of the corporation’s future cash flow and profits.
In both the cases the shareholders are equity investors, who contributes equity financing.

Agency Problem


Shareholders who owns the company are called principals and management who runs the company on behalf of the shareholders are called shareholder’s agents.
Conflicts between shareholders and management’s objectives create agency problem. Because, shareholders’ main priority involves seeking new investments to raise share value, while management may pursue job security, corporate luxury, and high compensation at the expense of shareholders.
Agency Cost
Conflicts of interests between principal and agent results in agency cost which include:
  • Corporate expenditure that benefits management, but costs stockholders. For example, a company buying an unneeded corporate jet.
  • The expense that arises from the need to monitor management actions. For example, an outside auditor hired to review financial statements.
  • Lost opportunities. For example, a company not taking a merger which could benefit the shareholders but not the management.
How to Mitigate Agency Problem?
Agency problems are mitigated by good systems of corporate governance. The most important measure is managerial compensation which could gather the interests of shareholders and management. For example, managers are spurred on by incentive schemes that produce big return if shareholders gain but are valueless if they do not. Besides, managers who pursue shareholders’ goals are in greater demand

Goals of a Corporation


All shareholders agree on one point and that is to maximize the current profit and overall value of the firm. But, for management there are two questions and decisions to take:
  1. A corporation may be able to increase current profit by cutting some investment which could benefit the corporation in the long-term and increase the value of the firm and thus increase future’s profit. Shareholders will not welcome increased current profit if long-term profits are damaged.
  2. A corporation may be able to increase corporation’s value which will increase future’s profit by cutting current year’s profit. In this case, the shareholders will not welcome current profit less than opportunity cost of their capital.
Should Firms Be Managed for Shareholders or All Stakeholders?
Shareholders want managers to maximize their wealth, but it does not mean they want maximum profit through unfair means.
The most successful corporations are those who not only satisfy their shareholders but also satisfy their employees and customers. Corporations can add value by building long-term relationships with their customers and establish a reputation for fair dealing and financial integrity.

From Sole Proprietorship to a Corporation

Suppose you decide to start a business from your personal savings of $1 million to produce some goods. You hired some work force for this purpose and start the business. In other words, you have created a sole proprietorship. You soon realize that the business would be more beneficial if it be carried out at a larger scale and by more people. You ask your friend, a rich person, for investment and partnership. Your friend was impressed with your business and invested $1.2 million into the business and became owner of the 50% of your business. In other words, you are your friend have created a partnership. Fortunately, this partnership was successful and you can spend your business to very large extent. And for this, your partnership needs continuous investment into the business. You and your friend (the two partners) divide the value of the firm into 1 million shares and register your business as a corporation (also called company or firm). So,
Total value of the firm = 1 million shares
So, in this newly created firm there are two members in the board of directors (you and your friend), a few managers (including you both) and dozens of workers. Now, your company can raise more capital either by:
A. Angel Investors, or
B. Venture Capital Firms
A. Angel Investors
Angel investors are wealthy individuals who invest in adolescent firms.
Suppose your company decide to raise capital from angel investor. The investor purchased 200,000 new shares for $10 each and became the third member in the board of directors. So, it was the first market price of the company’s shares ($10). Now, company’s number of shares are
1,000,000 (1 million) + 200,000 = 1,200,000
And, the value of the company is
1,200,000 x 10 = $12,000,000
B. Venture Capital Firms
These firms invest in adolescent firms, and then work with them to increase the value of the firm.
Suppose your company decide to raise capital from a venture capital firm. The firm purchased half of million new shares for $11 each, posted some of its specialist managers and got seat of the board of directors in your company. Now, company’s number of shares are
1,000,000 (1 million) + 500,000 = 1,500,000
And, the value of the company is
1,500,000 x 11 = $16,500,000

Bond

A bond is an asset that pays the regular interest payments and repay the original investment at the expiry date of the bond.
Regular interest payments are called coupon. The original investment is called the face value and the date of expiry is called maturity or the date of maturity.
Definition
A bond is an asset that pays the regular coupon, and repay the face value at the maturity.
There could be several types of bonds depends on the terms and conditions of the bonds. A bond issued by a government is called government bond, and a bond issued by a corporation is called corporate bond.

Bond Valuation

In financing decision we learned that bonds are issued to raise cash. Governments and corporations borrow money by issuing bonds. The bond issuer pays the bond holder regular interest payments and repay the original amount at the expiry date of the bond. For example, a company issued a bond of $100 for 5 years which pays regular payments of 10% of the investment (10% of 100 = 10) to the person who purchased the bond. In this case, the company received cash of $100 and will have to pay $10 each year for five years to the bond holder and have to repay the investment of $100 at the end of 5 years.
Regular interest payments are called coupon. The original investment is called the principal or face value and the date of expiry is called maturity or the date of maturity.

Bond Pricing (Valuing Bonds)

The value or price of a bond can be calculated as the present value of all the cash flows that will received by the bond holder. Suppose that a 4-year bond with a face value of $100 provides an annual coupon at the rate of 8% per annum. The cash flow from the bond is as follows:
Time (in years)1234
Cash Payments$8$8$8$108
NOTE: At the end of fourth year the bond holder will receive coupon and principal.
We can find value of the bond by calculating present value of the cash flow (suppose interest rate is 5% per annum).
Bond Pricing
Now, suppose that a 3-year bond with a face value of $100 provides a bi-annual coupon at the rate of 6% per annum. The cash flow from the bond is as follows:
Time (in years)0.51.01.52.02.53.0
Cash Payments$6$6$6$6$6$106
We can find value of the bond by calculating present value of the cash flow (again suppose interest rate is 5% per annum)
Valuing Bonds

Risk and Return


Risk in investments means future returns are unpredictable. There is risk in all investments, and even all transactions. In general, the greater the risk involved, the greater the expected return, and similarly, the smaller the risk involved the smaller is the expected return.
Consider the following three types of investments:
1. Treasury Bills
These are short-term government debt securities. These are the safest investment, and because of short maturity their prices are relatively stable.
2. Government Bonds
These are long-term government debt securities. Bonds’ prices are inversely proportional to the interest rates (Bond prices fall when interest rates rise and rise when interest rates fall).
3. Common Stocks (Shares in a corporation)
The investor who invests in common stocks shares in all the ups and downs of the issuing companies. And thus, it is the most risky investment among these three investments.
The following table shows the average annual rate of return on these three investments in United States over the period from 1900 to 2008.
INVESTMENTAVERAGE ANNUAL RATE OF RETURN (1900-2008)
Treasury Bills4.0
Government bonds5.5
Common stocks11.1
The above historical evidence confirms that the higher the risk means the higher the return, but remembers it also means higher the chances of loosing the money.
Risk Premium
The risk premium is the amount of money (or reward) the investor receive for taking on a risk.
The table above shows the average annual rate of return. So, the average risk premium, taking treasury bills as base, can be given as
INVESTMENTAVERAGE RISK PREMIUM
Treasury Bills0
Government bonds1.5 (5.5 − 4.0)
Common stocks7.1 (11.1 − 4.0)

Find more