Finance – 1

PGP – 1 : Term 2

Overview – Goals and Functions

K Kiran Kumar
IIM- Indore
Who am I?
Kiran Kumar, K
✓ Education n Research profile
✓ PhD Finance from Indian Institute of Science, Bangalore (2006)
✓ Have about thirty+ research papers and five best research paper awards
✓ Work Experience
✓Professor, IIM Indore June 2019 onwards
✓ Associate Professor, IIM Indore, June 2014 – June 2019
✓ Assistant Professor, National Institute of Securities Markets, Mumbai
✓ Was at ISB in various positions (Researcher, Senior Researcher and Visiting Scholar )
between April 2005 to April 2009
✓ Prior to that, with ICICI Research Centre (2004-05)
✓ Exposure - High Frequency data analysis / Market Microstructure / Derivatives
✓ Extensively dealt with high frequency data in my research
✓ One of very few academics holding proprietary NSE complete order book data
✓ Contact co-ordinates:
✓ kirankumar@iimidr.ac.in / Extn: 514 / 9589314520;

✓ Associate : Ms. Anwesha Sinha anweshinha95@gmail.com

 Finance – I Course Evaluation:
• Quiz : 40%
– Three scheduled quizzes – One quiz for every five sessions
immediately after session # 5, #10 and #15
– Comprises of short problem sets, conceptual questions
(True/False; Multiple choice; Fill up blanks, short problems)
• End Term : 40%
– Covers the entire course
– Comprises of short and long exercises / cases along with
conceptual questions
• Class Preparation, Participation : 20%
– Randomly pick names
– By end of the course, every one will get a chance
 What is Finance?
• Finance is the art and science of managing wealth.
– It is about making decisions regarding what assets to
buy/sell and when to buy/sell these assets.
– Its main objective is to make individuals and their
businesses better off.
• Finance is the study of how people and businesses
evaluate investments and raise capital to fund
them.

Why is it important for you??

 What is corporate finance?
• Every decision that a business makes has financial
implications, and any decision which affects the
finances of a business is a part of corporate finance.

• Defined broadly, everything that a business does fits

under the rubric of corporate finance.
Traditional Accounting Balance Sheet

The Balance Sheet

Assets Liabilities
Current Short-term liabilities of the firm
Long Lived Real Assets Fixed Assets Liabilties
Short-lived Assets Current Assets Debt Debt obligations of firm

Investments in securities & Financial Investments Other

assets of other firms Liabilities Other long-term obligations

Assets which are not physical, Intangible Assets

like patents & trademarks Equity Equity investment in firm

By now…you are very familiar with these….

 Reasoning behind Accounting B/Sheet
• An abiding belief in Book Value as the Best Estimate of Value:
Unless a substantial reason is given to do otherwise, accountants
view the historical cost as the best estimate of the value of an
asset.
• A Distrust of Market or Estimated Value: The market price of an
asset is often viewed as both much too volatile and too easily
manipulated to be used as an estimate of value for an asset.
• A Preference for under estimating value rather than over
estimating it: When there is more than one approach to valuing an
asset, accounting convention takes the view that the more
conservative (lower) estimate of value should be used rather than
the less conservative (higher) estimate of value.
– Exceptions: Current assets are valued close to market value; Banks are
also marked to market; Trend for Fair value accounting
 The Financial View of the Firm
Assets Liabilities
Existing Investments Fixed Claim on cash flows
Generate cashflows today Assets in Place Debt Little or No role in management
Includes long lived (fixed) and Fixed Maturity
short-lived(working Tax Deductible
capital) assets

Expected Value that will be Growth Assets Equity Residual Claim on cash flows
created by future investments Significant Role in management
Perpetual Lives

Growth Assets

Firm vs Equity ?
 Big Picture of Finance I & II
The Three Major Decisions
• The Allocation / Investment decision
– Where do you invest the scarce resources of your business?
– What makes for a good investment?

• The Financing decision

– Where do you raise the funds for these investments?
– Generically, what mix of owner’s money (equity) or borrowed money(debt) do
you use?

