Corporate Finance

Corporate
• Three forms of business
 Sole-proprietorship (single owner, unlimited liability)
 Partnership (more than one individuals, unlimited liability, partnership
agreement)

 Company or Corporation or Joint Stock Company –

a business entity created by law as an artificial
body distinct from its owners. Its ownership is in
the form of shares.
 Finance
• “is the study of how people allocate scarce resources
over time. (Bodie and Merton, 1998)
• Two feature that distinguish finance from other
allocation of resources
– Spread out over time
– Usually not known with certainty about the future
of allocation of resources.
• E.g., start of a computer business, you have to weigh
costs (spread) and future benefits (uncertain)
 History of Finance (Miller, 1999)...
• Nobel Prizes in Economics for Work in Finance
– Harry Markowitz – “Portfolio Selection” Journal of
finance, 1952
– Merton Miller – (along with Franco Modigliani, the
recipient of Nobel prize in economic) M&M
Propositions– “The Cost of Capital, Corporation
Finance, and the Theory of Investment” American
Economic Review, 1958
– William Sharpe - “Capital Assets Prices: A Theory of
Market Equilibrium Under Conditions of Risk” Journal
of Finance, 1964
 History of Finance (Miller, 1999)
• The Efficient Markets Hypothesis – by Fama
(1970)
• Options – Black-Scholes-Merton formula –
[Fischer Black, Myron Scholes, Robert Merton]
• Future of Finance – Options
 Financial Management
• “Financial Management is concerned with the
acquisition, financing, and management of
assets with some overall goal in mind”. (Horne
and Wachowicz, 2005)
• Three Basic Functions
– Investment Decision (acquisition)
– Financing Decision
– Asset Management Decision
 Decisions of Corporate Finance
(Ross et al.,
• Three Basic functions of Corporate financial
manager.
1. Capital Budgeting: The process of planning and
managing a firm’s long-term investments.
2. Capital Structure: Ways in which the firm obtains and
manages the long-term financing it needs to support
its long-term investments. It is the mixture of debt
and equity maintained by a firm. Also known as
financial structure.
3. Working Capital Management: The management of
firm’ current assets and liabilities.
Figure 1.2

