Overview of Corporate
Finance
Chapter 3
Corporate Finance :
• Corporate finance is the subfield of finance that deals with how corporations deal with funding sources, capital
structuring, accounting, and investment decisions.
• Corporate finance is often concerned with maximizing shareholder value through long and short-term financial
planning and the implementation of various strategies. Corporate finance activities range from capital
investment to tax considerations.
• Corporate finance is concerned with how businesses fund their operations in order to maximize profits and
minimize costs.
• Corporate finance deals with the day-to-day operations of a businesses' cash flows as well as on long-term
financing goals.
• In addition to capital investments, corporate finance deals with monitoring cash flows, accounting, preparing
financial statements, and taxation.
• 1. Capital Investments
• 2. Capital Financing
• 3. Short term Liquidity
Objectives of Corporate Finance :
• Financial management,also called corporate finance, focuses on decisions relating to how much and what
types of assets to acquire, how to raise the capital needed to buy assets, and how to run the firm so as to
maximize its value. The same principles apply to both for-profit and not-for-profit organizations.
• 1. Profit maximization
• 2. Wealth maximization
• 3. Proper estimation of total financial requirements
• 4. Proper mobilization
• 5. Proper utilization of finance
• 6. Maintaining proper cash flow
• 7. Survival of company
• 8. Creating reserves
• 9. Proper coordination
• 10. Create goodwill
• 11. Increase efficiency
• 12. Financial discipline
• 13. Reduce cost of capital
• 14. Reduce operating risks
• 15. Prepare capital structure
Functions of Corporate Finance :
Functions of Corporate Finance :
• Finance functions or decisions are divided into long-term and short-term decisions and include:
• Long-term financial decisions:
• Long-term asset-mix or investment decision
• Capital-mix or financing decision
• Profit allocation or dividend decision
• Short-term financial decisions:
• Short-term asset-mix or liquidity decision
• 1. Long-term Finance Decisions: The long-term finance functions or decisions have a longer time
horizon, generally greater than a year. They may affect the firm’s performance and value in the long
run.
a) Investment decision:
• A firm’s investment decisions involve capital expenditures. They are, therefore, referred as capital
budgeting decisions. A capital budgeting decision involves the decision of allocation of capital or
commitment of funds to long-term assets that would yield benefits (cash flows) in the future.
• Two important aspects of investment decisions are
• the evaluation of the prospective profitability of new investments
• the measurement of a cut-off rate against which the prospective return of new investments could be
compared.
• Risk in investment arises because of the uncertain [Link] proposals should, therefore, be
evaluated in terms of both expected return and risk.
• There is a broad agreement that the correct cut-off rate or the required rate of return on investments
is the opportunity cost of capital.
• The opportunity cost of capital is the expected rate of return that an investor could earn by investing
his or her money in financial assets of equivalent risk.
b) Financing decision
• The mix of debt and equity is known as the firm’s capital structure. The financial manager
must strive to obtain the best financing mix or the optimum capital structure for his or her
firm.
• The firm’s capital structure is considered optimum when the market value of shares is
maximized.
• In the absence of debt, the shareholders’ return is equal to the firm’s return.
• The change in the shareholders’ return caused by the change in the profits is called the
financial leverage.
• When the shareholders’ return is maximized with given risk, the market value per share will
be maximized and the firm’s capital structure would be considered optimum.
• Once the financial manager is able to determine the best combination of debt and equity, he
or she must raise the appropriate amount through the best available sources
c) Dividend decision :
• The financial manager must decide whether the firm should distribute all profits, or retain
them, or distribute a portion and retain the balance.
• The proportion of profits distributed as dividends is called the dividend-payout ratio and
the retained portion of profits is known as the retention ratio.
• The optimum dividend policy is one that maximizes the market value of the firm’s shares.
• If shareholders are not indifferent to the firm’s dividend policy, the financial manager must
determine the optimum dividend-payout ratio.
• Dividends are generally paid in cash. But a firm may issue bonus shares.
• Bonus shares are shares issued to the existing shareholders without any charge.
• 2. Short-term financial decisions :
• Short-term finance functions or decisions involve a period of less than one year. These decisions are
needed for managing the firm’s day-to-day fund requirements.
