Corporate Finance

MBA (2022-24)

Rajesh Pathak
Indian Institute of Management, Raipur
Corporate Finance Principles at a Glance
Financing Choices
There are only two ways in which a business can raise money.
• First is Debt.
• Perceived to be a bad thing in the human history, probably, owing to debt leading people into trouble very often.
• The essence of debt is that you promise to make fix payments in the future (interest payments and repaying
principal). If you fail to make those payments, you may lose control of your business.

• The other is Equity. With equity, you do get whatever cash flows are left over after you have made
debt payments (residual claim).
Debt Vs. Equity
Form of Financing: Life-cycle view

Not all firms go through

these phases.
Examples: Tesla, HUL,
ITC, Microsoft, TCS etc.
Transition
• The transitions that we see at firms – from fully owned private businesses to venture
capital, from private to public and subsequent seasoned offerings are all motivated
primarily by the need for capital.

• In each transition, though, there are costs incurred by the existing owners:
• When venture capitalists enter the firm, they will demand their fair share and more of the
ownership of the firm to provide equity.

• When a firm decides to go public, it has to trade off the greater access to capital markets
against the increased disclosure requirements (that emanate from being publicly lists), loss of
control and the transactions costs of going public.
 US Non-Financial Firms

How
companies
Actually
Finance
Themselves
?
Indian Non-Financial Firms
The Adani Group Debt Load
Measuring Financing Mix
• The simplest measure of how much debt and equity a firm is using currently is to look at
the proportion of debt in the total financing. This ratio is called the debt to capital ratio:

• Debt to Capital Ratio = Debt / (Debt + Equity)

• Debt includes all interest bearing liabilities, short term as well as long term. It should also include
other commitments that meet the criteria for debt: contractually pre-set payments that have to be
made, no matter what the firm’s financial standing.

• Equity can be defined either in accounting terms (as book value of equity) or in market value terms
(based upon the current price). The resulting debt ratios can be very different.
Tools/Processes of Raising Indian NFF

Capital & key steps

• VC or PE (Staying Private):
• Money invested to finance a new firm
• Restrictions placed on management by VC/PE
company.
• Funds usually dispersed in stages after certain
level of success.
• Process of Raising:
• Provoke Equity Investor’s Interest
• Valuation and Return Assessment
• Structuring the Deal
• Post-deal Management and exit

US’s NFF
 Steps in Going Public
• Initial Public Offerings (IPO):
• Approval of proposal to raise capital from public by BoD.
• Appointment of lead manager/managing underwriter (LM), usually a merchant banker
• Appointment of other intermediaries (Syndicate) by LM such as registrar, banker, depositories etc.
• The arrangement with the underwriters
• They offer companies procedural and financial advice such as price fixation and responsible to complete the public issue.
• May include Greenshoe option (typically allowing the underwriters to increase the number of shares bought by 15%). SEBI permitted
this in the year 2003 with an intent of post-listing price stabilization.

• Assessment of value and setting up offer details in draft prospectus by LM in consultation with management further approved
by board.
• Filing of prospectus with regulator (SEBI)
• A preliminary prospectus (red herring) is issued, and a preliminary price range is proposed.
• A roadshow is arranged to market the issue to potential investors. The managing underwriter builds a book of potential
demand (book building) and, if appropriate, sets a new preliminary price range.
• Alternate to book building is open auction where bids are invited from investors. Like Treasury auction. Google used this in 2004.
• Announcement advertisement and issue opening (stays open for minimum 5 to maximum 10 days).
• Issue closure followed by allotments and lastly listing of stock on exchange/s
• On average 8% of proceeds from issue turns out to be the cost of a reasonably sized IPO (underwriter’s commission, administrative charges etc).
Survey Evidence on the Motives for Going Public

Source: Brau and Fawcett (2006)

11
Reliance ‘Power’fool IPO and Pricing
Concerns
• In view of power deficits across the country, R-ADAG identified setting up power plants.
• In January, 2008; R-Power came with the then biggest IPO of Rs. 115000 millions with 260 millions
shares.
• Price band: Rs.405- Rs.450 per share with a face value of 10.
• IPO was oversubscribed 115 times (2 times within 50 seconds of opening and around 10 times by the
end of the opening day)
• Grey market premium around 180 so was expected to list over 600.
• On listing date (11th Feb, 2008), after a momentary small upside movement, fell by 13% in three
minutes and closed at 372.5 at EOD (down by >17%).
• Bonus issued (3 for every 5) to nullify the effect of poor debut (brining per share cost around Rs. 270)
but ineffective and was trading at around Rs.100 per share by year end of 2008.
• Never picked up historically and today trades at around Rs. 10/ share.

