This chapter can help for Economic students

1. Faculty of Economics
Corporate Finance
Lecturer: Mr. Khayal Nazar
Zakhil

2. Corporate Finance
Chapter One
Introduction to Corporate Finance

3. Overview of Corporate Finance and the Financial
Environment
 Corporate finance
Forms of business organization
Objective of the firm: Maximize wealth
Determinants of stock pricing
 The financial environment
Financial instruments, markets and institutions
Interest rates and yield curves

4. Corporate Finance
 Corporate finance is an area of finance that deals with sources of funding,
the capital structure of corporations, the actions that managers take to increase
the value of the firm to the shareholders, and the tools and analysis used to allocate
financial resources.
 They want the financial manager to increase the value of the corporation and its
current stock price.

5. Why is corporate finance important to all
managers?
 Corporate finance provides the skills managers need to:
 Identify and select the corporate strategies and individual projects that add
value to their firm.
 Forecast the funding requirements of their company, and devise strategies for
acquiring those funds.

6. Forms of Business Organizations
 Sole proprietorship
 Partnership
 Corporation

7. Cont.….
 There are three main forms of business organization: (1) sole proprietorships, (2)
partnerships, and (3) corporations. In terms of numbers, about 80 percent of busi-
nesses are operated as sole proprietorships, while most of the remainder are divided
equally between partnerships and corporations. Based on dollar value of sales, how-
ever, about 80 percent of all business is conducted by corporations, about 13 percent
by sole proprietorships, and about 7 percent by partnerships and hybrids. Because
most business is conducted by corporations, we will concentrate on them in this
book. However, it is important to understand the differences among the various
forms.

8. Sole Proprietorship
 A sole proprietorship is an unincorporated business owned by one
individual.
 Going into business as a sole proprietor is easy—one merely begins
business operations.
 However, even the smallest business normally must be licensed by a
governmental unit.

9. Sole Proprietorship
 Advantages:
Ease of formation
Subject to few regulations
No corporate income taxes
 Disadvantages:
Limited life
Unlimited liability
Difficult to raise large sum of capital

10. Partnership
 A partnership exists whenever two or more persons associate to conduct a
non-corporate business.
 Partnerships may operate under different degrees of formality, ranging from
informal, oral understandings to formal agreements filed with the secretary
of the state in which the partnership was formed.

11. Partnership
 Advantages:
Low cost business organization
Ease of formation
 Disadvantages:
Limited life
Unlimited liability
Difficulty transferring ownership
Difficult to raise large sum of capital

12. Corporation
 A corporation is a legal entity created by a state, and it is separate and
distinct from its owners and managers.
 This separateness gives the corporation some major advantages:

13. Corporation
 Advantages:
Unlimited life
Easy transfer of ownership
Limited liability
Ease of raising capital
 Disadvantages:
Double taxation
Cost of set-up and report filing

14. Unlimited and Limited Liability
 Suppose you invested $10,000 in a partnership that then went bankrupt owing $1
million.
 Because the owners are liable for the debts of a partnership, you could be assessed for
a share of the company’s debt, and you could be held liable for the entire $1 million if
your partners could not pay their shares. Thus, an investor in a partnership is exposed
to unlimited liability.
 On the other hand, if you invested $10,000 in the stock of a corporation that then went
bankrupt, your potential loss on the investment would be limited to your $10,000
investment.

15. Hybrid Forms of Organization
 Although the three basic types of organization-proprietorships, partnerships, and
corporations dominate the business scene, several hybrid forms are gaining
popularity.
 It is possible to limit the liabilities of some of the partners by establishing a limited
partnership, where in certain partners are designated general partners and others
limited partners.
 The limited liability partnership (LLP), sometimes called a limited liability company
(LLC).
 There are also several different types of corporations. One that is common among
professionals such as doctors, lawyers, and accountants is the professional
corporation (PC), or in some states, the professional association (PA).

16. The Primary Objective of the Corporation
 Shareholders are the owners of a corporation, and they purchase stocks
because they want to earn a good return on their investment without
undue risk exposure.
 Shareholders elect directors, who then hire managers to run the
corporation on a day-to-day basis.
 Managers are supposed to be working on behalf of shareholders, it
follows that they should pursue policies that enhance shareholder value.

17. Management’s Primary Objective
 The primary objective should be shareholder wealth maximization, which translates
to maximizing stock price.
 Maximize the sale of corporate business.
 Minimize the cost of manufacturing and the cost of labor.
 Maximize the profitability of the corporation.

