CIFA NOTES – CORPORATE FINANCE SAMPLE NOTES

CERTIFIED INVESTMENT AND FINANCIAL ANALYSTS (CIFA)

 

 

PART II SECTION 3

 

CORPORATE FINANCE

 

STUDY TEXT

 

CORPORATE FINANCE GENERAL OBJECTIVES

This paper is intended to equip the candidate with the knowledge, skills and attitudes that will enable him/her to make corporate finance decisions

LEARNING OUTCOMES

 On successful completion of this paper, the candidate should be able to:

  • Make capital budgeting decisions
  • Compute the cost of capital of a firm
  • Select the optimal capital structure of a firm
  • Manage the working capital of a firm
  • Undertake corporate restructuring
  • Evaluate mergers and acquisitions
  • Make decisions in the context of Islamic finance

CONTENT

  1. Overview of corporate finance…………………………………………………………………….. 2
  •  Nature and scope of corporate finance
  • Financial decision making process
  • Role of finance manager
  • Finance functions
  • Goals of a firm
  • Agency theory concept, conflict and resolutions
  • Measuring managerial performance, compensation and incentives

2.  Cost of capital…………………………………………………………………………………………….. 19

  •  The concept and significance of cost of capital
  • Components of cost of capital
  • Weighted average cost of capital (WACC) of a company
  • Marginal cost of capital (MCC) of a company
  • Use of marginal cost of capital and the investment opportunity schedule in determination of the optimal capital budget
  • Cost of debt capital using the yield-to-maturity approach and the debt-rating approach
  • Computation of the cost of non-callable and nonconvertible preferred stock
  • Computation of the cost of the cost of capital using the capital asset pricing model approach, the dividend discount model approach, and the bond-yield-premium approach
  • Computation of the beta and cost of capital for a project
  • Uses of country risk premiums in estimating the cost of equity
  • Treatment of floatation costs

3.    Capital structure……………………………………………………………………………………… 30

  • Sources of capital
  • Factors to consider when selecting sources of funds
  • Capital structure of a firm
  • Factors influencing capital structure
  • Capital structure theories: Net Income (NI) approach; Net operating Income (NOI) approach; Franco Modingiliani and Merton Miller (MM) propositions-MM without taxes, MM with corporate taxes, MM with corporate taxes and personal taxes, and MM with taxes and financial distress costs
  • Target capital structure; reasons why a company’s actual capital structure may fluctuate around its target
  • Measure of leverage: Overview of leverage; importance of business risk, sales risk, operating risk, and financial risk in leverage; classification of a risk; degree of operating leverage, the degree of financial leverage on a company’s net income and return on equity; breakeven quantity of sales levels; computational of the operating break-even quantity of sales
  • Role of debt ratings in capital structure policy
  • Evaluating the effect of capital structure policy on valuation: factors to consider
  • International differences in the use of financial leverage, factors that explain these differences, and implications of these differences for investment analysis

4.  Capital investment decisions under certainty………………………………………………… 68

  • Nature of capital investment decisions
  • Classification of capital budgeting decisions
  • Categories of capital projects
  • Basic principles of capital budgeting; evaluation and selection of capital projects: mutually exclusive projects, project sequencing, and capital rationing
  • Capital budgeting techniques
  • Estimating project cash flows

5.  Capital investment decisions under uncertainty……………………………………………. 90

  •  Nature and measurement of risk and uncertainty
  • Investment decision under capital rationing: Multiperiod; investment decision under inflation, investment decision under uncertainty
  • Techniques of handling risk: sensitivity analysis; scenario analysis; simulation analysis; decision theory models; certainty equivalent; risk adjusted discount rates; utility curves
  • Special cases in investment decision: projects with unequal lives; replacement analysis; abandonment decision
  • Real options in investment decisions: Types of real options; evaluation of a capital project using real options
  • Common capital budgeting pitfalls
  • Computation of accounting income and economic income in the context of capital budgeting
  • Evaluation of a capital project using economic profit, residual income, and claims valuation models for capital budgeting

