MBI 2020-2021 Corporate Finance Session 1 Course Outline Introduction To Corporate Finance

MBI 2020-2021
CORPORATE FINANCE
SESSION ONE PRESENTATION
COURSE OUTLINE & INTRODUCTION
TO CORPORATE FINANCE
Corporate Finance session 1 presenation

1
by: CPA Erasmus Mugerwa Musisi
Course Purpose and objectives
Course Purpose
This course is aimed at equipping students with skills in
corporate financial policy; finance planning, decision
making and control.
Course objectives
At the end of the course students should be able to:-
• Show an understanding of the key financial sources and
how they meet the financial needs of an organization.
• Demonstrate skills and competence in corporate
financial planning.

2
Course objectives continued
• Appreciate the role and efficiency of the
capital markets
• Understand the nature and importance of
capital structure and the cost of capital
• Comprehend and apply the principles of
working capital management
• Grasp the influence of global and multi
national operations on corporate financial
management.
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Course Content
COURSE UNIT DETAILS WEE
K
1 1
Financial i. Meaning of corporate finance
objectives ii. Key financial management decisions
iii. Financial functions in an organization
iv. Types of companies and key objective of a
firm
v. Regulatory framework of companies
vi. Management versus shareholder
relationship
vii. Objectives of multinational companies
viii. Objectives of public sector

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CONTENTS
2 2
Financial i. Types of planning
planning ii. Forecasting and budgeting
iii.Cash management
iv. Government influence on
financial management
v. Problems associated with public
sector financing.

5
Course Content continued
3 Financial i. Importance of financial markets 3
markets ii. Advisors to share issues
iii. Other sources of finance
iv. The capital market and money markets
v. Impact of the markets on market decisions.
4 Share i. Types of share capital 4

capital ii. Methods of issuing shares
iii. Pricing shares
iv. Cost of share issues
v. Share repurchases
vi. Dividend policy

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5 Loan i. Forms of loan capital 5
capital ii. Short term finance
and other iii. International capital markets
sources of iv. Finance for small businesses
finance
6 cost of i. Importance of cost of capital 6
capital ii. Cost of equity
iii. Cost of preference shares
iv. Cost of debt capital
v. Internally generated funds
vi. Weighted average cost of capital
vii. Assessment of risk in the debt vs. equity
decisions
viii. Cost of capital for non profit
organizations
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7
Portfoli i. Meaning of portfolio and importance of 7
o theory portfolio theory
ii. Return on portfolio
iii. Risk and return
iv. Diversification
v. Application of portfolio theory
vi. Limitations of portfolio theory
vii. Market efficiency
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Capital i. Types of risk 8
asset ii. Calculation of betas
pricing iii. Validity of CAPM assumptions
model iv. Testing and use of CAPM
v. CAPM and portfolio management
vi. Arbitrage pricing model
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9 Working i. Importance of working capital 9
capital and ii. Assessment of working capital
cash iii. Overtrading
management iv. Cash management
v. Management of short term finance
vi. Short term investments
vii. Debt portfolio management

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10 Planning i. Management of internally generated 10
and funds
control of ii. Management of stock (economic
working order quantity)
capital iii. just in time
iv. Management of debtors
v. credit control; creditor management.
11 Capital i. Capital expenditure decisions 11
investment ii. Return on investment
appraisal iii. Payback period
iv. Discounted cash flow methods
v. Net present value
vi. Internal rate of return
vii. Profitability index
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viii. Comparisons of methods
12 Planning i. Allowing for risk and uncertainty 12
capital ii. Impact of inflation on investment
investment iii. Capital rationing
decisions iv. Lease versus buy decisions
v. Post completion appraisal
vi. Use of capital asset pricing model

