Corporate Finance Chap 1[1]

7/30/2019 Corporate Finance Chap 1[1]

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Corporate Finance

Capital Structure, Financial Planning,Financial Markets, Growth, Cost of Money


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Business Organisation

What is an Organisation ?

Organisation is a social arrangement which pursues collective

goals, which controls its own performance, and which has a

boundary separating it from its environment.

Types of Business Organisation:

Sole Proprietorships.

Partnerships.

Corporations.

Limited Companies.

Limited Liability Companies.

Non-Profit Organisations.


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Sole Proprietorship

Easily and inexpensively formed.

Corporate tax obligations are eliminated.

Less prone to complex government regulations.

Raising capital from the market is a tedious tasks.

Full ownership of all liabilities associated with the organisation.

In many cases, the life of the organisation is linked to the life

of the individual who creates it. Complexities may arise in

terms of transfer of ownerships and liabilities from previousowners.


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Partnerships

Partnerships may operate under different degrees of formalityranging from informal, oral understandings to formal

agreements.

Unlimited Liabilities.

Limited life of an organisation and difficulty in transferringownership.

Difficulty in raising capital.

Enjoys certain tax advantages similar to that of a sole

proprietorships.

Partners can potentially loose all of their assets in case of

bankruptcy.

All partners are deemed to have equal share in both growth

and bankruptcy.


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Corporations

Corporations are legal entity created by the state and it isdistinct and separate from its owners and managers.

Unlimited life.

Easy transferability of ownership interest. Ownership may

come in the form of shares.

Limited liability losses limited to the actual fund invested.

Subject to comparatively higher taxation.

Setting up a corporation is time consuming. It requires drawingup charters, articles of association and Memorandum of

Association.


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LLP, Limited Company, NPO

In an LLP, also called Limited Liability Company, all partnersenjoy limited liability with regards to the businesss liability.

LLP combines the advantages of having limited liability to the

tax advantages enjoyed by partnership.

Non-Profit Organisations Government organisations, & Non-

Governmental organisations. More prone to organisations

slacks. Profit maximisation is not seen an objective and they do

not obviously work towards achieving it.


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Capital Structure

Capital Structure refers to the way a corporation finances itsassets through some combination of equity, debt or hybrid

securities.

In other words, a firm capital structure is the composition or

structure of its liabilities.

Financing can be done from within its own resources i.e. cash at

its disposal, through issue of equities or through debt financing

i.e. tapping the money market.

Firms can consider changing its capital structure through issue of

further shares, converting existing convertible assets like

bonds, rights issues, bonus issues, warrants etc.


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Capital Structure

Capital structure, therefore, forms an important aspect inassessing the companys value.

In a perfect market, the value of the firm is not so affected by

its capital structure.

Example: Proponents of the perfect market and classical taxsystem argue that there is deduction of taxes from interests on

debt financing which makes external financing a lot more

attractive and internal financing is of lesser value.

In reality, however, we know that such perfect market and

market norms is incorrect and that there is cost associated to

its external financing structure.

Bankruptcy costs, Agency Costs, Asymmetric Information all

adds up to the risk associated with long term external

financing.


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Capital Structure

Capital structure, in real world -

Trade off theory - explains the fact that firms or corporations

usually are financed partly with debt and partly with equity.

There is an advantage to financing with debt - the Tax Benefit

of Debt and the cost of financing with debt, the costs of

financial distress including Bankruptcy Costs of debt and non-

Bankruptcy costs such as employee attrition, suppliers

demanding disadvantageous payment terms.

The marginal benefit of further increases in debt declines as debt

increases, while the marginal cost increases, so that a firm thatis optimizing its overall value will focus on this trade-off when

choosing how much debt and equity to use for financing.

Bankruptcy Costs of Debt are the increased costs of financing

with debt instead of equity that result from a higher probability

of bankruptcy.


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Capital Structure

Pecking Order Theory - It states that companies prioritize theirsources of financing (from internal financing to equity)

according to the law of least effort, or of least resistance,

preferring to raise equity as a financing means of last resort.

Once internal funds have been used and on its depletion, debts

are issued, and when it is not sensible to issue any more debt

or once the marginal benefits coming from debt financing

reduces, equity is issued.

This theory maintains that businesses adhere to a hierarchy of

financing sources and prefer internal financing when available,and debt is preferred over equity if external financing is

required.


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Financial Planning

Financial planning is the process of solving financial problems andachieving financial goals by developing and implementing a

corporate "game plan."

Financial Planning do NOT focus on one aspect or process. It is a

series of processes that culminates into end-results which are

likely to be achieved in the long run. The process may require

many adjustments as economic scenarios can change. Short

run adjustment may be required to accommodate for the

changes in the long run.

In other words, most decisions pertaining to financial planning

have a long lead times, which means that they take a long

time to implement.


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Financial Planning

Various component that go into financial planning model

Sales forecast all financial plans require near accurate sales

forecast. Forecasting sales, however, cannot be predicted

accurately and depends significantly on prevailing and future

macroeconomic conditions.

Pro-forma statement based on forecasted sales and costs

(P&L statements), and various balance sheet components,

financial planning can be conducted and adjusted.

Asset requirement the plan will describe projected capital

spending. The use of net working capital can also be

discussed.

Feasibility different / alternative financial plans must fit into

overall corporate objective of maximizing shareholders wealth.


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Financial Planning

Financial requirements and options provides the opportunityfor the firm to work through various investment and financing

options.

