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Corporate Finance

Course Instructor : Suresh Herur

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Corporate Finance ( 8/e) - Stephan Ross, Randolph Westerfield, Jeffrey Jaffe, & Kakani

Principles of Corporate Finance (8/e) - Richard Brealey & Stewart Myers

Corporate Finance (2/e) - Aswath Damodaran

Reference Books

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Principles of Managerial Finance- Lawrence Gitman

Financial Management

- Prasanna Chandra Financial Management

- I M Pandey

Financial Services- Nalini Tripathy

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Sources of Financial Information:

The following sources apart from CMIE- PROWESS have extensiveinformation about corporate world, economy and markets.

Government-owned Websites: Securities and Exchange Board of India (SEBI), Reserve Bank of India (RBI)

Stock Exchange Websites: National Stock Exchange (NSE), andBombay Stock Exchange (BSE)

Financial Magazine/Newspaper Websites: Business Standard,

Hindu Business Line, Financial Express, Business Today, EconomicTimes, Economist, etc.

Other websites: Capital Market, Indiainfoline, Indiabulls, Equitymaster,

Sharekhan, iInvestor, CRISIL, CMIE, CapitalIdeasOnline, ICICIMarkets

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Recommended readings (Revision) Quick reading of Chapter 10 & 11 (Shareholders equity

and Financial statement analysis) of the text Financialaccounting Narayanaswamy

Pick up an Annual report of any company and have a clear understanding of the elements of the annual report and brieflyanalysethe financial reports of the company for the latest year.

Have an understanding of the various Accounting standards & their

relevance ( www.icai.org )

http://www.icai.org/http://www.icai.org/

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Course coverage (CF-1)

Time value of moneyValuation of Bonds / stocksCapital BudgetingFinancial markets in India

Risk & returnsCost of capitalCapital structure, LeverageDividend policy

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Working Capital Managementq Management of receivablesq Management of Cashq Management of Inventories

Short term Lending & BorrowingLeasing

International FinanceDerivativesValuation modelsMerger & acquisitions

CF 2 :Course coverage

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Evaluation scheme :

Quizzes/ assignments/presentations / case analysis - 30%

Mid term exam - 30%

End term exam - 40%

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Introduction to

Corporate Finance

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What is corporate finance?Every decision that a business makes has

financial implications, and any decision whichaffects the finances of a business is acorporate finance decision.

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Three Major Decisionsin Corporate Finance

The Allocation decisionWhere do you invest the scarce resources of your

business?What makes for a good investment?

The Financing decisionWhere do you raise the funds for these investments?What mix of owner s money (equity) or borrowed

money(debt) do you use?

The Dividend DecisionHow much of a firm s funds should be reinvested in the

business and how much should be returned to theowners?

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The Capital Budgeting Decision

Current Assets

Fixed Assets

1 Tangible

2 IntangibleShareholders

Equity

CurrentLiabilities

Long-TermDebt

What long-terminvestmentsshould the firmchoose?

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The Capital Structure Decision

How should thefirm raise fundsfor the selectedinvestments?

Current Assets

Fixed Assets

1 Tangible

2 IntangibleShareholders

Equity

CurrentLiabilities

Long-TermDebt

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Short-Term Asset Management

How should

short-term assets be managed andfinanced?

Net

WorkingCapital

ShareholdersEquity

CurrentLiabilities

Long-TermDebt

Current Assets

Fixed Assets

1 Tangible

2 Intangible

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Capital StructureThe value of the firm can bethought of as a pie.

The goal of the manager is toincrease the size of the pie.

The Capital Structuredecision can be viewed as

how best to slice the pie.

If how you slice the pie affects the size of the pie,then the capital structure decision matters.

50%

Debt

50%Equity

25%

Debt

75%Equity

70%

Debt30%

Equity

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Cash flowfrom firm (C)

The Firm and the Financial Markets

Taxes

( D )

Government

Retainedcash flows (F)

Investsin assets

(B)

Dividends anddebt payments(E)

Current assetsFixed assets

Short-term debtLong-term debtEquity shares

Ultimately, the firm mustbe a cash generating activity.

The cash flows from thefirm must exceed thecash flows from thefinancial markets .

Firm Firm issues securities (A) Financialmarkets

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First Principles of Corporate Finance

Invest in projects that yield a return greater than the minimum acceptable hurdle rate.

The hurdle rate should be higher for riskier projects

and reflect the financing mix used - owners funds (equity) or borrowed money (debt)

Returns on projects should be measured based oncash flows generated and the timingof these cashflows; they should also consider both positiveand negative side effects of these projects.