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13
13 Mergers and acquisitions Strategies for growth,
Justification for growth by
acquisition,
Valuation of the acquisition
target
Tactics for acquisitions and
mergers
Success and failure of mergers
and takeovers.
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14 Disinvestment, business failure Withdrawal or abandonment,
and capital reconstruction. Management buy outs
Buy ins, spin offs and sell offs
Demergers
Going private
Symptoms of corporate collapse
Predicting company failure
Company
Corporate Finance session liquidations
1 presenation
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Company reconstruction
Delivery &Assessment:
• Delivery Methods: straight lectures both
virtually through online live classes, case
studies and group participatory methods
• The course will be assessed on the basis of
one- take home course work and one- test
accounting for 40% of the overall score. A
written examination at the end of the
semester will be administered. The final exam
will be a three hour written Exam which will
constitute 60% giving an overall score of
100%.
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REFERENCES
1. Ross, Westerfield & Jaffe: Corporate Finance, Irwin
Publishers
2. Van Horne J.C: “Financial management and policy”
Prentice Hall.”
3. Brealey & Myers: “principles of corporate finance”
McGraw Hill
4. J.M Samuels, F.M. Wilkes & R.C Bray Shaw: Management
of company Finance, Thomson Business Press
5. Brigham and Gapenski: Financial management – Theory
and practice
6. J. F Weston and E.F Brigham: “Essentials of management
finance,” The Dry den Press.
7. M.S.Joel and D. Chew: The revolution in corporate finance,
Blackwell publishing
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Introduction to Corporate finance
Definition of Corporate finance:
Corporate finance is a basic component of how any
organization be it a charity, a profit making
business, a government enterprise or any non
profit making entity is run. Corporate finance means
planning, organising,directing and controlling the
financial activities of an entitry such as
Procurement and utilization of funds of an entity. It
means applying general management principles to
financial resources of an enterprise.
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Definition of corporate finance
continued:
• This is a field of finance dealing with financial
decisions that business enterprises make and the
tools of analysis used to make these decisions.
The primary goal of corporate finance is to
maximize corporate value while managing the
firm's financial risks.
• Although it is in principle different from
managerial finance which studies the financial
decisions of all firms, rather than corporations
alone, the main concepts in the study of
corporate finance are applicable to the financial
problems of all kinds of firms.
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What does corporate finance involve?
• Every decision that a business makes has
financial implications, and any
• Decision which affects the finances of a
business is a corporate finance decision.
• Defined broadly, everything that a business
does fits under the rubric of corporate finance

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• It is the focus on maximizing the value of the business
that gives corporate Finance its focus.
• As a result of this singular objective, we can:
• Choose the right investment decision rule to use, given a
menu of such rules(Investment decision) .
• Determine the right mix of debt and equity for a specific
business(Financing decisions)
• Examine the right amount of cash that should be
returned to the owners of a Business and the right amount
to hold back as cash balance (Dividend decisions).
This occurs at a cost. To the extent that you accept the
objective of maximizing firm value, everything in corporate
finance makes complete sense.

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• Corporate finance is universal…
Every business, small or large, public or private, US or
emerging market, has to make investment, financing and
dividend decisions. The objective in corporate finance for
all of these businesses remains the same: maximizing
shareholder/ corporate value.
• While the constraints and challenges that firms face
can vary dramatically across firms, the first principles of
corporate finance do not change. A publicly traded
firm, with its greater access to capital markets and
more diversified investor base, may have much lower
costs of debt and equity than a private business, but
they both should look for the financing mix that
minimizes their costs of capital.
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• A firm in an emerging market may face greater uncertainty,
when assessing new Investments, than a firm in a developed
market, but both firms should invest only if they believe they
can generate higher returns on their investments .
• The discipline of corporate finance can be divided into long-
term and short-term decisions and techniques. Capital
investment decisions are long-term choices about which
projects receive investment, whether to finance that
investment with equity or debt, and when or whether to pay
dividends to shareholders.
• On the other hand, short term decisions deal with the short-
term balance of current assets and current liabilities; the
focus here is on managing cash, inventories, and short-term
borrowing and lending (working capital management
decisions). by: CPA Erasmus Mugerwa Musisi
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What role does corporate financial
managemnt play ?
1. Forecast of future capital outlays
A finance manager has to make estimations with regard to
capital requirements of the company based on planned
strategies.This will depend upon expected costs, profits,
future programmes and policies of an entity.

