UNIT- 1

INTRODUCTION TO CORPORATE FINANCE

After study this unit, you will understand:
Corporate Finance – An Overview
 Principles of Corporate Finance
Tools of Corporate Finance
The Objective in Corporate Finance
Agency Problem
Corporate Finance – An Overview
Imagine that you were to start your own business.
No matter what type you started, you would have
to answer the following three questions in some
form or another:
What long-term investments should you take on?
That is, what lines of business will you be in and
what sorts of buildings, machinery, and
equipment will you need?
Where will you get the long-term financing to pay
for your investment? Will you bring in other
owners or will you borrow the money?
 How will you manage your everyday financial
activities such as collecting from customers and
paying suppliers?
These are not the only questions by any means,
but they are among the most important.
Corporate finance, broadly speaking, is the study
of ways to answer these three questions.
Therefore, corporate finance could then be
defined as any decisions made by a business that
affect its finances.
These decisions can be categorized into
investment decisions, financing decisions and
dividend decisions.
Corporate finance is the area of finance dealing
with
the sources of funding,
the capital structure of corporations and
the actions that managers take to increase the value of
the firm to the shareholders,
as well as the tools and analysis used to allocate
financial resources.
Corporate Finance is about decisions made by
corporations. Not all businesses are organized as
corporations.
Corporations have three distinct characteristics:
Corporations are legal entities, i.e. legally distinct from
Corporations
it owners and pay their own taxes,
Corporations have limited liability, which means that
shareholders can only loose their initial investment in
case of bankruptcy,
Corporations have separated ownership and control as
owners are rarely managing the firm.
The objective of the firm is to maximize
shareholder value by increasing the value of the
company's stock.
Although other potential objectives (survive,
maximize market share, maximize profits, etc.)
exist these are consistent with maximizing
shareholder value.
The Financial Manager and Corporation
A striking feature of large corporations is that the
owners (the stockholders) are usually not directly
involved in making business decisions, particularly
on a day-to-day basis.
Instead, the corporation employs managers to
represent the owners’ interests and make
decisions on their behalf.
In a large corporation, the financial manager
would be in charge of answering the three
questions as we raised in the above.
 The financial management function is usually
associated with a top officer of the firm, such as a
vice president of finance or some other chief financial
officer (CFO).
 The chief financial officer of finance coordinates the
activities of the treasurer and the controller.
 The controller’s office handles cost and financial
accounting, tax payments, and management
information systems.
 The treasurer’s office is responsible for managing the
firm’s cash and credit, its financial planning, and its
capital expenditures. (see Figure-1)
 These treasury activities are all related to the three
general questions raised earlier.
Principles of Corporate Finance
All of corporate finance is build on three such
principles, which we term the investment
principle, the financing principle, and the dividend
principle.
The Investment Principle:
This principle states simply that firms should
invest in assets only when they are expected to
earn a return greater than a minimum acceptable
return.
This minimum return, which we term a hurdle
rate, should reflect whether the money is raised
from debt or equity, and what returns those
investing the money could have made elsewhere
on similar investment.
The Financing Principle:
It posits that the mix of debt and equity chosen to
finance investments should maximize the value of
the investments made.
In the context of the hurdle rate specified in the
investment principle, choosing a mix of debt and
equity that minimize this hurdle rate allows the
firm to take more new investments and increase
the value of existing investments.
The dividend principle:
Firms some times cannot find investments that
earn their minimum required return or hurdle
rate.
If this shortfall persists, firms have to return any
cash they generate to the owners.
Tools of Corporate Finance
 In the process of developing the models that can be
used to make sensible investment, financing and
dividend decisions, we will draw on a number of tools
that apply across all these decisions.
 The first of these tools is the time value of the money,
which allows us to compare cash received or paid at
different points in time and to weight them based on
when they occur.
 The second tool is an understanding of financial
statements, since much of the information that we
get and provide in finance comes from these
statements.
 The third tool is an understanding of how to value an
asset.
Not only the above tools but also using the
following tools can help your corporation control
its finances, which will lead to greater efficiencies.
Risk and return,
Futures,
Forwards, and
Options.
 The Objective in Corporate Finance
 An objective specifies what a decision maker is trying to
accomplish, and by so doing, it provides measures that can
be used to choose between alternatives.
 In most firms, it is the managers of the firm, rather than the
owners, who make the decisions about where to invest or
how to raise funds for an investment.
