Topic 1 | BBMF2093 Corporate Finance

TOPIC 1: NATURE & SCOPE OF FINANCIAL

MANAGEMENT
Financial Management and its roles

1. The Financial Manager

2. What is Financial Management? BPP4

• Financial management involves the actual management of the firm.
➢ It concerns the acquisition, financing, and management of assets.
• Decision: Investment, financing and working capital management.
• It concerned the maintenance and creation of economic value or wealth.
• The Balance-Sheet Model of the Firm

Balance Sheet
(Statement of Financial Position)
Fixed Assets Shareholders’ Equity
(Investment) Shares outstanding + Retained earnings
Long-term Debt
(Financing / Capital)

Current Assets Current Liabilities

Working Capital

➢ In what fixed assets should the firm invest?

This is an investment or capital budgeting decision.

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➢ How can the firm raise cash for required capital expenditures?
This is a financing decision which will determine the capital structure of
the firm.
➢ How should short-term cash flows be managed?
Management of the net working capital.
• Examples of historical investment & financing decisions by major public
companies
Companies (Revenue Investment (Capital Financing Decision (Debt
in Billions) Budgeting Decision) or Equity)
Boeing ($52.5) Committed more than $7 Negotiated with
billion to design, build, suppliers to help finance
test & sell the 787 the Dreamliner project.
Dreamliner aircraft Japanese suppliers, who
series will build the wing, is
raising & investing more
than $1.5 billion
Bank of America Acquire Fleet Boston Issued about 600 million
($48.9) Financial for $49 billion new shares to finance
the acquisition.
Toyota ($164) Building an $800 million Total borrowing
automobile plant in San increased by $2.9 billion
Antonio, Texas during 2004, mainly due
to issues of short term
debt in the U.S.

• Example 1.1
➢ Are the following Investment (Capital Budgeting) or financing decisions?
a. Intel decides to spend RM1 billion to develop a new microprocessor.
b. Steve borrows RM350 million from Public Bank.
c. BP constructs a pipeline to bring natural gas onshore from a production
platform in the Gulf of Mexico.
d. Ying Hiap spends RM200 million to launch a new brand of beer in European
market.
e. Mulpa issues new shares to buy a small biotech company.

Financial Goals of the Corporation

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1. The primary financial goal is shareholder wealth maximization, which translates

to maximizing stock price. BPP5
• Maximise the present value of the expected future returns (dividend + price
appreciation) to the owners (shareholders).
• Shareholder wealth = No. of shares outstanding x Mkt. price per share.
(Market Capitalisation)

• Try BPP Activity 2 page 6

2. Other Possible Financial Goals of the Corporation:

• Survive or avoid financial stress and bankruptcy.
• Beat the competition.
• Maximise sales or market share
• Minimise costs
• Maintain steady earnings growth
• To do well in all of the above, ESG is increasingly playing a bigger role.
• For example, it’s easy to increase market share or unit sales: All we have to
do is lower our prices or relax our credit terms. Similarly, we can always cut
costs simply by doing away with things such as research & development and
ignore carbon foot prints left behind.
• Therefore, all of the above financial goals must be taken into consideration
and not just 1 in isolation.
3. What determines stock’s price? (Factors)
(a) Projected cash flows to shareholders
✓ Profit versus Cash Flow
Credit sales of Milo i.e. already sold but haven’t collect money from
customers (accounts receivable) = RM1,000,000
✓ Bought Milo for cash from supplier and paid RM900,000

Accounting View Corporate Finance View

Credit Sales RM1,000,000 Cash inflows RM 0

Cost of Sales 900,000 Cash outflows (900,000)
Profit 100,000 Net cash flows (900,000)
By generally accepted accounting The perspective of corporate finance
principles, the sale is recorded even is different. It is interested in
though the customer has yet to pay. The whether cash flows are being created
company seems to be profitable. by the operation of the company.

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(b) Timing of the cash flow stream

✓ The value of an investment made by the firm depends on the timing of
cash flows.
✓ "A dollar received today is worth more than a dollar received a year
from now".
—— can earn interest on money received today.