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What role does corporate financial
management play ?
2. The proper mix of capital
Once the future capital requirements have been
finalized , the proper capital mix has to be decided.
This involves the proportions of short term and
long-term Debt, preference share capital and equity
that a company shall employ over the strategic
planning horizon. Normally, this will depend on the
analysis of how indebted a company already is and
whether or not it qualifies to issue equity.
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Role of corporate Finance continued
3. Where to source the funds
The entity needs to evaluate all available avenues of
raising funds in terms of flexibility, speed, cost and risk.
These sources include bank loans, venture capital, stock
exchange listings, issue of bonds, among others. With
globalisation,a company in Uganda is no longer limited
to sources that are available in uganda only.Firms can
now have their shares listed across borders,or issue
bonds across borders. With the emergence of the east
African community for insitance,companies in uganda
can look all over East africa for funds
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4.Where to invest
The corporate finance manager has to decide on
where any funds raised should be invested. Each
investment needs to be evaluated in terms of risk
and return. Some forms of investments could have
high returns yet the possibility of loss could equally
be high.

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Role of corporate finance continued
5.Management of earnings
What happens to the net profit after all expenses
and taxes have been paid? Should managemnt
declare dividends to shareholders as a return for
their investments or should all earnings be re-
invested by managemnt to generate future
returns? The decision will depend on the dividend
policy of the company which is also dependent
upon several other factors that we shall discuss
later on.
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6.Working capital management
Every entity requires short term resources for the
day today running of the business. They include;
cash, sufficient stocks and a proper match
between debtors and creditors . Cash is required
for payment of salaries and wages, utility bills,
creditors, meeting current liabilities, maintenance
of enough stocks, purchase of raw materials etc…..

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Role of corporate finance continued
7.Financial analysis and control
When all the above finance decisions have been
implemented, management needs to evaluate and also
exercise control over finances.This can be done through
many techniques like ratio analysis, financial
forecasting, cost and profit control etc…
8. Risk management
This is the identification, evaluation, and prioritization
of risks followed by coordinated and economical
application of resources to minimize, monitor, and
control the probability or impact of unfortunate events
or to maximize the realization of opportunities.
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MAJOR FINANCE DECISION AREAS
1.THE INVESTMENT DECISION
This is also called the capital budgeting decision.
• It is concerned with the longtime assets that the firm
should acquire in order to create capacity.
• The nature of the business determines the types of assets
to be invested in. The investment decision therefore
determines the nature of the business risk for the
company.
• Business risk is the risk that the earnings of the business
will fluctuate due to the nature of business being dealt in
e.g. a fashion industry will have its earnings fluctuating due
to change in tests.

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THE INVESTMENT DECISION
The financial manager will need to:
• Obtain relevant and accurate information regarding
possible alternative investments. Such information will
include cash flows and risks involved in continuing with
such investments.
• Determine the discount rate or required rate of return or
cost of capital most appropriate in determining the
present worth (value) of future benefits from the
investments.
• Use investment appraisal techniques to ascertain the net
worth of the investments.
• Adjust the net-worth obtained for risk and other events, in
order to finally make a decision on whether the asset is30
MAJOR FINANCE DECISION AREAS
2. THE FINANCING DECISION
• How much and from where should funds be
obtained? It is concerned with acquisition of both
short term and long time funds.
• The sources fall into two broad categories viz.
owners capital (equity) and outsiders’ capital
(debt).
• The introduction of debt into the financing of the
firm introduces the element of leverage or
gearing, hence financial risk.
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THE FINANCING DECISION
• Financial risk is the risk that earnings will
fluctuate due to the nature of financing the
investments.
• Fixed financing costs such as agency costs,
bankruptcy costs and interest give rise to
financial leverage.
• Owners’ capital does not carry fixed costs while
debt is associated with fixed financial costs.
Financial risk arises because debt has fixed
financing obligations in form of interest, which
must be met before the shareholders can share
in the available earnings.
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3. THE WORKING CAPITAL
MANAGEMENT DECISION
• This is concerned with which short term assets
should be maintained in the firm so that the long
term capacity acquired through the investment
decision is efficiently operated.
• Short term assets refer to working capital items.
• Short term resources are needed to meet both
expected and un expected events during daily
operations. If the level of working capital is high,
the firm can meet its daily obligations very easily. It
shall also have good relationships with its suppliers
and be able to meet customer targets very easily.