8
 The Goal of the Firm
• Profit Maximization (EPS)
– Not a fair objective as no consideration for:
• Time value of money
• Risk with cash flow stream
• Dividend is not considered
• Society might be ignored.
• Wealth Maximization (market price/share)
– Encompasses different factors (economic, social,
financial)
– Focal judgement of many participants
 The Goal of the Firm...
• Analyse the two objectives from various
aspects:
– Capitalistic System
– Agency Theory
– Stakeholder Theory
– Efficient Market Hypothesis
 1. Capitalistic system (Arnold, 2005)
• Based on free market system...
• If a firm reduce the returns to shareholders;
the investors will switch over the investment
to other firms.....
• Adam Smith (1776, The Wealth of Nations)
also focused that society is best served by the
businesses focusing on returns to the owners.
 Agency Theories
• Agency type I
Adam Smith (1937)
Berle and Means (1932)
Jensen and Meckling (1976)
• Agency type II
(LaPorta and Lopez-de-silanes, (1999)
Demsetz & Lehn, (1985).
• Agency Type III
Damodaran, (1997)
 2. Agency Theory
• Jenson and Meckling (1976)
• A branch of economics relating to the behaviour
of principals (such as owners) and their agents
(such as managers)
• Agent: Individuals authorised by another person
or organisation (principal) to act of the latter’s
behalf.
• Both the parties have conflicting interests.
• Management is interested in “perks”
Agency Theory
 Introduction
Agency theory provides the framework for
discussing the relationships that exist between the
various interest groups in an organization.
It views the firm as a “composite unit” consisting of
separate interest groups.
Each interest group pursues its own interest and
ensures it stands at an advantageous position in
relation to the firm.
Each individual group however recognizes the fact
that its success is a function of the company vis-à-
vis other companies in the same industry.
 Agency theory
• The theory brings out a clear exposition of the
actions of some managers which are not in
consonance with the actions they were to
take, assuming shareholder’s wealth
maximization objective is pursued.
 Agency Relationship
• Agency relationship exists when one person (or a group
of persons) called the Principal, appoints another
person called the Agent to perform some work on its
behalf and gives the agent the appropriate decision-
making authority.
• In the context of Strategic Financial Management, such
relationships occur, among others between:
– Shareholder’s and managers; Type 1
– Majority and Minority Shareholders Type 2 and
– Creditors and shareholders type 3
 Agency Relationship
• It is natural that where such relationship
exists, there is bound to be conflict of interest
which creates a problem known as agency
problem.
• The reason underlining the conflict in the case
of shareholders-managers relationship is the
separation of ownership and control.
 Agency Costs
• Agency costs incur to protect principals
interests and to reduce the possibility that
agents will misbehave
• Monitoring expenditures by principals
• Bonding expenditures by agents
• Residual loss of the principal (“residual loss,” occurs whenever the
actions that would promote the self-interest of the principal differ from those that
would promote the self-interest of the agent, despite monitoring and bonding
activities.)
• Essential sources of agency problems
• Moral hazard more of the agents actions are hidden from the
principal or are costly to observe
 Agency Costs
• Adverse selection the agent posseses information that is, for
the principal unobservable or costly to obtain
• Risk aversion as organisations grow managers become risk
averse
• (they would like to protect their position, managers would
like to max. chance of success by projects that have already
brought success, managers build structures to increase their
chances of control)
 Shareholders vs Managers
• The reason underlining the conflict is the
separation of ownership and control. This
may arise in the following situations:
– Choice of Projects Appraisal Technique
In pursuit of their self-interests, managers may
prefer projects with short lives against those with
long lives. They may therefore want to use
Payback technique instead of the superior Net
Present Value technique.
 Shareholders vs Managers
– Appraisal of Risky Projects
Financial managers may not want to undertake
projects which bring substantial benefits to the
owners, but are highly risky, because of the
negative impact of this risk on their own financial
position. However, this risk has presumably been
well diversified away by the shareholders.
 Shareholders vs Managers
– Gearing
Financial managers may not want the company’s debt to
be unduly large in relation to equities so as to reduce the
financial risk of the company. Financial managers may
however, by doing this, not be taking advantage of tax-
deductible interest cost, where interest is treated by the
tax authorities as a charge against profits.
 Shareholders vs Managers
– Takeover bids
When a company is compulsorily taking over
another company, the target company’s
directors may be resisting such action in order to
protect their own jobs; even though it will bring
greater wealth to the existing shareholders.
 Shareholders vs Managers
– Leveraged Buy-Out
In a leveraged buy-out, the company’s
management borrows funds to purchase the
outstanding shares of the company via a tender
offer (an offer to buy the shares of a company
directly from the shareholders). There is the
possibility that managers might try to drive down
the price of the company’s share just before the
tender offer, so that they can buy the shares at a
bargain price.
 Shareholders vs Managers
– Dividend Policy
This is where financial managers are pursuing an
unduly conservative dividend policy: that is, trying
to keep dividends at a level which is much lower
than the normal level, given the industry norms.
The question , however, is: can the funds not
distributed be utilized better by the shareholders
themselves, if received as dividends?
 Shareholders vs Managers
– Disclosure of Information in the Financial Statements
This is where financial managers “paint” the financial
condition of the company via its balance sheet , rosier
than what it really is. This is known as “window
dressing” or, in a mild form, “creative accounting”. It is
made possible by the open-ended nature of the choice
of accounting policies, when directors prepare financial
statements. For example, directors might want to defer
certain type of expenditure (e.g. advertising) and
capitalize it or put value on intangibles such as patents.
 Shareholders vs Managers
– Ethics
Top management might display certain unethical