18. What type of actions can managers take to
maximize a firm’s stock prices?

19. Managerial Actions to Maximize Shareholders
Wealth
 Management’s decisions can significantly affect the firm’s value.
 Managers can increase the value of a firm by making decision that :
Cash flow- will focus on the cash flows
1. Size or Level of the Cash Flows
 Increase sale
Charge higher prices
To decrease direct expenses (labor/material cost)

20. 2. Timing of the Cash Flows
 principle of finance is that individual prefer to receive cash flows earlier than
later. A dollar receive today is worth more than a dollar receive tomorrow.
3. Certainty of the Cash Flows
Investors fear from risk, so they will pay more for stocks, whose cash flows are
certain, than for stocks whose cash flows are risky
Managerial Actions to Maximize Shareholders
Wealth

21. Capital Allocation Process
 One of the most important responsibilities of a company’s management team is
capital allocation. But what exactly is capital allocation?
 Capital allocation is the process of distributing an organizations financial
resources.
 The purpose of capital allocation in publicly traded corporations is to maximize
shareholder returns.
 As shareholders, it is our job to ensure that management is making intelligent
decisions for capital allocation. We must therefore understand the impact of
various capital allocation techniques.

22. The 5 Methods of Capital Allocation are Listed
Below:
 Invest in organic growth
 Mergers and acquisitions
 Repurchase shares
 Pay down debt
 Pay dividends

23. 1. Investing In Organic Growth
 Expansion of a firms operations form its own resources. When investing for organic
growth managers prefer to reinvest excess capital into the operating business that
originally generated it instead of diverting funds away from a core business line to
make balance sheet improvements, perform acquisitions, or return capital to
shareholders.
Examples of organic growth investments include:
 Research and development
 Building out the supply chain
 Launching a new product or service
 Improving an existing product or service

24. 2. Mergers & Acquisitions
1. Horizontal integration: if merged firms were competitors.
2. Vertical integration: if the merged firms were suppliers and customers of one another.
Acquisition: taking control of a firm by purchasing 51% of its voting shares. Or
purchasing of another firm.
3. Paying Down Debt
Repurchasing the debt securities before its maturity from the market and decreasing the
level of debt of the firm.
4. Paying Dividends
Distributing the financial resources among the shareholders.

25. Share repurchases occur when a company buys back its own shares,
reducing the number of shares outstanding. This has the beneficial effect of
improving important per-share financial metrics such as earnings-per-share,
book-value-per-share, and free-cash-flow-per-share.
5. Share Repurchases

26. What is Financial System?
Financial system is a framework for describing set of markets,
organisations, and individuals that engage in the transaction of financial
instruments (securities), as well as regulatory institutions.
The basic role of financial system is essentially channelling of funds
within the different units of the economy from surplus units to deficit
units for productive purposes.

27. Financial System

28. What are Financial Markets?
 Financial markets are markets where funds are transferred from people who have an
excess of available funds to people who have shortage.
 At any point in time in an economy, there are individuals or organizations with excess
amounts of funds, and others with a lack of funds they need for example to consume or
to invest.

29. Financial Markets

30. Types of Exchanges in Financial Markets
1. Direct Finance
• Borrowers borrow directly from lenders in financial markets by selling financial
instruments which are claims on the borrower’s future income or assets.
2. Indirect Finance
• Borrowers borrow indirectly from lenders via financial intermediaries
(established to source both loanable funds and loan opportunities) by issuing
financial instruments which are claims on the borrower’s future income or assets.

31. Structure or Types of Financial Markets
These are the types of financial markets in financial system.
 Money Market
 Capital Market
 Primary Market
 Secondary Market
 Stock Exchange Market

32.  Over the Counter Market
 Debt Market
 Equity Market
 Derivative Markets
 Spot versus future markets
Structure or Types of Financial Markets

33.  Capital in a free economy is allocated through the price system. The interest rate is the
price paid to borrow debt capital. With equity capital, investors expect to receive
dividends and capital gains, whose sum is the cost of equity money.
 The four most fundamental factors affecting the cost of money are (1) production
opportunities, (2) time preferences for consumption, (3) risk, and (4) inflation.
 the higher the perceived risk, the higher the required rate of return.
 When money is used, its value in the future, which is affected by inflation, comes into
play:
 the higher the expected rate of inflation, the larger the required return.

