Introduction to Corporate Finance
By Yogesh Chauhan
Why should we learn finance?
• Finance is the study of how value is created, managed, and measured
Value creation
• Is this asset (investment) “worth” what I’m paying for?
• Should I buy a car?
• Should I go for an MBA?
• All these questions require us to trade off current sacrifices (investments) for future
benefits (returns)
• It’s a ruthless logic at play. Value is created when you exceed the expectations of your
capital providers.
• If your capital providers expect a 10 percent return on the $100, they entrust to you,
and in one year you deliver $110, you have met their expected return. However, you
haven’t done anything exceptional. No value is created
• Value is created only by delivering, for example, a 15 percent return, which exceeds
their expectation of 10%
• If you generated an 8 percent return when they expected 10 percent, you have
destroyed value.
• The logic of value creation is based on two key outcomes
• First, exceeding investors’ expectations for one or two years is not exciting. Actual value
creation arises if you use their capital for multiple years and beat their expectations yearly.
Second, if you can grow and continue to reinvest their earnings at a high rate of return, that’s
even better than simply returning profits to your capital provider.
Don't confuse finance with accounting: Zomato’s balance sheet
What am I missing?
The current price-to-equity book value ratio of Zomato is 8.85
The financial balance sheet
Liabilities
Assets
Equity (Residual Claim on cash flows,
Perpetual lives)
Assets in place (value from Existing
investments’ cashflows)
Debt (Fixed claim on cash flows, Fixed life)
Growth assets (Expected value that will be
created by future investments)
Debt versus Equity
1. Fixed claim
2. Tax Deductible
3. High priority in
financial trouble
4. Fixed maturity
5. No management
control (why?)
Debt
Bank debt
Commercial paper
Corporate Bonds
1. Residual claim
2. Not Tax Deductible
3. Low priority in
financial trouble
4. Infinite
5. Management control
(why?)
Hybrid securities
Convertible Debt
Preferred stock
Option-linked bonds
Equity
Owner’s equity
Venture capital
Common stock
Warrants
The Value of future money (cash flow)
• Finance is completely and ruthlessly forward-looking. The only source of value today is the future cashflows.
• The first step of value creation is to look forward and project what you will get from the investment (firm).
• The second step is to translate those future benefits (cash flows) into today’s value.
Investment type
Value at 0 time (willingness to pay)
Expected return (Cashflow at
1 year).
Risky Bond (Corporate Bond)
100
Safe Bond (Govt Bond)
100
• We reduce the value of future cash flows based on the expected return (cost of capital) to determine how much
they are worth (value) today. The longer we wait to receive the cash flow (since we are inherently impatient) or the
more significant the uncertainty of receiving it (since we dislike risk), the less it is worth (value). This process of
adjusting future money to its present value is called discounting.
Intuition -2: Turning a dream into reality
• Ramesh intends to purchase a residential property valued at ₹30,00,000. Since he doesn't have
sufficient funds for an outright cash purchase, he is eligible for a loan of up to ₹27,00,000 with a
term of 10 years. As a result, he will need to provide a down payment of ₹3,00,000, which will be
his equity investment.
Intuition -2 Turning a dream into reality
% Change in End of the
House Price
year
Debt value
Equity Value
Equity
Invested
Profit/Loss
Return on
Equity
ROE without debt
15%
3450000
2700000
750000
300000
450000
150%
15%
10%
3300000
2700000
600000
300000
300000
100%
10%
5%
3150000
2700000
450000
300000
150000
50%
5%
0%
3000000
2700000
300000
300000
0
0%
0%
-5%
2850000
2700000
150000
300000
-150000
-50%
-5%
-10%
2700000
2700000
0
300000
-300000
-100%
-10%
-15%
2550000
2550000
-150000
300000
-300000
-100%
-15%
• Where are you facing more variance : in equity value or debt value?
• Where do you expect higher returns: in equity or debt?
The Cost of Financing
• Given that the return on equity is inherently uncertain and equity holders receive their returns only
after debt holders have been compensated, it follows that the cost of equity should be higher than the
cost of debt.
• This distinction stems from the higher risk associated with equity investments, which requires a higher
expected return to attract investors. Equity holders demand a premium to compensate for the increased
risk of potential loss, as they are subordinate to debt holders in the profit distribution.
Operating Profit
Firm’s profit
Less Interest payment
Service to debt holders
Earning Profit before Taxes
Less Corporate Tax
Government share ):
Net Profit
Belong to equity holders
The Dilemma of Securing Financing..
• The total investment of the firm is ₹200 million, with a cost of debt of 8% and a cost of equity of
12%.
• The annual cost of financing, if debt is used to fund the investment, would be ₹200 million ×
8% = ₹16 million..
• The annual cost of financing, if equity is used to fund the investment, would be ₹200 million ×
12% = ₹24 million
• If the cost of financing is lower with debt, the firm should opt for 100% debt financing.
