Corporate Finance_Class Notes - Dr Ojomolade_251206_160150.pdf

# Objectives of a business This section explores the primary goals of a business, with a particular focus on profit maximization and shareholder wealth maximization, and examines how profitability serves as a foundational element for other business objectives [1](#page=1). ### 1.1 Primary objectives The fundamental objectives of a business typically include profit maximization and shareholder wealth maximization [1](#page=1). #### 1.1.1 Profit maximization Profit maximization is a core objective for many businesses. It is often seen as a prerequisite for achieving other organizational goals [1](#page=1). #### 1.1.2 Shareholder wealth maximization Shareholder wealth maximization is another key objective, aiming to increase the overall value for the company's owners [1](#page=1). ### 1.2 Profitability as a foundation for other objectives Profitability is presented as the central pillar around which various other business objectives revolve. Without sufficient profit, achieving these secondary objectives becomes significantly more challenging or impossible [1](#page=1). #### 1.2.1 Survival Profitability is essential for a business's survival, ensuring it can cover its costs and continue operations [1](#page=1). #### 1.2.2 Employee welfare Sustained profitability allows businesses to invest in employee welfare, providing benefits, competitive salaries, and a positive work environment [1](#page=1). #### 1.2.3 Expansion To expand its operations, a business needs to generate profits that can be reinvested into new projects, markets, or facilities [1](#page=1). #### 1.2.4 Growth Similar to expansion, achieving business growth, whether in terms of market share, revenue, or asset base, is heavily dependent on a profitable operational model [1](#page=1). > **Tip:** When analyzing business objectives, always consider how profitability enables or underpins each stated goal. This hierarchical relationship is crucial for understanding a firm's strategic priorities. > **Example:** A company aiming for rapid expansion might need to forgo immediate dividend payouts (shareholder wealth maximization in the short term) to retain earnings for investment, demonstrating the interplay between different objectives and the foundational role of profit. --- # Functions of a finance manager The finance manager plays a fundamental role in the success, growth, and sustainability of an organization by overseeing critical financial decisions, fund management, risk analysis, and investment strategies [2](#page=2). ### 2.1 Financial decisions Financial decisions are core to the finance manager's role and involve several key areas that directly impact the organization's financial health and strategic direction [2](#page=2). #### 2.1.1 Adequacy of funds Ensuring the availability of sufficient funds is paramount for daily operations and future growth. This involves forecasting financial needs and planning to meet them proactively [2](#page=2). #### 2.1.2 Dividend decisions The finance manager is responsible for determining the appropriate dividend policy, balancing the need to retain earnings for reinvestment with the expectation of returning value to shareholders [2](#page=2). #### 2.1.3 Cost of funds determination Understanding and minimizing the cost of acquiring capital is crucial. This involves analyzing different sources of finance and their associated expenses to identify the most cost-effective options [2](#page=2). #### 2.1.4 Source of funds determination Identifying and securing the most suitable sources of funds, whether debt or equity, is a key responsibility. This decision impacts the organization's capital structure and financial risk profile [2](#page=2). ### 2.2 Risk analysis A comprehensive understanding and management of financial risks are essential for safeguarding the organization's assets and ensuring stability [2](#page=2). ### 2.3 Investment The finance manager is involved in evaluating and selecting investment opportunities that align with the organization's strategic goals and offer acceptable returns relative to risk [2](#page=2). #### 2.3.1 Efficient resource allocation This function involves directing financial resources to their most productive uses within the organization, ensuring that investments generate maximum value and contribute to overall efficiency [2](#page=2). #### 2.3.2 Assets management Effective management of the organization's assets, both tangible and intangible, is critical. This includes ensuring assets are utilized efficiently, maintained properly, and contribute to revenue generation [2](#page=2). #### 2.3.3 Liquidity management Maintaining adequate liquidity is essential to meet short-term obligations and unexpected financial demands. This involves managing cash flow, working capital, and short-term investments [2](#page=2). > **Tip:** Efficiently managing finances ensures that the organization has the necessary capital for operations, investments, and unexpected events, thereby promoting both growth and long-term sustainability [2](#page=2). --- # Bond valuation and types This section explores the fundamental characteristics of bonds, their pricing mechanisms, and their role within investment portfolios. ### 3.1 Introduction to bonds Bonds represent a debt instrument where an issuer owes the holders a debt and is obliged to pay interest (the coupon) and to repay the principal at a later date (maturity). A key relationship in bond markets is the inverse correlation between a bond's price and its yield. This means as bond prices rise, their yields fall, and conversely, as bond prices fall, their yields rise. Bonds can serve as an alternative to shares for reducing a portfolio's overall risk, contributing to diversification. Important terms associated with bonds include Yield to Maturity (YTM), Yield to Call (YTC), and Face Value (FCV) [3](#page=3). ### 3.2 Zero-coupon bonds Zero-coupon bonds are characterized by being issued at a discount to their face value and are redeemed at par value upon maturity. They do not pay periodic interest payments [4](#page=4). #### 3.2.1 Pricing a zero-coupon bond The price of a zero-coupon bond is determined by discounting its face value back to the present using the required rate of return or discount rate. The formula for the present value (price) of a zero-coupon bond is: $$ P = \frac{FV}{(1 + k)^n} $$ Where: * $P$ is the price of the bond. * $FV$ is the face value of the bond. * $k$ is the discount rate or yield. * $n$ is the number of periods to maturity. **Example:** A zero-coupon bond with a face value of 1,000 dollars and a 10% interest rate is issued at a price of 980 dollars. The yield can be calculated as: Yield = Coupon / Price Yield = 100 dollars / 980 dollars Yield = 0.102 or 10.2% [4](#page=4). However, the calculation for the discount factor ($k$) for a zero-coupon bond uses the pricing formula directly: $980 = \frac{1000}{(1+k)^2}$ [4](#page=4). $(1+k)^2 = \frac{1000}{980}$ [5](#page=5). $1+k = \sqrt{\frac{1000}{980}}$ [5](#page=5). $k = \sqrt{\frac{1000}{980}} - 1$ $k \approx 0.015$ or 1.5% [5](#page=5). This $k$ represents the discount factor. #### 3.2.2 Calculating the zero interest rate If the face value of a zero-coupon bond is 1,000 dollars and its maturity period is 2 years, with an issue price of 797.19 dollars, the zero interest rate can be calculated. Using the formula $DR = \frac{FCV}{(1 + K)^n}$, where $DR$ is the discount rate (zero interest rate): $(1 + k)^2 = \frac{1000}{797.19}$ [6](#page=6). $1 + k = \sqrt{\frac{1000}{797.19}}$ [6](#page=6). $k = \sqrt{\frac{1000}{797.19}} - 1$ $k \approx 0.12$ or 12% [6](#page=6). ### 3.3 Coupon bonds and current yield Coupon bonds pay periodic interest payments (coupons) in addition to repaying the face value at maturity. The current yield of a bond reflects the annual coupon payment relative to its current market price. #### 3.3.1 Calculating current yield The current yield is calculated as follows: Current Yield = Annual Coupon Payment / Current Market Price [6](#page=6). **Example:** A bond with a face value of 1,000 dollars and a coupon rate of 12% is currently selling at 800 dollars. The annual coupon payment is 12% of 1,000 dollars, which is 120 dollars. Current Yield = 120 dollars / 800 dollars = 0.15 or 15% [6](#page=6). ### 3.4 Yield to Maturity (YTM) Yield to Maturity (YTM) is the total return anticipated on a bond if the bond is held until it matures. YTM is considered a more comprehensive measure of return than current yield because it accounts for the time value of money and the fact that the bond will be redeemed at par. The formula for YTM is derived from the bond valuation equation: $$ P = \sum_{t=1}^{n} \frac{C_t}{(1 + YTM)^t} + \frac{TV}{(1 + YTM)^n} $$ Where: * $P$ is the current market price of the bond. * $C_t$ is the coupon payment in period $t$. * $YTM$ is the yield to maturity. * $n$ is the number of periods to maturity. * $TV$ is the terminal value (typically the face value or redemption value) of the bond at maturity. **Illustration:** Consider a bond with a face value of 1,000 dollars, issued 5 years ago with a coupon rate of 15%. The current market price is 900 dollars, and the bond is to be redeemed at par. We need to calculate the yield to maturity. The coupon payment ($C$) is 15% of 1,000 dollars, which is 150 dollars. The time to maturity ($n$) is not explicitly stated as remaining but implied by the context of calculating YTM from the current price and future cash flows. If it was issued 5 years ago and is being valued now, and maturity is not specified, we often assume the remaining term. For the purpose of this illustration, let's assume there are still 5 years left to maturity. The equation becomes: $900 = \frac{150}{(1+YTM)^1} + \frac{150}{(1+YTM)^2} + \frac{150}{(1+YTM)^3} + \frac{150}{(1+YTM)^4} + \frac{150+1000}{(1+YTM)^5}$ [7](#page=7) [8](#page=8). This equation cannot be solved directly for YTM and typically requires an iterative process or financial calculator. An approximation can be made using present value annuity tables. Using a 15% discount rate, the present value of an annuity factor for 5 years is approximately 3.352, and the present value of 1 dollar received in 5 years at 15% is approximately 0.4971. Approximate calculation: Present Value of Coupons = $150 \times 3.352 = 502.8$ Present Value of Face Value = $0.4971 \times 1000 = 497.1$ Total Present Value = $502.8 + 497.1 = 999.9$ [8](#page=8). This calculation at 15% yields a value close to the face value, suggesting the YTM is likely higher than 15% because the bond is trading at a discount (900 dollars). To find the exact YTM, one would try different rates. If we try a higher rate, say 20%, and the calculated present value falls below 900 dollars, it would indicate that the YTM is between 15% and 20%. The process of finding the YTM is essentially finding the Internal