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THE WORKING CAPITAL MANAGEMENT
DECISION
• However, working capital is idle resources i.e. not
producing any return, hence inconsistent with the
objective of earnings and maximizing shareholders’
returns.
• The finance manager must therefore decide on the level of
investment in short term assets. This level should neither
be too low nor too high, but rather what is optimal and
consistent with the objectives of return and risk.
• It should also be noted that investment in working capital
is not a matter of choice. Conditions, under which
businesses operate, dictate the working capital
requirements. However, thesession
Corporate Finance level of working capital is vital
1 presenation
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4. THE DIVIDEND DECISION
• This seeks to determine how much of the
earnings should be retained in the business to
finance further growth or distributed to owners
as dividends.
• If earnings are retained and invested in profitable
and vital ventures, the shareholder is assured of
capital gain or a positive return in future.
• On the other hand, the payment of dividend
resolves uncertainty and reduces the risk
perceived by the shareholders and therefore the
required rate of return demanded is lower,
thereby reducing the overall cost of capital.
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FINANCIAL ANALYSIS AND PLANNING
• Financial decisions are repetitive and continuous.
The finance manager needs to continuously
assess the performance and financial position of
the firm in order to strengthen the already strong
points or address the weak areas where they
arise.
• The finance manager needs also to plan ahead so
that future opportunities are identified and
taken advantage of.
• Financial analysis and planning therefore have
become permanent features in corporate
financial management.
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COMMON FORMS OF BUSINESS
ORGANIZATION
1. Sole proprietorships
Owned and managed by one individual, a sole
proprietorship is not a legal entity. It refers to an
individual who owns the business and is personally
responsible for its debts. Owners may freely mix
business and personal assets, cannot raise capital by
selling an interest in the business and they report all
income and expenses on the owner’s personal tax
return. Such businesses will terminate on the owner’s
death or withdrawal. However, an owner can sell the
business, but can no longer remain the proprietor.
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ORGANIZATION
2. General partnerships
A general partnership is a business organization formed when
two or more individuals or entities form a business for profit.
All partners share in the management and in the profits and
decide matters of ordinary business operations by majority of
the partners or by percentage ownership of each partner.
Each partner is liable for all business debts and bears
responsibility for the actions of each other partners. Each
partner reports partnership income on their individual tax
return. A partnership dissolves on the death or withdrawal of
a partner unless the partnership agreement provides
otherwise. They are relatively easy and inexpensive to form
and require few ongoing formalities.

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ORGANIZATION
3. Limited liability Company
This is a new and flexible business organization of one
or more owners that offers the advantages of liability
protection with the simplicity of a partnership, i.e.
shareholders are not personally liable for business
debts. Limited companies require few ongoing
formalities but usually require periodic filings with the
state and also require annual fees. They are therefore
more expensive to form than partnerships

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Types of organizations
It is important to distinguish between public and private
sector organizations, as they will have very different
characteristics and objectives.
• The Public Sector
These organizations are financed by the state and
they do not operate in order to make a profit but to
provide a public service. Examples of public sector
organizations are Government schools, hospitals,
libraries, police and the national defense.
• The Private Sector
These organizations operate in order to make a profit
and are split into 2 categories:
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Types of organizations
• Non-Limited Companies /organizations
This type of company can be set up with relatively few
formalities. It can be either a sole trader or partnership and
the owner(s) will be personally liable for all of the debts if
the business fails. There is no legal requirement for non-
limited companies to make any of their financial
information public. Non-limited companies are generally
referred to as "businesses".
• Limited Companies
Limited companies can be either privately owned when they
are referred to as private Limited (often abbreviated as Ltd)
or publicly owned (PLC). Some PLC's can sell shares to
members of the public on the stock exchange, unlike private
Ltd companies that cannot.
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Types of companies
The liability for both private Ltd companies 's and PlCs is
limited. This means that if the company fails, the liability
of the company's shareholders is limited to the value of
the shares and not their personal funds. Or, in the case of
companies limited by guarantee (with no share capital)
the liability of its members is limited to the amount their
members wish to contribute to the assets of a company in
the event of it being wound up. Note that for limited
companies, the term in the commercial world to use is
"company.

