L1 - Introduction to Corporate Finance

Question 1

What is corporate finance and what are its three pillars?

Answer 1

Corporate Finance –>Corporate finance is the area of finance that deals with sources of funding, the capital structure of corporations, the actions that managers take to increase the value of the firm to the shareholders, and the tools and analysis used to allocate financial resources. The primary goal of corporate finance is to maximize or increase shareholder value. (Wikipedia)

definition from book

• Investment –> which investment should I take, in what assets should I invest? (Capital budgeting describes the process of making and managing expenditures on long-lived assets)
• Financing –> how will I fund the project (equity v debt), Which financing source should be used for capital expenditures? (Capital Structure)
• Liquidity –> how we manage our cash, How to manage short-term operating cash flows? How we do we manage our Net Working Capital

Question 2

Why is Investment an important pillar in corporate finance?

Answer 2

• It is what is needed to start a firm. you need investment into the following four:
  
  • Inventory
  • Machinery
  • Land
  • Labour
• Obviously, for different companies like tech you may need each for more or less but still, generally need all 4 as input
• All of this creates Value
  
  • ​The purpose of a firm is to create value for the owner(s), who may or may not be the managers of the firm
  • The goal of financial management is to maximise the value of a company’s equity shares
    
    • ​But this has been critised as it ignores other important factors such as employtees (the social objectives) and sustainabiltiy (the environmental objectives)
    • Consequently the financial managers best serves shareholders by making decisions that are valued by sharehoders, who in turn rflect hte broader societal environment concern of the general population

Question 3

What does the balance sheet of a firm look like

Answer 3

• Total Asset = Total Liabilities + Equity
  
  • The right side shows you how we finance these assets
  • Asset - Liability = Equity
    
    • Liability holders get the first claim of revenues due to contractual agreements then what is left over Can be paid to dividend holders
• Current assets –> easy to turn into cash with 12 months
• current liabilities –> obligations the firm needs to meet within 12 months
  
  • We need Current assets to be equal to or greater than current liabilities or we are in trouble
  • Net work Capital = CA - CL

Question 4

What is Pie Theory?

Answer 4

• We can assume a firms value is equal to the below formula in a perfect capital market, assuming:
  
  • no corporate tax
  • no bankruptcy costs –> debt holders cannot force companies into paying them
  • no agency costs –> conflict of interest between shareholders and managers

Question 5

How does value creation depend on cashflows?

Answer 5

Financial managers create value from the firm’s capital budgeting finance nad net working cpaital acitivitie. How do they create value? The answer is that the firm should:

• Value should create a larger cash flow than what we receive from the Financial market
  
  • Try t obuy assets that generate more cash thatn they cost
  • sell bonds, shares and othe dinancial instruments that rise more cash than they cost

Question 6

What do we need to consider about cashflows?

Answer 6

• Identification
  
  • Cashflows or accounting figures?
• Timing
  
  • When do Cash flows occur?
• Risk
  
  • Are cash flows risky or certain?

Question 7

What is the risk of cash flows?

Answer 7

• Firms invest in a variety of assets, but these assets are risky in the sense that their future cash flows are uncertain (amount and timing).
• Given that future cash flows of assets are uncertain, investors and firms have to guess the value of assets.
• We assume that decisions under uncertainty are made on the basis of probability theory.

Question 8

What are the three common organisational structures?