Corporate Finance

What are the two necessary conditions for a decision situation?

• The existence of alternatives

• The existence of a clearly defined objective

What is the fundamental goal of a business?

To create value for the company’s owners aka maximisation of shareholders wealth.

Who are stakeholders?

individuals or groups who are affected by the activities of the firm.

Why do we focus on a single objective like maximising shareholder wealth?

Clear decisions can be made. Once this decision is made the complications of multiple (conflicting) objectives can be taken Ito account.

Who act as the principals in the principal-agent relationship?

Shareholders

Who act as the agents in the principal-agent relationship?

Managers

What is the principal-agent relationship?

Where one party (the principal) hires another party (the agent) to act on their behalf.

What could be a problem when it comes to the principal-agent relationship?

Shareholders want managers to take decisions that maximise the market value of the firm but management will have their own personal objectives and might not always act in the best interest of the shareholders.

What is maximising vs satisficing?

Managers might do just enough to keep shareholders satisfied but put their remaining efforts into the pursuit of their own objectives.

What is sensitivity analysis?

It incorporates uncertainty into decision making by taking each uncertain factor in turn, and calculates the change that would be necessary in that factor before the original decision is reversed.

What are the strengths of sensitivity analysis?

• There is no complicated theory to understand

• Information will be presented to management in a form which facilitates subjective judgement to decide the likelihood of the various possible outcomes considered.

• It identifies areas which are crucial to the success of the project. If the project is chosen, those areas can be carefully monitored.

What are the weaknesses of sensitivity analysis?

• It assumes that changes to variables can be made independently

• It only identifies how far a variable needs to change; it doesn’t look at the probability of such a change

• It provides information on the basis of which decisions can be made but it does not point to the correct decision directly.

What is overtrading?

Occurs when a business expands its sales and operations too quickly without having the financial resources to support that growth

What are the likely causes of overtrading?

• Growth is achieved by making significant capital investment in production or operations capacity before revenues are generated

• Sales are made on credit and customers take too long to settle amounts owed

• Significant growth in inventories is required in order to trade from the expanding capacity

• A long-term contract requires a business to incur substantial costs before payments are made by customers under the contract

What are the most effective steps to avoid overtrading?

• Introduction of new capital, possibly from shareholders

• Reducing inventory levels

• Scaling back the pace of revenue growth until profit margins and cash reserves have improved

• A reduction in business activity

• Obtaining better payment terms from suppliers

• Enforcing better payment terms with customers

What are the 3 components that make up the cash conversion cycle?

• Days Inventory Outstanding

• Days Sales Outstanding

• Days Payable Outstanding

What is the relationship between the DIO,DSO and DPO

CCC= DIO + DSO - DPO

Explain the significance of the cash conversion cycle in determining the working capital needed by a company.

Investment in working capital must be financed and the longer the cash conversion cycle the more capital is tied up and the higher the cost.

A company could reduce the working capital tied up by optimising the components of the cash conversion cycle. E.g. shortening the inventory conversion period could reduce the working capital requirement and increase profitability.

What is working capital?

• Capital invested in a firms short term assets and liabilities

• Funds a business needs to run day to day operations.

What are the 3 reasons why a firm chooses to hold cash?

1. Transaction motive

2. Precautionary motive

3. Speculative motive

What is the transaction motive?

• To meet the day to day operational payments of the business

• E.g. firms need cash to pay suppliers,wages,taxes,utilities etc

What is the precautionary motive?

• To have cash available for unexpected or uncertain events

• Businesses keep extra cash as a safety buffer against: sudden expenses, delay in receivables collection

What is the speculative motive?

• To take advantage of unexpected opportunities

• Firms hold cash to act quickly on profitable opportunities