Project Assignment: List out and discuss the IPO details for your company and its one month
post listing performance on the exchange
Average Initial Returns from Investing in IPOs in
Different Countries (1990-2020)

• Source: T. Loughran, J. R. Ritter, and K. Rydqvist, “Initial Public Offerings: International Insights,” Pacific-Basin Finance Journal 2
(May 1994), pp. 165–199, extended and updated February 2021 on bear.cba.ufl.edu/ritter.
13
IPO Proceeds in the United States and Average First-Day
Returns, 1990–2020

14
 Other Forms of Raising Capital: key steps
• Other forms of equity issue:
• FPO: subsequent public issue when more funds needed
• Fresh Issue Vs. Offer for sale
• Right Issues: issue to exiting shareholders at lower price than market.
• Indian law requires a non-IPO public issue to be sold to existing shareholders first unless passed a special resolution.
• Issue price of a right issue is irrelevant.
• Private placements: issue to select group/person in a privately negotiated deal
• Warrants: rights to buy stock in future at a price predetermined today for a premium paid upfront.
• ADRs/GDRs: equity issue for borrowing in foreign currency.
• Debt Raising:
• Bank Debt:
• Submission of loan application and processing of application - Appraisal of the project and letter of sanction - Acceptance
of T &C by borrower and Execution of loan agreement - Disbursement - Security creation and monitoring of projects
• Corporate Bonds
• Similar process to that of IPO
• Types of bonds: Zero-coupon bonds, Junk bonds, Samurai bonds, Panda bonds, Treasury bonds, Convertible bonds,
Callable/redeemable bonds, Puttable bonds, AT1 Bonds etc.
Value of Rights
 Quick Test: Rights Issues 1

Rights Issue: Issue of securities offered first to current stockholders.

Compute the value of rights for below example
Example
Deutsche Bank needs to raise billion of equity to reduce its debt ratio.
To do so, it offers existing shareholders the right to buy one new share for
every two they currently hold. New shares are priced at
about 35% below preannouncement price of

© McGraw Hill 17
 Soln: Rights Issues 2

Example continued
Imagine just before the rights issue you held two shares of Deutsche Bank
valued at The Deutsche Bank offer would give you the
right to buy one new share for If you take up the offer, what is the
value of the right to buy a new share for is this a good deal?

Value of Right= 18-15.88= 2.12

© McGraw Hill 18
The Financing Mix Question

• In deciding to raise finance for a business, is there an optimal mix of

debt and equity?

• If yes, what is the trade off that lets us determine this optimal mix?
• What are the benefits of using debt instead of equity?
• What are the costs of using debt instead of equity?
The Illusory Benefits of Debt
• At first sight, the benefit of debt seems obvious. The cost of debt is
lower than the cost of equity.

• That benefit is an illusion, though, because debt is cheaper than equity

for a simple reason. The lender gets both first claim on the cash flows
and a contractually pre-set cash flow. The equity investor is last in line
and must demand a higher rate of return than the lender does.

• By borrowing money at a lower rate, you are not making a business

more valuable, but just moving the risk around.
Trade-off
• Benefits of Debt
• Tax Benefits: The tax code is tilted in favour of debt, with interest payments being tax deductible in
most parts of the world, while cash flows to equity are not.

• Adds discipline to management: When managers are sloppy in their project choices, borrowing money
may make them less so.

• Costs of Debt
• Bankruptcy Costs: Borrowing money will increase your expected probability and cost of bankruptcy.

• Agency Costs: What’s good for stockholders is not always what’s good for lenders and that creates
friction and costs.

