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KENYATTA UNIVERSITY INSTITUTE OF OPEN LEARNING

CFI 200 FUNDAMENTALS OF CORPORATE FINANCE

Abungana Khahuu Khasiani

DEPARTMENT OF ACCOUNTING AND FINANCE

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1. Introduction Overview of Corporate Financial management Types of firms, Goals of the firm The Agency problem – Management Vs. Owners 2. The Time Value of Money Concept of time value of money The derivation of cash flows Application of the Time Value of money in project appraisal Project appraisal methods 3. Valuation of Bonds and Shares

4. Risk and Return Risk of returns Returns on securities &Asset returns Systematic and unsystematic risk 5. -

Capital Budgetting (Long term financing) Capital and financial structure The concept of leverage/gearing Cost of capital and importance

6. Dividend policies and decisions - When, How and how much to pay as dividends - Factors influencing firms dividends policy 7. Working Capital Management

LESSON 1 FINANCIAL MANAGEMENT

In everyday definition Financial Management refers to the management of organizations money. In professional terms it refers to the tasks in an organization, which lead to the planning for, acquiring and utilizing funds in order to maximize the efficiency and value of an enterprise.

A financial manager is concerned with 3 basic questions. 1) Capital budgeting 2) Capital structure 3) Working capital management

Capital budgeting is the processing of planning and managing a firm’s long-term investments. It’s evaluating the size, timing and value of future cash flows. Capital structure is the specific mix of long-term debt and equity the firm uses to finance its operations. Working capital management refers to firm’s short-term assets such as inventory, the money it is owed and its debts to suppliers. Managing the firm working capital is the day-to-day activity that ensures the firm has sufficient resources to continue generating without interruptions.

The goal of the firm In financial management of an enterprise, all things considered, it is assumed that management’s primary goal is to maximize shareholders wealth. This translates to maximizing the price of the shares of the shareholders. This price maximization is central to all financial management action and decisions.

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Shareholders buy stock because they seek to gain financially. The good decisions by the financial manager increase value of stock and poor decisions decrease it.

The goal of financials management is to maximize the current value per share of existing stock. Because the goal of financial management is to maximize the value of the stock, we need to learn how to identify those investments and financing arrangements that favorably impact on the value of the stock. Indeed you can think of corporate finance as the study of the relationship between business decisions and the value of the stock in the business.

What should management do or achieve in order to maximize share prices? First it must maximize profit. But profit to the firm is not necessarily profit to the shareholder and profit per share can be diluted by insurance of more shares. So a management interested in the well being of its shareholders should concentrate on earnings per share rather than total corporate earnings.

Two factors affect the efforts to increase value of a share 1. Timing of the earnings 2. Risk For example you are offered 200,000/- per year for 5 years, which is 1,000000/-. And you are offered a lump sum of 1,100,000/= in the fifth year only. Which is the better deal? We shall soon be able to tell using a tool called the time value of money to the investors. As regards risk, suppose one project gives 100/= per share but the other can give 150/= or 90/= per share. Which is better? We shall soon see that risk can be measured and that what one shareholder will accept another will reject though the risk be the same as investor’s attitude to risk differs. We shall soon appreciate that the riskiness of a project depends on how the firm is capitalized. Debt increases the risk ness- but usually also the profitability as the investor uses other people’s money for capital.

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We shall soon also see that Stockholders like cash dividends but it is by retaining earnings that the enterprise gathers capacity to undertake more profitable projects and produce more products and services leading to higher profits. The finance Manager must decide how much of current earnings should be paid out and how much retained. This is called the dividend policy decision. The optimal dividend policy is the one that maximizes the firm’s stock price. Other legitimate goals of the firm We have said that the goal of the firm is to increase shareholders value. This is the classical and longstanding understanding and it is made practical by the financial manager acting in the shareholders best interests by making decisions that increase value of the stock. Nonetheless the modern viewpoint is that there are other legitimate stakeholders in the firm who deserve recognition. These are; 

Employee welfare

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Environment (Ensuring of a)

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Suppliers – fair and honest dealing with

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Corporate social responsibility payment of taxes and observing legal other government requirements

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Another issue that interferes with the goal of the firm as understood classically is the fact that under limited liability the ownership of the company is separated from management. This brings into existence what is called agency relationship. This is where the owner (principal) lives another (agent) to represent his or her interests. In such a relationship the possibility exist for conflict of interest to arise. The agency problem describes a situation where the agent (management) pursues personal interest to the detriment of owner’s interests.