practices when it makes some decisions on
operations. Typical examples of such practices are
the degradation of the environment through
pollution and testing of products on human beings.
 Shareholders vs. Managers
• Possible solutions
• Shareholders need to ensure that there is “Goal
congruence”.
• Goal congruence means convergence of the
interests of different groups such that the
overall goal of the company can be achieved.
• It means the need for shareholders to ensure
that managers take actions in accordance with
their expectations and in their best interest.
 Shareholders vs. Managers
• Possible solutions
• The actions necessary to achieve goal congruence are as follows:
– Monitoring
The company needs to monitor every action of management.
However, some costs known as agency costs would be
incurred. This is an expensive way of ensuring goal
congruence. Agency costs would include expenditure that is
necessary to physically monitor the manager and expenditure
to restructure the organization so that bad elements within the
system are removed.
 Shareholders vs. Managers
• Possible solutions
• The actions necessary to achieve goal
congruence are as follows:
– Monitoring
They also include opportunity costs arising from
profits lost when managers take decisions as agents
instead of as owner-managers; decision-making is
slow in the former but fast in the latter.
 Shareholders vs. Managers
• Possible solutions
• The actions necessary to achieve goal
congruence are as follows:
– Compensation via allocation of shares in the
company
In this case costs might not be too prohibitive as
managers would gear their efforts toward
profitability and capital appreciation via cutting
down operational costs including salaries and fringe
benefits and taking less time off duty.
 Shareholders vs. Managers
• Possible solutions
• In between Monitoring and Compensation via allocation of shares in the
company are the following :
– Threat to Dismissal
This may not be effective as ownership in many big companies (where
ownership and control are highly separated) is widely dispersed and
shareholders often find it difficult to speak with one voice. Few
shareholders attend the annual general meetings and, in any case,
directors usually ensure they get enough proxies to support them at
meetings. It should be noted however, that the presence of institutional
investors could weaken the directors strength.
 Shareholders vs. Managers
• Possible solutions
• In between Monitoring and Compensation via allocation of shares
in the company are the following :
– Exposure to Take-over Bid
This could deter managers from taking actions that will be at
variance with share price maximization. If the company’s
earning potentials are being knowingly or unknowingly
suppressed through bad policies and the share is consequently
undervalued, in relation to its value, it may be exposed to
hostile-take-over bid. The result is that some top managers
might lose their jobs and the authorities of those remaining
might be drastically reduced.
 Shareholders vs. Managers
• Possible solutions
• In between Monitoring and Compensation via allocation of shares
in the company are the following :
– Executive Share Option Scheme
This is a performance-based scheme that allows top managers
to buy the shares of the company in future, at a price
determined now. The belief is that this will motivate the
managers to continually take actions that will be pushing up
the share price: the option has value if the price of the share
increases above the originally fixed option purchase price. It
should be noted, however that this scheme may not be
beneficial to managers in a period of market downturn.
 Shareholders vs. Managers
• Possible solutions
• In between Monitoring and Compensation via allocation of shares in the
company are the following :
– Performance Shares
These are shares given to top managers and linked to company’s
performance as mirrored by its fundamentals – earnings per share,
return on capital employed, return on equity, dividend per share and
so on. This scheme is valuable to the extent that it is not affected by
vagaries of the stock market.
 Creditors vs. Shareholders
 The agency problem of creditors and shareholders
(with managers as agents) arises from two situations:
 Capital Investments
Creditors would not like a situation where the acceptance
of a project will add greater business risk than is expected
by them. If this happens, they will increase their required
rate of return and the value of their outstanding debt will
fall. The major concern of creditors here is that if risky
project succeeds, creditors will only receive a fixed amount
(interest income) and shareholders will take all the
benefits’ whereas, if the project fails, they will share the
losses with the owners.
 Creditors vs. Shareholders
• The agency problem of creditors and
shareholders (with managers as agents) arises
from two situations:
– Gearing
Where the company increases its gearing
(debt/equity) ratio to a level that increases
financial risk to more than expected, the value of
the existing debt will fall because the earnings and
assets backing available for this debt will diminish
as a result of the new issue of debt.
 Creditors vs. Shareholders
In – built Solution
Shareholders do try as much as possible not to
exploit creditors as such action may attract
punitive high interest rates, restrictive covenants,
restricted access to capital market, all of which
may result in a fall in the long-term value of the
company’s share. Shareholders would, therefore,
want to continue to maintain good and cordial
relationship with their creditors, as it is by doing
so, that their wealth will be maximized.
 Agency Problem
• How do you resolve these conflicts?
– Monitoring
• Stockholders
• Bondholders
• Board of Directors
• Financial Press
• SEC and other government regulators
• Outside auditors
– Issues opinion regarding whether reports are consistent with
generally accepted accounting standards
– Qualified or unqualified opinion
 Agency Problem
– Incentives
• Provide a compensation package to managers
that try to induce them to act in stockholders’
interest
• Can’t determine this directly
– Difficult to separate effort from luck
• Usually this is performance (or value) based
incentives
– Stock options
 Agency Problem
• Problems with value based compensation
– Difficult to distinguish between effort and
competence, versus luck
– Could be subject to manipulation
• Enron, Fannie Mae,
• Stock options backdating scandal
– Compensation determined by Board
• Sarbanes Oxley: SOX: Compensation Committee must
be independent directors
 Agency Problem
• The Basic problem is how do you measure
performance, and how do you get information
that is unbiased?

