Corporate Finance

Fundamental of Corporate
Finance
Lecture Notes
For
MBA/M.Com/MEF/BS/BB
A
Sir M.Faseeh Khan
Sir M.Faseeh Khan-CF(notes) Page 1 of 21 copyright @TM

Federal Urdu Art and Science University
e-mail: faseeh_u@yahoo.com
Corporate Finance – Course Overview
_____________________________________________________________
Instructor: Sir M.Faseeh Khan e-mail: faseeh_u@yahoo.com
Subject: Corporate Finance
Class: BBA/MBA/M.Com Shift: Morning Session: Aug. – Dec. 2010
Purpose:
The course is design to assist the students in building a conceptual
framework which with to make prudent financial decision in their jobs, personal financial
planning and decision making.
Topics:
Chapter #1: Introduction to Corporate Finance
Chapter #2: Long-Term Financial Planning and Growth
Chapter #3: Interest Rates and Bond Valuation
Chapter #4: Introduction to Valuation: The Time Value of Money
Chapter #5: Discounted Cash Flow Valuation
Chapter #6: Stock Valuation
Chapter #7: Net Present Value and Other Investment Criteria
Chapter #8: Project Analysis and Evaluation
Chapter #9: Return, Risk, and the Security Market Line
Chapter #10: Cost of Capital
Chapter #11: Dividends and Dividend Policy
Chapter #12: Short-Term Finance and Planning
Evaluation:
The grading component and Scale:
Final Examination ---------> 60 Marks

Mid-Term ---------> 20 Marks
Class Test ---------> 20 Marks(each @ 10)
Chapter 1: Introduction to Corporate Finance

Corporate Finance
Some important questions that are answered using finance
What long-term investments should the firm take on?
Where will we get the long-term financing to pay for the investment?
How will we manage the everyday financial activities of the firm?
Financial Manager
Financial managers try to answer some or all of these questions
The top financial manager within a firm is usually the Chief Financial Officer (CFO)
Treasurer – oversees cash management, credit management, capital
expenditures and financial planning
Controller – oversees taxes, cost accounting, financial accounting and data
processing
Financial Management Decisions

Capital budgeting
What long-term investments or projects should the business take on?
Capital structure
How should we pay for our assets?
Should we use debt or equity?
Working capital management
How do we manage the day-to-day finances of the firm?
Forms of Business Organization
Three major forms in the United States
Sole proprietorship
Partnership
General
Limited
Corporation
S-Corp
Limited liability company
Sole Proprietorship
Advantages
Easiest to start
Least regulated
Single owner keeps all the profits
Taxed once as personal income

Disadvantages
Limited to life of owner
Equity capital limited to owner’s personal wealth
Unlimited liability
Difficult to sell ownership interest
Partnership
Advantages
Two or more owners
More capital available
Relatively easy to start
Income taxed once as personal income
Disadvantages
Unlimited liability
General partnership
Limited partnership
Partnership dissolves when one partner dies or wishes to sell
Difficult to transfer ownership
Corporation
Advantages
Limited liability
Unlimited life
Separation of ownership and management
Transfer of ownership is easy
Easier to raise capital
Disadvantages
Separation of ownership and management
Double taxation (income taxed at the corporate rate and then dividends taxed
at the personal rate)
Goal of Financial Management

What should be the goal of a corporation?
Maximize profit?
Minimize costs?
Maximize market share?
Maximize the current value of the company’s stock?
Does this mean we should do anything and everything to maximize owner wealth?

Chapter 2: Long-Term Financial Planning and Growth
2: Plowback and dividend payout ratios
Your company has net income of $1,600 for the year. You paid out $400 in dividends to
your stockholders.
What is the dividend payout ratio?

What is the plowback ratio?
What is the dollar increase in retained earnings?

Your company has net income of $1,600 for the year. You paid out $400 in dividends to
your stockholders.
Cash dividends
Dividend payout ratio 
Plowback ratio  1 - dividend Net income
payout ratio
 1 - .25
 Net $400
Addition t o retained earnings  income  plowback ratio
4:  .75 $1,600$1,600
.75
 .25
 $1,200
Plowback and dividend payout ratios
This year your company expects net income of $2,800. You now adhere to a 60%
plowback ratio.
What is the expected dollar increase in retained earnings?
How much do you expect to pay in dividends?
What is the dividend payout ratio?