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Forms of Business Organizations In the Kenyan economy we find these types of business organizations 1) Sole proprietorship 2) Partnerships 3) Corporations 4) Cooperatives 5) Parastatals I have little doubt in times to come the micro enterprise will be an addition to this list in its own right an distinct from the sole proprietorship. The difference between the two will be one is formally registered and often better capitalized while the other is informal and lowly capitalized. Sole proprietorship –. A sole proprietorship is a business owned by one person. It is easy and inexpensive to form and start. In most economies there are more proprietorship than any other type of business. While the owner gets to keep all the profit due to the principle of unlimited liability he is also responsible for all business debts/losses. Unlimited liability means the people the business owes money can look to the personal property of the proprietor should their debts remain unsettled. Partnership – Defined as the relationship that subsists between persons carrying on business in common with a view of profit, it is easy and inexpensive to form. A common characteristic in partnerships is pooling of skills. The advantages and disadvantages are more or less like those of sole proprietor partnership are easy is form and the main characteristic is pooling of professional expertise until view to exploring economics of stale and sharing resources.

Corporations: - A corporation is an artificial being, invisible intangible and existing only in the contemplation of the law. It possesses only those properties, which the charter of its creation confers upon it either expressedly or as incidental to its very existence. A corporation has following characteristics; 

Risk reduction for individual investor

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Separate legal entity

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Has perpetual existence

Is a liquid investment – shares can be sold In terms of size it’s the most important business organization. It is a more difficult business type to start but has the advantage of limiting each shareholders risk to the amount of share capital he contributes. The corporate form of organization has many variations around the world. While the exact laws and regulations differ from country to country the essential features of public ownership and limited liability remain. In Kenya the Cooperative society is an important form of business organization. A cooperative society is formed when individuals with some common bond come together register under the cooperative societies Act and carry on business by pooling produce or cash earnings. Produce is usually market in common and the cooperatives pooling cash are called savings and credit cooperatives in which members save money and lend to each other to carry productive activities periodically and repay the cooperative for the loans extended.

Some Important Financial statements Financial statements are the key source of information for financial decisions. The unit will not reach how to prepare financial statement. We will briefly examine such statement with view to identifying relevant features.

The balance sheet The balance sheet is a snapshot of the financial condition of the firm. It summarizes what the firm owns (assets) what a firm owns (liabilities) and the difference between the two, which is known as a firm’s equity, and any position time. Assets: are classified as fixed or current A fixed asset is one that has relatively long life. Fixed assets can be tangible or intangible. Land is a fixed asset. A patent or trademark is an intangible asset.

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Balance can be illustrated as follows Current assets

Current Liabilities

Net working assets Long-term debt Fixed assets 1. Tangible 2. Intangible

Shareholder Equity Assets = Liabilities + shareholders Equity Net working Capital= Current Assets minus Current Liabilities

The difference between firm’s current assets and its current liabilities. It’s the cash that is or will become available in the next 12months.

Building a balance sheet Suppose a firm has current assets of Ksh. 100,oo and net fixed assets of 5000,00 and a debt of 70000 and a long-term debt of 200000 what does the balance sheet look like?

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Assets

Liabilities

Current Assets

100,000

Current liabilities

70,000

Net fixed assets

500,000

Long-term debt

200,00

Shareholders + Equity

600

What is the net working capital?

Since Current Assets minus Current Liabilites equals working capital then 100,000-70000 = 30,000The working capital is Kshs 30000.

Another Example Kenyan Company Ltd Balance Sheet DEC 31 2003 +2004 Assets

Liabilities

Current assets

Current liabilities

Cash

104

160

Accounts taxable

232

266

Account Receivable 455

688

Notes payable

196

123

Inventory

553

555

Total C.L

428

389

1112

1403

L.T Def

408

454

O.E. Common stock 600

640

Fixed assets Plant +Equipment (Net) 1644 Total assets 2756

3112

1709 retained earnings Total liabilities& O.E

1320

1620 2756

Depreciation Another important concept we must familiarize ourselves with is depreciation.

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3112

When an enterprise buys a machine or other capital good it loses value with time. The firm recognizes this loss in value by charging depreciation against the machine/capital food. This is done every year or accounting period until the machine/capital food is fully depreciated. There are four principal methods of depreciation Straight line Sum of digits Double declining method Units of production

E.g. purchase price of 2500. Estimated useful life 6 years or 600 hours scrap value 400. The maximum depreciation allowable is cost minus salvage. Under straight line method the depreciation is found by 2500 - 400 = 2100 6

= 350pA

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Double declining method The double declining balance method of depreciation requires application of a constant ate of depreciation each year to the undepreciated value of the asset. In our example the life of the asset is 6 years so the first year 1/6 of the asset depreciates. Under double declining balance the 1/6 is doubled. 1/6 = .1667 x 2 = .333 x 25 = 833 Depreciation for 2nd year is

.3333 x (2500 – 833) = .3333 x (.1677) = 556

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The process is continued for other years until the total depreciation equals the cost of the asset less estimated salvage value.

Sum of digits (syd) Under syd, the yearly depreciation is determined as follows.