• The Dividend Decision

– How much of a firm’s funds should be reinvested in the business and how
much should be returned to the owners?
What are Investment Decisions / Principle?
• Scarce resources → Optimal allocation is required
• Long term and Short term decisions
• Not just those create revenues and profits
– Eg: New product line or expanding to new market
• But also that save money
– Eg: Building a new and more efficient system / machinery
– Even working capital decisions are investment decisions
• How much and What Inventory to maintain
• Whether and how much credit to grant to customers
• How to measure viability of these investments?

• Invest in projects that give a return greater than the minimum

acceptable hurdle rate.
– The hurdle rate should be higher for riskier projects and reflect the financing mix used - owners’ funds
(equity) or borrowed money (debt)
– Returns on projects should be measured based on cash flows generated and the timing of these cash
flows; they should also consider both positive and negative side effects of these projects.
 Financing Decisions : The Choices
• Equity can take different forms:
– For very small businesses: it can be owners investing
their savings
– For slightly larger businesses: it can be venture capital
– For publicly traded firms: it is common stock
• Debt can also take different forms
– For private businesses: it is usually bank loans
– For publicly traded firms: it can take the form of bonds
• Choose a financing mix that minimizes the hurdle
rate and matches the assets being financed.
 What are Financing Decisions / Principle?
• Different claim on cash flows of firm
• Degree of control each exercises on firm?

Debt versus Equity

Fixed Claim Residual Claim

High Priority on cash flows Lowest Priority on cash flows
Tax Deductible Not Tax Deductible
Fixed Maturity Infinite life
No Management Control Management Control

Debt Hybrids (Combinations Equity

of debt and equity)
 The Financing Mix Question
• In deciding to raise financing for a business, is
there an optimal mix of debt and equity?
– If yes, what is the trade off that lets us determine
this optimal mix?
– If not, why not?

Tax benefit; adds discipline to Mgmt / business

Agency costs
What are Dividend Decisions / Principle?
• At some stage or other, all businesses grow
mature

• If there are not enough investments that earn

the hurdle rate, return the cash to
stockholders.
– The form of returns – dividends ,stock buybacks etc - will depend upon the
stockholders’ characteristics.
 Big Picture
Corporate Finance
• Invest in projects that yield a return greater than the minimum
acceptable hurdle rate.
• Choose a financing mix that minimizes the hurdle rate and
matches the assets being financed.
• If there are not enough investments that earn the hurdle rate,
return the cash to stockholders.

• Who will take these decisions and what should be their objective?
 What n Why do we need an objective?

• An objective specifies what a decision maker is

trying to accomplish and by so doing, provides
measures that can be used to choose between
alternatives.

• Why do we need an objective?

– If an objective is not chosen, there is no systematic way to make the decisions that every
business will be confronted with at some point in time.
– A theory developed around multiple objectives of equal weight will create quandaries
when it comes to making decisions.
– The costs of choosing the wrong objective can be significant.
 Characteristics of a Good Objective Function

• It is clear and unambiguous

• It comes with a clear and timely measure that
can be used to evaluate the success or failure of
decisions.
• It does not create costs for other entities or
groups that erase firm-specific benefits and leave
society worse off overall. As an example, assume
that a tobacco company defines its objective to
be revenue growth.
Goal of a Corporation?
• Is it
– Profit Max / Cost Min
– Sales Max
– Cash flow Max , NPV Max
– Sustainability? / Long term profitability max ?
– Stock price Max / Shareholders wealth max
– Employee / Customer satisfaction ?
– Society welfare max ?
 The Objective in Decision Making
• In traditional corporate finance, the objective in decision making is to
maximize the value of the firm.
• A narrower objective is to maximize stockholder wealth. When the
stock is traded and markets are viewed to be efficient, the objective
is to maximize the stock price.

• All other goals of the firm are intermediate ones leading to firm value
maximization, or operate as constraints on firm value maximization.
 Why traditional corporate financial theory often focuses
on maximizing stock prices as opposed to firm value?

• Stock price is easily observable and constantly updated

(unlike other measures of performance, which may not
be as easily observable, and certainly not updated as
frequently).
• If investors are rational, stock prices reflect the wisdom
of decisions, short term and long term, instantaneously.
• The stock price is a real measure of stockholder wealth,
since stockholders can sell their stock and receive the
price now.
 Is stock price maximization the same as profit
maximization?

