1. WHAT IS CORPORATE FINANCE
The division of a company that is concerned with
the financial operation of the company. In
most businesses, corporate finance focuses on
raising money for various projects or ventures.
For investment banks and similar corporations,
corporate finance focuses on the analysis of
corporate acquisitions and other decisions
This is basically about money OBJECTIVES
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2. The primary goal of corporate finance is to
Maximize corporate value while managing the
firm’s financial risks
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3. ANALYSIS OF FINANCIAL STATEMENTS
Primary goal of financial management is to
maximize the stock price, not accounting
measures such as the bottom line or EPS.
Evaluation of accounting statements helps
management appreciate the company’s
performance trends, as well as to forecast where
the company is going
The primary financial statements include:
 The statement of financial position
 The income statement
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4.  The statement of retained earnings or called
statement of changes in equity
 The cash flow statement
OTHERS ARE
 Notes to the financial statements
 Accounting policies
 Statement of financial position-retrospective
restatement
Ratios analysis-important
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5. RATIOS
Solvency and financial strength
Profitability ratios
Earning value ratios (share value)
Efficiency ratios
Gearing/leverage ratios
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6. CONSIDER THESE OBJECTIVES OF FM
Provide support for decision making
Ensure the availability of timely, relevant and
reliable financial and non-financial information
Manage risks
Use resources efficiently, effectively and
economically
Strengthen accountability
Provide a supportive control environment
Comply with authorities and safeguard assets
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7. FINANCIAL PLANNING AND
FORECASTING
What is a plan?-explain this to the students
What is a forecast- explain this to the students
The optimal forecast becomes the budget
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8. CAPITAL BUDGETING TECHNIQUES
 Defined- This is the process of evaluating specific
investment decisions.
 Capital investment decisions are important because:
 They involve huge sums of money
 Hard to discover alternative economic use
 Difficult to get out of the project once funds are
committed
 Aim is to increase owners wealth and thus Control
 Capital used to mean operating assets used in
production
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9. Budget is a plan (activities) that details
projected cash flows during some future
period.
Thus capital budget is an outline of planned
investments in operating assets while capital
budgeting is the whole process of analysing
projects and identifying the ones to include in
the budget accordingly and these the ones
that add to firm’s value
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10. PROJECT CLASSIFICATION
 KEY Categories which firms analyse include:
 Replacement: MAINTENANCE OF BUSINESS-worn-out
or damaged equipments –depends on whether to
continue the business or go into new ventures- no
need of elaborate decision process
 Replacement: COST REDUCTION- detailed analysis
 Expansion of existing products or markets- higher level
decisions within the firm
 Expansion into new products or markets- boards
decision as a part of firm’s strategic plan
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11. Safety and/or environment projects-
mandatory investments to comply with
specific industry requirements
Research and development- may use decision
tree analysis rather than DCF techniques
Long-term contracts- to provide products or
services to specific customers- DCF analysis
necessary
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12. CAPITAL BUDGETING DECISION RULES
There are seven key methods namely
Payback
Discounted payback
Accounting rate of return
Net present value (NVP)
Internal rate of return ( IRR)
Modified internal rate of return (MIRR)
Profitability index
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13. PAYBACK PERIOD
Expected number of years required to cover the
original investment
Payback = year before full recovery +
unrecovered cost at start of year
Cash flow during the year
EXAMPLE
Take two projects X and Y
X= -1000 Y1 500 Y2 400, Y3 300 Y4 100
Y=-1000 Y1 100 Y2 300 Y3 400 Y4 600
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14. EXAMPLE CONT
Required: find payback period and advise which
project should be undertaken if both projects are
mutually exclusive
SOLUTION
X= 2 + 100/300 = 2.33
Y= 3+ 200/600= 3.33
CONCLUSION
 X has the shortest pay back period thus accepted
accordingly.
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15. DISCOUNTED PAYBACK
Here the expected cash flows are discounted
by the project’s cost of capital
Discounted payback period defined as the
number of years required to recover the
investment from discounted net cash flows
EXAMPLE OF OUR PROJECTS X AND Y
Discounting the cash inflows for both projects
assuming a cost of capital of 10%
Use tables accordingly
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16. EXAMPLE CONT
Project X = 2 + 214/225= 2.95 years
Project Y = 3 + 360/410= 3.88 years
Project X is preferred accordingly
Period discounting factor at 10%
1 .9091
2 .8264
3 .7513
4 .6830
5 .6209
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17. PROJECT X
 YEAR CASH FLOW DIS FAC PV BAL
0 -1000 1 -1000 -1000
1 500 .9091 455 -545
2 4OO .8264 331 -214
3 300 .7513 225 11
4 100 .6830 68 79
THUS: 2 + 214/225 = 2.95
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18. PROJECT Y
 Pay back 3 + 360/410 = 3.88
ADVANTAGES OF PAYBACK METHOD
Easy to understand and calculate
Provides some assessment of risk
 in a business environment of rapid technological
changes, new plant and machinery may need to
be replaced sooner than in the past, so a quick
payback on investment is essential
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19. The investment climate today in particular,
demands that investors are rewarded with fast
returns. Many profitable opportunities for
long-term investment are overlooked because
they involve a longer wait for revenues to flow
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20. DISADVANTAGES
Ignores cash flows after the payback period. Cash
flows are regarded as either pre-payback or post-
payback, but the latter tend to be ignored.
