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Corporate Finance

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Corporate Finance ­FIN 622
Lesson 32
In this hand out we will discuss the following topics:
Effects of discounts ­ Not effecting volume
Extension of credit
Management of creditors
Mergers & Acquisitions
Purpose of combinations
Effect of discounts ­ Not effecting volumes
As we have become aware of the fact that significant funds are invested in debtors, and therefore, it
becomes very critical issue in working capital management. Several factors must be addressed when a policy
for credit control is under discussion. These issues may include controlling collection cost, extra need of
funds when credit is extended in terms of increase in debtors' investment and increase in stocks. The cost
of additional loans / funds when credit is extended and saving that can be achieved by offering discounts of
customers are also outstanding issues surrounding debtors' management.
A firm will always try to generate cash from debtors as quickly as possible but most of the sales activity is
conduct on credit basis. One of the main reason companies have to allow credit to its customer due to
competitiveness or norms of trade or industry. However, a firm will try to recover the amount from debtors
quickly by surrendering some of its profit in terms of discount to clients. This is an inducement to the
customers to reduce their cost of sales by having cheaper inputs by paying earlier than agreed period.
The motive behind offering discount to customers may have different secondary meaning to the firm.
However, the main objective is to improve the cash flow. Other may include increasing the sales as the
discounts directly affect the cost of sales of customer and customer may place enhanced order, thus
increasing the turnover.
However, a fir may offer discounts just to improve the cash flow with no increase in volume. In this case,
we need to evaluate that by offering discount to customer can we decrease the investment in debtors? A
decrease in debtors will eventually release the investment which can be used elsewhere in business for more
The financial viability would be calculated by deducting the cost of discount from the return on investment
on the amount of funds released. For example, by offering 2% discount can reduce Rs. 200,000/- worth of
investment in debtors and this can be invested @ 10% in other business areas, then the net benefit would
Return on investment (Rs200,000)@10% = 20,000
Less: cost of discount 2%
= 10,000
(Assuming on sales of Rs. 1/2 million)
Net Benefit
= 10,000
Expansion of credit:
In this case we consider that if increase credit period is allowed to customers then what areas needs to be
assessed. This may result in increase sales, profitability from extra sales, and length of collection period and
required rate of return on additional investment in debtors as a result of increased credit period.
It is important to note that when the credit period is increased then a firm needs more investment in
debtors and these additional funds do carry some cost with them.
Further, these sorts of policies have different levels of bad debts risk, greater the credit period higher the
probability of default by the customers. Therefore, expansion of credit involves two types of risks ­
additional cost of funds and bad debts.
The financial viability would be computed by determining the total benefit of extra sales reduced by the cost
of additional funds and bad debts.
Corporate Finance ­FIN 622
Factoring refers to an arrangement where debt collections and some related functions are performed by
someone else than the firm itself. The person or entity who performs such functions charges a fee that may
be a specific percentage of total debtors. Factor normally advances a proportion of the amount to be
collected and the rest when he actually recovers the amount from firm's debtors after deducting his
commission or fee agreed in advance. The other factor functions may be like:
Main function of a factor is to collect the accounts receivables on behalf of seller but may also involve in
invoicing and sales accounting.
Exact term of factoring will depend on mutual agreement.
Factor also takes over the risk of loss in case of bad debt.
Factor also insures client against such losses. This type of factoring is known as non-recourse.
In case of action against defaulters, factor initiate action.
Factor makes advance payments to seller in return for commission of certain %age of total debt. This is
often referred as factor financing.
Factoring carries some advantages and disadvantages as well, which are as under:
Factoring has positive effect on cash cycle. Substantial portion of total debtors is received quickly and can
be used to pay off creditors and avail discount from them for early settlement of their invoices.
Optimum stock level can be maintained because the business will have ample liquidity to pay for stocks it
Financing (factor) is directly linked to level of sales / accounts receivables.
Reduction in collection expense and staff payroll costs because most the functions of sales administration
are taken over by the factor so there's no need of some of the sales staff.
The manager of the business have more time to concentrate on other areas rather than thinking and
confronting issues like slow payment from debtors.
Expensive: Normally factor charge hefty commission or fee for rendering such services.
It may have adverse effect on customers' loyalty. (Factor attitude may be harsh with customers) and may
tarnish company's image. Further, it can result in loss of customers and it turn this will result in loss of sales.
For computing financial feasibility the benefit would be reduction in debtors' administration cost, payroll
cost and bad debts and will be reduced by the expense like factor fee / commission. However, there may be
some other issues that need to be considered in reaching at net benefit of factoring.
