UNIVERSITY OF LUSAKA (UNILUS)
Faculty of Accounting and Finance
CORPORATE FINANCE/FINANCIAL MANAGEMENT
STUDY MODULE
COURSE CODE: BSP320/ECF210/AFIN209
PROGRAMS: LONG DISTANCE/FULL-TIME/PART-TIME
Table of Contents Page
Chapter 1: Introduction to corporate Finance [5]
Role of finance Managers……………………………………………………………………
Forms of Business Organizations…………………………………………………….
Goals of Corporation and agency Problem……………………………………
Corporate Governance issues………………………………………………………….
Financial Markets Operations……………………………………………………………
Chapter 2: Time Value of Money and Valuation Models [16]
Compounding and Discounting…………………………………………………………
Lumps Sum amounts, Annuities and perpetuities…………………………
Compounding interest more than once a year………………………………
Amortizations……………………………………………………………………………………………
Valuation Models for financial Securities…………………………………………
Bond Valuation and Yields……………………………………………………………………
Stock Valuation ………………………………………………………………………………………
Chapter 3: Risk and Return [38]
Risk and return relationship…………………………………………………………………
Measuring risk and expected return…………………………………………………..
Types of Risk and Capital Asset Pricing Model (CAPM)………………..
Efficient frontier and Capital market line (CML)……………………………….
Chapter 4: Capital budgeting or Investment Appraisal [51]
Techniques in Capital Budgeting; NPV, IRR, ARR, PI and Payback Period
Conflict of NPV vs. IRR………………………………………………………………………
Capital Rationing…………………………………………………………………………………
Inflation and Capital Budgeting………………………………………………………
Taxes and Capital allowances …………………………………………………………
Chapter 5: Cost of Capital, Capital Structure and Financial leverage [69]
Introduction……………………………………………………………………………………………
Cost of debt, Prefered Stock, equity and WACC…………………………
Financial Leverage and Capital structure……………………………………
Homemade Leverage…………………………………………………………………………
M&M I theory…………………………………………………………………………………………
M&M II theory…………………………………………………………………………………………
Chapter 6: Working Capital Management [80]
Working Capital cycle, investment and financing policies……………
Cash Management……………………………………………………………………………………
Marketable Securities………………………………………………………………………………
Credit Management…………………………………………………………………………………
Managing trade credit……………………………………………………………………………
Inventory Management………………………………………………………………………
Short-term sources of finance……………………………………………………………
Chapter 7: Efficient Market hypothesis Theory [102]
Introduction……………………………………………………………………………………………
Forms of market efficiency…………………………………………………………………
Analysis Techniques……………………………………………………………………………
Chapter 8: Dividend Policy [105]
Dividends and dividend payment………………………………………………………
Establishing a dividend policy……………………………………………………………
Alternatives to cash dividends……………………………………………………………
Chapter 9: Long-Term sources of Finance [109]
Equity financing………………………………………………………………………………………
Debt financing and debt instruments………………………………………………
Chapter 10: International Trade and Finance [123]
International trade documents……………………………………………………………
Foreign Exchange Markets and Risks………………………………………………
Hedging Tools and Purchasing power Parity…………………………………
Chapter 11: Financial Statement Analysis [133]
Common Size Analysis and Financial Ratios…………………………………
Review Questions………………………………………………………………………………………….…………… [141]
Key learning objectives for the course:
Upon completing this study module student should be able to:
1) Understanding the importance of corporate finance and its relevance in organization
2) Know the important role that financial managers play in contributing to the maximization of a firm’s value and shareholder wealth.
3) Understand how financial markets operate and how firms use these to raise capital for investments.
4) Articulate the relevance of time value of money the various concepts that underlie the topic and be able to use the various discounting and compounding methods to evaluate cash flows and financial assets.
5) Understand the relationship between risk and return.
6) Appraise investments using capital budgeting methods learnt.
7) Articulate theories underlying cost of capital and capital structure and also calculate various cost of capital including weighted average cost of capital.
8) Understand how to manage working capital components and able to explain the different sources of short term and long term capital.
9) Understand how pricing of share works through market information
10) Determine an appropriate dividend policy for a give firm.
11) Understand risk factors affecting international trade and finance and how to manage these risks
12) Analyze the performance of firms through financial analysis techniques.