Year New Product A New Product B

1 0 5,000

2 0 5,000

3 0 5,000

4 20,000 5,000

Total 20,000 20,000

✓ Which project would you choose? Why? (Learn more in Topic 2)

(c) Riskiness of the cash flows

✓ Concept of finance is “higher risk, higher return”.
✓ For an asset with uncertain cash flows (risky), a rational investor will
demand for a higher return than a risk-less asset.
✓ Stock market → high risk, high return 25%
✓ Bank savings and Treasury bond→ low risk , low return 4%
✓ For example, you are considering whether to invest your money in the
bank or stock market.
✓ Given that the current bank rate is 4% p.a. If your friend told you that
the expected return from stock market is around 4% p.a., would you
invest your money in shares? Why?
✓ Factors that affecting level and riskiness of cash flows
▪ Decisions made by financial managers:
i. Investment decisions
ii. Financing decisions (the relative use of debt financing)
iii. Dividend policy decisions
▪ The external environment

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Stock’s Market Price and Intrinsic Value

1. In equilibrium, a stock’s price should equal its “true” or intrinsic value.

• Intrinsic value: An estimate (not measured precisely) of a stock’s “true” value
based on accurate risk and return data.
• Market price: the stock value based on perceived but possibly incorrect
information as seen by the marginal investor
• To the extent that investor perceptions are incorrect, a stock’s price in the
short run may deviate from its intrinsic value.

2. If actual stock price (Market price) > Intrinsic value (IV)

Stock overvalued
Investors sell, Price down
3. If actual stock price (Market price) < Intrinsic value
Stock undervalued
Investors buy, Price up
4. Actual stock price moves up and down with estimated IV, but investors’ optimism
and pessimism, along with imperfect knowledge about the IV, led to deviations
between the actual stock price and IV.

Social Responsibility (ESG)

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1. Why is ESG important?

• The business with strong ESG measures, especially on Governance, invite less
scrutiny from the regulators and have greater operational freedom.
• They also face less pressure from climate change from activists, employee
unions etc. The consumers also prefer such brands too.

2. What does ESG mean for a business?

• Adopting ESG principles means that corporate strategy focuses on the 3

pillars of the environment, social, and governance.
i. Environment: This means taking measures to lower pollution, CO2 output,
and reduce waste.
ii. Social: It also means having a diverse and inclusive workforce, at the entry
level and all the way up to the board of directors.
iii. Governance : H ow a company is managed how shareholder rights are viewed,
and what types of internal controls exist to promote transparency and
accountability by leadership.

• ESG may be costly and time consuming to undertake, but can also be rewarding
into the future for those that carry it through.

3. Is ESG related to finance?

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• Yes -ESG is the latest buzz word/focal point of all regulatory and policymaking
agendas across the world.

4. Does ESG improve profitability?

• Social issues and environmental issues are now considered to be highly

relevant and financially material to the current market. Companies with high
ESG scores are outperforming their competitors, attracting top talent and
profiting from acting more sustainably.

5. Do companies with higher ESG standards have superior financial performance?

• The results of empirical analysis suggest that companies with superior ESG
performance perform better financially and are valued higher in the market
compared to their industry peers.

6. Why is ESG important to employees?

• This finding suggests that ESG performance can help companies both improve
employee satisfaction and attract prospective employees.
• This is significant because prior research shows that satisfied employees
work harder, stay longer with their employers, and seek to produce better
results for the organization.

7. Why is ESG important to investors?

• By considering ESG factors, investors gain a more holistic view of the

companies they back, which can help mitigate risk and identify opportunities
for growth and improvement.

8. What's the difference between CSR and ESG?

• CSR focuses on corporate volunteering, lowering carbon footprint, and

engaging with charities. ESG provides a more quantitative measure of
sustainability.
• ESG considers environmental, social, and governance factors. ESG improves
the valuation of the business.

9. Do firms have any responsibilities to society at large?

• Firms have an ethical responsibility

i. to provide a safe working environment,
ii. to avoid polluting the air or water, and

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iii. to produce safe products.

• However, this incurred cost in the short run.

• ESG is a way to build a more ethical and sustainable business. Capital providers
and investors are becoming increasingly interested in sustainability, and ESG
considers non-financial factors that assess an investment or company's
sustainability.

10. Should firms behave ethically?

• Yes. Positive correlation between ethics and long-run profitability.