6.  Management of working capital………………………………………………………………… 126

  •  Primary and secondary sources of liquidity; factors that influencing a company’s liquidity position
  • Company’s liquidity measure in comparison to those of peer companies
  • Evaluation of working capital effectiveness of a company based on its operating and cash conversion cycles; comparison of the company’s effectiveness with that of peer companies
  • Effect of different types of cash flows on a company’s net daily cash position
  • Computation of comparable yields on various securities; comparison of portfolio returns against a standard benchmark; evaluation of a company’s short-term investment policy guidelines
  • Company’s management of accounts receivable, inventory, and accounts payable over time and compared to peer companies
  • Evaluation of the choice of short-term funding available to a company

7.  Mergers and acquisitions……………………………………………………………………………. 162

  • Classification of mergers and acquisition (M &A) activities based on forms of integration and relatedness of business activities
  • Common motivations behind M & A activity
  • Bootstrapping of earnings per share (EPS); computation of a company’s post- merger EPS
  • The relation between merger motivation and types of mergers, based on industry life cycles
  • Contrast merger transaction characteristics form of acquisition, method of payment, and attitude of target management
  • Pre-offer defence mechanisms and post-offer takeover defence mechanism
  • Computation of Herfindahl- Hirschman index, and the likelihood of an antitrust challenge for a given business combination
  • Discounted cash flow analysis, comparable company analyses, and comparable transaction analyses for valuing a target company, including the advantages and disadvantages of each
  • Computation of free cash flows a for a target company, and estimation of the company’s Intrinsic value based on discounted cash flow analysis
  • Estimation of the value of a target company using comparable company and comparable transaction analyses
  • Evaluation of a takeover bid; computation of the estimated post-acquisition value of an acquirer and the gains accrued to the target shareholders versus the acquirer shareholders
  • Effect of price and payment method to the distribution of risks and benefits in M&A transactions
  • Characteristics of M&A transactions that create value
  • Equity carve-outs, spin-offs, split-offs, and liquidation

8 Dividend policy…………………………………………………………………………………………. 189

  • Forms of dividends
  • Dividend payment chronology
  • Theories of dividend policy
  • Factors that affect dividend policy
  • Dividend payout policies
  • Calculation of dividends

9.  Analysis of Corporate growth and restructuring………………………………………. 200

  • Measurements of growth: methods of determining growth rates, sustainable versus non sustainable growth analysis of potential growth, franchise value and the growth process
  • Return on assets (ROA) and return on capital (ROC)
  • Common reasons for restructuring
  • Relative company return analysis
  • Valuation and analysis of corporate restructuring; leveraged buyouts (LBO); divestitures; strategic alliances; liquidation; recapitalization
  • Financial distress, predicting organizational failure; solutions to financial distress

10.  Islamic Finance……………………………………………………………………………………….. 229

  • Justification for Islamic finance: history of Islamic finance; capitalism; halal; haram; riba; gharar; usury
  • Principles underlying Islamic finance: principles of not paying or charging interest, principles of not investing in forbidden items e.g. alcohol, pork, gambling or pornography; ethical investing; moral purchases
  • The concept of interest (riba) and how returns are made Islamic financial securities
  • Sources of finance in Islamic financing: muhabaha, sukuk, musharaka, mudaraba
  • Types of Islamic financial products: -sharia-compliant products: Islamic investment funds; tafakul the Islamic version of insurance Islamic mortgage, murabahah, ; leasing-ijara; safekeeping-wadiah; sukuk-islamic bonds and securitization; ; sovereign sukuk; Islamic investment funds; join venture- musharaka, Islamic banking, Islamic contracts, Islamic treasury products and hedging products, Islamic equity funds; Islamic derivatives
  • International standardization /regulations of Islamic finance: case for Islamic financial services board

11.  Emerging issues and trends

SAMPLE NOTES

TOPIC ONE

OVERVIEW OF CORPORATE FINANCE

Nature and scope of corporate finance

Finance is called “The science of money”. It studies the principles and the methods of obtaining control of money from those who have saved it, and of administering it those into whose control it passes.