This year your company expects net income of $2,800. You now adhere to a 60%
plowback ratio.
Dividends paid  Net income  Addition t o retained earnings

 $2,800  $1,680
Cash dividends
Dividend 1,120 ratio 
 $payout
Net income
Addition t o retained earnings  Net income  plowback ratio
$1,120
 $2,800  .60
6: 
$2,800
 $1,680
Constant  40%
growth
planning

Income Statement
Current Projected
Sales $800 $_______
Costs $700 $_______
Taxable income $100 $_______
Taxes (34%) $ 34 $_______
Net income $ 66 $_______
Balance Sheet
Current Projected Current Projected
Assets $400 $_______ Debt $150 $_______
Equity $250 $_______
Total $400 $_______ Total $400 $_______
You expect your sales, costs and assets to grow by 10% next year. You will not pay any
dividends. Can you complete the pro forma statement? Round all amounts to whole
dollars.
7: Constant growth planning
Income Statement
Current Projected
Sales $800 $880
Costs $700 $770
Taxable income $100 $110
Taxes (34%) $ 34 $ 37
Net income $ 66 $ 73
Balance Sheet
Current Projected Current Projected
Assets $400 $440 Debt $150 $117
Equity $250 $323
Total $400 $440 Total $400 $440
The computations are shown on the next slide.
8: Constant growth planning

Projected equity  Current equity  Projected net income
 $250s$73
Totalliabilitie equity Totalassets
 $323
Debt  (Total liabilities   $440 - equity
equity)
 $440
Sales - $323
 $800(1.10)  $880
 $117
Costs  $700(1.10)  $770
Taxes  $34(1.10)  $37 ( rounded )
Assets  $400(1.10)  $440
9: Percentage of sales planning
The assets and current liabilities of Jennings, Inc. vary in direct proportion to the increase
in sales. The current sales are $2,000 and you expect them to increase by 20% next year.
Net income is projected at 5% of sales. The firm is not planning on issuing any more
common stock nor paying any dividends.
Using this information, can you compile the pro forma balance sheet shown on the next
slide?

Current % of sales Projected
Cash $ 120 _____% $_______
Accounts receivable $ 500 _____% $_______
Inventory $ 840 _____% $_______
Fixed assets $2,600 _____% $_______
Total assets $4,060 _____% $_______
Accounts payable $ 600 _____% $_______

Long-term debt $ 700 _____% $_______
Common stock and paid in surplus $1,000 _____% $_______
Retained earnings $1,760 _____% $_______
Total liabilities and equity $4,060 _____% $_______
Refer to the prior slide for information pertaining to this problem.

Enter n/a where the % of sales does not apply.

Current % of sales Projected
Cash $ 120 6% $ 144
Accounts receivable $ 500 25% $ 600
Inventory $ 840 42% $1,008
Fixed assets $2,600 130% $3,120
Total assets $4,060 203% $4,872
Accounts payable $ 600 30% $ 720

Long-term debt $ 700 n/a $1,272
Common stock and paid in surplus $1,000 n/a $1,000
Retained earnings $1,760 n/a $1,880
Total liabilities and equity $4,060 n/a $4,872

$120
Cash   . 06  6 %
Sales  $2,000  1.20  $2,400
$500
Accounts receivable   . 25  25 %
$2,000
Cash  .06  $2,400  $144
$840
Inventory   . 42  42 %
13: Percentage of $2,000
sales planning Accounts receivable  $2,600
.25  $2,400  $600
Fixed assets   1 . 30  130 %
Common stock $2,000  $1,000  $0  $1,000
$4,060
Retained assets  .42
Inventory
earnings
Total  $2,400
 $1,760  $1,008
 2 . 03 
( .05  $2,400)  $1,880
203 %
$2,000
$600
Total liabilities andAccounts
owners' equity  Total
assets  1.30
Fixedpayable assets
 . 30
 $2,400
$2,000
 30 % $4,872
$3,120
Accounts payable  .30  $2,400  $720
Total liabilities and owners’ equity $4,872

Accounts payable -$ 720
Common stock and paid in surplus -$1,000
Retained earnings -$1,880
Long-term debt $1,272
14: External financing need

You project your sales will increase by $3,000 next year. Net income is 10% of sales and
accounts payable is 25% of sales. The capital intensity ratio is 2.5. No dividends are
anticipated.
How much external financing is needed to fund this growth?
Try to solve this problem without looking at the hints on the next slide.