• There is no room for unethical behavior in the business world.
• Many consumers prefer to buy from socially responsible companies rather
than from those that shun social responsibility.

Agency Relationship

1. An agency relationship exists whenever a principal hires an agent to act on their

behalf.

2. Within a corporation, agency relationships exist between:

i. Shareholders and managers

ii. Shareholders and creditors

3. Goal of a corporation is maximising shareholders’ wealth.

4. Shareholders (owners), elect directors, who hire managers to run the corporation.
Managers should pursue policies that enhance shareholders value i.e. maximizing
the price of the firm’s common stock.

5. Do managers really maximize value? —— Agency problem

6. Why does the agency problem arise? BPP9

• Difference in objectives between principal and agent or conflict of interest

• Separation of ownership and control.
• The consequence of these factors is that shareholder wealth is not maximised.
• A potential conflict of interests between the agent (manager) and (1) the
shareholders or (2) the creditors (debt holders).

7. Shareholders versus Managers

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• Managers are naturally inclined to act in their own best interests.

• Increased personal wealth, more leisure, luxurious offices, generous
retirement plans.
• The following factors affect managerial behavior:
i. Managerial compensation plans (Performance shares & Executive stock
options)
ii. Direct intervention by shareholders
iii. The threat of firing
iv. The threat of takeover

8. Shareholders versus Creditors

• Shareholders (through managers) could take actions to maximize stock price

that are detrimental to creditors.
• If projects successful, benefits go to shareholders; if projects
unsuccessful, creditors may have to share in the losses.
• In the long run, such actions will raise the cost of debt and ultimately lower
stock price.
• Managers must act in a manner that is fairly balanced between the interests
of the two classes of security holders.

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TOPIC 1A: FINANCIAL RATIO ANALYSIS

1. Short-term solvency; or Liquidity Ratio BPP11 – 13 (Try Activity 4)

Formulae Unit Formulae Unit
Current Current Assets Quick Current Assets - Inventory
Times Times
Ratio Current Liabilities Ratio Current Liabilities

Cash Net WC to Net Working Capital

Cash
Times total %
Ratio Current Liabilities Total Assets
Assets

Interval Current Assets

days
Measure Average Daily Operating Costs

2. Long-term solvency; or Financial Leverage Ratio

Formulae Unit Formulae Unit
Debt Ratio / Total Debts Debt Ratio / Total Debts
Gearing Ratio % Gearing Ratio %
(Debt to Equity) Total Equity (Debt to Asset) Total Assets
Equity Total Assets PBIT
Multiplier or Interest Cover /
Total Equity % Interest Expense Times
Financial TIE Ratio
Leverage
Long-term debt Long-term debt
%
ratio Long Term Debt + Equity

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3. Asset Management; or Efficiency Ratios or Turnover Ratios

Formulae Unit Formulae Unit
Inventory Inventory Inventory COGS
× 365 Days Times
Turnover COGS Turnover Inventory

Receivable Receivables Receivable Sales

× 365 Days Times
Turnover Sales Turnover Receivables

Payable Payables Payable COGS

× 365 Days Times
Turnover COGS Turnover Payables

NWC Sales Fixed Asset Sales

Times Times
Turnover Net Working Capital Turnover Fixed Assets

Operating Inventory Receivables Total Asset Sales

[ + ] ×365 Days Times
Cycle COGS Sales Turnover Total Assets

Cash Inventory Receivables Payables

Conversion [ + - ] ×365 Days
Cycle COGS Sales COGS

4. Profitability Ratios
Formulae Unit Formulae Unit
Net Profit Net Profit
Profit Mark-up % Profit Margin %
COGS Sales
Profit Net Profit
ROI % ROA %
Cost of Investment Total Assets
PBIT Net Profit
ROCE % ROE %
Capital Employed** Total Equity

Net Profit Sales Assets

× ×
ROE (Du Pont) Sales Assets Equity %
Profit Margin × Asset turnover × Equity Multiplier

5. Market / Investors related Ratios

Formulae Unit Formulae Unit
Net Profit Total Dividend
EPS $ DPS $
Total No. of Shares Total No. of Shares
Market Price Market Capitalisation
P/E or Times
EPS Net profit

