Corporate Finance CBMFM6T08

Syllabus topics (RTMNU)

• Meaning and definition of Corporate Finance
• Nature and scope of corporate finance
• Importance of corporate finance in modern business
• Objectives of corporate finance
• Functions of corporate finance
• Role and responsibilities of the finance manager
• Sources of Corporate Finance

Meaning and Definition of Corporate Finance

Corporate finance is the area of finance that deals with how companies raise money (financing), where they invest it (investment), and how they share profits with owners (dividend), so as to maximise the value of the firm for its shareholders.

Nature of Corporate Finance

1. Part of financial management applied to companies (joint stock companies).
2. Decision-oriented: centres on three decisions — investment, financing and dividend (plus liquidity).
3. Continuous function: funds are needed throughout the life of the company.
4. Risk–return trade-off: every decision balances risk and expected return.
5. Uses analytical tools: ratios, cash flows, time value of money, EBIT-EPS analysis.
6. Linked with other functions: production, marketing and HR all need finance.
7. Governed by law: Companies Act 2013, SEBI regulations, RBI rules, tax laws.

Scope of Corporate Finance

• Investment decision (capital budgeting): which long-term assets/projects to buy, e.g. a new plant.
• Financing decision: the mix of equity, preference shares, debentures and loans (capital structure).
• Dividend decision: how much profit to distribute and how much to retain.
• Working capital decision: managing cash, receivables and inventory.
• Other areas: mergers and acquisitions, corporate restructuring, risk management, valuation of the firm.

Importance in Modern Business

1. Raising large funds for expansion and technology (e.g. through IPOs on NSE/BSE).
2. Best use of funds: investing only in profitable projects.
3. Maintaining liquidity so that bills, wages and loans are paid on time.
4. Maximising shareholder wealth — reflected in the share price.
5. Reducing cost of capital through a proper debt–equity mix.
6. Facing competition and globalisation: access to foreign funds (ECBs, FDI).
7. Growth and survival: poor finance is a major cause of business failure.

Objectives of Corporate Finance

Other objectives: adequate liquidity, proper capital structure, optimum use of funds, growth, and meeting stakeholders' interests (employees, lenders, society).

Functions of Corporate Finance

1. Estimating capital requirement — fixed and working capital.
2. Determining capital structure — debt–equity mix.
3. Choosing sources of funds.
4. Investing funds through capital budgeting.
5. Disposal of surplus — dividends and retained earnings.
6. Cash management.
7. Financial control — budgets, ratio analysis, internal audit.
8. Risk management — insurance, hedging foreign exchange.

Role and Responsibilities of the Finance Manager

The finance manager (CFO) is the person responsible for the finance function of a company.

• Traditional role: only raising funds when required.
• Modern role: efficient use of funds, planning, control and value creation.

Responsibilities: financial forecasting and planning; raising funds at the lowest cost; capital budgeting; managing working capital; dividend policy; maintaining relations with banks, investors and SEBI/stock exchanges; ensuring legal and tax compliance; financial reporting and analysis; risk management; advising the board on mergers and restructuring.

Sources of Corporate Finance

Owned funds (equity, retained earnings) carry no fixed charge but have higher cost; borrowed funds (debentures, loans) carry interest but give tax benefit and leverage.

Likely exam questions

1. (Long, 8/16 marks) Define corporate finance. Explain its nature, scope and importance in modern business.
2. (Long, 8/16 marks) Explain the role and responsibilities of a finance manager in a modern company.
3. (Short, 4 marks) Distinguish between profit maximisation and wealth maximisation.
4. (Short, 4 marks) State the functions of corporate finance.
5. (Short, 4 marks) Explain any four sources of long-term corporate finance.

Syllabus topics (RTMNU)

• Meaning of financing decision
• Importance of financing decisions in corporate finance
• Objectives of financing decisions
• EBIT-EPS analysis: Introduction of EBIT-EPS analysis
• Constant EBIT with different financing patterns
• Varying EBIT with different financing patterns
• Financial break-even level
• Indifference point and levels of EBIT

Meaning of Financing Decision

Financing decision is the decision about how the company will raise the funds it needs — in what proportion from equity shares, preference shares, debentures and loans. The result of this decision is the capital structure of the company.

Importance and Objectives of Financing Decisions

1. Affects cost of capital: debt is cheaper (interest is tax-deductible) but risky.
2. Affects EPS and share price through financial leverage ("trading on equity").
3. Affects risk: too much debt means fixed interest burden and risk of insolvency.
4. Affects control: new equity dilutes control; debt does not.
5. Flexibility for raising funds in future.