You project your sales will increase by $3,000 next year. Net income is 10% of sales and
accounts payable is 25% of sales. The capital intensity ratio is 2.5. No dividends are
anticipated.
How much external financing is needed to fund this growth?
Hints:
Step 1: Compute the increase in total assets
Step 2: Compute the increase in accounts payable
Step 3: Compute the increase in retained earnings
Step 4: Compute the additional long-term debt and equity financing that is needed
Step 1

Totalassets Sales Capitalintensity ratio
Step 2
Accounts $3,000  2.5
payable  .25  Sales
Step 3  $7,500  .25  $3,000
Addition t o retained earnings  Net income - Dividends paid
Step 4
 ( .10
External financing need  Total assets - Accounts
$750
 sales)--Additions
payable 0 to retained earnings

 $7,500 - $750 - $300 .10  $3,000
 $6,450  $300
17: Pro forma with external financing

Your firm currently has long-term debt of $4,400, common stock and paid in surplus of
$10,000 and retained earnings of $4,600. The capital intensity ratio is 2.2 and the tax rate
is 35%. Costs are 72% of sales and accounts payable are 30% of sales. Sales currently
are $10,000 and are expected to increase by 10% next year. The dividend payout ratio is
20%. Long-term debt will be used to fund 40% of the external funding need.
Chapter 3: Interest Rates and Bond Valuation

2: Coupon payment
A bond has a 7% coupon and pays interest semi-annually.
What is the amount of each interest payment if the face value of a bond is $1,000?
3: Coupon payment

Coupon rate  Face amount
Interest payment 
Number of interest payments per year
.07  $1,000

2
$70

2
 $35
4: Bond price
A bond has a 9% coupon rate, matures in 12 years and pays interest semi-annually. The
face value is $1,000.
What is the current price of this bond if the market rate of return is 8.3%?
5: Bond price


 1  1 /(1  r ) t
PV  C  
  
F
t
  r 
 (1  r )
  .083 12 2  
 .09  $1,000 1  1 /(1  2 )   $1,000
    
.083 
 2  (1  .083 )122
 2  2
 ($45  15.015477)  $376.8577
 $675.6965  $376.8577
 $1,052.55
7: Time to maturity
A bond is currently selling at a price of $977.03. The face value is $1,000 and the coupon
rate is 8%. Interest is paid semi-annually.
How many years is it until this bond matures if the market rate of return is 8.4%?
8: Time to maturity
9: Yield to maturity
A 6% bond pays interest annually and matures in 14 years. The face value is $1,000 and
the current market price is $896.30.
What is the yield to maturity?
11: Current yield

An 8%, semi-annual coupon bond has a $1,000 face value and matures in 8 years.
What is the current yield on this bond if the yield to maturity is 7.8%?

12: Current yield
  
1  1 /(1  r ) t  F
PV   C   Current yieldAnnualt interest
  r (1  r ) price
 Current
  .Annual 8 2  
 $1,000
08.078
 .08 Current 1  1 
/(1 
  $1,011 ) interest
 
$1,000 yield 2 .74   $ 1,000
14:   Current price
 2 . 078$80  .078 82
 2 $80 (1  )
  $1,011.74   2
 .$1,011.74
 ($ 40  11 .73873 )  $ 542 .18967
07907
 .707907
 $469 .54920  $ 542 .18967 .91 %
 $1,011 .74  7.91%
Holding period yield
You bought a bond exactly one year ago for $1,004.50. Today, you sold the bond at a
price of $987.40. The bond paid interest semi-annually at a coupon rate of 6%.
What is your holding period yield on this bond?
15: Holding period yield
16: Interest rate risk

You own two bonds. Both bonds have a 6% coupon and pay interest semi-annually. Both
have a face value of $1,000. Bond A matures in two years while bond B matures in 10
years.
What is the price of each bond at a market rate of 6%? What happens if the rate increases
to 7%.
19: Interest rate risk

You own two bonds. Both bonds mature in 5 years, have a $1,000 face value and pay
interest annually. Bond X has an 8% coupon rate while bond Y has a 3% coupon rate.
What is the price of each bond if the market rate of return is 7%? What happens to the
price of each bond if the market rate falls to 6%?