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Market
P/E × Net Profit or Market Price ×Total No. of Shares $
Capitalisation

Dividend DPS Total Dividend

or %
payout ratio EPS Net profit

Market to Market Cap

Times
book ratio Total Book Value of Equity

DPS Total Dividend

Dividend yield or %
Market Price Market Cap

Capital Gain SP - PP Return to DPS + (SP - PP)

% %
Yield Market Price shareholders PP

Growth ROE × Plowback or PE ratio

% PE Growth times
(r x b) ROE × (1 - Dividend Payout) Earnings growth rate

6. Example 1.2
Prufrock Corporation
2009 Income Statement ($’millions)
Sales 2,311
Cost of goods sold 1,344
Depreciation 276
Earnings before interest and taxes 691
Interest paid 141
Taxable income 550
Taxes (34%) 187
Net income 363
Dividends 121
Addition to retained earnings 242

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Prufrock Corporation
2008 & 2009 Balance Sheet ($’million)
2009 2008 Change
Fixed Assets
Net plant and equipment 2,880 2,731 +149
Current Assets
Cash 98 84 +14
Accounts receivable 188 165 +23
Inventory 422 393 +29
Total 708 642 +66

Total Assets 3,588 3,373 +215

Owner’s equity
Common stock and paid-in-surplus 550 500 +50
Retained earnings 2,041 1,799 +242
Total 2,591 2,299 +292

Long-term debt 457 531 -74

Current liabilities
Accounts payable 344 312 +32
Notes payable 196 231 -35
Total 540 543 -3

Total liabilities and owner’s equity 3,588 3,373 +215

The share is currently traded at $88 per share and there are 33 million shares
in issue.
• Liquidity Ratio
➢ One advantage of looking at current assets and liabilities is that their book
values and market value s are likely to be similar.
➢ Often (though not always), these assets and liabilities just don’t live long
enough for the two to get seriously out of step.
➢ On the other hand, like any type of near-cash, current assets and liabilities
can and do change fairly rapidly, so today’s amounts may not be reliable
guide to the future.
➢ Here is Prufrock’s 2009 current ratio:

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Current Assets 708

Current Ratio = = = 1.31 times
Current Liabilities 540

➢ Because current assets and liabilities are, in principle, converted to cash

over the following 12 months, the current ratio is a measure of short term
liquidity.
➢ The unit of measurement is either dollars or times. So, we could say
Prufock has $1.31 in current assets for every $1 in current liabilities, or
we could say Prufock has its current liabilities covered 1.31 times over.

• Debt-Equity ratio = Total debt/ Total equity (or Total liability/ Total assets)
Total Debt 997
Debt to Equity Ratio = = = 38.5%
Total Equity 2,591
➢ Whether this is high or low or whether it even makes any difference
depends on whether capital structure matters eg. projects such as oil
pipelines financed with 90% debt and 10% equity. In that case the debt-
equity ratio is 90/10 = 9.

• Profitability Ratio
Net Profit 363
ROE = = =14%
Total Equity 2,591

➢ For every dollar in equity, therefore, Prufrock generated 14 cents in profit;

➢ ROE is more useful if it is compared to a benchmark such as the average
ROE in the industry where the company operates or the company's ROE in
the past years

• Market Value measure- Price-Earning ratio.

Market Price $88
P/E = = = 8 times
EPS $11
➢ Prufrock shares sell for eight times earnings, or we might say that
Prufrock shares have or “carry” a PE multiple of 8.
➢ Higher PEs are often taken to mean the firm has significant prospects
for future growth.

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TOPIC 1B: WORKING CAPITAL MANAGEMENT

Working Capital Management BPP44

1. Working capital is concerned with short term resources and short term funding.

2. Net Working Capital = Current Assets less Current Liabilities

3. The need for liquidity must be balanced against the need for profitability.

Cash Conversion Cycle BPP46 – 49 (Try Activity 1 – 3)

1. Cash conversion cycle is the time between paying for inputs and receipt of cash
from sales.

2. Length of cash conversion cycle is a factor in determining the level of working

capital.

3. Level of working capital also depends upon working capital policy.

4. Operating cycle links material and cash flows

5. Cash Conversion Cycle = Inventory Conversion Period + Receivables Conversion

Period – Payables deferral period.