 Thus, if stock price maximization is the objective, a
manager choosing between two alternatives will choose
the one that increases stock price more.
 In most cases, the objective is stated in terms of maximizing
some function or variable (profits, size, value, social
welfare) or minimizing some function or variable (risk,
costs).
 This part of the unit will take you through the models
developed in corporate finance to maximize stakeholders’
wealth.
 The need for an objective
 Overtime, there had been this controversy over the ‘right’
objective to use in corporate finance, though this may seem
somehow difficult to develop.
 Sometimes, questions could arise, why do one objective, why
not have multiple objectives that try to satisfy all sides.
 In the midst of all these competing objectives, an option came
which try to explain the differences using the following reasons:
 If an objective is not chosen, it will be difficult to have
alternative to decision rules.
In corporate finance, the net present value (NPV) is the
best approach to selecting projects.
In this wise, NPV is the objective of maximizing
stakeholders’ wealth.
Without an objective, there would be several approaches
for selecting projects ranging from reasonable ones to
absurd ones.
 If multiple objectives are chosen, we would be faced
with numerous problems.
A theory developed around multiple objectives of equal
weight will create quandaries when it comes to making
decisions.
To illustrate, assume that a firm chooses as its objectives
maximizing market share and maximizing current earnings.
If a project increases both market share and current
earnings, the firm will encounter no problems, but what if
the project being analyzed increases market share while
reducing current earnings?
The firm should not invest in the project if the current
earnings objective is considered, but it should invest in it
based on the market share objective.
If objectives are prioritized, we are faced with the same
stark choices as in the choice of single objective.
Should the top priority be maximizing current
earnings, or should it be maximizing market share?
Because there is no gain from having multiple
objectives, and developing theory becomes much
more difficult with multiple objectives, we should
argue that there should be only one objective.
 The characteristics of the ‘Right’ objective
When it comes to decision making, a firm can
choose between a number of different objectives.
How can it know whether the objective it has
chosen is the “right” objective?
A good objective should have the following
characteristics.
It must be clear and unambiguous:
An ambiguous objective will lead to decision rules
that vary from case to case and from decision
maker to decision maker.
Consider, for instance, a firm whose objective is to
increase growth in the long-term.
This is an ambiguous objective since it does not
answer at least two questions.
The first is growth in what variable?
Is it in revenue, operating earnings, net income,
or earnings per share?
The second is in the definition of the long-term: is
it three years, five years, or a longer period?
 It must come with a clear and timely measure:
 That can be used to evaluate the success or failure of
decisions.
 Objectives that sound good but do not come with a
measurement mechanism are likely to fail.
 For instance, consider a retail firm that defines its
objective as maximizing customer satisfaction.
 Exactly how is customer satisfaction defined, and
how is it to be measure?
 If no good mechanism exists for measuring
customers’ satisfaction with their purchases, not only
will managers be unable to make decisions based on
this objective, but the firm will also have no way of
holding them accountable for any decisions they do
make.
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.
Managers of this firm will then be inclined to
Managers
increase advertising to teenagers, since it will
increase sales.
Doing so, however, may create significant costs for
society that will overwhelm any benefits arising
from the objective.
 Why corporate finance focuses on stock price
maximization
 Even though stock price maximization as an objective
is the narrowest of the value maximization objectives,
it is the most prevalent one.
 There are three reasons for the focus on stock price
maximization in traditional corporate finance.
 The first is that stock prices are the most observable
of all measures that can be used to judge the
performance of a firm.
 Unlike earnings or sales, which are updated once
every quarter or year, stock prices are updated
constantly to reflect new information coming out
about the firm.
 Thus, managers receive instantaneous feedback on
every action they take from investors in markets.
The second reason is that stock prices, in a market
with rational investors, reflect the long-term
effect of the firm’s decisions.
Unlike accounting measures such as earnings or
sales measures such as market share, which
examine the effects of the firm’s decisions on
current operations, the stock price reflects the
long-term effects of this decisions on value.
In a rational market, the stock price represents
the investors’ attempt to measure this value.
Finally, the stock price is a real measure of
stockholder wealth, since stockholders can sell
their stock and receive the price now.
Thus, when firms maximize stock prices,
stockholders can cash in on the gain immediately,
if they so desire.
 When is stock price maximization the only
objective a firm needs?