Economic Assumption the plan must explicitly include thecurrent state of economic affairs and the likely consequences

from such economic indicators i.e. the prevailing and

forecasted rate of interest

See: the sample example.

Ross Westerfield Jaffe, Corporate Finance, Chap-3, Financial Planning and Growth, pg 48/49


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Financial Planning & Growth

Growth In simple terms, growth refers to an increase in somequantity over some time. In economic terms, growth imply an

increment in the monetary value of goods and services

produced in the economy.

Growth vs. Value Maximisation

Rappaport in applying the shareholder value approach, growth

should not be the goal in itself but rather a consequences of

decisions that maximises shareholder value.

Growth ideally should not be the principle goal but a secondary

consequences that emerge out of value maximisation.

Quality in Growth is paramount in value maximisation.

A. Rappaport, Creating Shareholder Value: The New Standard for Business Performance (New York:

Free Press, 1986)


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Recall from the example that the

1. Firms assets will grow in proportion to the sales.

2. Firm is reluctant to meet in financial requirement through

external equities.

3. Net Income is a constant proportion of the sales because cost

of sales remains constant.

4. Firm has given determined dividend-payout policy.

Asset = Debts + Equities

Therefore,

Changes in Assets = Changes in Debts + Changes in Equity.


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Variables in determining growth rate

T: ratio of total assets/sales.

p: net profit margin (NP/Sales).

d: dividend payout ratio.

L: debt equity ratio.

S0

: current sales.

S1: projected sales.

S: changes in sales (S1 S0).


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Donaldson suggests that most major industrial companies arevery reluctant to use external equity as a major part of their

financial planning. Supposing that the firm wants to achieve

growth (sales) through increase sales, how can the firm

increase sales and what could be used as source of funding ?

To increase sales by S, the firms need to increase its assets by

TS. TS can financed through

Retained Earnings / Reserves and Surpluses which is a

component in Equity Funding. Retained earnings is depended

on the sales, dividend-pay out ratio.

External Borrowings.


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Total Capital Spending (TS) to achieve growth

Equity Financing: (S1 * p) * (1 d)

External Borrowings: [(S1 * p) * (1 d)] * L

Therefore,

TS: [(S1 * p) * (1 d)] + [(S1 * p) * (1 d)] * L]

Given the above equation, we can now derive the sales growth

p * (1 - d) * (1 + L)

T [p * (1 d) * (1 + L)]=

S

S0


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T: 1

p: 16.5 %

d: 72.4 %

L: 1

Sustainable Growth Rate = 0.165 * (1 0.724) * (1 + 1)

1 [0.165 * (1 0.724) * (1 + 1)]

= 0.10 or 10 percent


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Can growth be achieved beyond the sustainable level ?

In principle it can be done

Sell news shares of stock.

Increase its reliance on debts.

Reduce its dividend pay out ratio.

Increase profits margin.

Decrease its asset-requirement ratio.


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Financial Markets

Physical asset markets are those that primarily deal in physicalassets such as wheat, cars, automobile, machineries. Financial

asset markets deal in stocks, bonds, notes, mortgages and

other financial instruments.

Types of market:

Spot, forwards and futures markets.

Money markets those that deal in short and medium term

highly liquid securities.

Capital markets medium and long term debts and corporatestocks.

Mortgage Market.

IPO market, Primary markets and Secondary markets


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Financial Markets

S1

D1

D2 RecessionInduced

Interest Rate

Low Risk Securities High Risk Securities

8

1012

Interest Rate

D1

S1S Rate Hike


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Interest Rate and Determinants

Quoted / Nominal Interest Rate refers to the rate of interest ratebefore adjusting for inflation.

Real / Effective Interest Rate - effective rate is the interest rate on

a loan or financial product restated from the nominal interest

rate as an interest rate with annual compound interest.

Consider Debt Security with a quoted/nominal interest rate ofr.

r = r* + IP + DRP + LP + MRP

Nominal rate r is composed of

r* : Risk-free interest rate. IP: Inflation premium.

DRP: Default risk premium. LP: Liquidity premium.

MRP: Maturity risk premium.


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Real Risk-Free Rate (r*) interest rate on a risk-less security if noinflation exist. Risk free rate are never static and it is adjusted

with changing economic circumstances.

Therefore,

Nominal Risk-Free Rate (rRF) risk free rate (r*) plus premium forexpected inflation. Securities that boast of offering such

nominal interest rate tend to enjoy no risk of default, no

maturity risk, no liquidity risk, no risk of loss if inflation rises.

rRF = r* + IP

Inflation Premium is the average expected inflation rate over the

life of the security.


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Inflation Premium Example

Consider:

Investment Amount: $1000.

Market Interest Rate: 5%

Investment Horizon: 1 year

TTM: 1 year.

Inflation Rate: 10%

Investment Product: Oil at $1 per gallon

In the spot market

1000 gallons @ $1000.

Forward spot price of oil@ 10% inflation rate -$1.10

$1000 @ 5% = $1050.

NPV = $955.

Cost of Oil: $1 @ 10 %

= $1.10


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Default Risk Premium premium added to the interest rate for therisk that the borrower will default on a loan. In general,

government securities do not have default risk premium as

they are unlikely to default on interest payments.

Liquidity Premium the risk of not being able to convert the

underlying security into cash at a fair market value.

Maturity Risk Premium premium added to the expected returnswhen the duration of an underlying securities is longer. Since

longer duration leads to longer payment schedules, the risk of

default is higher. Also the underlying security is more prone to

changing interest rates.

Corporate Finance Chap 1[1]

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