Involves the task of raising funds required the firm at the most favorable terms.

It’s the study of how best to raise funds needed the business and allocation of the utilized and the distribution of returns generated.

The above definition will therefore cover the four financial management functions namely;

  1. Financing function
  2. Investing function
  3. Dividend function
  4. Liquidity function

 

Financing function

The finance management is responsible for making projections of the firms’ future financial needs. He has to determine the companies fixed capital needs in the short, medium and long-term as well as the working capital needs.

He has to  ensure  that the finance  is provided in the most  appropriate form and for  the  purpose for  which it  is required at the  lowest possible  cost to the  company.

He needs to be well equipped with the requirement of financial markets.

SAMPLE NOTES

TOPIC TWO

COST OF CAPITAL

Refers to the minimum required rate of return of a given security. It’s the return that a security (ordinary share, preference share or even debenture) must promise for it to become acceptable to investors. It’s a cost to the company since the company has to pay return to the investors for the capital provided to the company

 

Significance of cost of capital

  1. It is useful in long term investment decisions so as to determine which project should be undertaken. The techniques used to make this decision include net present value and IRR.
  2. It is also used in capital structure decisions to determine the mix of various components in the capital structure. The cost of capital of each component is determined.
  3. Used for performance appraisal. A high cost of capital is an indicator of high risk attached to the firm usually attributed to the performance of the management of a firm.
  4. In making lease or buy decisions. In lease or buy decisions the cost of debt is used as the discounting rate.

 

Factors influencing firms cost of capital

What are the elements in the business environment that cause a company’s weighted cost of capital to be high or low? We identify four primary factors : general economic conditions, the marketability of the firm’s securities (market conditions), operating and financing conditions within the company, and the amount of financing needed for new investments.

SAMPLE NOTES

TOPIC 3

THE CAPITAL STRUCTURE

 The financing decision is concerned with capital – mix (Financing – mix) or Capital Structure of a firm. The term Capital Structure refers to the proportion of debentures capital (debt) and equity share capital. Financing decision of a firm relates to the financing – mix. This must be decided taking into account the cost of capital, risk and return to the shareholders. Employment of debt capital implies a higher return to the shareholders and also the financial risk. There is a conflict between return and risk in the financing decisions of a firm. So, the Finance Manager has to bring a trade – off between risk and return maintaining a proper balance between debt capital and equity share capital. On the other hand, it is also the responsibility of the Finance Manager to determine an appropriate Capital Structure.

 

Determining Sources of Funds:

The Finance Manager has to choose sources of funds. He may issue different types of securities and debentures. He may borrow from a number of financial institutions and the public. When a firm is new and small and little known in financial circles, the Finance Manager faces a great challenge in raising funds. Even when he has a choice in selecting sources of funds, that choice should be exercised with great care and caution.

SAMPLE NOTES

TOPIC 4

CAPITAL INVESTMENT DECISIONS

One of the important aspects of Financial Management is proper decision making in respect of investment of funds. Successful operation of any business depends upon the investment of resources in such a way as to bring in benefits or best possible returns from any investment. An investment can be simply defined as an expenditure in cash or its equivalent during one or more time periods in anticipation of enjoying a net inflow of cash or its equivalent in some future time period or periods. An appraisal of investment proposals is necessary to ensure that the investment of resources will bring in desired benefits in future. If the financial resources were in abundance, it would be possible to accept several investment proposals which satisfy the norms of approval or acceptability. Since resources are limited a choice has to be made among the various investment proposals evaluating their comparative merit. It is apparent that some techniques should be followed for making appraisal of investment proposals. Capital Budgeting is one of the appraising techniques of investment decisions. Capital Budgeting is defined as the firm’s decision to invest its current funds most efficiently in long term activities in anticipation of an expected flow of future benefits over a series of years. It should be remembered that the investment proposal is common both for fixed assets and current assets.

