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Corporate Finance

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Corporate Finance ­ FIN 622
VU
Lesson 01
INTRODUCTION TO SUBJECT
Corporate finance is the study of planning, evaluating and drawing decisions in the course of business. Let's
take a simple example to determine the scope of our subject. This would cover around 85% to 90% of
scheme of studies of corporate finance.
Suppose you intend to kick start a business. Three up-front questions that hit our top of the head are:
What type of investments do we need? In other words, what type of assets will be required to
support the intended business?
Where the money will come from? Sources of investments to be determined in black and white.
How we will finance our day to day monetary matters like purchase of raw materials and payment
of salaries etc?
To answer these question let's explore them individually for twin purpose: to know what is corporate
finance and secondly, to determine the scope of the subject.
Referring to question # 1 ­ Types of investment or assets needed in the business:
The answer to this question can be found by defining Capital Budgeting process.
Capital Budgeting:
It involves planning, analyzing and acquiring capital assets like Plant and Machinery or Land or Building.
These investments take ample amount of resources and therefore, these decisions are irreversible in nature.
That in turn means that once the decision is implemented it would incur heavy losses if we want to un-do it
subsequently. Therefore, making investment in capital assets is a very risky process and must be handled
with care and skill.
SWOT analysis is also very helpful in capital budgeting process.
SWOT stands for:
·  Strengths
·  Weaknesses
·  Opportunities
·  Threats
Strengths are connected to Opportunities and in order to tap the lucrative opportunities you need to make
capital investment, which must be handled with due care and skill ensuring effective decision making. This
means that type of assets to be acquired depends on the nature, need and resources of business besides
some other factors. For example, a large airline industry would acquire bigger plane than a smaller airline
which may opt for a relatively cheaper plane.
Taking up the second question in line, that is, "where the money will come from?"
Broadly speaking there are two potential sources for making investments. The first sources emerge from
the contributions of sponsors or directors who commence the business. This portion of investment is
called Capital or Equity contribution.
The other source of investment is from loans and various financial instruments and markets. Banks provide
long term and short loans to the business world and this has been the most important source of business
finance and is being used widely.
Other source of external financing is issuance of bonds and securities in primary and secondary markets.
This process is known as Capital Structure Decisions in which it is determined that how much of the total
cost shall be financed by Equity contribution and Loans.
Moving to third and last question:
To finance day to day financial needs is in fact an issue that fall within the ambit of Working Capital
policies. Following are the typical questions in this context:
·  What would be our purchases level for raw materials?
·  Do we need to import or are locally available?
·  How much finances will be needed to procure raw materials?
·  What are our customers or markets?
·  How many days credit to be extended to customer and taken from creditor?
1
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Corporate Finance ­ FIN 622
VU
FINANCIAL STATEMENTS & CORPORATE FINANCE WITH SOME IMPORTANT
CONCEPTS:
There are basically three financial statements that every business entity runs periodically. It includes:
·  Balance Sheet
·  Income Statement
·  Cash Flow
·
Balance Sheet:
This is a statement of resources controlled by and obligations to settle by an entity as on a specified date.
The format of Financial Statements is governed by International Financial Reporting Standard in Pakistan.
However, in US these are governed by the provisions of Generally Accepted Accounting Principles
(GAAP).
Balance Sheet Contents are:
i)  Fixed Assets
ii) Current Assets
iii) Current Liabilities
iv) Long Term Liabilities
v) Capital & Reserves
Assets (both fixed and current) are placed in balance sheet in the order of less liquid or illiquid to liquid.
This means that current assets are more liquid than fixed assets. Then question arises "what is liquidity?" or
"what is a liquid asset?"
An asset that can be converted to cash quickly and without loss of value is liquid asset. For example, prize
bond is not a currency but you can get the face or par value of a prize bond when you sell the bond to any
one. But this is not the case when you want to sell your motorcycle or car. Therefore, car or motor cycle is
not a liquid asset but prize bond or gold are highly liquid.
Current Assets and Current Liabilities when clubbed together, give birth to another concept known as
working capital.
Current assets are those that form part of the circulating capital of a business. They are replaced
frequently or converted into cash during the course of trading. The most common current assets are stocks,
trade debtors, and cash.
Current liabilities are those short-term liabilities which are intended to be constantly replaced in the
normal course of trading activity. Current liabilities typically comprise: trade creditors, accruals and bank
overdrafts.
There is another concept of Cash Cycle associated with working capital. Take a compact example to
understand.
You acquire goods or raw materials from vendors on credit. It takes time (say in days) to process or
transform raw materials to finished goods, which are sold to customers on credit. Customers or Debtors
are allowed a time period (in days) to settle or pay their bills and money received from debtors is used to
pay off creditor, who provided goods on credit. Let's assume you allowed your customers 30 days to pay
for goods you sold to them on credit. And on the other hand you sought 35 days cushion from creditors to
pay off purchases of raw materials. In this simple example you were still able to use money for 5 days
before paying to creditors. This means the operating cycle is positive.
Other concepts from financial statements shall be taken up in the next hand out.
2
Table of Contents:
  1. INTRODUCTION TO SUBJECT
  2. COMPARISON OF FINANCIAL STATEMENTS
  3. TIME VALUE OF MONEY
  4. Discounted Cash Flow, Effective Annual Interest Bond Valuation - introduction
  5. Features of Bond, Coupon Interest, Face value, Coupon rate, Duration or maturity date
  6. TERM STRUCTURE OF INTEREST RATES
  7. COMMON STOCK VALUATION
  8. Capital Budgeting Definition and Process
  9. METHODS OF PROJECT EVALUATIONS, Net present value, Weighted Average Cost of Capital
  10. METHODS OF PROJECT EVALUATIONS 2
  11. METHODS OF PROJECT EVALUATIONS 3
  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
  42. FOREIGN EXCHANGE MARKET’S OPTIONS
  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