Does not measure profitability. Payback takes no
account of the effect on business profitability. Its
sole concern is cash flow
Ignores time value of money
It lacks objectivity. Who decides the length of
optimal payback time? No one does - it is decided
by pitting one investment opportunity against
another.
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21. NB/It is probably best to regard payback as
one of the first methods you use to assess
competing projects. It could be used as an
initial screening tool, but it is inappropriate as
a basis for sophisticated investment decisions
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22. ACCOUNTING RATE OF RETURN (ARR)
Focuses on a project’s net income and not its
cash flow
Is the ratio of the project’s average annual
expected net income to its average investment
Formula
ARR = Average annual income * 100
Average investment
EXAMPLE
Lets Assume the case of our TWO projects X and Y
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23. PROJECT X
Lets further assume that both projects will be
depreciated using the straight line method- in
their useful economic life of FOUR years and
have a scrap value of zero
The depreciation expense = 1000/4= 250 per
year
AVERAGE ANNUAL INCOME= Average cash
flow- Average annual depreciation
Thus: (500+400+300+100)/4=325-250=75
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24. AVERAGE INVESTMENT =Cost + Scrap Value
2
THUS: 1000 + 0/2 = 500
THUS
ARR = 75/500*100= 15%
Lets determine ARR for Project Y- EVERY BODY
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25. PROJECT Y
1,400/4= 350-250= 100
1000+0/2= 500
THUS
ARR = 100/500*100= 20%
CONCLUSION
The ARR method ranks project Y over project X.
If the firm accepts projects with say 18%, Then
accordingly, project Y will be accepted and
project X rejected.
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26. ADVANTAGES OF ARR
Easy to understand and calculate
Managers familiar with the key concepts
Brings into consideration the income earned over
the whole life of project
The idea of return on capital employed is
generally understood and this aids the
comprehension of the accounting rate of return
The minimum required rate of return can be set
with reference to the cost of the finance used by
the company plus the additional return it requires
for its own profit.
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27. DISADVANTAGES OF ARR
Ignores the time value of money
The timing of income arising from alternative
projects is ignored
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28. WHATS MORE ?
We note that the rankings under the ARR
method are exactly the opposite of the ones
based on the Payback method
What's the problem here?
This is an argument we can have right here!
Is it worth?
Probably NO- Because these two method
ignore a very fundamental issue- THE TIME
VALUE of money.
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29. CONCLUSION ON THE TWO METHODS
They both do not give us complete
information on the projects contribution to
the firm’s intrinsic value.
DCF-Discounted Cash Flow techniques are
therefore reliable because they address this
problem
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30. NET PRESENT VALUE (NPV)
Present value (PV) is an accounting term that
measures how money needs to be invested today
in order to finance business initiatives, projects,
and obligations tomorrow
In order to determine the present value of future
costs, accountants use formulas based on the
time value of money. These formulas feature
variables such as the length of time involved and
the prevailing interest rate and/or inflationary
rates
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31. In other words, the present value of an amount
to be received in the future is the discounted face
value considering the length of time
the receipt is deferred and the required rate of
return (or appropriate discount rate under the
circumstances)
Present value is the result of the time value of
money concept, which works in recognition that
today's Shilling is worth more than the same
Shilling received at a future point in time.
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32. NPV PROCEDURE
Find the present value of each cash flow,
including all inflows and outflows, discounted at
the project’s cost of capital
Sum these discounted cash flows; this particular
sum is called the project’s NVP
If the NPV is positive, the project is accepted but
rejected if the NPV is negative
If two projects with positive NPV are mutually
exclusive, the one with the higher NPV is selected
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33. THE FORMULA
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34. The formula (We know it!)