CHAPTER 1
1.0 COPRORATE FINANCE
Introduction
Today Corporations are the main drivers of modern economies. Unlike other forms of business organization, limited companies or firms especially those that are public command most of the business transaction and trade around the world. Due to the structure of most of these public limited companies (Plcs), the ownership of the company is so diverse and separate from the management of the company. Management usually makes decision on the best way to manage the financial resources and other assets of the business on behalf of the shareholders. Shareholders expect that management will always manage the shareholders’ investment in such a way that they achieve the goals and expectation of the owners of the company.
Corporate Finance involves understanding how Corporate Managers (Financial Managers) will solve organizational problems to do with the following:
i. What long term investments should the business undertake? What assets to invest in and line of business to be considered. Is it minining, retail trade or transport etc?
ii. The other questions are with how to raise the required finance for the business venture identified. Should a stock issue be made or should the company borrow?
iii. Finally once the resources are secured how the day to day operation should be managed prudently so that they add value to the shareholders investments.
As mentioned earlier since owners (shareholders) are not involved in the daily operations of the firm, these decisions are made by top management, which includes the Financial Manager. Since prudent financial management is important in planning for such investments, the financial manager’s role becomes critical.
The role of the Financial Manager
When share holders create a firm (corporation), their intention is to make a profit. In the initial stage of setting up the firm shareholders, are involved in the day to day management of the company. However, as the company grows shareholders will in most cases employ managers to run the company on their behalf. Management is engaged, to make decisions on behalf of the shareholders in line with shareholder expectations. Finances play a critical role in the performance of a company. The finance manager’s role is to plan for the acquisition of assets and use of these assets, so as to increase the value (wealth) of the firm.
As the firm plans regarding the shareholders’ investments and ways of increasing the value of the firm the finance Manager engages in making the following financial decisions:
i. Investment Decisions:
These are decisions that have to do with the firm deciding on what investments it wishes to make. It also includes determining what assets to invest in. The decision making process involves selecting viable projects by applying investment appraisal techniques depending on the nature of business the firm is involved in (e.g. mining,retail,manufacturing or tourism).
ii. Financing Decisions:
These are decisions regarding, how the investment(s) selected will be financed. Firms have three options regarding where they source finances. They can source them internally by using retained earnings, borrowing from the Debt capital market or Issuing stocks (Ordinary Shares).
The decision to use a specific source of finance is determined by the period of investment (long-term of Short-term),use of funds for either Capital investment or Working Capital requirements and desired capital structure for a given firm. That is, the balance between equity and debt used in financing the assets of the firm.
iii. Dividend Decisions
These decisions involve determining a dividend policy for the firm which describes how the returns from the investment are distributed to shareholders as dividends. The policy describes when and how much of the profits are distributed as dividends including the mode of payment.
As the finance manager performs these functions the overriding goal is to ensure that the firm’s value is maximized.
Forms of Business Organizations
Businesses across the world operate in three main forms which include: Sole Proprietorship, Partnerships and Corporation (Companies or limited Companies).
i. Sole Proprietorship (Sole trader)
A sole trade business is a form of business owned by one individual. Going into business as a sole trader is very easy and is common with very small establishments. Most large companies present today started as sole proprietorships.
Advantages of Sole proprietorship:
1. It is easily and inexpensively formed since there are no stringent legal requirements and are usually subject to a few government regulations.
2. The businesses pay small amounts of taxes and are nonexistent in some cases.
Some limitations of sole proprietorship
1. It is in most cases difficult for a sole proprietorship to sources for large sums of capital.
2. There is no limited liability with a proprietorship for business debts and can lose assets beyond those invested in the business.
3. The life of a proprietorship is limited to the life of the individual who created it.
ii. Partnerships
A partnership exists whenever two or more persons associate to conduct a business with a view to make a profit. Partnerships operate under a partnership agreement entered into by the partners. Where such an agreement has not been signed the law is taken to apply. The major advantage of a partnership is its low cost of formation. The limitations of partnerships are:
1. Unlimited liability for the partners.
2. The limited life of the business as it is tied to the continued relationship of the partners.
3. There is difficulty in transferring of ownership.
4. Difficulty in raising large capital amounts.
iii. Corporations(Limited Companies)
A corporation or Company is a legal entity or person created under law, distinct from its owners and managers.
The separation gives the corporation three major advantages:
1. It has unlimited life and it continues beyond the original owners or existing shareholders.
2. It permits easy transfer of ownership interest (shares).
3. It has limited liability meaning that the shareholders only stand to lose what has been invested in the company in case of liquidation of the company.