• No, despite a generally high correlation amongst

stock price, EPS, and cash flow.
• Current stock price relies upon current earnings, as
well as future earnings and cash flow.
• Some actions may cause an increase in earnings, yet
cause the stock price to decrease (and vice versa).
 Maximize stock prices as the only objective function

• For stock price maximization to be the only

objective in decision making, we have to assume
that
– The decision makers (managers) are responsive to the owners (stockholders) of the firm
– Stockholder wealth is not being increased at the expense of bondholders and lenders to
the firm; only then is stockholder wealth maximization consistent with firm value
maximization.
– Markets are efficient; only then will stock prices reflect stockholder wealth.
– There are no significant social costs; only then will firms maximizing value be consistent
with the welfare of all of society.
The Classical Objective Function
STOCKHOLDERS

Hire & fire Maximize

managers stockholder
- Board wealth
- Annual Meeting

Lend Money No Social Costs

BONDHOLDERS Managers SOCIETY
Protect Costs can be
bondholder traced to firm
Interests
Reveal Markets are
information efficient and
honestly and assess effect on
on time value

FINANCIAL MARKETS
 The Agency Cost Problem
• The interests of managers, stockholders, and
bondholders can diverge. What is good for one
group may not necessarily for another.
– Managers may have other interests (job security, perks, compensation) that they put
over stockholder wealth maximization.
– Actions that make stockholders better off (increasing dividends, investing in risky
projects) may make bondholders worse off.
– Actions that increase stock price may not necessarily increase stockholder wealth, if
markets are not efficient or information is imperfect.
– Actions that makes firms better off may create such large social costs that they make
society worse off.

• Agency costs refer to the conflicts of interest that

arise between all of these different groups.
 What can go wrong?
STOCKHOLDERS

Managers put
Have little control their interests
over managers above stockholders

Lend Money Significant Social Costs

BONDHOLDERS Managers SOCIETY
Bondholders can Some costs cannot be
get ripped off traced to firm
Delay bad
news or Markets make
provide mistakes and
misleading can over react
information

FINANCIAL MARKETS
 I. Stockholder Interests vs. Management Interests

• Theory: The stockholders have significant control

over management. The mechanisms for
disciplining management are the annual meeting
and the board of directors.
• Practice: Neither mechanism is as effective in
disciplining management as theory posits.
 The Annual Meeting as a disciplinary venue

• The power of stockholders to act at annual

meetings is diluted by three factors
– Most small stockholders do not go to meetings because the cost of going to the meeting
exceeds the value of their holdings.
– Incumbent management starts off with a clear advantage when it comes to the
exercising of proxies. Proxies that are not voted becomes votes for incumbent
management.
– For large stockholders, the path of least resistance, when confronted by managers that
they do not like, is to vote with their feet.
 II. Stockholders' objectives vs.
Bondholders' objectives
• In theory: there is no conflict of interests
between stockholders and bondholders.
• In practice: Stockholders may maximize their
wealth at the expense of bondholders.
– Increasing dividends significantly: When firms pay cash out as dividends,
lenders to the firm are hurt and stockholders may be helped. This is because
the firm becomes riskier without the cash.
– Taking riskier projects than those agreed to at the outset: Lenders base
interest rates on their perceptions of how risky a firm’s investments are. If
stockholders then take on riskier investments, lenders will be hurt.
– Borrowing more on the same assets: If lenders do not protect themselves, a
firm can borrow more money and make all existing lenders worse off.
 III. Firms and Financial Markets
• In theory: Financial markets are efficient.
Managers convey information honestly and
truthfully to financial markets, and financial
markets make reasoned judgments of 'true
value'. As a consequence-
– A company that invests in good long term projects will be rewarded.
– Short term accounting gimmicks will not lead to increases in market value.
– Stock price performance is a good measure of management performance.

• In practice: There are some holes in the

'Efficient Markets' assumption.
 Are Markets Short Sighted?
Some evidence that they are not..

