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Introduction to Strategic Finance- Lecture No. 1

1. Strategic Finance: 2-Pillars i.e. "Behavioral Finance" & "Strategic

Finance"
1.1 Behavioural Finance: Behavioural finance offers an alternative block for each of the
foundation blocks of standard finance. According to behavioural finance, (1) investors are
normal, not rational (allows for issues of psychology and emotion, understanding these
factors alter the actions of the investors, leading to decisions that may not be entirely
rational). (2) Markets are not efficient, even if they are difficult to beat. (3) Investors design
portfolios according to the rules of behavioural portfolio theory, not mean-variance portfolio
theory (investors divide their money into many mental account layers of a portfolio pyramid
corresponding to goals such as secure retirement, college education, or being rich enough to
hop on a cruise ship whenever they please). And, (4) expected returns follow behavioural
asset pricing theory, in which risk is not measured by beta and expected returns are
determined by more than risk. (Emerged in 1990)
1.2 Standard Finance: Standard finance, also known as modern portfolio theory, has four
foundation blocks: (1) investors are rational (A rational behaviour decision-making process is
based on making choices that result in the most optimal level of benefit or utility for the
individual); (2) markets are efficient (a stock is efficient if the price of a stock is always equal
to its intrinsic value. A stocks intrinsic value is the present value of cash flows the stock can
reasonably be expected to generate, such as dividends. Over the years) ; (3) investors should
design their portfolios according to the rules of mean-variance portfolio theory (According to
this theory, differences in expected returns are determined only by differences in risk, and
beta is the measure of risk) in which beta is the only characteristic that determines expected
stock returns; and, in reality, do so; and (4) expected returns are a function of risk and risk
alone.
1.2.1 Corporate Finance (1920-1950)
Corporate Finance also called as Business Finance or Financial Management
Focus: From where to generate money, when required (Traditional Finance)
o Narrow Single Decision
o Episodic in Nature - (No routine; No Investment)
Merger/Acquisition/Restructuring
Financing Depended upon external relationship: as how to or from where to source
finance?
o Institutions: A financial institution is an establishment that conducts financial
transactions such as investments, loans and deposits. Almost everyone deals with
financial institutions on a regular basis. Everything from depositing money to
taking out loans and exchanging currencies must be done through financial
institutions.
o Markets: A financial market is a broad term describing any marketplace where
buyers and sellers participate in the trade of assets such as equities, bonds,
currencies and derivatives. Financial markets are typically defined by having
transparent pricing, basic regulations on trading, costs and fees, and market
forces determining the prices of securities that trade.
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Note: Initially, all the decisions were external; no internal decision were not undertaken:
which is why, after critics, new theories emerged i.e. Capital structure (What is the best way
to finance these long-term investments? Debt or equity?), capital budgeting (What long-term
investments should the firm undertake?), dividend policies (set of guidelines a company uses
to decide how much of its earnings it will pay out to shareholders), working capital
management (How should the firm manage its short-term assets and liabilities, such as
cash?), CAPM (a model that describes the relationship between systematic risk and expected
return for assets, particularly stocks); and by 1950 Investment decision was added into the
domain of Management decision. [All discussions, in consideration of public listed
companies, not private companies).

"Corporate finance is the study of a business's money-related decisions, which are essentially
all of a business's decisions. Despite its name, corporate finance applies to all businesses, not
just corporations. The primary goal of corporate finance is to figure out how to maximize a
company's value by making good decisions about investment, financing and dividends. In
other words, how should businesses allocate scarce resources to minimize expenses and
maximize revenues? How should companies acquire these resources -
through stock or bonds, owner capital or bank loans? Finally, what should a company do
with its profits? How much should it reinvest into the company, and how much should it
pay out to the business's owners? This walkthrough will explore each of these business
decisions in greater depth"