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First Principles of Corporate Finance

Choose a financing mix that minimizes thehurdle rate and matches the assets beingfinanced.

If there are not enough investments that earn thehurdle rate, return the cash to stockholders.

The form of returns - dividends and stock buybacks- will depend upon the stockholders characteristics.

Objective: Maximize the Value of the Firm

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Why do we need an objective?

An objective specifies what a decision maker is

trying to accomplish and by so doing, provides

measures that can be used to choose between

alternatives.

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Characteristics of aGood Objective Function

It is clear and unambiguous

It comes with a clear and timely measure that can be

used to evaluate the success or failure of decisions.

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 atobacco company defines its objective to be revenuegrowth.

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Good Objective Function

Which is a good objective function?

Maximize profit?

Minimize costs?Maximize market share?

Maximize shareholder wealth?

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The Objective in Decision MakingIn traditional corporate finance, the objective in

decision making is to maximize the value of thefirm.

A narrower objective is to maximize stockholder wealth. When the stock is traded and markets areviewed to be efficient, the objective is to maximizethe stock price.

All other goals of the firm are intermediate onesleading to firm value maximization, or operate asconstraints on firm value maximization .

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Why focus on maximizing stock prices ?

Stock price is easily observable and constantlyupdated (unlike other measures of performance, which may not be as easily observable, and certainly not updated asfrequently).

If investors are rational , stock prices reflect thewisdom of decisions, short term and long term,instantaneously.

The stock price is a real measure of stockholder wealth, since stockholders can sell their stock and receive the price now .

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Maximize stock prices as the only objective function

For stock price maximization to be the only objectivein decision making, we have to assume that

The decision makers (managers) are responsive to

the owners (stockholders) of the firm Stockholder wealth is not being increased at the

expense of bondholders and lenders to the firm;only then is stockholder wealth maximization

consistent with firm value maximization.

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Maximize stock prices as the only objective function

Markets are efficient; only then will stock pricesreflect stockholder wealth.

There are no significant social costs; only then willfirms maximizing value be consistent with thewelfare of all of society.

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The Classical Objective FunctionSTOCKHOLDERS

Maximizestockholder wealth

Hire & firemanagers- Board- Annual Meeting

BONDHOLDERSLend Money

Protect bondholder Interests

FINANCIAL MARKETS

SOCIETYManagers

Revealinformationhonestly andon time

Markets areefficient andassess effect onvalue

No Social Costs

Costs can betraced to firm

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Financial MarketsPrimary Market

Issuance of a security for the first time

Secondary MarketsBuying and selling of previously issued

securities (NSE / BSE)

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Financial Markets

FirmsInvestors

SecondaryMarket

money

securitiesSueBob

Stocks and

BondsMoney

Primary Market

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The Agency Cost ProblemThe interests of managers, stockholders, bondholders

and society can diverge. What is good for one groupmay not necessarily for another.

Managers may have other interests (job security, perks,compensation) that they put over stockholder wealthmaximization.

Actions that make stockholders better off (increasing dividends, investing in risky projects) may make

bondholders worse off .

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The Agency Cost Problem

Actions that increase stock price may notnecessarily increase stockholder wealth, if markets are not efficient or information is

imperfect. Actions that make firms better off may create suchlarge social costs that they make society worseoff.

Agency costs refer to the conflicts of interest thatarise between all of these different groups.

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Managerial GoalsManagerial goals may be different from

shareholder goalsExpensive perquisites

SurvivalIndependenceIncreased growth and size are not necessarily

equivalent to increased shareholder wealth

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Managing Managers

Managerial compensationIncentives can be used to align

management and stockholder interests

The incentives need to be structuredcarefully to make sure that they achievetheir intended goal

Corporate control The threat of a takeover may result in

better management

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Stockholder Interests vs.Management Interests

Theory : The stockholders have significant controlover management. The mechanisms for

disciplining management are the annual meeting and the board of directors.Practice : Neither mechanism is as effective in

disciplining management as theory assumes.

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The Annual Meeting as a disciplinary venue

The power of stockholders to act at annual meetingsis diluted by three factors

Most small stockholders do not go to meetings because thecost of going to the meeting exceeds the value of their holdings.

Incumbent management starts off with a clear advantagewhen it comes to the exercising of proxies. Proxies that arenot voted becomes votes for incumbent management.

For large stockholders, the path of least resistance, whenconfronted by managers that they do not like, is to vote withtheir feet.

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Directors lack the expertise to ask thenecessary tough questions..