Working Capital Policies

1. Policies should cover:

i. overall level of investment in working capital

ii. investment in working capital components
iii. method of financing

2. Taking account of:

i. Taking account of: Nature of business

ii. Credit policy
iii. Seasonal factors
iv. Manufacturing period

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3. An aggressive policy regarding level of working capital will have lower levels of
investment than a conservative policy.

• An aggressive policy will have higher risk and higher profitability

• A conservative policy will have lower risk and lower profitability

4. Current assets are divided into permanent current assets and fluctuating
current assets

5. Short term finance is cheaper than long term finance

6. Short term finance is riskier than long term finance

7. Moderate Policy / Matching Policy

• Short term funds for fluctuating current assets

• Long term funds for permanent current assets and non-current assets

8. Conservative Policy BPP46

• Long term funds used for permanent and some fluctuating current assets

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9. Aggressive Policy BPP46

• Short term funds for fluctuating and some permanent current assets
• Long term funds for non-current assets and some permanent current assets
• Choice of policy depends upon company’s attitude to risk and return

Overtrading BPP51

1. Overtrading occurs when capital base is too small to support volume of trade.

2. Caused by too rapid an increase in turnover or erosion of capital base.

3. Overtrading can be indicated by:

• deterioration in key financial ratios

• decreasing liquid resources
• increasing reliance on short-term finance

4. Solutions:

• Solutions seek to bring capital base and volume of trade back into balance
• Introduction of new capital.
• Consolidation of business activity.
• Better working capital management.

5. Note that overtrading can result from aggressive working capital policies.

Management of Cash

1. Holding cash for short term needs incurs an opportunity cost of lost profit.

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2. Causes of cash flow problems:

• Making losses on a continuing basis

• Inflation
• Growth
• Seasonal factors
• Significant expenditure

3. Cash flow shortages can be eased by:

• postponing expenditure
• accelerating income
• obtaining new cash resources

4. Optimum cash levels reflect liquidity needs

• future cash needs and borrowing capability
• efficiency of cash management
• tolerance of risk

5. Short-term cash surplus can be invested in appropriate short-term instruments

• Must be no risk of capital loss

• Choice of investment depends upon:

i. size of the cash surplus

ii. maturity of asset
iii. yield required
iv. penalties for early encashment
• Appropriate short term instruments: Term deposits, Treasury bills & gilt
edged stock, Bank certificates of deposit, Local authority bonds.

Management of Receivables BPP56

1. Credit management is constrained by:

• Liquidity
• Production
• Availability of staff
• Acceptable level of bad debts

2. Receivables levels depend on:

• Terms of sale

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• Ability to finance receivables

• Pricing policy
• Receivables collection procedures

3. The benefits of additional contribution must be set against administrative and

financial costs of offering credit

• Administrative costs include:

i. recording, monitoring, collecting debts

ii. bad debt collection costs
iii. credit insurance

• Finance costs include:

i. investment in receivables
ii. losses due to bad debts

4. Credit analysis should be based on:

• Company’s own experience

• Analysis of credit reports
• Analysis of published information

5. Credit extended should reflect assessment of creditworthiness of prospective

client.

6. Credit assessment should consider:

i. Previous experience
ii. Consideration of credit reports
iii. Analysis of published information

7. Company must take steps to ensure agreed terms of sale are adhered to:

i. Periodic review of credit limits

ii. Aged debtor analysis
iii. Efficient administration
iv. Agreed overdue account procedures

8. Cash discounts may be used to encourage early payment

• Cost of discount must be compared with benefit of lower financing charges

and any decrease in risk of bad debts.
• Benefits should exceed costs.

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9. Example 1.3

MB plc has £15m per year credit sales and gives 90 days credit

Proposal: introduce 3% discount for payment in 15 days, lower credit to 60 days

60% of customers will take discount

Sales will be unaffected

Short-term borrowing is at 20%

Current receivables: £15m x (90/365) = £3.7m
Proposed receivables:
£15m x 60% x (15/365) = £0.4m
£15m x 40% x (60/365) = £1.0m
£1.4m
Decrease in receivables: £2.3m

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