• Loss of Future Flexibility: Using up debt capacity today will mean that you will not be able to draw on
it in the future.
 Tax-Deductibility
• When you borrow money, you are allowed to deduct interest expenses from your income to arrive at taxable income.
This reduces your taxes.
• When you use equity, you are not allowed to deduct payments to equity (such as dividends) to arrive at taxable
income.

• The dollar tax benefit from the interest payment in any year is a function of your tax rate and the interest payment:
• Tax benefit each year = Tax Rate * Interest Payment
• The caveat is that you need to have the income to cover interest payments to get this tax benefit.
• Would you expect Zomato to raise debt for tax deductibility?

• Proposition 1: Other things being equal, the higher the marginal tax rate of a business, the more debt it will have in
its capital structure.

• The Germany, US, UK or Japan based firm, on average, should hold more debt than firms in most other countries
given their recent tax codes attracting highest of taxes: T/F
• True
• (Ryanair, an Ireland based airline, is probably having lowest debt among airlines around the world given very low corporate tax in Ireland, just around 12%)
• What you expect firms, on average, doing about their debt when corporate tax are reduced in a country
• Zomato I/S
Added Discipline
• If you are managers of a firm with no debt, and you generate high income and cash flows each
year, you tend to become complacent. The complacency can lead to inefficiency and investing
in poor projects. There is little or no cost borne by the managers

• Forcing such a firm to borrow money can be an antidote to the complacency. The managers
now have to ensure that the investments they make will earn at least enough return to cover the
interest expenses. The cost of not doing so is bankruptcy and the loss of such a job.

• The Volvo Analogy for Jensen’s Free cash-flow Argument

• Which of the following firm should consider debt for disciplining managers?
• A Private Business conservatively financed with little debt
• A company with dispersed holding (held by millions of investors) and conservatively financed with little debt
• A company with activist investors and conservatively financed with little debt
Bankruptcy Cost
• The expected bankruptcy cost is a function of two variables-
• the probability of bankruptcy, which will depend upon how uncertain you are about future cash
flows
• the cost of going bankrupt (Enron-$757m; Lehman Bros. $2b (upto 40% of liquidation proceeds)
• Direct costs: Legal and other deadweight Costs
• Indirect costs: Costs arising because people perceive you to be in financial trouble (difficult to measure
but circumstantial evidences indicate their importance)
• Proposition 2: Firms with more volatile earnings and cash flows will have higher
probabilities of bankruptcy at any given level of debt and for any given level of
earnings.
• Proposition 3: Other things being equal, the greater the indirect bankruptcy cost, the
less debt the firm can afford to use for any given level of debt.
• Which can have the least indirect bankruptcy
Customers who shopcost:
at grocery store won’t care much about the default risk
• A grocery store of the store.
• A high-technology firm Low priced and short lived product manufacturers face lower indirect
bankruptcy cost compared to firms selling durable products witch require
• An aircraft mfg. firm? post sales service and support.
Agency Cost
• An agency cost arises whenever you hire someone else to do something for you. It arises because your
interests (as the principal) may deviate from those of the person you hired (as the agent).
• ¨When you lend money to a business, you are allowing the stockholders to use that money in the course
of running that business. Stockholders interests are different from your interests, because
• You (as lender) are interested in getting your money back safely (return of and on money)
• Stockholders are interested in maximizing their wealth (risky bets)

• In some cases, the clash of interests can lead to stockholders

• Investing in riskier projects than you would want them to
• Paying themselves large dividends when you would rather like them keep the cash in the business.

• Proposition 4: Other things being equal, the greater the agency problems associated with lending to a firm, the
less debt the firm can afford to use.
• As a Bank, whom would you consider having highest agency cost of lending or you feel least comfortable lending
• A regulated utility firm
• A Real estate company (Watch the Movie-Other People’s Money)
• A Technology company https://www.youtube.com/watch?v=xJRhrow3Jws
https://www.youtube.com/watch?v=62kxPyNZF3Q&t=108s
Flexibility Loss
• When a firm borrows up to its capacity, it loses the flexibility of financing future
projects with debt.

• Thus, if the firm is faced with an unexpected investment opportunity or a business

shortfall, it will not be able to draw on debt capacity, if it has already used it up.