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Types of companies
• " All Limited companies are legally required to
submit Company Accounts and Annual Returns
every year. This information is available to the
public.
• A limited company has similar rights to a person;
for example it can buy assets, own property and it
can sue or be sued independently of its directors.
It can have detrimental information registered
against it too.

by: CPA Erasmus Mugerwa Musisi 43
Private Limited companies (Ltd )
• Private company limited by shares (Ltd)
This is the most common type of private limited
company. The shareholders' liability is limited to
the amount of unpaid shares that they hold if the
company is wound up. Shareholders can also be
officers of a company. That means that they can
be a director and/or secretary of a company. A
company need only have one director as long as
that sole director is not also the company
secretary.
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Private company limited by guarantee
(Ltd)
The members' liability is limited to the amount they
have agreed to contribute to the company's assets if
wound up. The amount is agreed at the time of
forming the company. A company only needs one
director, and one company secretary who may or
may not be a Director.

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Advantages of limited companies and
LLP's.
1. If a limited company should fail, there is less risk to
personal assets.
2. The status of a company is commonly perceived to
be higher.
3. Registration with the registrar of Companies
protects the company name by law and prevents
anyone else trading with it.
4. The death or resignation of a director does not
affect the structure of the company and it can
continue to trade as before.
5. Companies with very low turnover do not need an
audit, reducing the cost of year-end accounts.
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Disadvantages of limited companies
1. More complex and costly start-up procedure.
2. If the turnover of the company is big, company
accounts need to be submitted every year. This
can be costly as accountants and auditors are
required.
3. More formal and restrictive - you cannot exceed
the powers granted to you by the Articles of
Association.
4. You will not normally be allowed to borrow
money from your company.
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Public Limited companies (PLC)
a) Public Company Limited by Shares (PLC)
The Company’s shares can be offered for sale to
both the general public and shareholders by floating
the shares on the stock markets. Their liability is
limited to the amount unpaid on shares held by
them. They must have a statutory audit, and must
have allotted shares.

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Public limited companies
Advantages
Often, the perception is that
• PLC's are larger,
• more established and
• more stable than the private Ltd companies.
Disadvantages
• Ownership of listed companies can change very quickly.
Other companies can mount takeover bids by buying
shares.
• Formation is relatively complicated and expensive.
• If it is a large PLC, effecting change can be difficult as there
may be a lot of people (shareholders) to consult.
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Modern corporations
A corporation is a legal entity having most of
the rights and duties of a natural person but
with perpetual life and limited liability.
Shareholders of a corporation usually
appoint a Board of Directors (BOD) and the
B.O.D appoints officers for the corporation,
who have the authority to manage the day-
to-day operations of the corporation

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Modern corporations
Shareholders are generally liable for the amount
of their investment in corporate stocks . A
Corporation pays its own taxes and shareholders
pay tax on their dividends. The corporation has its
own legal entity and can survive the death of
owners, partners and shareholders. Corporations
can raise capital through the sale of securities and
can transfer ownership through the transfer of
securities. They require Annual General meetings
(AGM) and require owners and directors to
observe certain formalities. They are more
expensive to form than partnerships and sole
proprietorship. Corporations require periodic
filing with the state and also require annual fees.
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Modern corporations
• The word "corporation" is derived from corpus,
the Latin word for body, or a "body of people."
• A corporation is therefore a formal business
association with a publicly registered charter
recognizing it as a separate legal entity having its
own privileges, and liabilities distinct from those
of its members. There are many different forms of
corporations, most of which are used to conduct
business.
• Corporations exist as a product of corporate law
and their rules balance the interests of the
management who operate the corporation,
creditors, shareholders, and employees who
contribute their labour.
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Modern corporations
• By the end of the 19th century the Sherman Act,
New Jersey allowing holding companies, and
mergers resulted in larger corporations with
dispersed shareholders.
• The 20th century saw a proliferation of enabling
law across the world, which helped to drive
economic booms in many countries before and
after World War I. Starting in the 1980s, many
countries with large state-owned corporations
moved towards privatization, the selling of
publicly owned services and enterprises to
corporations.
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Modern corporations
Deregulation (reducing the regulation of
corporate activity) often accompanied
privatization as part of a laissez-faire policy.
Another major postwar shift was towards the
development of conglomerates, in which large
corporations purchased smaller corporations
to expand their industrial base. Japanese firms
developed a horizontal conglomeration
model, the keiretsu, which was later
duplicated in other countries as well.
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Characteristics of business corporation
Although corporate law varies in different
jurisdictions, there are four core
characteristics of the business corporation:
i. Legal personality
ii. Limited liability
iii. Transferable shares
iv. Centralized management under a board
structure