4. These three factors allow corporation to easily access large amounts of capital.
The most preferred form of running a business is to organize it as a corporation or limited company. The major thrusts are:
1. Limited liability reduces risk to investors and the lower the firm’s risk the higher its value.
2. A firm’s value is dependent on its growth opportunities which in turn are dependent on the firm’s ability to attract capital. Since corporations can attract capital more easily than unincorporated businesses they have superior growth rate.
3. The value of an asset also depends on its liquidity, which means the ease of selling the asset and converting it to cash. Since an investment in the stock (shares) of a corporation is much more liquid than a similar investment in other businesses, this too means that the corporation form of organization can enhance the value of a business.
4. Corporation may in some instances be taxed at a lower rate or be given tax holidays or other tax incentives. These incentives in most cases may not be available for the other forms of businesses.
Goals of the Corporation
Decisions in corporations are not made in a vacuum but rather with some objective in mind. Firms have different objectives such as profit maximization, market share growth, and Sales maximization, minimize costs among others. However, among all these the most important goal of the firm is to maximize the wealth of shareholders which translates to maximizing of share prices. Value creation occurs when we maximize the share price for current shareholders.
Example 1.1
Goal statement by firms;
1. “Creating superior shareholder value is our top priority.” Associated Banc-Corp 2006 Annual Report.
2. “The desire to increase shareholder value is what drives our actions.” Phillips 2006 Annual Report.
3. “FedEx’s main responsibility is to create shareholder value.” FedEx Corporation, SEC Form Def 14A for the period ending 9/25/2006.
4. “… the Board of Directors plays a central role in the Company’s corporate governance system; it has the power (and the duty) to direct Company business, pursuing and fulfilling its primary and ultimate objective of creating shareholder value.” Pirelli & C. S.p.A. Milan Annual Report 2006.
Wealth Maximization is superior because it takes account of current and future profits and EPS; the timing, duration, and risk of profits and EPS; dividend policy; and all other relevant factors. Thus, share price serves as a barometer for business performance.
On the other hand profit maximization has the short comings such as increasing current profits while harming a firm (e.g., defer maintenance, issue common stock to buy T-bills, etc.) It also ignores changes in the risk level of the firm.
Now since the goals of shareholders may not represent the goals of managers who run the firm, managers may not always act in the best interest of shareholders. This creates conflict of interest.
The Agency Problem
This is defined as a potential conflict of interest between the principals (Shareholders) and the agents (Managers).This is created when managers act in contrast to the expectations of the shareholders regarding the objective of wealth maximization. It is necessary for shareholders to put in place incentives to ensure that managers maximize shareholder wealth.
Managerial Incentives to maximize shareholder wealth
To ensure that managers act in line with shareholder expectation agency costs are incurred by firms. These costs take several forms:
i. Expenditure to monitor managerial actions. e.g external audits
ii. Expenditure to structure the organization so that the possibility of undesirable managerial behavior will be limited.
iii. Opportunity costs associated with lost profits opportunities because the organizational structure does not permit managers to take actions on as timely basis as would if the managers were shareholders.
Mechanism applied to force managers to act in the shareholders best interest include:
i. The threat of being fired.
ii. The threat of take over which takes the form a hostile takeover. When a new firm takeover another company managers are usually replaced by these appointed by the new board. Management would want to avoid a takeover for fear of losing their jobs to competition.
iii. Structured Managerial Incentives, which include executive share options, where executive, are given an opportunity to buy share in the future at some discounted price and performance shares awarded on the basis of performance using some criteria.
Corporate Governance Issues
Due to the structure of modern corporations’ conflicts arise as a result of differences in perception and needs of shareholders, managers, society and other stakeholders regarding how the corporation functions. The goal of corporate governance is to:
o Eliminate or mitigate conflicts of interest particularly those between managers and shareholders.
o Ensure that the assets of the company are used efficiently and productively and in the best interest of its investors and other stakeholders.
o Promote sustainability: Meeting the needs of the present without compromising the ability of future generations to meet their own needs.
o Instill corporate Social Responsibility (CSR) by promoting a business outlook that acknowledges a firm’s responsibilities to its stakeholders and the natural environment.
Attributes of an effective corporate governance system are:
1. Delineation of rights of shareholders and other stakeholders;
2. Clearly define manager and director governance responsibilities to stakeholders;