Objectives: minimum cost of capital, maximum EPS and shareholder wealth, acceptable risk, retaining control, flexibility, and compliance with legal limits.

Introduction to EBIT-EPS Analysis

EBIT-EPS analysis is a technique that shows how earnings per share (EPS) change under different financing plans at a given level of EBIT (earnings before interest and tax). It helps choose the plan that gives the highest EPS.

Constant EBIT with Different Financing Patterns

Illustration 1: A company needs ₹20,00,000. Expected EBIT is ₹4,00,000. Tax rate 25%. Equity shares of ₹10 each. Plans: A — all equity ₹20,00,000; B — equity ₹10,00,000 + 10% debentures ₹10,00,000; C — equity ₹5,00,000 + 10% debentures ₹10,00,000 + 8% preference shares ₹5,00,000. Calculate EPS.

Conclusion: Plan C gives the highest EPS because the return on total funds (EBIT ₹4,00,000 on ₹20,00,000 = 20%) is more than the cost of debt (10%) — favourable financial leverage. But Plan C also carries the highest risk.

Varying EBIT with Different Financing Patterns

Illustration 2: Capital required ₹10,00,000. Plan X: all equity (1,00,000 shares of ₹10). Plan Y: equity ₹5,00,000 (50,000 shares) + 10% debt ₹5,00,000 (interest ₹50,000). Tax 30%. Find EPS at EBIT of ₹60,000, ₹1,00,000 and ₹2,00,000, and the indifference point.

So debt financing is better only when EBIT is above a certain level.

Indifference Point and Levels of EBIT

The indifference point is the level of EBIT at which EPS is the same under two financing plans.

Solution for Illustration 2: X(0.70) ÷ 1,00,000 = (X − 50,000)(0.70) ÷ 50,000 → 50,000X = 1,00,000X − 5,00,00,00,000 → 50,000X = 5,00,00,00,000 → X = ₹1,00,000. Check: EPS under both = ₹0.70.

• EBIT above indifference point → choose debt plan (higher EPS).
• EBIT below indifference point → choose equity plan.
• At the point → both are equal; decide on other factors (risk, control).

Financial Break-even Level

Financial break-even point is the level of EBIT at which EPS is zero, i.e. EBIT just covers interest and preference dividend.

For Plan C of Illustration 1: 1,00,000 + 40,000 ÷ 0.75 = 1,00,000 + 53,333 = ₹1,53,333 (approx.). Below this EBIT, equity shareholders get nothing. Plan A has financial BEP of zero; Plan B ₹1,00,000.

Limitations of EBIT-EPS analysis: ignores risk of debt, ignores cost of equity and market value, assumes EBIT can be correctly estimated, and focuses only on EPS rather than wealth.

Likely exam questions

1. (Long, 8/16 marks) What is EBIT-EPS analysis? Explain its significance in financing decisions along with the concepts of financial break-even point and indifference point.
2. (Long, 8/16 marks) A company needs ₹12,00,000. EBIT is ₹2,40,000, tax 30%, shares of ₹10 each. Plan I: all equity; Plan II: ₹6,00,000 equity + ₹6,00,000 10% debentures. Calculate EPS under both plans and state which is better.
3. (Short, 4 marks) Define financing decision and state its objectives.
4. (Short, 4 marks) Explain the indifference point with formula.
5. (Short, 4 marks) Find the financial break-even point if interest is ₹50,000, preference dividend ₹21,000 and tax rate 30%.

Syllabus topics (RTMNU)

• Meaning and importance of financial analysis
• Objectives of financial analysis
• Techniques of financial analysis
• Cash flow analysis: Meaning, Benefits and Uses of Cash Flow Statement
• Significance and Limitations of Cash Flow Statement
• Format of Cash Flow Statement as per AS-3

Meaning and Importance of Financial Analysis

Financial analysis is the process of studying the financial statements (balance sheet, profit and loss account, cash flow statement) to judge the profitability, liquidity, solvency and efficiency of a business.

Importance: helps management in planning and control; helps investors decide whether to buy shares; helps banks judge creditworthiness; helps government in taxation and policy; shows trends and weak areas; allows comparison with other firms.