Calculate the syd. In own example its 1+2+3+4+5+6 = 21 Also sum – N (N+1) = 6 (6+1) = 6x3.5 = 21 2

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Year = Divide the number of remaining years by syd and multiply the result by the depreciable cost – which is cost minus salvage. Thus year I

= 6

(2100) = 600

21 year II = 5

(2100) = 500

21 etc Units of production Under this method, the expected useful life of 6000 hours is divided into the depreciable cost (cost minus salvage) to arrive at an hourly rate, i.e. 2100 = .35 cents 6000 With this method depreciation charges cannot be estimated precisely ahead of time; the firm must wait until the end of the year to determine what usage has been made of the machine and hence its depreciation. Assets are depreciated over their estimated useful lives. However they may not be depreciated faster than or below a reasonable estimated salvage.

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Questions What was Kenyan Co. Ltd long-term funding in 2004?

You take long-term debt

454

add

Total equity i.e. common stock 640 2269 add Retained earnings Total L.T. Financing

1629 2723

Of the long-term financing what was the portion of long-term debt? 454 = 16.67% 2723 There are 3 important items for a financial manager to look for in a balance sheet. (1) Liquidity – refers to the ease with which an asset can be converted to cash. A highly liquid asset is one that can easily be converted into cash without significant cost of value. An illiquid asset cannot be equally converted into cash without substantial price reduction.

The more liquid enterprise is the less likely it is to experience financial distress – where distress refers inability to paying debts due or inability to buy needed assets. Unfortunately liquid assets are less profitable to hold. Therefore there is a trade –off between advantages of liquidity and for some potential profits.

Debt vs. Equity At this early stage we must learn to distinguish debt and equity. Equity holders are only entitled to residual value. The portion left after creditors are paid, i.e.

Equity = Assets – Liabilities The use of a debt in a firm’s capital structure is called financial leverage. The more debt a firm has as a percentage of assets, the greater the degree of financial leverage. Debts act as a lever because

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they can greatly magnify both gains and losses. Financial leverage increases potential for reward to shareholders and potential for financial distress and business failure.

Market value vs. Book value This is another concept to assist in understanding corporate finance. The values shown on the balance sheet of a firm are the book values. They are shown at historical cost. In other words, assets are carried on the books at what the firm paid for them. Depending on the asset and industry the book value may markedly differ from current value particularly for fixed assets or long-term securities.

For current assets the market value and book value are likely to be similar or near similar as they are bought and converted into cash over a relatively short period. For fixed assets it’s only rarely that book value is equal to market value.

The balance sheet is potentially useful to many parties. A supplier might look at accounts receivable to see how promptly a firm pays its debts. A creditor might want to determine the liquidity and degree of leverage. Managers within the firm use it to track such things as the amount of cash and inventors the firm has on hand. Managers and investors will also be frequently be interested in knowing the value of the firm. The process to the determination of this starts with the balance sheet. The moment we speak of the value of the firm we are concerned not with the book value but the market value.

Example East African Cables Ltd has fixed assets with a book value of Kshs. 200,000 but which have a recent valuation of Kshs.1 million. Net working capital is Kshs. 400,000 in the books but approximately Kshs. 600,000 would be realized. EAC has Kshs. 550,000 long-term debt. The sum is both the book and market value. Using both book and market values; I)

What is the book value of its equity?

II)

What is the market value?

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East African Cables Ltd Balance Sheet Market value vs. Book Value Book

Market

Book

Market

Long-term debt

500

500

Shareholders

600

1,100

TOTAL

1,100

1,600

Assets Net working capital

400

600

Net fixed assets

700

1,000

1,100

1,600

It’s noted the market shareholders equity is twice as big in value as its book value. The distinction is important as book values may significantly differ from economic values. One of the useful statistics that can be lifted for a set of accounts is dividends per share and earnings per share.

From a Profit and Loss a/c with the Figures in millions Net Sales

1,509,000

Cost of goods

750,000

Depreciation

65,000

EBIT Interest

694 70

Taxable income

624

Taxes

212

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Net income Dividends

412 103

Retained earning 309 Suppose there are book shares outstanding, what are EPS and DPS?

EPS = Net income/total shares 412 = 2.06 200 Total Dividends Total Shares 103

= .515 per share

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A Word on Planning A lack of effective long-term planning can be reason for financial stress and failure. Financial planning establishes guidelines for change and growth in the firm. It is concerned with the major elements of a firm financial and investment policies without exercising the individual components. To develop an explicit financial plan management must establish certain elements of the firm’s financial policy. The basic elements are: (1) The firms needed investment in new assets (2) The degree of financial leverage the firm chooses to employ. This determines the amount of borrowing the firm will use to finance investments in real assets. (3) The firm’s dividend policy (4) The amount of liquidity and working capital the firm needs on an ongoing basis.

The decisions a firm makes in these areas will affect its future profitability, external funding and opportunities for growth.

The firm’s financing and investment policies interact and cannot be

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considered in isolation from each other. For most firms the goal for their f...