34.  Commercial banks
 Savings & Loans, mutual savings banks, and credit unions
 Life insurance companies
 Mutual funds
 Pension funds

35. How are secondary markets organized?
 By “location”
 Physical location exchanges
 Computer/telephone networks
 By the way that orders from buyers and sellers are matched
 Open outcry auction
 Dealers (i.e., market makers)
 Electronic communications networks (ECNs)

36. Physical Location vs. Computer/telephone Networks
 Physical location exchanges: e.g., NYSE, AMEX, CBOT, Tokyo Stock Exchange
 Computer/telephone: e.g., Nasdaq, government bond markets, foreign exchange
markets

37. Auction Markets
 NYSE and AMEX are the two largest auction markets for stocks.
 NYSE is a modified auction, with a “specialist.”
 Participants have a seat on the exchange, meet face-to-face, and place orders for
themselves or for their clients; e.g., CBOT.
 Market orders vs. limit orders

38. Dealer Markets
 “Dealers” keep an inventory of the stock (or other financial asset) and place bid and
ask “advertisements,” which are prices at which they are willing to buy and sell.
 Computerized quotation system keeps track of bid and ask prices, but does not
automatically match buyers and sellers.
 Examples: Nasdaq National Market, Nasdaq SmallCap Market, London SEAQ,
German Neuer Markt.

39. Electronic Communications Networks (ECNs)
 ECNs:
 Computerized system matches orders from buyers and sellers and
automatically executes transaction.
 Examples: Instinet (US, stocks), Eurex (Swiss-German, futures contracts),
SETS (London, stocks).

40. Over the Counter (OTC) Markets
 In the old days, securities were kept in a safe behind the counter, and passed “over
the counter” when they were sold.
 Now the OTC market is the equivalent of a computer bulletin board, which allows
potential buyers and sellers to post an offer.
 No dealers
 Very poor liquidity

41. Financial Intermediaries
• A financial intermediary is an organization that raises money from
investors and provide financing for individuals, companies and other
organizations.
• For corporations, intermediaries are important source of financing.

42. Types of Financial Intermediaries
1. Mutual Funds
2. Pension Funds

43. 1. Mutual Funds
• Mutual fund is an investment company which raises money by selling
shares to investors, the investors money is pooled and invested in
portfolio of securities.
• Mutual Funds offers investors low cost diversification and
professional management for most investors, it is more efficient to buy
a mutual fund than to assemble a diversified portfolio of stocks and
bonds.
• In exchange of their services, the funds managers take out the
management fee.

44. 2. Pension Fund
• Pension Fund is an investment plan set up by an employer to provide
for employees’ retirement.
• It is set up on behalf of its employees.
• It is defined contribution plan, a percentage of the employees monthly
paycheck is contributed to pension fund.
• Contribution from all participating employees are pooled and invested
in securities or mutual fund.

45. Financial Institution
• A financial institution is an intermediary that does more than just pool
and invest savings. (by accepting deposits or selling insurance polices
and they provide additional financial services).
• They not only invest in securities but also loan money directly to
individuals, businesses and other organizations.

46. Banks
• Banks are financial intermediaries that does more than just pool and
invest money.
• They raise money by accepting deposits and provide loans.
• To cover the cost of services, it charges higher interest from borrowers
and pays lower interest to depositors.

47. Insurance Companies
• Insurance companies are more important for the long term financing of
business.
• The money to make loan comes mainly from the sale of insurance
policies.

48. Types of Market Transactions
1. Private Placement
2. Seasoned Issued
3. Initial Public Offerings

49. The Cost of Money
 Capital in a free economy is allocated through the price system.
 The interest rate is the price paid to borrow debt capital.
 With equity capital, investors expect to receive dividends and capital
gains, whose sum is the cost of equity money.

50.  What do we call the price, or cost, of debt capital?
The interest rate
 What do we call the price, or cost, of equity capital?
Required Dividend Capital
return yield gain

51. What four factors affect the cost
of money?
• Production opportunities
• Time preferences for consumption
• Risk
• Expected inflation

52. Real versus Nominal Rates
r* = Real risk-free rate.
T-bond rate if no inflation;
1% to 4%.
= Any nominal rate.
= Rate on Treasury securities.
r
rRF

53. r = r* + IP + DRP + LP + MRP.
Here:
r = Quoted interest rate or
Required rate of return on a
debt security.
r* = Real risk-free rate.
IP = Inflation premium. IP is equal to the
average expected inflation rate over the life of
the security.

54. Real versus Nominal Rates
DRP = Default risk premium.
This premium reflects the possibility that the issuer will not pay interest or
principal at the stated time and in the stated amount.
LP = Liquidity premium.
This is a premium charged by lenders to reflect the fact that some securities
cannot be converted to cash on short notice at a “reasonable” price.
MRP = Maturity risk premium.
Longer-term bonds, even Treasury bonds, are exposed to a significant risk
of price declines, and a maturity risk premium is charged by lenders to
reflect this risk.

55. Premiums Added to r* for Different Types of Debt
• ST Treasury: only IP for ST inflation
• LT Treasury: IP for LT inflation, MRP
• ST corporate: ST IP, DRP, LP
• LT corporate: IP, DRP, MRP, LP

56. What is the “term structure of interest rates”?
What is a “yield curve”?
• Term structure: the relationship between interest rates (or yields) and
maturities.
• A graph of the term structure is called the yield curve.