Intuition -3
• Mr. Ramesh invested in Mr. Kamlesh’s shop a decade ago, during which time the shop has consistently
generated a 15% after-tax profit. While Mr. Ramesh has not previously requested any profit
distribution, allowing Mr. Kamlesh to reinvest the profits for future growth, he is now seeking a
distribution of profits in the current year, even though he does not have any liquidity needs
• What could be the reasons behind Mr. Ramesh's demand for profit distribution this year and,
therefore, not allowing him to reinvest in the shop?
The Building Blocks of Corporate finance
1.
The Concept and Structure of Business
• Forward-looking, not backward-looking
• The Measurement and Importance of Cash Flows
• Reported earnings are influenced by accounting rules and standards, which can be difficult to
fully understand. Therefore, cash flow becomes crucial for assessing the firm’s economic value.
2. The Definition and Measurement of Risk
• Risk is neither good nor bad. It is part of business.
3. The Time Value of Money
• A dollar today is worth more than a dollar in the future
Corporate Finance: The Big Picture
Maximize the value of the business (firm)
Investment Decision
The investment decision should
involve investing in assets that
earn a return greater than the
minimum acceptable hurdle
rate (expected returns).
The Financing Decision
Identify the right type of debt for
your firm and the optimal mix of
debt and equity to fund your
operations
while
minimizing
financing costs.
• The optimal mix of
debt and equity that
The return should
The hurdle rate should
maximizes
firm
reflect the cash flow’s
reflect the riskiness of
value.
magnitude, timing,
the investment.
• The right kind of
and all side effects.
debt.
The Dividend Decision
If you cannot find investments that
meet investors’ minimum acceptable
rate of return, return the cash to the
owners of the business.
How much cash you can return
depends upon current & and
potential investment opportunities.
Value creation: the role of Corporate finance
• V𝑎𝑙𝑢𝑒 𝑜𝑓 𝑓𝑖𝑟𝑚=present value of future cash flow.
Investment activities (project investments)
add value to a firm's value when a
manager selects a project with a return
greater than the cost of capital.
V𝑎𝑙𝑢𝑒 𝑜𝑓 𝑓𝑖𝑟𝑚 =
𝑛 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝐶𝑎𝑠ℎ 𝑓𝑙𝑜𝑤𝑖
𝑖=1 (1+𝑐𝑜𝑠𝑡 𝑜𝑓 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 )
𝑖
A CEO creates value for shareholders when the financing
mix results in a lower cost of capital
Principle 1: Corporate finance is “common sense”
• From the following projects, which one would you choose to invest in?
• Project A: the return on the project is 15%, and the cost of financing is 10%.
• Project B: the return on the project is 8%, and the cost of financing is 10%.
• From the following financing mix, which one would you choose to finance your project?
• Option A: Equity 50% and debt 50% results in cost of financing 10%
• Option B: Equity 40% and debt 60% results in cost of financing 15%
• From the following firms, where do you expect the firm to pay you dividends?
• Firm A: the return on investment is 15%, and the cost of financing is 10%.
• Firm B: the return on investment is 8%, and the cost of financing is 10%.
Principle 2: Corporate finance is focused
• The sole objective of corporate finance is maximizing the value of the business.
For that, we can,
• Choose the “right” investment
• Determine the “right” mix of debt and equity for a specific business
• Determine the 'right' amount of cash to return to the owners of the business
and the 'right' amount to retain as a cash balance
Principle 3: Corporate finance is universal
• Every business, whether small or large, public or private, in the US or emerging markets, must
make decisions regarding investment, financing, and dividends
• While the constraints and challenges firms face may vary significantly, the fundamental principles
remain the same.
• A publicly traded firm, with greater access to capital markets and a more diversified investor
base, may have significantly lower debt and equity costs than a private business. Nevertheless,
it should seek a financing mix that minimizes its capital costs.
• A firm in an emerging market may face greater uncertainty when assessing new investments
compared to a firm in a developed market. Still, both firms should invest only if they believe
they can generate returns higher than their respective (and very different) hurdle rates (cost of
capital).
Principle 4: If you forget first principles, you will pay a
price.
• Some investors, analysts, or managers convince themselves that the first principles don’t apply to them
due to their superior education, status, or past successes, particularly since they graduated from top
business schools. They then proceed to implement strategies or schemes that violate these principles.
• Paytm announced a share buyback, while Nykaa announced bonus stocks. 😊.
• Almost every corporate disaster or bubble originates in a violation of first principles.
The focus of corporate finance evolves throughout the firm's life
cycle
Grading Basis
• Project =10%
• Class participation=10%
• Quiz=20% (2 quizzes)
• End term=30%
• Mid-term=30%
Project details
• Two project reports must be submitted before the midterm, and one before the end term
• Each student must choose two publicly listed firms with at least one year of trading history and
replicate the process I will explain in the class. I will send more details to the class soon.
• Please avoid selecting financial services and loss-making firms.
• Each firm should be unique to the class, so it's best to choose your firms quickly
• I (or my TA) prefer to review your work after every five classes."