Foundations of Corporate Finance: Capital, Markets, and Valuation

Topic 1: Business Finance Fundamentals

Methods of Raising Money

There are only two ways in which a business can raise money:

1. Debt: The firm makes a promise to make fixed payments in the future (principal plus interest).
2. Equity: The firm keeps the earnings, and this form of financing is perpetual.

Key Financial Decisions

• Working Capital Management Decisions: Deal with day-to-day financial matters and affect current assets and liabilities. Example: Deciding how much stock to keep on hand to avoid overstocking.
• Investment Decisions: Determine what long-term productive assets the firm will purchase. Example: Deciding whether to invest in long-term assets or projects, such as buying new machinery or launching a new product line.
• Financing Decisions: Determine the mix of debt and equity that will be used to finance the firm’s long-term productive assets.

Business Structures

Sole Proprietorship

A type of business unit where one person is responsible for providing capital and managing the business.

• Features: Business owned by a single person; no separation of ownership and management.
• Advantages: Simple, easy to form, least expensive and regulated form of business, no sharing of profit and loss, taxed once as personal income.
• Disadvantages: Limited access to capital, costly to transfer ownership, unlimited liability.

Partnership

A business unit in which two or more owners have joined together legally to manage a business and share its profits.

• General Partnership: All of the partners are owners and active in managing the business.
• Limited Partnership: Has both general partners (who are owners and managers) and limited partners (who are owners but not managers).
• Advantages: Two or more owners, more capital available, relatively easy to start, income taxed once as personal income.
• Disadvantages: Unlimited liability (General partnership), partnership dissolves when one partner dies or wishes to sell, difficult to transfer ownership.

Corporation

Legal process used to form a corporate entity.

• Advantages: Separate legal entity from its owners, easy transfer of ownership, limited liability (protects the personal assets of founders of the company in case of bankruptcy).
• Disadvantages: Separation of ownership and management may create conflicts of interest, all profits are taxed at a corporate tax rate, costly to establish and register.

Agency Problem

The agency problem is a potential agency cost (cost incurred because of conflicts of interest between a principal and agent) to the firm which may diminish firm value. Examples: Managers can make decisions that hurt firm value, or managers lie to shareholders by holding good or bad news back.

Financial Intermediaries and Markets

• Financial Institution (Intermediary): An institution whose business is to bring together savers with money to invest or lend with other firms that need money.
• Primary Market Transaction: Firm issues new securities and sells them to investors (IPO).
• Secondary Market Transaction: Securities continue to trade between investors without involvement of the firm.

Functions of Financial Markets

• Assist companies to obtain large amounts of capital to grow their businesses.
• Enable the government to finance fiscal deficits.
• Enable the satisfaction of the investment needs of both corporate firms and investors.
• Allow investors to trade securities among themselves; when the need for cash arises, investors have a place to sell their securities in the secondary markets (liquidity).

Topic 2: Interest Rates and Compounding

Interest Rate Definition

Interest rate (expressed as a percentage of principal) is a rate that is charged or paid for the use of assets (physical, financial).

Simple vs. Compound Interest

• Simple Interest: Interest rate applied only to the principal. Formula: $PV + (PV \times R \times T)$. Example: $1000 + (1000 \times 4\% \times 3) = \$1120$.
• Compound Interest: Interest rate is applied to the principal invested and any accumulated interest (interest can be reinvested). Formula: $P \times (1+r/n)^t$. Example: $1000 \times (1+4\% )^3 = 1124.86$.
• Interest on Interest: The interest that is earned upon the reinvestment of interest payments. Calculation: (Compound Interest - Simple Interest). Example: $1124.86 - 1120 = \$4.86$.

Topic 3: Time Value of Money Concepts

Types of Cash Flows

• Ordinary Annuity: Cash flows (CFs) that are equal in size, equally spaced in time interval, occur sometime in the future, are finite, and the first cash flow occurs one period from now or at the end of each period.
• Annuity Due: Equally spaced in time, equal in size, finite in number, CFs begin at the beginning of the payment period.
• Ordinary Perpetuity: Stream of even cash flows that go on forever, payments made at the end of each period.
• Growing Perpetuity: Stream of cash flows that go on forever, where each payment grows at a constant rate.

Types of Loans

• Pure Discount Loan: Interest and principal are paid at maturity. The borrower receives money today and repays a single lump sum at some time in the future.
• Interest Only Loan: Interest is paid periodically, and the principal is paid at maturity.
• Amortized Loan: Equal payments are made. Each payment includes partial interest and principal. Amortization is a process where the loan is paid off by making regular principal reductions.

Loan Amortization Schedule

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Topic 4: Bond Valuation and Term Structure

Bond Valuation Basics

Yield to Maturity (YTM): Market interest rate used to discount coupon and principal payments to give the current bond price.

Calculating the Price of a Bond

You have to calculate the first half of the formula first, and then do the lump sum (face value part).

If the bond is calculated semi-annually or quarterly, you need to adjust the Coupon Rate (CR) to find the Coupon Payment (C), as well as the time period ($t$) and the YTM.

To find C: Coupon rate $\times$ Face Value (e.g., $5\% \times 1000 = 50$).

Zero Coupon Bond Formula: $FV / (1+R)^t$.

Interest Rate Impact on Bond Price

• When the interest rate (YTM) rises, the present value of the bond’s cash flows declines, and the bond is worth less.
• When the interest rate (YTM) declines, the present value of the bond’s cash flows rises, and the bond is worth more.

Bond Trading Status

• If YTM = Coupon Rate: Bonds trade at par (i.e., face value).
• If YTM > Coupon Rate: Bonds trade at a discount.
• If YTM < Coupon Rate: Bonds trade at a premium.

The Yield Curve

The Yield Curve is the graph of the term structure:

• Normal: Upward-sloping; long-term yields are higher than short-term yields.
• Inverted: Downward-sloping; long-term yields are lower than short-term yields.
• Other shapes: E.g., humped.

Topic 5: Equity Valuation

Share Valuation

To find the value of a share, calculate the dividend price divided by the required return rate, compounded. Example: $\$7.50 / 12\%$ divided by 2, as it is semi-annual.