INTRODUCTION TO

CORPORATE
FINANCE
RT
Corporate Finance addresses the following four
questions

1. What long-term investments should the firm engage in?

2. How can the firm raise the money for the required
investments?

3. How much short-term cash flow does a company need

to pay its bills?

4. How much should the company pay as dividend?

Main tasks of corporate finance

 Investment Decision
 Capital Budgeting
 Tangible Assets
 i.e. Expanding stores
 Intangible Assets
 i.e. Research and development for new drug
 Financing Decision
 Capital Structure
 Choice between debt and equity financing
 Working capital management
 short-term assets and liabilities (current assets and current
liabilities)

 Dividend Decisions
 Profit distribution
Types of Assets
 Purchase of real assets
 Real Assets: Used to produce goods and services

 Sale of financial assets

 Financial Assets: Financial claims on income
generated by firm’s real assets
 Table 1.1 Recent Investment/ Financing
Decisions
Company Recent Investment Decisions Recent Financing Decisions
Delivers first Dreamliner after investing a
Boeing (U.S.) Reinvests $1.7 billion of profits.
reported $30 billion in development costs.
ExxonMobil Spends $7 billion to develop oil sands at
Spends $12 billion buying back shares.
(U.S.) Fort McMurray in Alberta.
GlaxoSmith- Spends $4 billion on research and
Pays $3.2 billion as dividends.
Kline (UK) development for new drugs.
LVMH LVMH acquires the Italian Jeweler, Pays for the acquisition with a mixture of cash
(France) Bulgari, for $5 billion. and shares.
Procter & Raises 100 billion Japanese yen by an issue of 5-
Spends $8 billion on advertising.
Gamble (U.S.) year bonds.
Opens a plant in India to produce the
Tata Motors
world's cheapest car, the Nano. The facility Raises $400 million by the sale of new shares.
(India)
costs $400 million.
Invests $330 million in 100 new
Union Pacific
locomotives and 10,000 freight cars and Repays $1.4 billion of debt.
(U.S.)
chassis.
Maintains credit lines with its banks that allow
Opens a copper mine at Salobo in Brazil.
Vale (Brazil) the company to borrow at any time up to $1.6
The project cost nearly $2 million.
billion.
Invests 12.7 billion, primarily to open 458 Issues $5 billion of long-term bonds in order to
Walmart (U.S.)
new stores around the world. repay short-term commercial paper borrowings.
Forms of Business Organization

 Three major forms

 Sole proprietorship
 Partnership
 General
 Limited

 Corporation
 Professional corporations
Sole Proprietorship
 A sole proprietorship is a business owned by one
person.
 Low investments are required
Sole Proprietorship
 Advantages
 Easiest to start
 Least regulated
 Single owner keeps all the
profits
 Taxed once as personal
income
 Disadvantages
 Limited to life of owner
 Equity capital limited to
owner’s personal wealth
 Unlimited liability
 Difficult to sell ownership
interest
Partnership
 Two or more persons can get together and form a
partnership.
 General partnership: All partners agree to provide
some fraction of the work and cash and to share the
profits and losses.
 Limited partnership: Liability of some of the partners
are limited to the amount of cash each has contributed.
Partnership
 Advantages
 Two or more owners
 More capital available
 Relatively easy to start
 Income taxed once as
personal income
 Disadvantages
 Unlimited liability
 Partnership dissolves
when one partner dies or
wishes to sell
 Difficult to transfer
ownership
What Is a Corporation?
 Legal entity, owned by shareholders
 Can make contracts, carry on business, borrow, lend,
sue, and be sued
 Shareholders have limited liability and cannot be held
personally responsible for corporation’s debts
Corporation
 Advantages
 Limited liability
 Unlimited life
 Separation of ownership
and management
 Transfer of ownership is
easy
 Easier to raise capital
 Liquidity
 Disadvantages
 Limited control of owners
 Separation of ownership
and management
 Double taxation (income
taxed at the corporate rate
and then dividends taxed
at the personal rate)
Professional Corporations
 Commonly used by doctors, lawyers and
accountants.
 In this case, the business has limited liability, but
the professionals can still be sued personally, for
malpractices.
Role of Financial Managers

To create value, the financial manager should:

1. Try to make smart investment decisions.
2. Try to make smart financing decisions.
 Figure 1.1 Cash Flow between Financial
Markets and Firm’s Operations

(2) (1)

Firm's Financial Financial

operations manager (4a) markets

(3) (4b)

(1) Cash raised from investors

(2) Cash invested in firm
(3) Cash generated by operations
(4a) Cash reinvested
(4b) Cash returned to investors
The Investment Trade-off
 Hurdle Rate/Cost of Capital
 Minimum acceptable rate of return on investment

 Opportunity Cost of Capital

 Investing
in a project eliminates other
opportunities to use invested cash
Figure 1.2 The Investment Trade-off
The Financial Goal of the Corporation

 What should be the goal of a corporation?