Chapter 4: The Time Value of Money
2: Simple versus compound interest
First United Bank pays 4% simple interest on their savings accounts. Second Federal
Bank pays 4% interest compounded annually on their savings accounts.
If you invest $1,000 in each bank, how much will you have in your accounts after twenty
years?
Why are the balances different?
3: Simple versus compound interest
First United Bank

Second Federal Bank
Difference
FVt  PV  (1  r) t
 $1,000
$ 2,191 . 12  $391
$1,8001.0420
.12
 $2,191
$1,000 .04.12
 $40
4: Future value $40  20  $800
You invest $3,000 in the
stock market today. $1, 000  $800  $1,800
How much will your account be worth forty years from now if you earn a 9% rate of
return?
5: Future value
FVt  PV  1  r 
t
7: Present
 $3,000  1  .09
value 40
You want to
have $7,500
 $3,000  31.40942
three years
from now to
buy a car. You
can earn 6% on
your savings.  $94,228.26
How much money must you deposit today to have the $7,500 in three years?
8: Present value
FVt
10: Interest rate for a
PV 
single period
Last year your
investments were worth
1  r  t
$369,289. Today they are

worth $401,382. No $7,500
deposits or withdrawals 
were made during the
year. 1  .06 3
What rate of return did
$ 7 ,500

you earn on your
investments this year?
1.191016 t
FVt  PV $6,2971.14r 
$401,382  $369,289  1  r 
1
1.086905  1  r
r  .086905
r  8.6905%

Chapter 5: Discounted Cash Flow Valuation
3: Financial review
If you invest $100 today for one year at a 10% rate of return, how much money will you
have one year from now?
You are spending $100 by investing it. You input that as a negative value using the “±”
key. You are receiving $110 back at the end of one year. That is the positive value.
Positives and negatives are used to denote the direction of the cash flow. Generally you
use a positive value to indicate a cash inflow and a negative value to indicate a cash
outflow. All dollar amounts in this type of problem are, in actuality, positive values.
5: Ordinary annuity present value

You will receive $12,000 a year for the next ten years from a trust fund your grandmother
is establishing.
What is this gift worth today at a 9% discount rate?
 
6: Ordinary annuity present value
1  1 / 1  r  t 
APV  C   
 r 
1  1 /(1  .09)10 
 $12,000   
 
 .09 
.5775892 
 $12,000   
 . 09 
 $12,000  6.4176578
 $77,011.89
8: Annuity due present value
You are buying some land from your parents today. You agree to pay them $5,000 a year
for six years. The first payment is due today.
What is the actual selling price of the land if your parents are only charging you 3%
interest?
 
1  1 / 1  r  t 
A Due PV  C     1  r 
 r 
1  1 / 1  .03 6 
 $5,000  

  (1  .03)

 .03 
 $5,000 
 .162515743
1.03
.03
 $5,000  5.4171914 1.03
 $27,898.54
11: Ordinary annuity future value

You are planning on investing $3,500 in the stock market every year for your retirement.
You will make your first investment at the end of this year. The average rate of return you
expect to earn is 7%.
How much money do you expect to have when you retire forty years from now?
12: Ordinary annuity future value

 (1  r ) t  1
AFV  C  
14:

 r 
 (1.07) 40  1
 $3,500   
 .07 
 $3,500 199.63511
 $698,722.89
Annuity due future value
Your parents are giving you $3,000 at the beginning of each year for four years. You are
saving this money and earning a 2.5% rate of return on your savings.
How much money will you have at the end of the four years?
15: Annuity due future value

( 1  r)t 1
AFV  C     (1  r )
 r 
 (1.025) 4 1
 $3,000    (1  .025)
 .025 
 $3,000 4.15251561.025
 $12,768.99
17: Annuity – annual payments
You plan on retiring at age 60 and then living another 25 years. Your goal is to have
$500,000 in your retirement savings on the day you retire and spend it all by the time you
die. During your retirement, you expect to earn 5% on your savings.
How much money can you withdraw from your savings each year during your retirement
if you withdraw the funds on the last day of each year?
What if you withdraw the money on the first day of each year?
18:
Annuity –
annual APV  C  

1  1 / 1  r  t 


payments
 r 
$ 500 ,000  C 

1  1 / 1  .05  25 
C 

C AD 
20:
Annuity –
1  r  . 05 
monthly $ 500 ,000  C  14.0939446
$35,476.2286
payments