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Regulatory frame work (Corporate law)
The existence of a corporation requires a
special legal framework and body of law that
specifically grants the corporation legal
personality, and typically views a corporation
as a fictional person, a legal person, or a moral
person (as opposed to a natural person).
Corporate statutes typically empower
corporations to own property, sign binding
contracts, and pay taxes in a capacity separate
from that of its shareholders (who are
sometimes referred to as "members").
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According to Lord Chancellor Haldane, ...a
corporation is an abstraction. It has no mind of
its own any more than it has a body of its own;
its active and directing will must consequently
be sought in the person of somebody who is
really the directing mind and will of the
corporation, the very ego and Centre of the
personality of the corporation.

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The legal personality has two economic
implications:
• First, it grants creditors (as opposed to
shareholders or employees) priority over the
corporate assets upon liquidation. Second,
corporate assets cannot be withdrawn by its
shareholders, nor can the assets of the firm be
taken by personal creditors of its shareholders.
• The second feature requires special legislation
and a special legal framework, as it cannot be
reproduced via standard contract law.
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Principal versus agent relationship
Shareholder management relationship:
There is a divorce between management and
ownership in a modern business organization
(corporation). The decision taking authority in
the organization lies in the hands of the
managers. The objectives of management may
differ from those of the firm’s stockholders. In a
large corporation, the stock may be so widely
held that stock holders cannot even make
known their objectives, and have much less
control or influence to management.
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Principal versus agent relationship
Often ownership and control are separate, a
situation that allows management to act in
its own best interests rather than those of
the shareholders. Shareholders are the
owners of the firm and are the principals and
their agents are the managers to whom they
delegate decision making authority to
conduct and control business on their behalf.

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What Is Agency Theory ?
Agency theory is the branch of financial
economics that looks at conflicts of interest
between people with different interests in
the same assets. This most importantly
means the conflicts between:
1. Shareholders and managers of companies
2. Shareholders and bond holders.