 Maximize profit
 Minimize costs
 Maximize market share
 Maximize the market value of the company’s stock
 Contd…

Does this mean we should do anything

and everything to maximize owner’s
wealth?
The Agency Problem

 Shareholders desire wealth maximization

 Managers have many constituencies,

“stakeholders”
 Agency problem

 Conflict of interest between principal and agent

 Agencyrelationship: Stockholders (principals) hire
managers (agents) to run the company
Agency costs

 Agency costs are incurred when:

 Managers do not attempt to maximize firm value

 Shareholders incur costs to monitor managers and

constrain their actions
 Managing Managers
 Tools to Ensure Management Pays Attention to the
Value of the Firm
 Manager’s actions subject to the scrutiny of board of
directors
 Shirkers are likely to find they are ousted by more
energetic managers
 Financial incentives provided, such as stock options
 AN OVERVIEW OF
CORPORATE FINANCING
Patterns of Corporate Financing

 How Firms Raise Funds

 Plowing back profits

 Seeking external financing

Debt sources
Equity sources
Figure 14.1 Sources of Funds: Indian
Nonfinancial Corporations
Table 14.1 Indian Manufacturing
March, 2013 (Millions)
 14-1 Patterns of Corporate Financing

 How Do We Define Debt?

Debt 18,347, 710  30,829,556

  .67
Total assets 73, 799,143

Long-term liabilities 18,347, 710

  0.43
Long-term liabilities  equity 18,347, 710  24, 601,878
Common Stock

 Common Stock
 Residual claim on assets and cash flow
 Mostly held by financial institutions
 Stockholders have ultimate right of control
Figure 14.3 Corporate Equity Holdings, March,
2013
Common Stock
 Preferred Stock
 Takes priority over common stock when
receiving dividends

 Gains some voting rights if corporation fails

to pay preferred dividend
Debt

 Debt Comes in Many Forms

 Short-term versus long-term
 Fixed versus floating rate
 Rupee versus foreign currency
 Senior versus junior debt
 Straight versus convertible bonds
Figure 14.4 Indian. Bond Holdings, March, 2013
Debt
 Debt by Any Other Name
 Some debts treated differently in accounts
 Accounts Payable
 Good received, not yet paid for
 Very short-term debt
 Unfunded obligations
 Senior debt, e.g., employee pensions
 Lease finance
 Do not show up on balance sheet
Figure 14.5 Flow of Savings to Investment

Financial Markets and Institutions

Financial Markets and Institutions
 Financial Markets
 Used to raise money through primary issues
 Allow investors to trade amongst themselves
 Help firms manage risks

 Financial Intermediaries
 Raise money from investors, provide financing
 Banks, insurance companies, investment funds
 Contd…
 Investment Funds
 Mutual Fund
 Raises money by selling shares to investors
 Attempts to beat market

 Money Market Fund

 Invests in short-term safe securities

 Closed-End Fund
 Fixed number of shares
 Contd…
 Exchange-Traded Fund (ETF)
 Portfolio bought or sold in single trade
 Differs from MFs because shares trade like common stock

 Hedge Fund
 Hedge funds are alternative investments using pooled
funds that employ numerous different strategies to
earn high return for their investors.
 Restricted access
 Performance-related fees
 Contd…

 Financial Institutions
 Commercial banks
 Provide loans, safe money storage
 Investment banks
 Assist companies in raising financing
 Advise on takeovers, mergers, and acquisitions
 Insurance companies
 Invest in corporate stocks and bonds
The Role of Financial Markets
and Intermediaries
 Payment Mechanism
 Allows individuals to make and receive
payments quickly and safely over long
distances

 Borrowing and Lending

 Channels savings towards those who can best
use them
The Role of Financial Markets
and Intermediaries

 Pooling Risk
 Allows individuals to share risk, i.e.,
insurance companies

 Information
 Allows estimation of expected rates of
return
Thank you