1.3 Goal of the Corporation or Financial Objectives

Two Objectives:
Profit maximization: Profit maximization is an inadequate goal to guide officers and
directors of the corporation.
It is a vague term: creates confusion in the mind of people i.e. which profit?
It fails to consider the risks undertaken by the firm in pursuit of profit.
Its focus is on accounting profit; Its focus is on one years accounting profit,
potentially at the expense of longer-term interests of the shareholder.
It ignores the time value of money.
Shareholder's wealth maximization: Shareholder wealth maximization is
considered the most appropriate goal to guide officers and directors of the
corporation.
Also called as EPS maximization, share price maximization, wealth
maximization, NPV maximization criteria, value maximization: different
indexes but same link.
Its overcome all the technical limitations of profit maximization.
Its focus is on genuine economic profit.
It reflects the value of all economic profits of the corporation now and into the
future.
Despite the attention given to major corporations because of negative
externalities, the agents of the corporation must:
Operate legally and in compliance with contractual responsibilities, In
the interests of its owners by creating value for them.
Note: shareholder wealth maximisation has a technical limitation i.e.
Principal-Agent Problem.
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Every manager take decision based on the goal of the firm

Financing,
Why Investment &
Market price
organization Dividend
maximization
exist? policy
decisions
Decisions,
that lead to
Goal of the
increase in
firm
market price
of the shares

Question arises as how NPV criteria: based on cash flow system i.e. Inflow and outflow.

We cannot compare the cash flows of today with the cash

flows of future, because of the time difference i.e. Time
value of Money.
The amount of which you have today, is worth more than
the amount you have tomorrow; rational investor shall
prefer todays.
Discount rate is 15% i.e. 0.15; Investment is 100 or cost is 100

Year 0 1 2 3
Cash Flow 0 50 60 50
40

52

35

Total: 127 (Present value of Future Cash Flows)

PVFCF-Cost= NPV i.e. 127-100= 27

Using the NPV formula, the net present value rule decides if an acquisition or project is worth
it based on the following criteria:
If NPV < 0, the project/acquisition will lose the company money and therefore may not be
considered.
If NPV = 0, the project/acquisition will neither increase nor decrease value of the company
and non-monetary benefits may instead be considered before a decision is made.
If NPV > 0, the project/acquisition should be accepted as it will increase profit and therefore
value of the company.
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Example: Let's assume Company XYZ wants to buy Company ABC. It takes a careful look at
Company ABC's projections for the next 10 years. It discounts those cash flow projections
back to the present using its weighted average cost of capital (WACC) and then subtracts the
cost of buying Company ABC.
Cost to purchase Company ABC today: $1,000,000
Projected total of cash inflows for the next 10 years: $2,000,000
Net Present Value (NPV) = $1,000,000
Using the net present value rule, Company XYZ should purchase Company ABC because the
net present value of this project is Positive. It will generate a cash benefit that will exceed the
cost of the acquisition and will therefore add value to the company.

Question: Why buy share?

Positive NPV signals good news to
Get periodic dividends the investor
Capital gains
Market price of shares
Share Price Maximizations Strength:

Risk of Investor is Project:

o High risk Unexpected profit You will Invest
o Low risk You will demand less
Follows time value of money
Precise connotation
o Cash inflow
o Cash outflow
It is for long-term: No earning management
Share Price Maximizations Limitations:

Calculation of NPV is a complex method

It focusses only on shareholder wealth maximization; as it ignores all other
stakeholders
o Important stakeholder: in operations.
These limitations lead to Agency Problem: Separation of Ownership (shareholders) and
the management (those who run the company).
Shareholder- Principal Manager-Agent
An agency relationship occurs when a principal hires an agent to perform some duty. A
conflict, known as an "agency problem," arises when there is a conflict of interest
between the needs of the principal and the needs of the agent. In finance, there are two
primary agency relationships: Managers and stockholder
Ignore the role of Manager Run the company on shareholders behalf.
They make decisions just to satisfy stakeholders.
Consume more profit for most of their own preferences
they focus on their own problem than shareholders.
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Question: How corporation Reduce Agency Problem? or How we can maximise

the shareholders wealth and mitigate the effect of Agency Problem?