Objectives of Financial Analysis

1. To judge profitability — return on capital, profit margins.
2. To judge liquidity — ability to pay short-term debts.
3. To judge solvency — long-term financial strength.
4. To judge efficiency in using assets (turnover ratios).
5. To study trends and forecast the future.
6. To compare performance with competitors and industry.

Techniques of Financial Analysis

• Comparative statements: two or more years' figures side by side, with change in ₹ and %.
• Common-size statements: each item as a % of total (sales or total assets).
• Trend analysis: base year = 100, later years as index numbers.
• Ratio analysis: relationship between two related figures (current ratio, debt-equity ratio, net profit ratio).
• Funds flow analysis: changes in working capital.
• Cash flow analysis: inflows and outflows of cash.
• Break-even analysis and EBIT-EPS analysis.

Cash Flow Statement: Meaning, Benefits and Uses

Definition: A cash flow statement is a statement that shows the inflows and outflows of cash and cash equivalents of an enterprise during a period, classified into operating, investing and financing activities.

Cash equivalents are short-term, highly liquid investments easily convertible into cash with little risk of change in value (generally maturing within three months).

• Operating activities: main revenue-producing activities — cash from sales, payments to suppliers and employees, income tax.
• Investing activities: purchase and sale of long-term assets and investments; interest and dividend received (for non-financial companies).
• Financing activities: issue/redemption of shares and debentures, loans taken/repaid, interest and dividend paid.

Benefits and uses: shows the true cash position; helps in short-term cash planning; explains why profit and cash differ; shows ability to pay dividends and debts; helps evaluate capital expenditure; required for companies under the Companies Act 2013 (Schedule III).

Significance and Limitations

Significance: (1) better liquidity analysis; (2) basis for cash budgeting; (3) helps lenders and investors; (4) less affected by accounting policies than profit; (5) shows sources of cash for growth.

Limitations: (1) ignores non-cash transactions (e.g. issue of shares for assets); (2) historical, not forward-looking; (3) not a substitute for the income statement; (4) cash position can be "window-dressed" near year-end; (5) does not show profitability.

Format of Cash Flow Statement as per AS-3 (Indirect Method)

Illustration 1: Cash from Operating Activities

Net profit before tax ₹5,00,000; depreciation ₹80,000; loss on sale of machinery ₹10,000; profit on sale of investments ₹20,000; interest on debentures paid ₹30,000; debtors increased by ₹40,000; inventory decreased by ₹25,000; creditors increased by ₹15,000; outstanding expenses decreased by ₹5,000; income tax paid ₹1,20,000.

Illustration 2: Complete Cash Flow Statement

Using Illustration 1, and: machinery purchased ₹3,00,000; machinery sold for ₹40,000; investments sold for ₹1,20,000; equity shares issued ₹2,00,000; debentures redeemed ₹1,00,000; interest paid ₹30,000; dividend paid ₹75,000; opening cash and cash equivalents ₹50,000.

Likely exam questions

1. (Long, 8/16 marks) What is financial analysis? Explain its objectives and techniques.
2. (Long, 8/16 marks) Net profit before tax ₹3,00,000; depreciation ₹50,000; profit on sale of land ₹20,000; increase in debtors ₹30,000; increase in creditors ₹10,000; income tax paid ₹70,000. Calculate cash flow from operating activities as per AS-3.
3. (Short, 4 marks) Define cash flow statement and state its uses.
4. (Short, 4 marks) State the limitations of a cash flow statement.
5. (Short, 4 marks) Classify the following as operating, investing or financing activity: purchase of machinery, dividend paid, cash sales, issue of debentures.

Syllabus topics (RTMNU)

• Meaning and concept of dividend
• Retained earnings
• Importance of dividend
• Factors affecting dividend decision
• Types of dividends
• Dividend and valuation of the firm
• Relevance model of dividend policy
• Irrelevance model of dividend policy
• Other theories of dividend policy
• Stability of Dividends
• Bonus shares

Meaning and Concept of Dividend; Retained Earnings

Dividend is the part of a company's profit that is distributed to its shareholders as a return on their investment. It is declared on the face value of shares (e.g. 20% dividend on a ₹10 share = ₹2 per share).

Retained earnings are the part of profit not distributed but kept in the business (reserves) for growth. Profit after tax = Dividend + Retained earnings.

Dividend policy is the policy that decides how much of the profit will be paid as dividend (payout ratio) and how much will be retained (retention ratio).