• Proposition 5: Other things remaining equal, the more uncertain a firm is about
its future financing requirements and projects, the less debt the firm will use for
financing current projects.
A survey Outcome of Chief Financial Officers

CFOs of several large companies provided the following ranking (from most
important to least important) for the factors that they considered important in the
financing decisions Factor Ranking (0-5)
1. Maintain financial flexibility 4.55
2. Ensure long-term survival 4.55
3. Maintain Predictable Source of Funds 4.05
4. Maximize Stock Price 3.99
5. Maintain financial independence 3.88
6. Maintain high debt rating 3.56
7. Maintain comparability with peer group 2.47
Summary
Quick Application Test
• Considering, for a particular firm,
• The potential tax benefits of borrowing
• The benefits of using debt as a disciplinary mechanism
• The potential for expected bankruptcy costs
• The potential for agency costs
• The need for financial flexibility
• Make a wise guess if you would expect your firm to have a high debt ratio or a
low debt ratio?
• Does the firm’s current debt ratio meet your expectations?
Application test
• Let’s consider Tata Motors:
• Advantages
• For Tax benefits:
• Yes (Profitable firm with marginal Tax rate around 33.5%)
• For Added discipline:
• Smaller (owing to concentrated holding (42.5% approx. by promoters, around 30% by various institutions; rest almost equally shared by foreign
and domestic individuals)

• Disadvantages:
• Expected Bankruptcy cost:
• Direct bankruptcy cost exist due to cyclicality in reported revenue and earnings of Tata Motors
• Indirect Bankruptcy cost reasonable due to costly offerings with long term post sales support requirements

• Agency Cost
• Low due to Tata’s large amount of tangible assets, also has family group backing.

• Flexibility Needs
• The flexibility needs should be lower at Tata Motors since it’s almost a mature company with well-established investment needs and
reputation in capital markets.

Assessment: Seems to be tilted in favor of benefits, hence moderate level of debt may be suitable
Tata’s Debt/Equity (X) 1.17 1.14 1.14 (Last 3 Years)
Utopian World View
• There are no taxes
• Managers have stockholder interests at heart and so they pick the projects with utmost care.
• No firm ever goes bankrupt
• Equity investors are honest with lenders; there is no subterfuge or attempt to find loopholes in
loan agreements.
• Firms know their future financing needs with certainty

• What happens to the trade off between debt and equity? How much should a
firm borrow?

• It does not Matter (MM Proposition I)

MM
• In an environment, where there are no taxes, default risk or agency costs,
• capital structure is irrelevant for value of a firm (MM I).
• All else being equal, value of a levered firm would be same as that of an unlevered firm.

• In the Miller Modigliani world:

• A firm's value will be determined by the quality of its investments and not by its financing mix.
• The cost of capital of the firm will not change with leverage. As a firm increases its leverage, the cost of
equity will increase just enough to offset any gains to the leverage (MM-II).
MM Proposition Illustration

Value of an unlevered firm= VU= EL

Value of a levered firm= VL=DL+EL

Hence, Law of one price recommends: VL= VU

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MM Proposition- Home Made Leverage

35
MM Hypothesis with taxes
Effect with Personal Taxes
• Based of firm’s Capital Structure, a rupee of operating income would accrue to investor’s either
as interest income or as equity income (dividend or CG)
• If distributed to equity investors after paying corporate tax (Tc) and equity holders paying Te on individual
income, then investor’s net cash-flows: (1-Tc) (1-Te)
• If paid as interest and bond-holders paying Td, their cash-flows: (1-Td)
If (1-Tc) (1-Te)= (1-Td), firm should be indifferent between debt and equity

• VL = Vu + [1- (1-tc) (1-te))/(1-td)] B

• What if the personal tax rates on both equity and debt income are zero
• What if the personal tax rate on equity is the same as the tax rate on debt
• VL = Vu + tc B
• The tax rate on equity income is just low enough to compensate for the doubletaxation i.e. (1
- td) = (1-tc) (1-te)
• Debt is irrelevant
• If (1 - td) > (1-tc) (1-te), then corporate borrowing is better.
Other Exiting Theories

Traditional Approach NI Approach

What is the optimal

debt level??
Is there a financing hierarchy?