Management of creditors:
There is comparatively less room in management of creditors than debtors. However, this side of working
capital is not less important because it is a spontaneous source of financing and also provides the basic
inputs to the business.
There are three aspects of creditors' management. First, the company would like to obtain credit as big as it
can. The firm must have amicable relationship with vendors. The credit period obtained from vendors will
effect the operating cycle significantly.
During the period of uneven or lower cash flow the firm will try to get extension in credit. In order to
adjust the operating cycle, a firm normally defers the payments to creditors rather than to take loans to
finance the deficit.
Like a firm offers discounts to its customers for early recovery of invoices, creditors do offer discount for
early payment from its customers. Therefore, this is very important point in creditors' management because
it directly affects the cost of sale of the company. Any discount offered by the creditors for early payment
of their invoices, the firm must evaluate whether or not to avail the discount. This evaluation is on the same
pattern as we had for debtors. The fundamental idea will be to determine the cost and benefit and then to
compute the net benefit / cost. There are two types of decisions to be made by the company. First, is to
reduce the cost by taping the discount offered by creditors by paying earlier than allowed time. This is as
good as increasing profit. The other side of this issue would be to burden the cash flow and company may
have to seek loans. Second, would be keep the operating cycle in positive and there will not be any burden
on the cash flow however, the firm will loose the discount.
These decisions are predominantly are based on level of discount, cash flow pattern, operating cycle and the
portion of total creditors offering discount. These will vary firm to firm and business to business.
Corporate Finance ­FIN 622
Growth is very essential for a company because a company can add value by expanding it business and can
attract the first rate human resources. The growth can be internal and external.
During our previous studies we have covered internal growth and evaluation process. Companies acquire
assets for its expansion or make investment in business. External growth involves taking over or acquiring a
separate entity or already established business. However, there are significant differences in internal and
external growth method.
This rationale is particularly alluring to companies when times are tough. Strong companies will act to buy
other companies to create a more competitive, cost-efficient company. The companies will come together
hoping to gain a greater market share or to achieve greater efficiency. Because of these potential benefits,
target companies will often agree to be purchased when they know they cannot survive alone.
One plus one makes three: this equation is the special alchemy of a merger or an acquisition. The key
principle behind buying a company is to create shareholder value over and above that of the sum of the two
companies. Two companies together are more valuable than two separate companies - at least, that's the
reasoning behind M&A.
The important reason for merger and acquisition is the increase in the sales. Operating economies can be
achieved by increasing sales and utilizing fixed cost effectively.
Synergy and sources of synergy:
One plus one makes three: this equation is the special alchemy of a merger or an acquisition. The key
principle behind buying a company is to create shareholder value over and above that of the sum of the two
companies. Two companies together are more valuable than two separate companies - at least, that's the
reasoning behind M&A.
Synergy is the magic force that allows for enhanced cost efficiencies of the new business. Synergy takes the
form of revenue enhancement and cost savings. By merging, the companies hope to benefit from the
·  Staff reductions - As every employee knows, mergers tend to mean job losses. Consider all the
money saved from reducing the number of staff members from accounting, marketing and other
departments. Job cuts will also include the former CEO, who typically leaves with a compensation
·  Economies of scale - Yes, size matters. Whether it's purchasing stationery or a new corporate IT
system, a bigger company placing the orders can save more on costs. Mergers also translate into
improved purchasing power to buy equipment or office supplies - when placing larger orders,
companies have a greater ability to negotiate prices with their suppliers.
·  Acquiring new technology - To stay competitive, companies need to stay on top of technological
developments and their business applications. By buying a smaller company with unique
technologies, a large company can maintain or develop a competitive edge.
·  Improved market reach and industry visibility - Companies buy companies to reach new markets
and grow revenues and earnings. A merge may expand two companies' marketing and distribution,
giving them new sales opportunities. A merger can also improve a company's standing in the
investment community: bigger firms often have an easier time raising capital than smaller ones.
That said, achieving synergy is easier said than done - it is not automatically realized once two companies
merge. Sure, there ought to be economies of scale when two businesses are combined, but sometimes a
merger does just the opposite. In many cases, one and one add up to less than two.
Sadly, synergy opportunities may exist only in the minds of the corporate leaders and the deal makers.
Where there is no value to be created, the CEO and investment bankers - who have much to gain from a
successful M&A deal - will try to create an image of enhanced value. The market, however, eventually sees
through this and penalizes the company by assigning it a discounted share price. We'll talk more about why
M&A may fail in the next tutorial.