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What Is Agency Theory ?
The theory explains the relationship
between principals, such as a
shareholders, and agents, such as a
company's managers.
In this relationship the principal delegates
(or hires) an agent to perform work on his
behalf. The theory attempts to deal with
two specific problems:
1. How to align the goals of the principal so
that they are not in conflict (agency
problem), and
2. That the principal and agent reconcile
different tolerances for risk.
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Potential Agency Problems
An agency relationship occurs when a principal
hires an agent to perform some duty. A conflict,
known as an "agency problem", arises when
there is a conflict of interest between the needs
of the principal and the needs of the agent. In
finance, the two primary agency relationships
that exist are between:
i. Managers and stockholders
ii. Managers and creditors
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. Stockholders versus Managers
1
If the manager owns less than 100% of the
firm's common stock, a potential agency
problem between managers and
stockholders exists.
Managers, at times, may make decisions that
have the potential to be in conflict with the
best interests of the shareholders. For
example, managers may grow their firm to
escape a takeover attempt to increase their
own job security. However, a takeover may
be in the shareholders' best interest.
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2. Stockholders versus Creditors
• Creditors decide to loan money to a
corporation based on the riskiness of the
company, its capital structure and its
potential capital structure. All of these
factors will affect the company's potential
cash flow, which is the main concern of
creditors.
• Stockholders, however, have control of such
decisions through the managers.
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Stockholders versus Creditors
Since stockholders will make decisions based
on their best interest, a potential agency
problem exists between the stockholders
and creditors. For example, managers could
borrow money to repurchase shares to
lower the corporation's share base and
increase shareholder return. Stockholders
will benefit; however, creditors will be
concerned given the increase in debt that
would affect future cash flows.
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1. SELF-INTERESTED BEHAVIOR
Agency theory suggests that, in imperfect labour
and capital markets, managers will seek to
maximize their own utility at the expense of
corporate shareholders.
Agents have the ability to operate in their own
self-interest rather than in the best interests of
the firm because of asymmetric information
(e.g., managers know better than shareholders
whether they are capable of meeting the
shareholders' objectives) and uncertainty (e.g.,
myriad factors contribute to final outcomes, and
it may not be evident whether the agent directly
caused a given outcome, positive or negative).
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SELF-INTERESTED BEHAVIOR
• Evidence of self-interested managerial
behaviour includes the consumption of some
corporate resources in the form of
perquisites and the avoidance of optimal risk
positions, whereby risk-averse managers by
pass profitable opportunities in which the
firm's shareholders would prefer they invest.
• Outside investors recognize that the firm will
make decisions contrary to their best
interests. Accordingly, investors will discount
the prices they are willing to pay for the
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Managers are supposed to act in the best
interest of shareholders and their actions and
decisions should lead to shareholders wealth
maximization. But in practice, managers may
pursue their own interests and personal goals.
Managers may unfortunately perform any of
the following goals against the wish of their
principal - the shareholders:
 Maximizing their own wealth in the form of
high salaries at the expense of the
shareholders Corporate Finance session 1 presenation
70
 May play safe and create just satisfactory
wealth for shareholders instead of
maximizing it
 They may avoid taking high risk investments
and financing Risks that may otherwise be
necessary to maximize shareholder wealth.
Such self satisfying behavior will frustrate
the objective of shareholder wealth
maximization.
 It is also in the interests of the managers
that the firm survives over the long run.
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 They also wish to enjoy independence and
freedom outside interference, control and
monitoring
Thus the managers’ goals are likely to be directed
towards the goals of survival and self sufficiency.
 A modern firm is complex consisting of multiple
stakeholders such as employees, debt-holders,
consumers, suppliers, government and the society
in which the firm operates. Managers in practice
may thus perceive their role as that of reconciling
the conflicting objectives of stakeholders thereby
compromising the prime objective of shareholder
72
 This possibility of managers pursuing their own
goals is reduced by the oversight roles of the
shareholders and the other different
stakeholders keeping a keen eye on the
managers’ performance to ensure that their
respective interests in the firm are properly
addressed by management actions.
 Despite the existence of such monitoring
mechanisms there still exists a conflict between
shareholders and managers goals.
 Under such a situation, the shareholders wealth
maximization goals should have precedence
over the goals of other stakeholders.
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Agency Problems
That conflict between the interests of
shareholders and those of the managers is what
we call the agency problem in business and it
results into agency costs. Agency costs include:
less than optimum share value of shareholders
and the costs incurred by them to monitor more
frequently the actions of managers and control
their behavior. Monitoring can be done by bonding
the agent, systematically reviewing management
terms and conditions of service, auditing financial
statements and explicitly limiting management
actions.

74
Agency Problems continued
• These monitoring activities necessarily
involve costs leading to an inevitable
separation of ownership and control of a
firm. It is for this reason that the
shareholders must take extra care when
employing management to run the business
on their behalf.
• A high integrity and competent management
may help in reducing the agency costs and
the reverse is true when you employ an
75
incompetent and un trust worthy
Agency problems
• The less the ownership percentage of
managers, the less the likelihood that
they will behave in a manner that is
consistent with maximizing
shareholders’ wealth.
• Agency problems also arise in creditors
and shareholders having different
objectives, thereby causing each party’s
desire to monitor the others.
In practice: Stockholders may maximize
their wealth at the expense of
bondholders.
76
Agency problems
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.

77
Agency Problems
Similarly, the other stakeholders we saw such
as the employees, suppliers, customers and
the community may have different agendas
and may want to monitor the behavior of
shareholders and management. Agency
problems occur in investment, financing and
dividend decisions..