Answer: Through Market Forces or Agency Cost

Market Forces:
o Behaviour of Market Participants: The participants include institutional investors
(mutual funds, insurance etc.) actively participate in management. They use their voting
rights to replace more competent management.
Direct Intervention by Stockholders: Today, most of a company's stock is
owned by large institutional investors, such as mutual funds and pensions. As
such, these large institutional stockholders can exert influence on mangers and,
as a result, the firm's operations.
Threat of Firing: If stockholders are unhappy with current management, they
can encourage the existing board of directors to change the existing
management, or stockholders may re-elect a new board of directors that will
accomplish the task.
o Hostile Take over
If a stock price deteriorates because of management's inability to run the
company effectively, competitors or stockholders may take a controlling interest
in the company and bring in their own managers. Which can either be done
through a friendly meeting or by a hostile takeover i.e. a company will go for
maximization of proportionate share; there exist companies that search for
undervalued shares. Company having more than 50% share of a company can
exercise voting rights or acquire the company. Constant threats motivates.
Agency Cost:
o Monitoring Expenditure:
Provide mechanism i.e. Internal and external audit; Shareholder pay the audit
team to ensure whether transactions are done for managers personal benefit or
not? And working for shareholders wealth maximisation?
o Opportunity cost
Are those which results from the inability of the firm to respond to new
opportunities. Due to organisational structure, hierarchy etc. the
management faces difficulties in seizing profitable investment
opportunities.
o Structuring Expenditure- Incentive Plans and Performance Plans
Managerial compensation should be re-constructed not only to retain competent
managers, but to align managers' interests with those of stockholders as much as
possible. This is typically done with an annual salary plus performance bonuses
and company shares.
Company shares are typically distributed to managers either as:
Performance shares: where managers will receive a certain number of
shares based on the company's performance
Executive stock options: which allow the manager to purchase shares at
a future date and price. With the use of stock options, managers are
aligned closer to the interest of the stockholders as they themselves will
be stockholders.
The Expenditure structure should be linked with the share price: whether
maximised or minimised.
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1.4 Role of Management and Agency Issues

Agency Relationship:
o Managers work on behalf of the shareholders
Agency Problems:
o Problems that arise due to potential divergence of interest between managers,
shareholders and creditors
Agency Costs: The costs associated with agency problems
o Direct Agency Costs: Arise because suboptimal decisions are made by
managers when the act in a manner that is not in the best interests of
shareholders. Example:
Managers avoiding high risk projects because they have an
undiversified stake in the health of the corporation (they could lose
their job if the outcome is negative).
Managers spending corporate resources on luxurious offices, executive
aircraft, pension plans and poison pills that favour their own self-
interest at the expense of shareholders.
o Indirect Agency Costs: Are incurred by the corporation in the attempt to
avoid direct agency costs. Examples:
Reporting requirements placed on management including, annual
report, audited financial statements, requirements for notice of annual
and special shareholders meetings
Elaborate compensation schemes including use of stock options used to
try to align the interests of managers with shareholders.
Shareholder approval required before management can change the
articles of incorporate or bylaws or make major changes in share
capital.
Agency Compensation: To align managements interests with shareholders, Boards of
Directors have tried to tie compensation to performance measures. These
compensation schemes are not always effective in achieving their goal and have led to
concerns about excessive management compensation.
Areas of For Potential Disagreement:
o Managers and shareholders may have differing goals, attitudes toward risk,
and differential access to information this can lead to areas of disagreement.
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Additional:
Institutions
o Financial Institutions:
Commercial Banks
Investment Banks
Insurance Companies
Brokerages
Investment Companies
Unit Investment Trusts (UITs)
Face Amount Certificates
Management Investment Companies
o Closed-End Investment Companies
o Open-End Investment Companies
o Non Financial Institution
Savings and Loans
Credit Unions
Shadow Banks
Markets
o Capital Markets
Stock Markets
Bond Markets
o Money Market
Cash or Spot Market
Derivatives Markets
Forex and the Interbank Market
The OTC Market (Secondary Market)