Table of Contents:
  4. Discounted Cash Flow, Effective Annual Interest Bond Valuation - introduction
  5. Features of Bond, Coupon Interest, Face value, Coupon rate, Duration or maturity date
  8. Capital Budgeting Definition and Process
  9. METHODS OF PROJECT EVALUATIONS, Net present value, Weighted Average Cost of Capital
  12. ADVANCE EVALUATION METHODS: Sensitivity analysis, Profitability analysis, Break even accounting, Break even - economic
  13. Economic Break Even, Operating Leverage, Capital Rationing, Hard & Soft Rationing, Single & Multi Period Rationing
  14. Single period, Multi-period capital rationing, Linear programming
  15. Risk and Uncertainty, Measuring risk, Variability of return–Historical Return, Variance of return, Standard Deviation
  16. Portfolio and Diversification, Portfolio and Variance, Risk–Systematic & Unsystematic, Beta – Measure of systematic risk, Aggressive & defensive stocks
  17. Security Market Line, Capital Asset Pricing Model – CAPM Calculating Over, Under valued stocks
  18. Cost of Capital & Capital Structure, Components of Capital, Cost of Equity, Estimating g or growth rate, Dividend growth model, Cost of Debt, Bonds, Cost of Preferred Stocks
  19. Venture Capital, Cost of Debt & Bond, Weighted average cost of debt, Tax and cost of debt, Cost of Loans & Leases, Overall cost of capital – WACC, WACC & Capital Budgeting
  20. When to use WACC, Pure Play, Capital Structure and Financial Leverage
  21. Home made leverage, Modigliani & Miller Model, How WACC remains constant, Business & Financial Risk, M & M model with taxes
  22. Problems associated with high gearing, Bankruptcy costs, Optimal capital structure, Dividend policy
  23. Dividend and value of firm, Dividend relevance, Residual dividend policy, Financial planning process and control
  24. Budgeting process, Purpose, functions of budgets, Cash budgets–Preparation & interpretation
  25. Cash flow statement Direct method Indirect method, Working capital management, Cash and operating cycle
  26. Working capital management, Risk, Profitability and Liquidity - Working capital policies, Conservative, Aggressive, Moderate
  27. Classification of working capital, Current Assets Financing – Hedging approach, Short term Vs long term financing
  28. Overtrading – Indications & remedies, Cash management, Motives for Cash holding, Cash flow problems and remedies, Investing surplus cash
  29. Miller-Orr Model of cash management, Inventory management, Inventory costs, Economic order quantity, Reorder level, Discounts and EOQ
  30. Inventory cost – Stock out cost, Economic Order Point, Just in time (JIT), Debtors Management, Credit Control Policy
  31. Cash discounts, Cost of discount, Shortening average collection period, Credit instrument, Analyzing credit policy, Revenue effect, Cost effect, Cost of debt o Probability of default
  32. Effects of discounts–Not effecting volume, Extension of credit, Factoring, Management of creditors, Mergers & Acquisitions
  33. Synergies, Types of mergers, Why mergers fail, Merger process, Acquisition consideration
  34. Acquisition Consideration, Valuation of shares
  35. Assets Based Share Valuations, Hybrid Valuation methods, Procedure for public, private takeover
  36. Corporate Restructuring, Divestment, Purpose of divestment, Buyouts, Types of buyouts, Financial distress
  37. Sources of financial distress, Effects of financial distress, Reorganization
  38. Currency Risks, Transaction exposure, Translation exposure, Economic exposure
  39. Future payment situation – hedging, Currency futures – features, CF – future payment in FCY
  40. CF–future receipt in FCY, Forward contract vs. currency futures, Interest rate risk, Hedging against interest rate, Forward rate agreements, Decision rule
  41. Interest rate future, Prices in futures, Hedging–short term interest rate (STIR), Scenario–Borrowing in ST and risk of rising interest, Scenario–deposit and risk of lowering interest rates on deposits, Options and Swaps, Features of opti
  43. Calculating financial benefit–Interest rate Option, Interest rate caps and floor, Swaps, Interest rate swaps, Currency swaps
  44. Exchange rate determination, Purchasing power parity theory, PPP model, International fisher effect, Exchange rate system, Fixed, Floating
  45. FOREIGN INVESTMENT: Motives, International operations, Export, Branch, Subsidiary, Joint venture, Licensing agreements, Political risk