Welcome to Corporate Finance

Professor Pavle Radicevic

PhD UNSW, Sydney
 Welcome to
Corporate Finance

• Email: Pavle Radicevic, pradicevic@nes.ru, NES 2.08

• TA (to be confirmed at a later date):

– Dmitry Vaskovskiy

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Corporate Finance
Definition (rather loose and imprecise):

Corporate finance is the study of decision-making

with a focus on capital allocation and financial
structure where the objective is to maximize the
value of the firm.

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Corporate Finance
The integrating theme of finance is Valuation
• Where to Invest: Capital Budgeting
– Should you take a particular project? What is it worth?
– How to choose among projects? What to invest it?

• How to Finance: Capital Structure

– How should/can the manager finance these investments?
– Borrow money (banks, suppliers) / sell shares (own funds, partner, IPO) /
other instruments?
– Long-term (banks, IPO) vs short-term (suppliers + cash management)

• How to Distribute Proceeds: Payout Policy

– Reinvest back or return to the owners?
– Dividends vs buybacks ?
These areas are all interrelated and connected through the issue of
valuation!
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Corporate Finance

Core issues:
• Maximization of which Value?
Corporate Governance:
– Agency problems due to information asymmetries
– Conflicts of interests between stakeholders
– How to make the manager maximize the value of the company and not just
her own utility?
– How to divide the rights and responsibilities between different participants in
the corporation (board of directors, managers, shareholders, creditors,
auditors, regulators, and other stakeholders)?

These topics are at the core of Corporate Finance but

beyond the scope of this course and will not to be
covered.
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 Tools

To answer these questions, Finance is a hybrid of

1. Economics
o the science of choosing among trade-offs
2. Statistics (more specifically Probability Theory)
o the science of dealing with uncertainty
3. Accounting
o the language of business

The relative importance is probably in this order, too.

© 2017 Pavle Radicevic 6

 Course Structure

• Intro to Accounting and Financial Analysis (Brief)

• Capital budgeting (investment decisions): how to select
projects (not so brief)
– How to forecast project cash flows?
• Will need some Accounting here

– How to take into account risk and uncertainty?

• Will need some Asset Pricing here

– Selecting projects using investment rules

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 Course Structure

• Capital Structure (financing decisions): how to raise

capital for implementing projects
– How much debt and equity should we issue (if at all)?
I.e. what is the optimal capital structure?
• Effects of taxes
• Effects of costs of financial distress
• Effects of agency problems
• Effects of information asymmetries
• Effects of Private Benefits
• Valuation of projects and firms taking into account
capital structure

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 Valuation

• Valuation is forward looking, not backward looking.

– Value today depends on (cash) flows from here on to
eternity. These cash flows can in turn depend on the
“stock” of your assets today (assets in place).

• Valuation is not easy:

– Simplest formulae, but lots of assumptions.
– Devil in the detail.

• Finance cannot estimate philosophical/moral values.

– However, finance can deal with such values if you can
translate them into a monetary value. Attaching such
values may often be subjective, not objective.
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 Relative vs. Absolute Valuation

• All financial valuation is relative to alternatives.

• The “Law of One Price:” Same things should cost the same.
– A natural extension: Similar things should cost similarly.
– Relative valuation can be easy or hard, depending on the closeness to
alternatives.

• “Easier” valuation:
– One share of PepsiCo vs. one share of Coca Cola.
– 2-room apartment on Arbat St. vs. 1-room apartment in Skolkovo (and
hedonic pricing in general)

• “Harder” valuation:
– Mars Exploration vs. …?
– The value of leaving Antarctica undisturbed vs. ... ?

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 Capital Budgeting

• Capital budgeting is the process of

analyzing investment opportunities and
deciding which ones to accept.

• For this we will need an approach that

can make projects with different timing
and risks comparable.

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 A Project

A project is anything that generates a series of cash flows.

• A bicycle repair shop. Cost: $500.
Expected earnings: $1,000 per month, starting next month, for 24 months.
• A company’s environmental spill cleanup project.
Cash flows: –$5b per year for 5 years.
• An investor deposits $10,000. The bank will repay $12,000 in two years.
• Educational program. Costs $13,000 per year for a few years (in which you could have
earned some salary), and pays off (say, an additional) $20,000 in salary for 30 more
years. Also add the non-monetary benefits and costs.
• A lottery ticket that costs $1, and pays $14,000,000 with some probability.