Capital budgeting decision may be defined as “Firms decisions to invest its current funds most efficiently in long term activities in anticipation of an expected flow of future benefits over a series of years.”

The firm’s investment decision would generally include:-

  • Expansion
  • Acquisition
  • Modernization
  • Replacement of long term assets
  • Addition

Types of capital budgeting decisions

  1. Mutually exclusive decisions/projects

Are projects that serve the same purpose and compete with each other in terms of resources i.e. if one project is undertaken then others will have to be excluded.

  1. Independent projects

Are projects that serve different purposes and don’t compete for resources. Therefore, they can be undertaken subject to availability of funds.

  1. Dependent/contingent projects/decisions

Are those projects that depend on each other thus when one is undertaken then the other will have to be undertaken.

  1. Divisible and indivisible projects

Divisible – Are those which generate income before they are complete

Indivisible – Don’t generate income before they are complete.

  1. Outright acquisition projects

It involves purchase of a new long term assets for the first time

Usually done to meet the changing need of an enterprise

  1. Expansion and diversification projects

Involves expanding of existing facilities which have become inadequate due to diversification into new areas of operation.

  1. Replacement and modernization projects

Involves replacing an existing asset which has become technologically outdated in order to modernize operations of the business

SAMPLE NOTES

TOPIC FIVE

WORKING CAPITAL MANAGEMENT

Working capital refers to the portion of capital which is employed in the business to run it on a day to day basis. Working capital management are the policies and procedures relating to management of cash, inventory and debtors or simply current assets.

Components of working capital

There are 2 components of working capital;

  1. Current assets
  2. Current liabilities

 Gross working capital

Represents the sum of all current assets only

Net working capital

Represents the difference between the total Current asset and Current liabilities

Negative working capital

Represents the excess of current liabilities over current assets

Positive working capital

Represents the excess of current assets over current liabilities

SAMPLE NOTES

TOPIC SIX

 MERGER AND ACQUISITION 

 

Introduction

When we use the term “merger”, we are referring to the joining of two companies where one new company will continue to exist.

The term “acquisition” refers to the purchase of assets one company from another company. In an acquisition, both companies may continue to exist.

Definition of Merger:

However, we will loosely refer to mergers and acquisitions ( M & A ) as a business transaction where one company acquires another company. The acquiring company (also referred to as the predator company) will remain in business and the acquired company (which we will sometimes call the Target Company) will be integrated into the acquiring company and thus, the acquired company ceases to exist after the merger.

Classification / Types of Mergers

 Mergers and acquisitions are the ways in which businesses get combined. They can be little intricate to understand with all the legal and tax issues surrounding the deals. Mergers and acquisitions are two different business combinations, although they are thought of as a generic term. Both mergers and acquisitions can be classified further to differentiate the ways the companies can do business combinations.

Basis of Classifications: Mergers can be differentiated into various types depending on the following:

 Integration Form:

Mergers can be classified depending on how both the companies physically combine themselves in the transaction to form one entity.

Relatedness of Business Activities:

Mergers can be classified depending on how the business activities of both the companies relate to each other. The economic function and the purpose of the transaction define the types of mergers.

Classification the Form of Integration:

 The mergers can be classified as follows on the basis of forms of integration:

1.        Statutory Merger:

A statutory merger is one in which all the assets and liabilities of the smaller company is

SAMPLE NOTES

TOPIC SEVEN

 ANALYSIS OF CORPORATE GROWTH AND RESTRUCTURING

 

Sustainable Growth

 In simple terms and with reference to a business, sustainable growth is the realistically attainable growth that a company could maintain without running into problems. A business that grows too quickly may find it difficult to fund the growth. A business that grows too slowly or not at all may stagnate. Finding the optimum growth rate is the goal. A sustainable growth rate (SGR) is the maximum growth rate that a company can sustain without having to increase financial leverage. In essence, finding a company’s sustainable growth rate answers the question: how much can this company grow before it must borrow money?