78
Motivating Managers to Act in
Shareholder's Best Interest
The agency theory, considering the potential
conflicts of interest between shareholders
and management may arise as a result of
several factors, some of such factors include:
i. Reward to management
ii. Risk attitudes of management and
shareholders
iii. Takeover decisions by management
iv. Time horizon of management
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Motivating Managers to Act in
Shareholder's Best Interest
Four primary mechanisms are used
to motivate managers to act in
stockholders' best interests:
1. Managerial compensation
2. Direct intervention by stockholders
3. Threat of firing
4. Threat of takeovers

80
1. Managerial Compensation
Managerial compensation should be
constructed not only to retain competent
managers, but to align managers' interests
with those of stockholders as much as
possible. This is typically done with an
annual salary plus performance bonuses and
company shares.

81
Managerial Compensation continued
Company shares are typically distributed to
managers either as:
– Performance shares, where managers will
receive a certain number of shares based on
the company's performance.
– Executive stock options, which allow the
manager to purchase shares at a future date
and price. With the use of stock options,
managers are aligned closer to the interest of
the stockholders as they themselves will be
stockholders.
82
2. Direct Intervention by Stockholders
Today, the majority of a company's stock is
owned by large institutional investors, such
as mutual funds and pensions. As such,
these large institutional stockholders have
the ability to exert influence on managers
and, as a result, the firm's operations.

83
3. Threat of Firing
If stockholders are unhappy with current
management, they can encourage the
existing Board Of Directors to change the
existing management, or stockholders may
even re-elect a new Board Of Directors that
will accomplish the task.

84
4. Threat of Take overs
If a stock price deteriorates because of
management's inability to run the company
effectively, competitors or stockholders may
take a controlling interest in the company
and bring in their own managers.

85
Multinational corporations
• A multinational corporation (MNC) or multinational
enterprise (MNE) is a corporation that is registered
in more than one country or that corporation that
has operations in more than one country. It is a large
corporation which both produces and sells goods or
services in various countries. It can also be referred
to as an international corporation.
• They play an important role in globalization. The first
multinational company was the British East India
Company, founded in 1600. The second
multinational corporation was the Dutch East India
Company, founded March 20, 1602.

86
Objectives of multinational corporations
Multinational corporations are important factors in the
processes of globalization. National and local
governments often compete against one another to
attract MNC facilities because of:
i. The expectation of increased tax revenue,
ii. Employment to the citizens of that particular country
iii. Increased economic activity in a particular country.
iv. Competition, political powers push towards greater
autonomy for corporations, or both.
v. MNCs play an important role in developing the
economies of developing countries like investing in
these countries provides market to the MNC but also
provides employment and choice of multi goods to
the citizens.
87
Criticisms of multinational corporations
Anti-corporate advocates criticize multinational
corporations for entering countries that have low
human rights or environmental standards. Their
arguments are:
i. They claim that multinationals give rise to huge
merged conglomerations that reduce competition
and free enterprise.
ii. They raise capital in host countries but
export(repatriate) the profits.
iii. They exploit countries for their natural resources,
iv. limit workers' wages.
v. They erode traditional cultures.
vi. They challenge national sovereignty.
88
Objectives of public sector corporations
• They are at times referred to as ; government-
owned corporations, state-owned companies,
state-owned entities, state enterprises, publicly
owned corporations, government business
enterprises, commercial government agencies,
public sector undertakings or parastatal
organizations
• These organizations are financed by the state and
they do not operate in order to make a profit but
to provide a public service. Examples of public
sector organizations are schools, hospitals,
libraries, police and the national defense.
89
They are legal entities created by a government to
undertake commercial activities on behalf of an
owner government. Their legal status varies from
being a part of government to stock companies
with a state as a regular stockholder. The defining
characteristics are that they have a distinct legal
form and they are established to operate in
commercial affairs. While they may also have public
policy objectives, they must be differentiated from
other forms of government agencies or state
entities established to pursue purely non-financial
objectives.
90
Government-owned corporations are
common with natural monopolies and
infrastructure such as railways and
telecommunications, strategic goods and
services (mail, weapons), natural resources
and energy, politically sensitive business,
broadcasting, demerit goods (alcohol) and
merit goods (healthcare).

91
END OF SESSION ONE PRESENTATION

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