Importance of Dividend

1. Gives regular income to shareholders.
2. Affects the market price of shares and the image of the company.
3. Signals management's confidence about future earnings.
4. Affects funds available for growth.
5. Helps raise future capital easily.

Factors Affecting Dividend Decision

1. Earnings and their stability.
2. Liquidity/cash position.
3. Growth and investment opportunities.
4. Shareholders' preference for current income or capital gains.
5. Taxation: dividends are now taxed in the hands of shareholders (DDT abolished from 1 April 2020) — check latest.
6. Legal restrictions: Companies Act 2013 — dividend only out of profits, after depreciation, transfer to reserves as the company thinks fit.
7. Access to capital market.
8. Contractual restrictions in loan agreements.
9. Inflation and need to replace assets.
10. Control: retaining profits avoids issuing new shares.

Types of Dividends

• Cash dividend — the usual form.
• Stock dividend / bonus shares — free shares instead of cash.
• Interim dividend — declared by the board between two AGMs.
• Final dividend — declared at the AGM.
• Regular dividend and extra/special dividend.
• Property/scrip dividend — in assets or promissory notes (rare in India).

Dividend and Valuation of the Firm

Does dividend policy affect the value (share price) of the firm? Two views: the relevance theory (Walter, Gordon) says yes; the irrelevance theory (Modigliani–Miller) says no.

Relevance Model: Walter's Model

Illustration 1: E = ₹10, k_e = 10%. Find P when payout is 0%, 40% and 100% if r = 15%, 10%, 8%.

Working (r = 15%, D = 4): P = [4 + (0.15/0.10)(10 − 4)] ÷ 0.10 = (4 + 9) ÷ 0.10 = ₹130.

Relevance Model: Gordon's Model

Illustration 2: E = ₹20, k_e = 12%, r = 15%, retention 40%. D = 20 × 0.60 = ₹12; g = 0.40 × 0.15 = 6%. P = 12 ÷ (0.12 − 0.06) = ₹200. Gordon's conclusions are like Walter's; he also argues that investors prefer present dividends ("bird-in-hand" argument).

Irrelevance Model: Modigliani–Miller (MM) Approach

MM say that in perfect markets the value of a firm depends on its earning power and investment policy, not on how earnings are split between dividend and retention. If dividend is paid, the firm raises the same amount by issuing new shares, so shareholders' wealth stays the same.

Illustration 3: n = 1,00,000 shares, P₀ = ₹100, k_e = 10%, expected dividend ₹5, net income ₹10,00,000, investment ₹20,00,000.

Value is the same in both cases — dividend is irrelevant. Criticism: markets are not perfect — taxes, floatation costs, transaction costs and information gaps exist.

Other Theories of Dividend Policy

• Bird-in-hand theory (Gordon, Lintner): a certain dividend today is preferred to uncertain future gains.
• Signalling theory: a dividend increase signals good future prospects.
• Clientele effect: different investor groups prefer different payout policies.
• Residual theory: pay dividends only from earnings left after financing all profitable projects.
• Tax preference theory: if capital gains are taxed lower, investors prefer retention.

Stability of Dividends

Stable dividend means a regular, steady dividend over the years. Forms: constant dividend per share; constant payout ratio; small constant dividend plus extra dividend in good years. Merits: builds investor confidence, raises share price, suits investors needing regular income (retired persons, institutions), and helps raise capital. Danger: may force payment even in bad years.

Bonus Shares

Bonus shares are fully paid shares issued free to existing shareholders in proportion to their holding, by capitalising reserves (free reserves, securities premium, capital redemption reserve) under Section 63 of the Companies Act 2013. Example: a 1:2 bonus gives 1 free share for every 2 held.

Merits: conserves cash; brings share price to an attractive range; signals strength; increases liquidity of shares. Demerits: future dividend burden rises; EPS falls; may be seen as a sign of no growth plans. Bonus cannot be issued in lieu of dividend.

Likely exam questions

1. (Long, 8/16 marks) Explain the factors affecting dividend decision and the types of dividend.
2. (Long, 8/16 marks) Explain Walter's model of dividend policy. From the following find the market price per share under Walter's model when payout is 0%, 50% and 100%: EPS ₹8, ke 10%, r 12%.
3. (Short, 4 marks) Explain the MM irrelevance theory in brief.
4. (Short, 4 marks) What are bonus shares? State their merits.
5. (Short, 4 marks) Using Gordon's model, find price if E = ₹10, b = 50%, r = 12%, ke = 10%.