Rate of Return (IRR) that equates the present value of future cash flows to the current market price [9](#page=9). > **Tip:** Calculating YTM manually is often an iterative process. Financial calculators or spreadsheet software are typically used for precise calculations. The concept of YTM is crucial as it represents the expected rate of return if the bond is held to maturity, considering all coupon payments and the principal repayment. --- ## Common mistakes to avoid - Review all topics thoroughly before exams - Pay attention to formulas and key definitions - Practice with examples provided in each section - Don't memorize without understanding the underlying concepts

| Term | Definition | |------|------------| | Profit maximization | The objective of a business aiming to achieve the highest possible profit within a given period, often considered a primary driver for survival and expansion. | | Shareholder wealth maximization | A business objective focused on increasing the market value of a company's shares, thereby maximizing the return for its owners or shareholders. | | Liquidity | Refers to a company's ability to meet its short-term financial obligations using its most liquid assets; it is a key consideration in financial management and business survival. | | Financial decisions | Key choices made by a finance manager regarding how to raise capital, how to invest funds, and how to manage existing assets and liabilities to achieve organizational objectives. | | Adequacy of funds | The assessment of whether a business has sufficient financial resources available to meet its operational needs, investment opportunities, and strategic goals. | | Dividend decision | A financial decision concerning the proportion of profits that a company will distribute to its shareholders as dividends versus retaining earnings for reinvestment. | | Cost of funds determination | The process of calculating the weighted average cost of all sources of capital used by a company, including debt and equity, which influences investment decisions. | | Source of funds determination | The process of identifying and selecting the most appropriate and cost-effective ways for a business to raise the necessary capital for its operations and investments. | | Risk analysis | The systematic identification, assessment, and evaluation of potential risks that could impact a business's financial performance or objectives, enabling mitigation strategies. | | Investment | The allocation of capital with the expectation of generating future income or profit; in finance, this involves selecting assets or projects that offer the best risk-adjusted returns. | | Efficient resource allocation | The strategic deployment of a company's limited resources, including financial capital, to their most productive uses to maximize output and achieve organizational goals. | | Assets management | The process of overseeing and controlling a company's assets, including both tangible and intangible assets, to ensure they are utilized effectively and generate optimal returns. | | Liquidity management | The practice of managing a company's cash flows and short-term assets and liabilities to ensure it can meet its immediate financial obligations. | | Bonds | A type of debt instrument where an issuer owes the holders a debt and is obliged to pay interest (the coupon) and repay the principal at a later date (the maturity). | | Price and yield relationship (for bonds) | An inverse relationship where as the price of a bond increases, its yield to maturity decreases, and vice versa, assuming other factors remain constant. | | Portfolio diversification | A strategy of investing in a variety of assets to reduce overall risk; holding different asset classes, including bonds and stocks, can help mitigate losses. | | YTM (Yield to Maturity) | The total return anticipated on a bond if the bond is held until it matures, calculated by considering the current market price, par value, coupon interest rate, and time to maturity. | | YTC (Yield to Call) | The return anticipated on a bond if the bond is held until its call date, which is typically before its maturity date; it assumes the issuer will exercise the call option. | | FCV (Face Value) | The nominal value of a bond, which is the amount the issuer promises to pay the bondholder at maturity; it is also known as the par value. | | Zero-coupon bonds | Bonds that do not pay periodic interest but are issued at a discount to their face value and pay the full face value at maturity; the investor's return is the difference between the purchase price and the face value. | | Discounted price | A price at which a bond is sold for less than its face value, typically used for zero-coupon bonds or when market interest rates rise above the bond's coupon rate. | | Discount factor | A factor used in discounting future cash flows back to their present value; it reflects the time value of money and the required rate of return. | | Coupon rate | The annual interest rate paid on a bond's face value, expressed as a percentage; this is the rate used to calculate the periodic interest payments. | | Current yield | The annual interest payment of a bond divided by its current market price, providing a measure of the income return on the investment based on its present trading value. | | Inflation | A general increase in prices and a fall in the purchasing value of money, which erodes the real return on investments. |