WHERE
 CFt= the expected net cash flow at period t
 r= the projects cost of capital
 n= the projects life
 CF0= a negative number being the cash outflows
NOTE
We can also use the tables of discounted factors
accordingly
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35. EXAMPLES
Lets compute NPV Of both our projects X and
Y
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36. NPV RATIONALE
A NPV of zero signifies that the project’s cash
flows are exactly sufficient to repay the invested
capital and provide the required rate of return on
that capital.
A positive NPV means the project is generating
more cash than needed to service the debt and
to provide the required return to shareholders;
and that this excess cash accrues solely to the
entities stockholders
Positive NPV means the wealth of the
stockholders increases
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37. We may at this stage compare our two projects, X
and Y, and see by how much each of them
increases the shareholders wealth.
NOTE: there is a direct relationship between NPV
and EVA (Economic Value Added- which is the
estimate of a business’s true economic profit for
the year- and represents the residual income that
remains after the cost of all capital, including
equity capital. Quite different from accounting
profit which does not include a charge for equity
capital)
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38. NPV is equal to the present value of the project’s
future EVAs.
Thus accepting a project with positive NPV results
in a positive EVA and a positive MVA (Market
Value Added- being the excess of a firm’s market
value over its book value).
Since entities should in fact reward managers for
producing positive EVA-MVA; then NPV becomes
a better method for making capital budgeting
decisions accordingly.
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39. ACCOUNTING OR ECONOMIC PROFIT
Economic profit = (explicit and implicit
revenue) Minus (explicit and implicit cost)
Accounting Profit = TR (Total Revenue= Price
* Quantity) - (Cost of land) - (cost of labor) –
(cost of capital)
Economic profit = accounting profit – cost of
equity capital
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40. ADVANTAGES OF NPV
Links capital budgeting decisions to EVA-MVA
Recognizes the time value of money
Correct ranking of mutually exclusive projects
Dependent on forecast cash flows and
opportunity cost of capital, instead of
arbitrary guess work by management
No arbitrary guess work
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41. DISADVANTAGES
Possible errors in forecasting
Hard to determine the minimum rate of
return of a project
Other factors which may affect a project’s
structure of cash flows e.g. government
grants, taxation etc
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42. THE INTERNAL RATE OF RETURN
Defined as the discount rate that equates the
present value of a project’s expected cash inflows
to the present value of the project’s costs.
This means:
PV (Inflows) = PV (Investment costs)
Further, this means IRR is simply the rate of
return that forces the NPV to equal to Zero
Formula : CF0 + CFI + CF2 + CFn =0
(1+irr)0 (1+irr)1 (1+irr)2 (1+irr)n
Can use the calculator to solve the equation
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43. ALTERNATIVE FORMULAR TO IRR
IRR = X + x * (Y-X)
x+y
Where
 X = Discount rate for positive NPV
 Y= Discount rate for negative NPV
 x= positive NPV found using X
 y= negative NPV found using Y
 Ignore negative signs
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44. EXAMPLE-OUR PROJECT X AND Y
NOTE- this is a trial and error process-
whereby a higher rate of return (than the
provided cost of capital) is used- until the
result is a negative NPV
Lets use 18% as cost of capital
Discount factors are: YEAR1 .8475, Y2.7182,
Y3.6086,Y4.5158,Y5.4371
Then solve IRR for both projects.
Lets all do it
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45. SOLVED-X
 10 + 78.82 (18-10)
78.82+54
= 14.75
SOLVED Y
10+ 49.18 (18-10)
49.18+ 148
=11.99
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46. DECISION MAKING
Both projects have a cost of capital ( hurdle rate)
of 10%
IRR rule indicates that if the projects are
independent of each other, then the both are
accepted since they earn more than the cost of
capital needed to finance them
If the two projects are mutually exclusive, the
project X ranks higher and should be selected and
Y rejected
If the cost of capital is above 14.75, both projects
will be rejected
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47. NOTE
Both NPV and IRR will always lead to the same
decision (accept or reject) for INDEPENDENT
projects (mathematical reasons)
This so because if NPV is positive, IRR must
exceed r (the cost of capital in NPV)
This scenario is however not true for projects
that are mutually exclusive
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48. IRR RATIONALE
 This particular rate is critical because:The IRR on
a project is the expected rate of return
 If the IRR exceeds the cost of capital (funds used
to finance the project), then a surplus will remain
after paying for the capital. This surplus
 will accrue to the entity’s stockholders
 This means a project whose IRR exceeds its cost
of capital increases shareholders wealth.
 If the IRR is less than the cost of capital, then that
particular project will impose a cost on
stockholders
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49. NOTE: This break-even quality of IRR makes it
fairly useful in evaluating capital projects
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50. NPV VERSUS IRR
NPV is better than IRR in many aspects.
