CHAPTER 1-Introduction

to Corporate Finance
 Functions of Managerial
Finance
 Issues of the New Millennium
 Forms of Businesses
 Goals of the Corporation
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 Functions of Managerial Finance
 1. Procurement of funds: There are alternative sources of fund like a
company can take loan or it can issue common stock to raise the fund
required. Taking loan can also be of different forms like bank loan,
bond or debentures. Preference shares can also be another source. In
case of debt, bond and debentures the company must pay a fixed rate
of interest which is a compulsory obligation. In case of preference
shares the preference dividends are fixed and compulsory payments
for profitable firms. In case of ordinary stock the firm is expected to
pay the return expected by the share holders. These kinds of
payments of interest or dividends refer to the cost of capital. Cost
minimization is the goal of financing. Finance managers need to select
the best possible sources of funds among the different alternatives
called Capital structure Decision. Ordinary stock holders are the
owners of the firm (like they have voting rights) but debtors are not
the owners. So, common stock is called Internal source; and bond,
debenture and loan are called external sources. Purpose is also
important in the choice of funds.
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 Functions of Managerial Finance
(Contd)
2. Utilization of funds: Capital Budgeting decision. Long term investment
decision is made on the basis of risk and return. The goal is profit
maximization. This is the most important and challenging function of
finance. To predict future profit is difficult as Profit=Total Revenue-
Total Cost. TC=FC+TVC.
3. Short term asset management: Examples of current assets are cash,
marketable securities, receivables, etc., and examples of current
liabilities are accounts payable, notes payable, short term loans, etc. A
unique feature of current assets is that (unlike fixed assets) current
assets does not generate return. Most of the source of financing has
some costs. So financing current assets by costly sources is not wise.
Current liability is almost cost free. The part of current assets that is
financed by current liability is not a problem. The excess of that is
called working capital. So, Working capital management deserves
attention. The principle is known as Liquidity vs. profitability.
4. Distribution of funds: Dividend policy decision. Dividend policy,
repurchase of shares and amortization of debt.
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Career Opportunities in
Finance
 Financial Market and Institution bridges the gap
between net borrowers and net savers. Money and
capital markets include bank, insurance & leasing,
investment companies, development institutions, and
stock exchange.
 Investments: Investors are risk averse. Best possible
risk-return combination can be found by financial
analysis, security analysis and portfolio (optimal mix
of securities) selection.
 Managerial Finance: Financial aspects of all kinds of
profit-seeking firms may it be manufacturing or
trading firms.

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Evolution of Finance
 A study of mergers (1900-1920)
 A study of bankruptcy & reorganization (1930s)
 Institutional subject of cash budgeting &
management (1940s-1950s)
 Evaluation of profitable investments (1960s)
 Modern Finance of risk-return approach (1970s)
 Inflation and innovation effects, and
deregulations. (1980s)
 Globalization effects (1990s)

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Alternative Forms of Business
Organization
 Sole proprietorship
 Partnership
 Corporation

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Sole proprietorships &
Partnerships
 Advantages
 Ease of formation
 Subject to few government regulations
 No corporate income taxes
 Disadvantages
 Difficult to raise capital
 Unlimited liability
 Limited life
 Lack of liquidity

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Corporation
 Advantages
 Unlimited life
 Easy transfer of ownership
 Limited liability
 Raising huge capital
 Formal monitoring by government agencies
 Disadvantages
 Double taxation
 Cost of set-up and report filing

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 Financial Goals of the Corporation
 The conventional goal of a firm is profit-
maximization. However, since profit is
reported by the management so it can
be manipulated. Moreover, accounting
profit is not estimated on cash basis. So,
the modern goal of firm is shareholders’
wealth maximization, which refers to
maximizing stock prices at the market.
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The Goals of a Firm
 Value Creation: through maximizing profits
and wealth of share holders
 Maximizing profits can be done through
Maximizing Earning per share
 Market Price per share serve as barometer /
measuring instrument for creating value which
requires management to find out alternative
investment, financing and asset management
in terms of their effect on share holder value.
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Agency Problems
 Conflict between ownership and control
“Agents” and “Principal” or in other words
Management and share holders
 Objectives of Management may differ from

Firm’s share holders

Agency arrangements where shareholder can

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 Determinants of wealth
CF1 CF2 CF3 CF 
CFt
Po  1
 2
 3
 
 t
.
(1  k) (1  k) (1  k) (1  k) t 1 (1  k)

 CF means cash flow from the firm to the shareholder. This depends on
profit, EPS and dividend policy. Tax plays a role as the shareholder is
interested in after-tax income.
 k is the cost of capital required by the shareholders to leave the share price
unchanged. It is proportional to risk. If risk increases k increases and the
contribution of CF to Po goes down. So, Po is inversely related with risk.
 t or timing matters. A distant cash flow is less valuable than an immediate
cash flow.

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Goal of a firm:
Profit Maximization Vs.
Wealth Maximization
 There are many definitions of Profit and so it is
vaguely defined. Wealth is the present value of all
future dividends which is readily observed in
current share price at the market.
 Profit is an annual concept and so it is a short
term concept but wealth is a long term concept.
 Profit can be manipulated by the management
(like window dressing) but wealth is beyond the
direct manipulation of management.
 Risk consideration. The theory of risk says that risk
and return is proportional. Profit can not be
increased without increasing risk.

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