FM211 Lecture Notes
Week 1 notes
Introduction to Corporate Finance
Corporate finance studies how firms make financial decisions.
A corporation is a legal entity distinct from its owners (shareholders), characterized
by:
Separation of ownership and control: Shareholders own the firm but do not
manage it.
Limited liability: Shareholders are not personally liable for corporate debts; the
most they can lose is their investment.
Corporation invest in real assets and finance these investments by selling financial
assets (e.g., equity, debt).
As legal entity, corporations:
Can be sued and sue others.
Are liable for taxation.
Can enter contracts.
Goal of the firm: Maximize shareholder wealth
Organizational Chart of a Typical Corporation
Chief Financial Officer (CFO): Oversees the financial management of the firm.
Controller: Manages tax and accounting.
Treasurer: Manages investments in real assets and interactions with financial
markets.
,The Key Financial Decisions
Four main areas:
1. Valuation and Investment Decisions – How does the firm invest money?
Ensuring cash flows are correctly computed.
Evaluating if the return rate is appropriate.
2. Financing Decisions – How does the firm get the money?
Identifying costs and benefits of various financing options (debt, equity, etc.).
Choosing the optimal mix of financing instruments.
3. Dividend Decisions – What does the firm do with the leftover money?
Determining how much to return to shareholders
Deciding in what form (dividends, share buybacks, etc.)
4. Risk Management and Hedging – How does the firm manage financial risks?
Identifying which risks should be hedged.
Selecting appropriate instruments to hedge risk.
Capital Budgeting
The process of selecting and managing a firm’s long-term investments.
Investment projects involve expenditures that generate future returns.
Types of Investment Evaluations
1. Standalone projects
A project is evaluated independently.
Decision rule: Accept if it is better than doing nothing.
2. Mutually exclusive projects
Choosing one project excludes another.
Decision rule: Accept the highest positive NPV project.
, Opportunity Cost of Capital
Definition: The return shareholders could earn on a financial asset of equivalent risk
The minimum return a project must generate to be considered worthwhile.
If a firm does not invest, shareholders could invest their money elsewhere.
Net Present Value (NPV)
The sum of all expected discounted cash flows over a project’s life.
Formula:
E (C F t )
NPV =∑ t
( 1+r )
Where,
E(C Ft ): expected cash flows
r : opportunity cost of capital
t : time period
Decision rule:
Standalone projects: Accept if NPV>0.
Mutually exclusive projects: Accept the project with the highest NPV.
Interpretation:
NPV > 0: Project increases firm value.
NPV < 0: Project decreases firm value.
NPV =0 : Project neither adds or reduces firm value.
Week 1 notes
Introduction to Corporate Finance
Corporate finance studies how firms make financial decisions.
A corporation is a legal entity distinct from its owners (shareholders), characterized
by:
Separation of ownership and control: Shareholders own the firm but do not
manage it.
Limited liability: Shareholders are not personally liable for corporate debts; the
most they can lose is their investment.
Corporation invest in real assets and finance these investments by selling financial
assets (e.g., equity, debt).
As legal entity, corporations:
Can be sued and sue others.
Are liable for taxation.
Can enter contracts.
Goal of the firm: Maximize shareholder wealth
Organizational Chart of a Typical Corporation
Chief Financial Officer (CFO): Oversees the financial management of the firm.
Controller: Manages tax and accounting.
Treasurer: Manages investments in real assets and interactions with financial
markets.
,The Key Financial Decisions
Four main areas:
1. Valuation and Investment Decisions – How does the firm invest money?
Ensuring cash flows are correctly computed.
Evaluating if the return rate is appropriate.
2. Financing Decisions – How does the firm get the money?
Identifying costs and benefits of various financing options (debt, equity, etc.).
Choosing the optimal mix of financing instruments.
3. Dividend Decisions – What does the firm do with the leftover money?
Determining how much to return to shareholders
Deciding in what form (dividends, share buybacks, etc.)
4. Risk Management and Hedging – How does the firm manage financial risks?
Identifying which risks should be hedged.
Selecting appropriate instruments to hedge risk.
Capital Budgeting
The process of selecting and managing a firm’s long-term investments.
Investment projects involve expenditures that generate future returns.
Types of Investment Evaluations
1. Standalone projects
A project is evaluated independently.
Decision rule: Accept if it is better than doing nothing.
2. Mutually exclusive projects
Choosing one project excludes another.
Decision rule: Accept the highest positive NPV project.
, Opportunity Cost of Capital
Definition: The return shareholders could earn on a financial asset of equivalent risk
The minimum return a project must generate to be considered worthwhile.
If a firm does not invest, shareholders could invest their money elsewhere.
Net Present Value (NPV)
The sum of all expected discounted cash flows over a project’s life.
Formula:
E (C F t )
NPV =∑ t
( 1+r )
Where,
E(C Ft ): expected cash flows
r : opportunity cost of capital
t : time period
Decision rule:
Standalone projects: Accept if NPV>0.
Mutually exclusive projects: Accept the project with the highest NPV.
Interpretation:
NPV > 0: Project increases firm value.
NPV < 0: Project decreases firm value.
NPV =0 : Project neither adds or reduces firm value.
