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INDEXUnit I Role of Financial Institution 3-4 Valuation of the Firm 4 Dividend Valuation Model 4-15 Dividend Policies 4-15 Walter Model 16-18 Gordon Model 18-21 Payment Ration divided as a residual payment M.M. Irrelevance Doctrine. 21-24 Unit II Investment Decision Investment Analysis Risk Analysis Probability Approach. Business Failures, Mergers, Consolidations and liquidation. Unit III Capital Markets 47-60 Fiscal Policies, Government Regulations affecting Capital Market 55 Role of SEBI 60-65 Stock Markets 65-76 Unit IV Lease Financing, Mutual Funds. Venture Capital, Derivatives Futures and Options Inflation and Financial Decisions. Unit V Foreign Collaboration Business Ventures Abroad. Multinational Corporations International Financial Institutions1
24 24-25 25-38 38-41 42-46
76-90 90-98 98-115 115-123 123-129
1. CORPORATE FINANCE1.1 What is corporate finance? Corporate finance is the study of the decisions that every firm has to make. Corporate finance covers all decisions made by business that affect their finances, ultimately then marketing, strategic, and advertising decisions are all corporate finance decisions.
In decision making, there is only one objective in corporate finance to maximize firm value. To achieve this objective, three core corporate financial principles must be observed.
The investment principle specifies that firm should not invest in assets that earn less than a minimum acceptable hurdle rate. Where the hurdle rate will reflect the risk of the investment and the mix of debt and equity used by the firm. The financing principle, posts that firms should use a mix of debt and equity that maximizes their value. The dividend principle, Argues that firms that do not have enough investments that earn the hurdle rate return the cash to the owners of the business. Every decision that a business makes has financial implications, and any decision which affects the finances of a business is a corporate finance decision.
Financial System Financial System: These are the five main parts that together make up financial system:
Money: To pay for purchases and store wealth. Financial Instruments: To transfer wealth from savers to investors and to transfer risk to those best equipped to bear it. Financial Markets: Buy and sell financial instruments. Financial Institutions: Provide access to financial markets (a finical intermediary) A financial institution is an institution that provides2
financial services for its clients or members. Financial institutions are often regulated be Government bodies. Central Banks: Monitor financial Institutions and stabilize the Economy.
FINANCIAL INSTITUTIONSFinancial Institutions: Financial institutions act as financial intermediaries that gather the savings of many individuals and reinvest them in the financial markets. For example, banks raise money by taking deposits and by selling debt and common stock to investors. They then lend the money to companies and individuals. Of course banks must charge sufficient interest to cover their costs and to compensate depositors and other investors. Financial Institutions are one important pillar of the financial system. A financial institution is an institution that provides financial services for its clients or members. Act as financial intermediaries. Their main functions include (Role of Financial Institution): Reduce transactions cost by specializing in the issuance of standardized securities Reduce information costs of screening and monitoring borrowers. Issue short term liabilities and purchase long-term loans. Banks and their immediate relatives, such as savings and loan companies, are the most familiar intermediaries. But there are many others, such as insurance companies and mutual funds. In the United States insurance companies are more important than banks for the long-term financing of business. They are massive investors in corporate stocks and bonds, and they often make long-term loans directly to corporations. Most of the money for these loans comes from the sale of insurance policies. Say you buy a fire insurance policy on your home. You pay cash to the insurance company, which it invests in the financial markets. In exchange you get a financial asset (the insurance policy). You receive no interest on this asset, but if a fire does strike, the company is obliged to cover the damages up to the policy limit. This is the return on your investment. Of course, the company will issue not just one policy but thousands. Normally the incidence of fires averages out, leaving the company with a predictable obligation to its policyholders as a group. Financial intermediaries contribute in the smooth functioning of the economy. Some examples. The Payment Mechanism Think how inconvenient life would be if all payments had to be made in cash. Fortunately, checking accounts, credit cards, and electronic transfers3