57. How can you construct a hypothetical
Treasury yield curve?
• Estimate the inflation premium (IP) for each future year. This is the
estimated average inflation over that time period.
• Step 2: Estimate the maturity risk premium (MRP) for each future
year.

58. Step 1: Find the average expected
inflation rate over years 1 to n:
n
 INFLt
t = 1
n
IPn = .
Assume investors expect inflation to be 5% next year, 6% the
following year, and 8% per year thereafter.

59. IP1 = 5%/1.0 = 5.00%.
IP10 = [5 + 6 + 8(8)]/10 = 7.5%.
IP20 = [5 + 6 + 8(18)]/20 = 7.75%.
Must earn these IPs to break even versus inflation; that
is, these IPs would permit you to earn r* (before taxes).

60. Step 2: Find MRP based on this equation:
MRPt = 0.1%(t - 1).
MRP1 = 0.1% x 0 = 0.0%.
MRP10 = 0.1% x 9 = 0.9%.
MRP20 = 0.1% x 19 = 1.9%.
Assume the MRP is zero for Year 1 and increases by 0.1% each
year.

61. Step 3: Add the IPs and MRPs to r*:
rRFt
= r* + IPt + MRPt .
rRF = Quoted market interest
rate on treasury securities.
Assume r* = 3%:
rRF1 = 3% + 5% + 0.0% = 8.0%.
rRF10 = 3% + 7.5% + 0.9% = 11.4%.
rRF20 = 3% + 7.75% + 1.9% = 12.65%.

62. Hypothetical Treasury Yield Curve
0
5
10
15
1 10 20
Years to Maturity
Interest
Rate (%) 1 yr 8.0%
10 yr 11.4%
20 yr 12.65%
Real risk-free rate
Inflation premium
Maturity risk premium

63. What factors can explain the shape of this yield
curve?
• This constructed yield curve is upward sloping.
• This is due to increasing expected inflation and
an increasing maturity risk premium.

64. What kind of relationship exists between the Treasury
yield curve and the yield curves for corporate issues?
• Corporate yield curves are higher than that of the Treasury bond.
However, corporate yield curves are not necessarily parallel to the
Treasury curve.
• The spread between a corporate yield curve and the Treasury curve
widens as the corporate bond rating decreases.

65. Hypothetical Treasury and Corporate Yield Curves
0
5
10
15
0 1 5 10 15 20
Years to
maturity
Interest
Rate (%)
5.2%
5.9%
6.0%
Treasury
yield curve
BB-Rated
AAA-Rated

66. What is the Pure Expectations
Hypothesis (PEH)?
• Shape of the yield curve depends on the investors’ expectations about
future interest rates.
• If interest rates are expected to increase, L-T rates will be higher than S-
T rates and vice versa. Thus, the yield curve can slope up or down.

67. • PEH assumes that MRP = 0.
• Long-term rates are an average of current and future short-term rates.
• If PEH is correct, you can use the yield curve to “back out” expected
future interest rates.

68. Observed Treasury Rates
If PEH holds, what does the market expect will be the interest
rate on one-year securities, one year from now? Three-year
securities, two years from now?
Maturity Yield
1 year 6.0%
2 years 6.2%
3 years 6.4%
4 years 6.5%
5 years 6.5%

69. 0 1 2 5
6.0%
3 4
x%
6.2%
PEH tells us that one-year securities will
yield 6.4%, one year from now (x%).
6.2% =
12.4% = 6.0 + x%
6.4% = x%.
(6.0% + x%)
2

70. 0 1 2 5
6.2%
3 4
x%
6.5%
[ 2(6.2%) + 3(x%) ]
5
PEH tells us that three-year securities
will yield 6.7%, two years from now (x%).
6.5% =
32.5% = 12.4% + 3(x%)
20.1% = 3(x%)
6.7% = x%.

71. Conclusions about PEH
• Some argue that the PEH isn’t correct, because securities of different
maturities have different risk.
• General view (supported by most evidence) is that lenders prefer S-T
securities, and view L-T securities as riskier.
• Thus, investors demand a MRP to get them to hold L-T securities (i.e.,
MRP > 0).

72. What various types of risks arise
when investing overseas?
Country risk: Arises from investing or doing business in a particular
country. It depends on the country’s economic, political, and social
environment.
Exchange rate risk: If investment is denominated in a currency other
than the dollar, the investment’s value will depend on what happens to
exchange rate.

73. What two factors lead to exchange rate fluctuations?
• Changes in relative inflation will lead to changes in exchange rates.
• An increase in country risk will also cause that country’s currency to
fall.