• Liquidity decision:
• Management of current assets that affects a firm’s liquidity is yet another important finance function.
• Current assets should be managed efficiently for safeguarding the firm against the risk of illiquidity.
• If the firm does not invest sufficient funds in current assets, it may become illiquid and therefore,
risky. It would lose profitability, as idle current assets would not earn anything.
• Thus, a proper trade-off must be achieved between profitability and liquidity.
• The profitability-liquidity trade-off requires that the financial manager should develop sound
techniques of managing current assets.
• He or she should estimate the firm’s needs for current assets and make sure that funds would be
made available when needed.
FINANCIAL RATIO
ANALYSIS
INCOME STATEMENT & BALANCE
SHEET
SAMPLE
INCOME
STATEMENT
SAMPLE BALANCE SHEET
Definitions
Current Liabilities: Amounts due Current Assets: Cash and other
to be paid to creditors within assets that are expected to be
twelve months converted to cash within a year
Creditors: A creditor is a party
that has a claim on the services
of a second party. It is a person
Debenture: In corporate finance,
or institution to whom money is
a debenture is a medium- to
owed. The first party, in general,
long-term debt instrument used
has provided some property or
by large companies to borrow
service to the second party
money, at a fixed rate of interest
under the assumption that the
second party will return an
equivalent property and service
◦ Reserves: In financial accounting, "reserve" always has a
credit balance and can refer to a part of shareholders'
equity, a liability for estimated claims, or contra-asset for
uncollectible accounts. A reserve can appear in any part
of shareholders' equity except for contributed or basic
share capital.
◦ Capital can refer to funds raised to support a particular
business or project. Capital can also represent the
Definitions accumulated wealth of a business, represented by its
assets less liabilities . Capital can also mean stock or
ownership in a company.
◦ Capital = Assets - Liabilities, this means, capital is used to
invest in assets, and pay for expenses. What ever is left
after assets minus liabilities is the residual capital. If the
capital is zero or below, liabilities are more. If it is more
that zero, that means, company has more value. (*In a
Balance Sheet*)
◦ Fixed Assets: Fixed assets, also known as tangible
assets or property, plant and equipment, is a term
used in accounting for assets and property that
cannot easily be converted into cash. This can be
compared with current assets such as cash or bank
accounts, described as liquid assets
Definitions ◦ Intangible Asset: An intangible asset is an asset that
lacks physical substance; in contrast to physical
assets, such as machinery and buildings, and
financial assets such as government securities. An
intangible asset is usually very hard to evaluate.
Examples are patents, copyright, franchises,
goodwill, trademarks, and trade names
◦ Tangible Asset: These assets that have a physical
form. Tangible assets include both fixed assets,
such as machinery, buildings and land, and current
assets, such as inventory
Definitions ◦ A term loan is a monetary loan that is repaid in
regular payments over a set period of time. Term
loans usually last between one and ten years, but
may last as long as 30 years in some cases. A term
loan usually involves an unfixed interest rate that
will add additional balance to be repaid
Ratio Analysis
◦ RATIO ANALYSIS involves methods of
calculating and interpreting financial
ratios to analyze and monitor a firm’s
performance
◦ FINANCIAL RATIOS involve the use of
numerical values taken from both
Income Statement and Balance Sheet
CAPITAL
STRUCTURE
RATIOS
LIQUIDITY
RATIOS
TURNOVER
RATIOS/ACTIVITY
RATIOS