• There are some who argue that firms follow a financing hierarchy, with retained earnings being the
most preferred choice for financing, followed by debt and that new equity is the least preferred choice
(Pecking Order Theory).
• In particular,
• Managers value flexibility.
• Managers value being able to use capital (on new investments or assets) without restrictions on that use
or having to explain its use to others.
• Managers value control.
• Managers like being able to maintain control of their businesses.

With flexibility and control being key factors:

• Would you rather use internal financing (retained earnings) or external financing?
• With external financing, would you rather use debt or equity?
Survey Score (CFOs)

• You are reading the Wall Street Journal and notice a tombstone ad for a company, offering to sell
convertible preferred stock. What would you hypothesize about the health of the company
issuing these securities?
• Nothing
• Healthier than the average firm
• In much more financial trouble than the average firm
Is there an Optimal Debt ratio?
• Important Pathways to Optimal:
• The Cost of Capital Approach: The optimal debt ratio is the one that minimizes the cost of capital for a firm.
• Value of a Firm = Present Value of Cash Flows to the Firm, discounted back at the cost of capital.
• ¨ If the cash flows to the firm are held constant, and the cost of capital is minimized, the value of the firm will be maximized.

• The Sector Approach: The optimal debt ratio is the one that brings the firm closes to its peer group in terms of
financing mix.

• The Life Cycle Approach: The optimal debt ratio is the one that best suits where the firm is in its life cycle.
The U shape Cost of Capital: Illustration
Assume that you are given the costs of equity and debt at different debt levels for a hypothetical firm
and that the after-tax cash flow to this firm is currently $200 million. Assume also that these cash
flows are expected to grow at 3% a year forever, and are unaffected by the debt ratio of the firm. The
cost of capital schedule for the company is presented below:
Mechanics of Cost of Capital
• Estimate the Cost of Equity at different levels of debt:
• Equity will become riskier -> Beta will increase -> Cost of Equity will increase.
• Use of cost of equity models
• Estimation will use levered beta (Beta L) calculation
• Beta UL= Beta L/(1+(1-T)D/E))

BetaL = Betau (1 + (1-t) (D/E))

• Estimate the Cost of Debt at different levels of debt:
• One easy approach is the bond’s YTM on existing bonds/rate on recent loans of
firms
• May not be liquid/not borrowed recently
• Default risk will go up and bond ratings will go down as debt goes up -> Cost of
Debt will increase.
• To estimating synthetic bond ratings, we can use the interest coverage ratio
(EBIT/Interest expense)

• Estimate the Cost of Capital at different levels of debt

• Like previous illustration
• Calculate the effect on Firm Value.
Cost of Debt Estimation(Approx EBIT= $1000)
Sectoral Approach
• The “safest” place for any firm to be is close to the industry average.
• Subjective adjustments can be made to these averages to arrive at the right debt
ratio.
• Higher tax rates -> Higher debt ratios (Tax benefits)
• Lower insider ownership -> Higher debt ratios (Greater discipline)
• More stable income -> Higher debt ratios (Lower bankruptcy costs)
• More intangible assets -> Lower debt ratios (More agency problems)
• Estimation Process:
• Step 1: Run a regression of debt ratios on the variables that you believe determine debt ratios in the sector. For
example, Debt Ratio = a + b (Tax rate) + c (Earnings Variability) + d (ownership) + e (R&D exp). Check this
regression for statistical significance (t statistics) and predictive ability (R squared).
• Step 2: Estimate the values of the proxies for the firm under consideration. Plugging into the cross-sectional
regression, we can obtain an estimate of predicted debt ratio.
• Step 3: Compare the actual debt ratio to the predicted debt ratio.
 Exercise
• Using 2022 data for US listed firms, we looked at the determinants of
the market debt to capital ratio. The regression provides the following
results –
• DFR = 0.27 - 0.24 ETR -0.10 g– 0.065 INST -0.338 CVTO+ 0.59 E/V
(15.79) (9.00) (2.71) (3.55) (3.10) (6.85)
• Where,
• DFR = Debt / ( Debt + Market Value of Equity) Disney had the following values for these inputs in 2022.
• ETR = Effective tax rate in most recent twelve months Estimate the optimal
• INST = % of Shares held by institutions debt ratio using the debt regression.
• CVTO = Std dev in TO in last 10 years/ Average TO in last 10 years Effective Tax Rate (ETR) = 31.02%
• E/V = EBITDA/ (Market Value of Equity + Debt- Cash) Expected Revenue Growth = 6.45%
• g is revenue growth Institutional Holding % (INST) = 70.2%
Coefficient of Variation in TO (CVTO) = 0.0296
EBITDA/Value of firm (E/V) = 9.35%
Optimal Debt Ratio??
Getting to Optimal
Designing the Kind of Debt
• The objective in designing debt is to make the cash flows on debt match up as
closely as possible with the cash flows that the firm makes on its assets.
• By doing so, we reduce our risk of default, increase debt capacity and increase
firm value.
• The perfect financing instrument will
• Have all the tax advantages of debt while preserving the flexibility offered by equity
Hybrid Instrument- Separation of Values
EBIT-EPS Analysis
• EBIT-EPS analysis gives a scientific basis for comparison among various
financial plans and shows ways to maximize EPS.