IRR however can not be ignored- popular with
many managers and seriously entrenched into
the business industry
Important to understand why a project with a
lower IRR may be more attractive to a mutually
exclusive one with a higher IRR
Look at the NVP Profile curve SLIDE 56- simply
plots a projects NPV and cost of capital- And if a
project has its cash flows coming in the early
year;
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51. Then its NPV will not decline very much if the
cost of capital increases but a project with
cash flows which come later will be severely
penalized by high capital costs. –Y in our case
and it has a steeper slope
NOTE NPV profiles decline as the cost of
capital increases
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52. EVALUATING INDEPENDENT PROJECTS
Both the NPV and IRR criteria always lead to
the same accept/reject decision
EVALUATING MUTUALLY EXCLUSIVE PROJECTS
If we assume that our projects X and Y are
mutually exclusive
This means we can either choose X or Y or
reject both BUT cannot accept both
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53.  A conflict exists where the cost of capital is less than
the crossover rate- NPV will choose X whereas IRR will
choose Y
 If r is greater than cross point-both NPV and RRR take X
 This conflict is resolved by asking the question- how
useful is it to generate cash flows sooner rather than
later
 This really depends on how on the return we can earn
from those cash flows ie the rate at which we can
reinvest them.
 The NPV assumes that the rate at which cash flows can
be reinvested is the cost of capital
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54. IRR assumes that the firm can reinvest at the
IRR rate
In this particular case, NPV prevails as a better
method since it is better to reinvest at the cost
of capital rather than at IRR rate
Thus where the conflict exist, NPV is used
accordingly
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55. • NPV
• 400
• 300 Ys NPV profile
• Xs NPV profile
• IRR
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56. MULTIPLE IRRs
 This exists if a project is regarded as having nonnormal
cash flows.
 Nonnormal cash flows occur when there is more than
one change in the sign e.g. a project starts with
negative cash flows and switch to positive cash flows
and switch again to negative cash flows
 These kinds of projects can have two or more IRRs
ILLUSTRATION
Imagine a firm is considering the expenditure of Ksh 1.6
million to develop an equipment to manufacture balls.
The balls will produce a cash flow of Ksh 10 million at
the end of year 1.
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57. At the end of year 2, additional Ksh 10 million must be
utilised to expand this project due to increasing
demand due to the upcoming world cup championship
REQUIRED
IRR of the project
SOLUTION
NPV=Ksh 1.6 + Ksh 10 + -Ksh10 = 0
(1+IRR)0 (1+IRR)1 (1+IRR)2
=Ksh 1.6 +Ksh 10 + -Ksh10 = 0
(1+IRR)1 (1+IRR)2
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58. 1.6 (1+IRR)2 = 10(1+IRR) -10
1.6(1+IRR)2= 10 + 10IRR -10
1.6IRR2 + 3.2IRR + 1.6= 10IRR
1.6IRR2 -6.8IRR +1.6 = 0
4IRR2 -17IRR +4 =0
SOLVING EQUATION
IRR = 25% OR 400%
MULTIPLE IRRs
MEANING
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59. 1. If NPV were used, then there would be no
dilema in making the decision
2. if the r were between 25% and 400%, the
NPV would be positive
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60. MODOFIED IRR
NPV prevails over IRR in times of conflict but IRR
continues to be popular and many executives
prefer IRR to NPV because it is apparently easy to
work with a percentage
The idea here is to device a percentage evaluator
that is better than IRR
This is basically done by modifying the IRR rate
and make it a better indicator of relative
profitability and therefore better for use in capital
budgeting
This is called MIRR
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61.  Formula :
 PV OF COSTS= TERMINAL VALUE
(1+MIRR)n
- COF= Cash outflows (negative numbers)
- CIF = cash inflows (positive numbers)
- r= the cost of capital
- The compounded future value of the cash inflows is called the
TERMINAL VALUE (TV)
- The discount rate that makes PV of TV equal to the PV of the costs
is the MIRR
ASSIGNMENT
Lets attempt the MIRR for projects X and Y
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62. PROJECT X
1000= 1579.50
(1 +irr)4
Irr= 12.1%
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63. IRR ADVANTAGES
The rate of return measured is familiar with
managers
 incorporates the time value of money
DISADVANTAGES
Nonnormal cash flows produces multiple IRRs
For mutually exclusive projects, there is conflict
with NPV- although this problem is solved by
MIRR
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64. PROFITABILITY INDEX
Computed as
PI = PV of future cash flows
Initial cost
EXAMPLE PROJECT X
PIX = 1,078.82/1000= 1.079
A project is accepted if its PI is greater than 1
The higher the PI the higher the project’s ranking
SSIGNMENT
Which project would be selected between X and
Y
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