In classical corporate finance, the managers of
firms need to concentrate only on maximizing
stock prices and can set aside all other concerns
they might have for other claim holders.
Although this single-mindedness sounds extreme
and may actually be damaging to other claim
holders in the firm (lenders, employees, and
society), it is appropriate if the following
assumptions hold.
1. The managers of the firm put aside their own
objectives and focus on maximizing stockholder
wealth as measured by the stock prices.
 This might occur either because they are terrified
of the power stockholders have to replace them
or because they own enough stock in the firm
that maximizing stockholder wealth becomes
their primary objective as well.
2. The lenders to the firm feel secure that their interests
will be protected and that the firm will live up to its
contractual obligations.
 This might occur for one of two reasons.
 The first is that stockholders might be concerned
about the damage to the firm’s reputation if they
take actions that hurt lenders and about the
consequence of that damage for future borrowing.
 The second is that lenders might be able to protect
themselves fully when they lend by writing in the
restrictions (covenants) that proscribe the firm’s
taking any actions that hurt the lenders.
3. The managers of the firm do not attempt to
mislead or lie to financial markets about their
future prospects, and there is sufficient
information for markets to make judgments about
the effects the firm’s actions on its value.
 Markets are assumed to be reasoned and rational
in their assessment of these actions and the
consequent effects on stock price.
4. There are no burdens that are created for society,
in the form of health, pollution, or infrastructure
costs, in the process of stockholders wealth
maximization.
 All costs created by firm in its pursuit of
stockholder wealth maximization can be traced
and charged to the firm.
With these assumptions, no other group is hurt as
stockholders maximize wealth, and stock prices
reflect stockholders wealth.
Consequently, managers can concentrate on one
objective-maximizing stock prices.
Agency Problem
The relationship between stockholders and
management is called an agency relationship.
Such a relationship exists whenever someone (the
principal) hires another (the agent) to represent
his/her interests.
For example, you might hire someone (an agent)
to sell a car that you own while you are away at
the place.
In all such relationships, there is a possibility of
conflict of interest between the principal and the
agent.
Such a conflict is called an agency problem.
Suppose that you hire someone to sell your car
and that you agree to pay that person a flat fee
when he/she sells the car.
The agent’s incentive in this case is to make the
sale, not necessarily to get you the best price.
If you offer a commission of, say, 10 percent of the
sales price instead of a flat fee, then this problem
might not exist.
 In a large corporation, for example, the managers
may enjoy many fringe benefits, such as golf club
memberships, access to private jets, and company
cars.
 These benefits (also called perquisites, or “perks”)
may be useful in conducting business and may help
attract or retain management personnel, but there is
room for abuse.
 What if the managers start spending more time at
the golf course than at their desks?
 What if they use the company jets for personal
travel?
 What if they buy company cars for their teenagers to
drive?
The abuse of perquisites imposes costs on the
firm—and ultimately on the owners of the firm.
There is also a possibility that managers who feel
secure in their positions may not bother to
expend their best efforts toward the business.
This is referred to as shirking, and it too imposes a
cost to the firm.
Another possibility that managers will act in their
own self-interest, rather than in the interest of
the shareholders when those interests clash.
 Finally, to see how management and stockholder
interests might differ, imagine that the firm is
considering a new investment.
 The new investment is expected to favorably impact
the share value, but it is also a relatively risky
venture.
 The owners of the firm will wish to take the
investment (because the stock value will rise), but
management may not because there is the possibility
that things will turn out badly.
 If management does not take the investment, then
the stockholders may lose a valuable opportunity.
 This is one example of an agency cost.
To mitigate the agency problem, the following
agency costs may incur:
1. Monitoring costs are costs incurred by the
principal to monitor or limit the actions of the
agent.
In a corporation, shareholders may require
managers to periodically report on their activities
via audited accounting statements, which are sent
to shareholders.
The accountants’ fees and the management time
lost in preparing such statements are monitoring
costs.
2. Bonding costs are incurred by agents to assure
principals that they will act in the principal’s best
interest.
The name comes from the agent’s promise or
bond to take certain actions.
A manager may enter into a contract that
requires him or her to stay on with the firm even
though another company acquires it.
3. Executive Compensation. Incentives may be
offered in the form of cash bonus and perks that
are linked to certain performance targets.
Stock options that grant managers the right
purchase equity shares at a certain price thereby
giving them a stake in ownership when certain
goals are achieved, and so on.