Chapter 1: Introduction

What is corporate finance?

1. What long-term investments should the firm choose? (Capital budgeting)
2. Where will we get the long-term financing to pay for the investments? (Capital
structure)
3. How will we manage the daily financial activities of the firm? (Working capital)
Corporate finance, broadly speaking, is the study of ways to answer these three questions.

1.1 FINANCIAL MANAGEMENT DECISIONS

Decisions made by financial manager:

1. Capital budgeting decision
• The process of planning and managing a firm’s long-term investments
• What type of asset should be purchased to help generate expected future cash
inflows?
• Alternate/investment opportunities that are worth more to the firm than they
cost to acquire are considered
• Evaluation criteria: size, timing and risk of future cash flows
2. Capital structure decision
• How much capital has to be raised?
• What is the proportion of debt and equity?
• What type of debt and equity should be used?
• What are the least expensive sources of funds for the firm?
3. Dividend policy decision
• What to do with the net cash flows generated?
• Reinvest them in the business or payout dividend?

1.2 THE TWO BASIC OBJECTIVES OF FINANCIAL MANAGEMENT

1. Profit maximization objective
2. Wealth maximization or shareholder’s wealth maximization objective

PROFIT MAXIMIZATION OBJECTIVE

• For any firm profit maximization is the implied objective
• It is a Yardstick to measure the efficiency of firm
• How is the profit measured??
The profit can be measured in terms of the total accounting profit.
All decisions are evaluated in light of profits. If the result of a decision is perceived to
have a positive effect on the profits, the decision is taken further for implementation.

Limitations of profit maximization objective

1. It ignores the risk
2. The profit maximization concentrates on the profitability only and ignores the
financing aspect of that decision and the risk associated with that financing
3. It ignores the timing of costs and returns
4. The profit maximization as an objective is vague and ambiguous
5. The profit maximization may widen the gap between the perception of the
management and that of the shareholders
 6. The profit maximization borrows the concept of profit from the field of accounting
and thus tends to concentrate on the immediate effect

STOCKHOLDERS WEALTH MAXIMIZATION

• Companies have the primary objective of maximizing shareholder wealth.
• Investors invest in companies by buying their shares. Maximized shareholder wealth
is reflected in,
1. Higher share price
2. Higher dividend payments

THREE KEY ISSUES

• The companies are expected to maximize the wealth of their shareholders by
generating profit from trading operations. . . (cash flow is preferred over profit)
• Return measures should be sufficient to cover the cost of capital
• Taking into account both short and long term perspectives

Factors that investors prefer

1. More value rather than low value

2. Investors prefer to receive a particular cash flow sooner rather than later
3. Investors are generally risk averse… they are willing to pay more for investments
with more certain future cash flows

So, a financial manager can maximize the wealth of shareholders by taking right decision
which are going to affect the size future CFs and its timing and risk associated.

The managers primary objective is stockholders wealth maximization .. Which translates into
maximizing the value of the firm.
 Value of the firm

Value of firm is function of PV of net CFs that the firm is expect to generate in the future and
the expected rate of return at which the SHs are willing to provide funds to the firm. Many
external factors like economic conditions, government regulations etc affects the
determination of the expected cash flows and expected rate of return that the investors
demand.

Problems in implementation:
1. In practice, the share price is subject to the influence of other factors
2. Stakeholder conflict

1.3: Stakeholders
A stakeholder is person or a group who has interest in what the organization does.

Stakeholder Expectation/Need
Better,
• Pay
Employees
• Working conditions
Internal stakeholders:
• Security
People who are
Improvement in,
intimately connected to
• Status
the company.
Managers/Directors • Bonus
• Security
• Pay
• Higher dividends
Connected stakeholders: Shareholders • Capital growth
 People who have Value for money products and
Customers
contractual relationship services
with the company Suppliers Payment made promptly
• Payment of finance and
Finance providers interest
• Security of investment
Environmental pressure Organization decisions should
External stakeholders: groups not harm the environment
People who are directly Company’s activities are within
not related to the Government the legal system of country and
company leads to success of economy
Taking active part in decision
Trade unions
making process

1.4: Stakeholder conflict: Principal agent problem

The conflict may arise between different stakeholders as their needs are different.
•One such conflict is between shareholders (principals) and directors (agents)
Agency theory: where management of business is separated from its ownership
•In case of Joint stock companies shareholders delegate the control to professional managers
•Shareholder has no role in day to day management
•Principals are shareholders and directors are agents

Possible areas of conflict between principal and agent,

1. Management goals … conflicting goals
Agency cost:
a. Direct cost : i) Corporate expenditure; ii) Expense that arise from need
to monitor management actions
b. Indirect cost : lost opportunity
2. Poor control of business
Maximize the resources over which you have control: this could
overemphasize on corporate size or growth
3. Short termism: Managers making decisions to maximize short term profit
4. Managerial compensation: High salaries and benefits given to directors/managers

Mechanism used by large corporations to motivate managers to act in the shareholder’s

best interest:
1. Managerial compensation (Incentive)
2. Shareholder intervention
3. Threat of takeover (hostile takeover)

1.5 Risk and return: dimensions of financial decisions

• Return: the gain/loss expected over a given period of time by the decision maker…
gain/loss on the investment made.
• Risk: variability of expected returns from an investment
 • A financial manager takes various decisions i.e., investment decision, capital structure
decision and dividend decision. A finance manager takes these decisions in the light of
objective of maximization of shareholder's wealth as reflected in the market price of
the share. Wwhen a financial manage takes any decision there are two aspects
associated to it i.e., Risk and return. Risk-return trade off needs to be achieved in decision
making

Financial management, risk-return and value of the firm

Wealth maximization Vs Profit maximization

How is wealth maximization superior to profit maximization?
• Wealth maximization focuses on cash flows
• It takes into account the timing and risk associated
• Corporates – owners are shareholders
• profit maximization may not benefit the shareholders
• wealth maximization criterion which is reflected in value of shares in the
market.

• Society gains and customer needs

• Evaluation of performance of listed firms
• maximization of market value of shares will lead to maximization of the net wealth
of shareholders