• Helps to understand how sensitive EPS is to the change in EBIT.

• Indifference point or break-even level

• Refers to the EBIT level at which the EPS is same for two alternative financial plans
 Numerical
Debarathi Co. Ltd., is planning an expansion programme. It requires Rs 230 lakhs of external
financing for which it is considering two alternatives.
• The first alternative calls for issu­ing 150,000 equity shares of Rs 1000 each and 30,000 15% Preference Shares of Rs
100 each and Rs. 5000, 000 8% debentures;
• the second alternative requires 80,000 equity shares of Rs 1000 each, 20,000 15% Preference Shares of Rs 100 each
and Rs 13000,000 8% Debentures.
• The company is in the tax bracket of 30%. At what level of EBIT the company would be indifferent in choosing either
option w.r.t. EPS?

(EBIT - $400,000)(1 - 0.3) - $450,000 (EBIT - $1,040,000)(1 - 0.3) - $300,000

 
=
150,000   80,000
Leverage Based Analysis
• Leverage Types
• Degree of operating leverage (DOL)
• Percentage change in EBIT/ Percentage change in sales (Contribution/EBIT)
• Degree of financial leverage (DFL)
• Percentage change in EBT/ Percentage change in EBIT (EBIT/EBT)
• Degree of total/combined leverage (DTL/DCL)
• DOL*DFL
Numerical
XYZ Ltd. has an average selling price of Rs.10 per unit. Its variable unit costs are
Rs. 7, and fixed costs amount to Rs. 1,70,000. It finances all its assets by equity
funds. It pays 35% tax on its income. ABC Ltd. is identical of XYZ Ltd. except in
the pattern of financing. The latter finances its assets 50% by debt, the interest on
which amounts to Rs. 20,000. Determine the degree of operating, financial and
combined leverage at Rs. 7,00,000 sales for both the firms, and interpret the results:
Practice Question
Consider the following information for companies A and B
Additional Assignments (other than those in project
description)

• Discuss details of your company’s IPO and draw on one year stock market
performance post listing for your firm.

• Compute the optimal cost of capital for your firm using recent one year data

• Compute DOL, DFL and DCL for your firm in the last year.

(take relevant assumptions wherever needed)

Any plagiarism would be severely penalized.
References
• http://people.stern.nyu.edu/adamodar/pdfiles/acf4E/acf4Ebook.pdf
• https://www.ft.com/content/876d46c6-c208-11dc-8fba-0000779fd2ac
• https://icmai.in/Knowledge-Bank/upload/case-study/2014/Debacle-of-Reliance.pdf
• http://pages.stern.nyu.edu/~adamodar/
• http://www.accountingnotes.net/financial-management/capital-structure/top-4-theories-of-capit
al-structure/6792
• http://www.yourarticlelibrary.com/financial-management/capital-structure/capital-structure-of-a
-firm-top-4-approaches-with-calculations/71705

• http://www.yourarticlelibrary.com/financial-management/ebit-eps-analysis-in-leverage-concept-a
dvantages-and-other-details/44224