• There are hundreds of start-up and small firms, with

no earnings expected in the near future, that raise
money on financial markets
• If the evidence suggests anything, it is that markets
do not value current earnings and cash flows enough
and value future earnings and cash flows too much.
– Low PE stocks are underpriced relative to high PE stocks

• The market response to research and development

and investment expenditure is generally positive
 IV. Firms and Society
• In theory: There are no costs associated with the firm
that cannot be traced to the firm and charged to it.
• In practice: Financial decisions can create social costs
and benefits.
– A social cost or benefit is a cost or benefit that accrues to society as a whole and NOT to the
firm making the decision.
• -environmental costs (pollution, health costs, etc..)
• Quality of Life' costs (traffic, housing, safety, etc.)
– Examples of social benefits include:
• creating employment in areas with high unemployment
• supporting development in inner cities
• creating access to goods in areas where such access does not exist
 Traditional corporate financial theory
breaks down when ...
• The interests/objectives of the decision makers in
the firm conflict with the interests of
stockholders.
• Bondholders (Lenders) are not protected against
expropriation by stockholders.
• Financial markets do not operate efficiently, and
stock prices do not reflect the underlying value of
the firm.
• Significant social costs can be created as a by-
product of stock price maximization.
 The Counter Reaction
STOCKHOLDERS

1. More activist Managers of poorly

investors run firms are put
2. Hostile takeovers on notice.

Protect themselves Corporate Good Citizen Constraints

BONDHOLDERS Managers SOCIETY
1. Covenants 1. More laws
2. Collaterals 2. Investor/Customer Backlash
Firms are
punished Investors and
for misleading analysts become
markets more skeptical

FINANCIAL MARKETS
 The Modified Objective Function
• For publicly traded firms in reasonably efficient
markets, where bondholders (lenders) are protected:
– Maximize Stock Price: This will also maximize firm value

• For publicly traded firms in inefficient markets, where

bondholders are protected:
– Maximize stockholder wealth: This will also maximize firm value, but might not maximize the
stock price

• For publicly traded firms in inefficient markets, where

bondholders are not fully protected
– Maximize firm value, though stockholder wealth and stock prices may not be maximized at the
same point.

• For private firms, maximize stockholder wealth (if

lenders are protected) or firm value (if they are not)
What kind of compensation program might
you use to minimize agency problems?

• “Reasonable” annual salary

• Cash (or stock) bonus
• Options to buy stock or actual shares of stock to reward
long-term performance
• Tie bonus/options to EVA

Studies find only a modest positive correlation between CEO compensation and share
prices. Generous pay packages in poor performing companies!!!
 Increasing Shareholder Value
Revenue
• Greater customer service
(higher market share,
increased gross margins).
• Greater product availability

Profitability
• Lower cost of goods sold,
transportation, warehousing,
Costs material handling and
distribution management
costs
Shareholder
value
• Lower raw materials and
finished goods inventory
Working • Shorter ‘order-to-cash’
capital cycles

Invested
capital
•Fewer physical assets (e.g.
Fixed trucks, warehouses, material
capital handling equipment)
 Session plan – Finance I
• Session 2 & 3 – Projecting Financial Statements
• Session 4, 5 & 6 -- Investment Decision (Working Capital)
• Session 7 & 8 – Overview of Financial System & Markets
• Session 9 – Framework to value cash flows (Discounting &
Compounding)
• Session 10 – Valuing Debt instruments (Cost of Debt)
• Session 11 – Valuing un-listed firm &
• Session 12 – Framework of Risk & Return
• Session 13 – CAPM (Cost of Equity)
• Session 14 – Efficient Markets – Predicting future returns ?
• Session 15 – Behavioral Finance and tie up topics covered to
Firm Value Maximization
For Session 2: Review different ratios that you learnt . Match the companies (1), (2), (3), (4) &
(5) with that of selected ratios of (A), (B),(C),(D) and (E).
Identify the Industry: Operating and Competitive characteristics of a company’s industry
greatly influence its investment in the various types of assets, the riskiness of these investments
and the financial structure of its balance sheet.
Match following companies with their corresponding b/s and financial ratios for the year 2009
(1) Electric Utility (4) Automated test equipment / systems comp
(2) Japanese Automobile Manufacturer (5) Upscale apparel retailer
(3) Discount general merchandise retailer