PROFITABILITY
RATIOS
COVERAGE
RATIOS
SUMMARY
Example
Liabilities Amount Assets Amount
Term loan balance 300 Prepaid expenses 30
Reserves 160 Land & building 250
Bank overdraft 200 Investment in shares 50
Provisions 50 Goodwill 40
Debentures 200 Debtors 320
Capital 240 Plant & Machinery 190
Creditors 180 Preliminary expenses 10
Expenses payable 40 Cash in hand 30
Loans from friends 100 Stocks 560
Advance from customers 50 Advance to suppliers 40
Total liabilities 1520 Total assets 1520
Sales 2500 Net profits 250
Classification of B-Sheet for Ratio Analysis
Sr. No. Liabilities Amount Assets Amount
1. Term loan balance (LTL) 300 Prepaid expenses (CA) 30
2. Reserves (NW) 160 Land & building (FA) 250
3. Bank overdraft (CL) 200 Investment in shares (NCA) 50
4. Provisions (CL) 50 Goodwill (IA) 40
5. Debentures (LTL) 200 Debtors (CA-QA) 320
6. Capital (NW) 240 Plant & Machinery (FA) 190
7. Creditors (CL) 180 Preliminary expenses (IA) 10
8. Expenses payable (CL) 40 Cash in hand (CA-QA) 30
9. Loans from friends (LTL) 100 Stocks (CA) 560
10. Advance from customers 50 Advance to suppliers (CA-QA) 40
(CL)
Total liabilities 1520 Total assets 1520
Sales 2500 Net profits 250
Summary of B-Sheet
Liabilities Amount Assets Amount
Capital & Reserves 400 Fixed Assets 440
Long Term Liabilities 600 Non-current assets 50
Current Liabilities 520 Intangible assets 50
Current assets (Quick assets) 980 (*390)
Total liabilities 1520 Total assets 1520
Sales 2500 Profit after tax 250
Add up respective amounts under Liabilities as per the
following categories:
Capital + Reserves (Sr. no.2+ Sr. no.6)
Long Term Liabilities (Sr. no.1+ Sr. no.5+ Sr. no.9)
Summary of Current Liabilities (Sr. no. 3+ Sr. no.4+ Sr. no. 7+ Sr. no.8+ Sr.
no.10)
B-Sheet Add up respective amounts under Assets as per the
following categories:
Fixed Assets (Sr. no.12+ Sr. no.16) Non-Current Assets (Sr.
no.13) Intangible Assets (Sr. no.14+ Sr. no.17)
Current Assets (Sr. no.11+ Sr. no.15+ Sr. no.18+ Sr. no.19+
Sr. no.20) Quick Assets (Sr. no.15+ Sr. no.18+ Sr. no.20)
Calculation of Ratio
Ratio & Formulae Ratio
Current Ratio= 980/520= 1.88:1
Current Asset (CA)/Current Liability (CL)
Quick Ratio= 390/520= 0.75:1
Quick Asset (QA)/Current Liability (CL)
Debt Equity Ratio= 600/350= 1.71:1
Long Term Liabilities (LTL)/Tangible Net Worth (TNW)
Tangible Net Worth= Net Worth - Intangible Assets where, Net
Worth= Capital+Reserves
Total Outstanding Liabilities= (600+520)/350=
Long Term Liabilities (LTL) + Current Liability (CL)/ Tangible Net 3.2:1
Worth (TNW)
Calculation of Ratio
Ratio & Formulae Ratio
Stock Turnover Ratio= Sales/Stock (Also called as Inventory Turnover 2500/560= 4.5 times
Ratio)
Debtors Turnover Ratio= Sales/Debtors 2500/320= 7.8 times
Debtors Velocity or Debtors Collection= (Debtors/Sales)*12 (320/2500)*12= 1.54
months
Net Profit/Sales= (Net Profit/Sales) *100 (250/2500)*100= 10%
Return on Equity= (Net Profit/ Tangible Net Worth) *100 (250/ 350)*100= 71%
Return on Investment= 250/ (350+600)*100=
Net Profit/ (Tangible Net Worth+Long Term Liabilities) *100 26%
Calculation of Financial Ratios
Current Ratios: Current Assets/Current Liability
Quick Ratio (Acid Test Ratio)= Quick Asset/Current Liability
Debt Equity Ratio= (Long Term Liabilities/Tangible Net Worth)
Tangible Net Worth= Net Worth - Intangible Assets where, Net
Worth= Capital+Reserves (Sr. no.2+ Sr. no.6)
Total Outstanding Liabilities= (Long Term Liabilities+ Current Liability)/ Tangible Net Worth
Calculation of Financial Ratios
Stock Turnover Ratio= Sales/Stock (Also called as Inventory Turnover Ratio)
Debtors Turnover Ratio= Sales/Debtors
Debtors Velocity or Debtors Collection= (Debtors/Sales)*12
Net Profit= (Net Profit/Sales) *100
Return on Equity= (Net Profit/ Tangible Net Worth) *100
Return on Investment= (Net Profit/ (Tangible Net Worth+Long Term Liabilities) *100
8/18/2021