allow individuals and firms to send and receive payments quickly and safely over long distances. Banks are the obvious providers of payments services, but they are not alone. For example, if you buy shares in a money-market mutual fund, your money is pooled with that of other investors and is used to buy safe, short-term securities. You can then write checks on this mutual fund investment, just as if you had a bank deposit. Borrowing and Lending Almost all financial institutions are involved in channeling savings toward those who can best use them. Thus, if Ms. Jones has more money now than she needs and wishes to save for a rainy day, she can put the money in a bank savings deposit. If Mr. Smith wants to buy a car now and pay for it later, he can borrow money from the bank. Both the lender and borrower are happier than if they were forced to spend cash as it arrived. Of course, individuals are not alone in needing to raise cash. Companies with profitable investment opportunities may also wish to borrow from the bank, or they may raise the finance by selling new shares or bonds. Governments also often run at a deficit, which they fund by issuing large quantities of debt. Pooling Risk Financial markets and institutions allow firms and individuals to pool their risks. For instance, insurance companies make it possible to share the risk of an automobile accident or a household fire. Here is another example. Suppose that you have only a small sum to invest. You could buy the stock of a single company, but then you would be wiped out if that company went belly-up. Its generally better to buy shares in a mutual fund that invests in a diversified portfolio of common stocks or other securities. In this case you are exposed only to the risk that security prices as a whole will fall.
FIRM VALUATIONThe value of the firm is obtained by discounting expected cash flows to the firm, i.e., the residual cash flows after meeting all operating expenses and taxes, but prior to debt payments, at the weighted average cost of capital, which is the cost of the different components of financing used by the firm, weighted by their market value proportions.
Where, CF to Firmt = Expected Cash flow to Firm in period t WACC = Weighted Average Cost of Capital In the adjusted present value approach, the value of the firm is written as the sum of the value of the firm without debt (the unlevered firm) and the effect of debt on firm value.
Firm Value = Unlevered Firm Value + (Tax Benefits of Debt Expected Bankruptcy Cost from the Debt) The optimal dollar debt level is the one that maximizes firm value
DIVIDEND AND DIVIDEND POLICYDividend: Dividend refers to the corporate net profits distributed among shareholders. Dividends can be both preference dividends and equity dividends. Preference dividends are fixed dividends paid as a percentage every year to the preference shareholders if net earnings are positive. After the payment of preference dividends, the remaining net profits are paid or retained or both depending upon the decision taken by the management. Kinds of Dividend: Cash Dividend Stock Dividend or Bonus Shares Interim Dividend Extra Dividend Property Dividend Scrip Dividend Bond Dividend Composite Dividend Steps to the Dividend Decision
Measures of Dividend Policy Dividend Payout = Dividends/ Net Income5
Measures the percentage of earnings that the company pays in dividends If the net income is negative, the payout ratio cannot be computed. Dividend Yield = Dividends per share/ Stock price Measures the return that an investor can make from dividends alone Becomes part of the expected return on the investment. Two bad reasons for paying dividends 1. The bird in the hand fallacy 2. We have excess cash this year Three good reasons for paying dividends 1. Clientele Effect: The investors in your company like dividends. 2. The Signaling Story: Dividends can be signals to the market that you believe that you have good cash flow prospects in the future. 3. The Wealth Appropriation Story: Dividends are one way of transferring wealth from lenders to equity investors (this is good for equity investors but Bad for lenders) A Dividend Matrix
A Practical Framework for Analyzing Dividend Policy
Different Types of Dividends The distribution of excess cash to shareholders can take two forms: dividends and/or share repurchase. Different Types of Dividends: 1. Cash dividends: Usually paid four times a year in cash.2. Stock dividends: Stock dividends simply amount to distribution of
additional shares to existing shareholders. They represent nothing more than recapitalization of earnings of the company. (That is, the amount of the stock dividend is transferred from the R/E account to the common share account. Because of the capital impairment rule stock dividends reduce the firms ability to pay dividends in the future. e.g. 10% stock dividen