You
$500,000
1  .05
currently
owe C 
14.0939446
$33,786.88
C  $35,476.22
Sir M.Faseeh Khan-CF(notes)
86
Page 18 of 21 copyright @TM
C  $35,476.23 (rounded)
$3,780 on your credit card. You are not charging any more on the account. The interest
rate is 1.5% per month.
How much do you have to pay each month if you want to have this bill paid off within
two years?
21: Annuity – monthly payments
22: Annuity – APV  C  


1  1 / 1  r  t 


monthly
 r 
 
payments
23: Annuity – 1  1 / 1  .015  ( 212 ) 

quarterly $3,780  C   
payments  .015 
Your company
recently
 .300456 
borrowed $3,780  C   
$12,000 to buy
some office
 .015 
equipment. The
financing terms
$3,780  C  20.0304
call for eight
$3,780
equal quarterly
payments. The
C
20.0304
 
interest rate is
10%. 1  1 / 1  r  t 
C  $188.71
APV  C   
What is the
amount of each  r 
quarterly
payment?    .10 8  
1  1 /1   
24: Annuity –    4   
quarterly $12,000  C   
payments
 . 10 / 4 
Chapter  
 
6: Stock
Valuation $12,000  C  
.1792534 

 .025 
2: Zero growth
stock $12,000  C  7.170136
$12,000
C 
7.170136Page 19 of 21 copyright @TM
C  $1,673.61
Rainbow Rentals pays a constant annual dividend of $1.00 per share on their common
stock.
How much are you willing to pay for one share of this stock if you want to earn a 9% rate
of return?
3: Zero growth stock
D
Bits ‘n Pieces pays a constant P0 
annual dividend of $.50 a
share. The market price of the
stock is $5.41 today.
r
What is the rate of return on $1.00
this stock?

.09
D
The common stock of
P0 
$11r.11
Kathy’s Antiques, Etc.
is priced at $12.50 a
share. The stock
$. 50
provides a 10% rate of
return. The company $ 5 . 41 
pays a constant
dividend.
r
What is the amount of $ 5 .41 r  $. 50
the annual dividend?
r  . 09242
r  9D
. 24 %
P0 
8: Constant growth
stock
JLE, Inc. just paid their
annual dividend of $1.10
a share. JLE’s policy is to r
increase the dividend by
2% annually.
D
$12.50
.10
Page 20 of 21 copyright @TM
D  $1.25
How much are you willing to pay today for a share of this stock if you require an 11%
rate of return?

Corporate Finance

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Corporate Finance

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Fundamental of Corporate

Sir M.Faseeh Khan

Sir M.Faseeh Khan-CF(notes) Page 1 of 21 copyright @TM

Chapter #2: Long-Term Financial Planning and Growth

Chapter #3: Interest Rates and Bond Valuation

Chapter #4: Introduction to Valuation: The Time Value of Money

Chapter #5: Discounted Cash Flow Valuation

Chapter #6: Stock Valuation

Chapter #7: Net Present Value and Other Investment Criteria

Chapter #8: Project Analysis and Evaluation

Chapter #9: Return, Risk, and the Security Market Line

Chapter #10: Cost of Capital

Chapter #11: Dividends and Dividend Policy

Chapter #12: Short-Term Finance and Planning

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Chapter 1: Introduction to Corporate Finance

Financial Management Decisions

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Goal of Financial Management

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What is the dividend payout ratio?

3: Plowback and dividend payout ratios

5: Plowback and dividend payout ratios

Dividends paid  Net income  Addition t o retained earnings

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7: Constant growth planning

The computations are shown on the next slide.

8: Constant growth planning

10: Percentage of sales planning

Accounts payable $ 600 _____% $_______

Refer to the prior slide for information pertaining to this problem.

11: Percentage of sales planning

Accounts payable $ 600 30% $ 720

12: Percentage of sales planning

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Accounts payable  .30  $2,400  $720

Total liabilities and owners’ equity $4,872

14: External financing need

How much external financing is needed to fund this growth?

15: External financing need

16: External financing need

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17: Pro forma with external financing

Chapter 3: Interest Rates and Bond Valuation

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What is the yield to maturity?

11: Current yield

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What is your holding period yield on this bond?

15: Holding period yield

16: Interest rate risk

19: Interest rate risk

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Why are the balances different?

3: Simple versus compound interest

First United Bank

$369,289. Today they are

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5: Ordinary annuity present value

What is this gift worth today at a 9% discount rate?

10: Annuity due present value

11: Ordinary annuity future value

12: Ordinary annuity future value

Accounts payable $ 600 _% $___