The models used to calculate sustainable growth assume that the business wants to: 1) maintain a target capital structure without issuing new equity; 2) maintain a target dividend payment ratio; and 3) increase sales as rapidly as market conditions allow. Since the asset to beginning of period equity ratio is constant and the firm’s only source of new equity is retained earnings, sales and assets cannot grow any faster than the retained earnings plus the additional debt that the retained earnings can support. The sustainable growth rate is consistent with the observed evidence that most corporations are reluctant to issue new equity. If, however, the firm is willing to issue additional equity, there is in principle no financial constraint on its growth rate. Indeed, the sustainable growth rate formula is directly predicated on return on equity.

To calculate the sustainable growth rate for a company, one must know how profitable the company is based on a measure of its return on equity (ROE). One must also know what percentage of a company’s earnings per share it pays out in dividends, which is called the dividend-payout ratio. With these figures one can multiply the company’s ROE its plowback ratio, which is equal to 1 minus the dividend-payout ratio. [Sustainable growth rate = ROE × (1—dividend-payout ratio). Just as the break-even point for a business is the ‘floor’ for minimum sales required to cover operating expenses, the SGR is an estimate of the ‘ceiling’ for maximum sales growth that can be achieved without exhausting operating cash flows. The SGR can be thought of as a growth break-even point.

THE CHALLENGE OF ATTAINING SUSTAINABLE GROWTH

 Creation of sustainable growth is a prime concern of small business owners and big corporate executives alike. Obviously, however, achieving this goal is no easy task, given rapidly changing political, economic, competitive, and consumer trends. Each of these trends presents unique challenges to business leaders searching for the elusive grail of sustainable growth. Customer expectations, for example, have changed considerably over the last few generations. Modern consumers have less disposable wealth than their parents, which makes them more

SAMPLE NOTES

TOPIC EIGHT

DIVIDEND DECISION

 

Dividends are part of earnings which are distributed to ordinary shareholders for investing in the company. This decision is important to the company because of two main reasons:-

  1. Provides a solution to the dividend puzzle i.e. does payment of dividend increase or decrease value of the firm.
  2. It is part of company’s financing strategy – payment of high dividends means low retained earnings and hence need for more debt capital in the capital structure.

 

Dividend policy decisions

  1. When should the company pay dividends?
  2. How much should the company pay?
  3. How should the firm pay dividends?
  4. Why should the company pay dividends?

 

a) When should the firm pay dividends?

A company can pay dividends twice in the course of the year i.e. interim and final or once in a year i.e. final dividend.

The question whether to pay interim or final dividend will depend on:-

  1. Liquidity positions
  2. Expectation of shareholders
  3. Need for cash for financing purposes

 

b) How much dividend to pay?

There are four different dividend policies which influence the amount of dividend/per share a company can pay:

SAMPLE NOTES

CHAPTER NINE

ISLAMIC FINANCE

History of Islamic finance

The financial industry has historically played an important role in the economy of every society. Banks mobilize funds from investors and apply them to investments in trade and business. The history of banking is long and varied, with the financial system as we know it today directly descending from Florentine bankers of the 14th – 17th century. However, even before the invention of money, people used to deposit valuables such as grain, cattle and agricultural implements and, at a later stage, precious metals such as gold for safekeeping with religious temples.

Around the 5th century BC, the ancient Greeks started to include investments in their banking operations. Temples still offered safe-keeping, but other entities started to offer financial transactions including loans, deposits, exchange of currency and validation of coins. Financial services were typically offered against the payment of a flat fee or, for investments, against a share of the profit.

The views of philosophers and theologians on interest have always ranged from an absolute prohibition to the prohibition of usurious or excess interest only, with a bias towards the absolute prohibition of any form of interest. The first foreign exchange contract in 1156 AD was not just executed to facilitate the exchange of one currency for another at a forward date, but also because profits from time differences in a foreign exchange contract were not covered canon laws against usury.

In a time when financial contracts were largely governed Christian beliefs prohibiting interest on the basis that it would be a sin to pay back more or less than what was lent, this was a major advantage.

SAMPLE NOTES

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