Projects can range from true physical investments (the bicycle repair shop), to pure
monetary investments (Corporate Debt), to gambles (the lottery ticket) to pure intangibles
(“customer relations”).
Whatever the source of the funds, finance concerns itself primarily with the actual cash
flows coming in and going out. The inside of the “black box” that eats cash and produces
cash is the domain of other disciplines (e.g., microeconomics and production theory,
marketing, etc).
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 A Firm
A firm is a collection of projects, financed by claims, that provide the inflows that
eventually should generate outflows.

• A firm or company invests in various projects.

• These projects generate expenses and produce revenues.
• Revenues in excess of expenses go either to new investments or to the firm’s
claimants.
• Holders of debt and equity are often called financial security holders. Other
claimants can be suppliers who sold the product on credit, or government who
is owed income or sales tax.
• The sum of the value of all claims is, virtually by definition, the value of the
firm.
Firm = “Debt (Loans)” + “Other Liabilities” + “(Levered) Equity”
= “All Future (Net) Payouts”
Firm Value = Value of all current claims
= Value of all future net payouts

If you own all claims, you own the firm!

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The Firm and the Financial Markets

Firm Firm issues securities (A) Financial

markets
Invests
Retained
in current and cash flows (F)
fixed assets
(B) Short-term debt
Cash flow Debt payments Long-term debt
from firm (C) and dividends (E)
Equity shares

Taxes (D)

Ultimately, the firm

must be a cash Government
generating activity. 14
 Corporate Securities as Contingent Claims on Firm Value

• The basic feature of a debt is that it is a promise by

the borrowing firm to repay a fixed dollar amount by
a certain date.

• The shareholder’s claim on firm value is the residual

amount that remains after the debt-holders are paid:
– If the value of the firm is less than the amount promised to
the debt-holders, the shareholders get nothing (Limited
Liability).

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Debt and Equity as Contingent Claims
Payoff to Payoff to
debt holders shareholders
If the value of the
firm is less than $F,
share holders get
nothing.
$F

$F $F
Value of the firm (X) Value of the firm (X)

Debt holders are promised $F. If the value of the firm

is more than $F, share
If the value of the firm is less than $F, they
holders get everything
get the whatever the firm if worth.
above $F.
Algebraically, the bondholder’s Algebraically, the shareholder’s
claim is: Min[$F,$X] 16
claim is: Max[0,$X – $F]
 Forms of Business Organizations

• Sole Proprietorship
• Partnership (General / Limited/ LLC)
• Corporation
• Advantages and Disadvantages
– Liability
– Liquidity and Marketability of Ownership
– Continuity of Existence
– Tax Considerations
– Separation of Ownership and Control

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 Separation of Ownership and Control
Shareholders (principals):
Elect Directors;
Vote on most important decisions (e.g. large transactions,
by-laws, compensation of directors)

Board of Directors:
Major strategic decisions
Monitors, controls and gives advice to managers
Hires, creates incentives, evaluates, fires CEO

Management (agents): Debt holders:

Day-to-day management. Own the company
in case of bankruptcy

Debt
Assets
Equity 18
 Shareholder Objectives (Goals)

• Profit maximization?
• Market share maximization?
• …?

• Value maximization

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 Managerial Objectives

• Managerial goals may be different from shareholder goals

– Expensive perquisites (“perks” of Private Benefits)
– Survival
– Empire building

• Increased growth and size are not necessarily the same thing
as increased shareholder wealth.

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 Separation of Ownership and Control

- Almost necessary in any large company (many owners

and many managers)

- Matching the needs and management skills

- Better access to capital

- Liquidity and existence of the company

- ?

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 Do Shareholders Control Managerial Behavior?

• Shareholders vote for the board of directors, who in

turn hire the management team.
• Contracts can be carefully constructed to be incentive
compatible.
• There is a market for managerial talent—this may
provide market discipline to the managers—they can be
replaced.
• If the managers fail to maximize stock price, they
may be replaced in a hostile takeover.
• What about the firm’s creditors?

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