Theory Structure Objective Function Risk & Return

On Perfect Markets, Moral Hazards, &

Asymmetric Information
BM63002: Corporate Finance

Abhijeet Chandra, PhD

Vinod Gupta School of Management

Indian Institute of Technology Kharagpur

6 January 2020
Theory Structure Objective Function Risk & Return

Dening Finance

Finance is a scientic discipline which studies how to allocate

scarce resources over time under conditions of
uncertainty.

• Resource allocation,
• Time factor, and
• Uncertainty

Examples: Companies initiating a new project; Investing your

savings for future usages such as buying a car; Career choices
(involving investment and future outcomes), and so on.
Theory Structure Objective Function Risk & Return

Major aspects of nance:

• Optimization over time (maximize prots and minimize

risk/costs);

• Valuation of assets (of all types, e.g. nancial assets, real

assets, etc.);

• Management of risk arising out of uncertainty and other

factors.
Theory Structure Objective Function Risk & Return

Finance Theory

• A set of concepts that help to organize one's thinking about

how to allocate resources over time ;

• A set of quantitative models to help us evaluate options,

make decisions, and implement them.
Theory Structure Objective Function Risk & Return

Financial Systems

• The nancial system is dened as the set of markets and

other institutions used for nancial contracting and the
exchange of assets and risks;

• The ultimate function of the system is to satisfy economic

agent's consumption preferences.
Theory Structure Objective Function Risk & Return

Why Should Everyone Study Finance?

• To manage our personal economic and nancial resources,

• Investing our savings,
• Whether to rent or buy a house.
• To deal with the world of business,
• Whether to take up a project,
• Whether to borrow or raise equity funds.
• To pursue interesting and rewarding career opportunities,
• Why not to take a job in nance: http://goo.gl/Vn3Gnq.
• To make informed (??) public choices as a citizen,
• Liberal paternalism; Read Nudge by Richard Thaler and
Cass Sunstein
Theory Structure Objective Function Risk & Return

Finance: Nine Axioms

• The risk-return tradeo: We won't take on additional risk
unless we expect to be compensated with additional return.
• The time value of money: A rupee received today is worth
more than a rupee received in the future.
• Cash is king: Measuring the timing of costs and benets.
• Incremental cash ows: It's only what changes that counts.
• The curse of competitive markets: Why it's hard to nd
exceptionally protable projects.
• Ecient capital markets: The markets are quick and the
prices are right (??)
• The agency problem: Managers won't work for the owners
unless it's in their best interest.
• Taxes bias business decisions.
• Ethical behavior is doing the right thing, and ethical dilemmas
are everywhere in nance.
Theory Structure Objective Function Risk & Return

Structure: Corporate Finance

• Is the business worth it?

• Capital Budgeting
• How do I raise money?
• Capital Structure
• How do I survive, day to day?
• Working Capital Management
• What do I do with prots?
• Dividend Policy
• Misc.
• Other random yet relevant stu!
Theory Structure Objective Function Risk & Return

What about RISK?????

Theory Structure Objective Function Risk & Return

Structure: Investments

• Securitized Borrowings/Loans
• Bonds
• Securitized Ownership
• Stocks
• Portfolio Theory = Optimization
• Allocation + Correlation Issues
• What to optimize?
• Asset Pricing Models
• CAPM, APT, and so on!
Theory Structure Objective Function Risk & Return

The principal - agent conict

• Corporate Governance Framework

• The manager - shareholder relationship
• The director - shareholder relationship

• Dodge vs Ford Motor Co. et al.: owners vs managers

(1919)

• Peregrine - SteadySafe: $265 mn bond underwriting

(1998)

• Cadbury report - The Committee on the Financial

Aspects of Corporate Governance (Adrian Cadbury, 1992)
Theory Structure Objective Function Risk & Return

Finance Decisions of Corporate Entities

• Generating revenue, its consumption and saving decisions,

• Investment decisions, both short term and long term,

• Financing decisions (whether to go for debt or equity),

• Risk-management decisions.
Theory Structure Objective Function Risk & Return

The rst principles of Corporate Finance1

1 Source: Damodaran, 2015

Theory Structure Objective Function Risk & Return

The Classical Objective Function

First principles: Managerial function ⇒ Maximize rm's value
• Stockholders
• Hire and re managers
• through BoD and AGMs
• Maximize stockholder wealth

• Lenders
• Include bondholders
• Lend money
• Protect bondholder interests

• Financial Markets
• Reveal information honestly on time
• Markets are ecient and assess eect on value

• Society
• No direct costs
• All costs can be traced back to rm
Theory Structure Objective Function Risk & Return

Issues with the classical objective function

Value maximization: Utopian perspective!
• Stockholders: Conict of interests
• Less control over managers
• Managers putting self-interest above shareholders

• Lenders/bondholders
• Unprotected bondholders
• e.g. taking up riskier projects, borrowing more on same asstes

• Financial Markets: Ineciency

• Delayed or misleading information
• Over-reaction of markets

• Social costs
• Signicant social costs, e.g. environmental costs.
• Some costs cannot be traced back to rm, e.g. trac, etc
Theory Structure Objective Function Risk & Return

So far, so good...

• Traditional corporate nance theory breaks down:

• Principal-agent problem
• Debt versus equity issue
• Inecient nancial markets
• Huge social costs
• Modify the classical objective function
• TBD!
• Let's get back to the First Principles
• The Investment Decision
• The Financing Decision
• The Dividend Decision
Theory Structure Objective Function Risk & Return

The Investment Decision

Basic premise : Invest your money in assets that earn a return

greater than the minimum acceptable hurdle rate.
1. The return: includes the magnitude and the timing of cash
ows originating out of any such investments, as well as all
side eects.
2. The hurdle rate: reects the risk associated with the
investments, and the mix of debt and equity that is used to
fund the investments.
Theory Structure Objective Function Risk & Return

The Big Picture