The CEO sets the agenda, chairs the meetingand controls the information.

The search for consensus overwhelms anyattempts at confrontation.

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Overpaying on takeovers The quickest and perhaps the most decisive way

to impoverish stockholders is to overpay on atakeover.

The stockholders in acquiring firms do not seem toshare the enthusiasm of the managers in these

firms. Stock prices of bidding firms decline onthe takeover announcements a significantproportion of the time.

Many mergers do not work, as evidenced by anumber of measures.

The profitability of merged firms relative to their peergroups, does not increase significantly aftermergers.

An even more damning indictment is that a largenumber of mergers are reversed within a few years,

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Stockholders' objectives vs. Bondholders' objectives

Nov 07,2006 Close: 497.35 High: 512.95 Low: 495.00 Open: 511.00 Volume: 1422075

Tata Corus

deal on Oct 22

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Stockholders' objectives vs.Bondholders' objectives

In theory: there is no conflict of interestsbetween stockholders and bondholders.

In practice: Stockholders may maximize their

wealth at the expense of bondholders.Increasing dividends significantly: When firms

pay cash out as dividends, lenders to thefirm are hurt and stockholders may behelped. This is because the firm becomesriskier without the cash.

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Stockholders' objectives vs.Bondholders' objectives

Taking riskier projects than those agreed to atthe outset: Lenders base interest rates ontheir perceptions of how risky a firms

investments are. If stockholders then take onriskier investments, lenders will be hurt.

Borrowing more on the same assets: If lendersdo not protect themselves, a firm can borrow

more money and make all existing lendersworse off.

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Firms and Financial Markets

In theory: Financial markets are efficient. Managersconvey information honestly and truthfully to financial markets,and financial markets make reasoned judgments of 'true value'. Asa consequence-

A company that invests in good long term projects will be

rewarded. Short term accounting gimmicks will not lead to increases in

market value. Stock price performance is a good measure of management

performance.

In practice : There are some holes in the 'EfficientMarkets' assumption.

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Managers control the release of information to the general public

There is evidence thatthey suppress information, generally negative

information

they delay the releasing of bad newsbad earnings reportsother news

they sometimes reveal fraudulent information

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Even when information is revealed to financial markets, themarket value that is set by demand and supply maycontain errors.

Prices are much more volatile than justified by theunderlying fundamentals

Eg. Market Crash in Jan 2008

Financial markets overreact to news, both good and badFinancial markets are short-sighted, and do not consider the long-term implications of actions taken by the firm

Eg. the focus on next quarter's earnings

Financial markets are sometimes manipulated by insiders;Prices do not have any relationship to value .

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Are Markets Short Sighted?Some evidence that they are not..

There are hundreds of start-up and small firms, withno earnings expected in the near future, that raisemoney on financial markets

If the evidence suggests anything, it is that markets donot value current earnings and cashflows enoughand value future earnings and cashflows too much.

Low PE stocks are underpriced relative to high PE stocks

The market response to research and developmentand investment expenditure is generally positive

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Firms and Society

In theory : There are no costs associated with the firmthat cannot be traced to the firm and charged to it.

In practice : Financial decisions can create social costsand benefits .

A social cost or benefit is a cost or benefit that accrues tosociety as a whole and NOT to the firm making the

decision.environmental costs (pollution, health costs, etc..)Quality of Life' costs (traffic, housing, safety, etc.)

Examples of social benefits include:creating employment in areas with high unemploymentsupporting development in under developed areas

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The Bondholders defense againstStockholder excesses

More restrictive covenants on investment, financing anddividend policy have been incorporated into bothprivate lending agreements and into bond issues

New types of bonds have been created to explicitly

protect bondholders against sudden increases inleverage or other actions that increase lender risksubstantially. Two examples of such bonds

Puttable Bonds, where the bondholder can put the bond backto the firm and get face value, if the firm takes actions that

hurt bondholders Ratings Sensitive Notes, where the interest rate on the notesadjusts to that appropriate for the rating of the firm

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The Bondholders Defense AgainstStockholder Excesses

More hybrid bonds (with an equity component, usually in the form of a conversionoption or warrant) have been used. Thisallows bondholders to become equityinvestors, if they feel it is in their bestinterests to do so.

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The Societal ResponseIf firms consistently flout societal norms

and create large social costs, thegovernmental response (especially in ademocracy) is for laws and regulations to bepassed against such behavior.

Finally, investors may choose not to investin stocks of firms that they view as socialoutcasts .

e.g.. Tobacco firms and the growth of socially responsible funds

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