• You get what you measure

 Incentive Issues
• Monitoring - Reviewing the actions of managers and
providing incentives to maximize shareholder value.

• Free Rider Problem - When owners rely on the

efforts of others to monitor the company.

• Management Compensation - How to pay managers

so as to reduce the cost and need for monitoring and
to maximize shareholder value.
 Residual Income & EVA

• Emphasizes NPV concepts in performance

evaluation over accounting standards.

• Looks more to long term than short term

decisions.

• More closely tracks shareholder value than

accounting measurements.
 Performance Evaluation
• How do you know if management is doing a
good job or not:
• What you measure is what you get
• Must consider tradeoffs of high early return
versus growth
• You want to capture the economic value of
investment not book values
 Message of EVA
+ Advantages
Managers are motivated to only invest in
projects that earn more than they cost.
EVA makes cost of capital visible to managers.
Leads to a reduction in assets employed.
Present Value of EVA measures NPV and thus
consistent rewarding via EVA leads to good
decisions
- Disavantages
EVA does not directly measure present value
Rewards quick paybacks and ignores time value of
money
 What is Economic Value Added (EVA)
EVA = Residual Income = Income earned –
Income required

= Income earned – Cost of Capital X Capital Invested

Note: Earned income can be written as:
ROI X Book Value of Capital
Income required can be written as:
CoC X Book Value of Capital

SO:
= (ROI – CoC) X BV of Capital
(see spreadsheet)
 Management and Stockholders
• Management objective is different from shareholders...
• If max of profit is the objective then:
– There is conflict in the objectives of the two parties as
management are interested in high salaries which in turn
decrease the profit.
– Agency Problem (Principle (owner) and Management
(agent)
• Management may behave well in line with max shareholder’
wealth.
– The dissatisfied shareholders will sell the shares; so
managers will focus on increasing the value (share price)
 Role of the Board of Directors
• Corporate governance
– refers to the relationship among the board of
directors, top management and shareholders in
determining the direction and performance of the
corporation
– Corporate governance is the system by which
companies are directed and controlled. Boards of
directors are responsible for the governance of
their companies.

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Responsibilities of the Board

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 Responsibilities of the Board
• Due care
– the board is required to direct the affairs of the
corporation but not to manage them
• If a director or the board as a whole fails to act with
due care and, as a result, the corporation is in some
way harmed, the careless director or directors can be
held personally liable for the harm done.

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 Role of the Board in
Strategic Management
• Monitor developments inside and outside the
corporation
• Evaluate and Influence management
proposals, decisions and actions
• Initiate and Determine the corporation’s
mission and strategies

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Board of Directors’ Continuum

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 Members of a Board of Directors
• Inside directors
– typically officers or executives employed by the
corporation
• Outside directors
– may be executives of other firms but are not
employees of the board’s corporation

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 Members of a Board of Directors
• Agency theory
– states that problems arise in corporations because
the agents (top management) are not willing to
bear responsibility for their decisions unless they
own a substantial amount of stock in the
corporation

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 Members of a Board of Directors
• Stewardship theory
– proposes that, because of their long tenure with
the corporation, insiders (senior executives) tend
to identify with the corporation and its success
– Stewardship theory is a theory that managers, left on
their own, will act as responsible stewards of the
assets and resources they control. Stewardship
theorists assume that given a choice between self-
serving behavior and pro-organizational behavior, a
steward will place higher value on cooperation than
defection
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 Members of a Board of Directors
• Affiliated directors
– not employed by the corporation, handle legal or
insurance work
• Retired executive directors
– used to work for the corporation, partly responsible
for past decisions affecting current strategy
• Family directors
– descendants of the founder and own significant
blocks of stock

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 Codetermination: Should Employees
Serve on Boards?
• Codetermination
– the inclusion of a corporation’s workers on its
board, began only recently in the United States
• Although the movement to place employees on the
boards of directors of U.S. companies shows little
likelihood of increasing, the European experience
reveals an increasing acceptance of worker
participation on corporate boards.

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 Interlocking Directorates
• Direct interlocking directorate
– when two firms share a director or when an
executive of one firm sits on the board of a
second
• Indirect interlocking directorate
– when two corporations have directors who serve
on the board of a third firm

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 Interlocking Directorates
• Interlocking directorates
– useful for gaining both inside information about
an uncertain environment and objective expertise
about potential strategies and tactics

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 Trends in Corporate Governance
• Boards shaping company strategy
• Institutional investors active on boards
• Shareholder demands that directors and top
management own significant stock
• More involvement of non-affiliated outside
directors
• Increased representation of women and
minorities
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 Trends in Corporate Governance
• Boards evaluating individual directors
• Smaller boards
• Splitting the Chairman and CEO positions
• Shareholders may begin to nominate board
members
• Society expects boards to balance profitability
with social needs of society

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 The Role of Top Management
• Top management responsibilities
– involve getting things accomplished through and
with others in order to meet the corporate
objectives.
– are multidimensional and are oriented toward the
welfare of the total organization

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 3. Stakeholders Approach
Social Responsibilities
• A firm should not ignore the social
responsibilities such as consumer protection,
supporting education, care about
environment, donations etc.
• Stakeholders Approach: All
organisations/individuals who have any type
of interest in the fortune of a organisation.
E.g., shareholders, creditors, supplier,
employees...
 4. Efficient Market Hypothesis
• Share prices the true reflection of all the
available information in the market.
• Under EMH, the performance of management
is also reflected in share prices.
 A Normative Goal
• Maximization of wealth provides a rationale guide for
efficient allocation of resources
• Capital market provide a platform for savers to invest...
• Allocation of saving is based on expected benefits
along with risk..
• Market prices embodied both return and risk
components...
• And share prices is the true reflection of acquisition,
financing and investment decisions of financial
management