Module 1

Introduction to Corporate finance

Module 1: Introduction to Corporate Finance 4 hours
Financial decisions in a firm, objectives of financial management- profit maximization and
wealth maximization, finance function, CFO role, Treasury & Controller, Simple
illustrations on identification of financing, investment and dividend decisions.

Learning outcome: Outline the theories and practices of contemporary corporate finance

Core concepts
• Corporate finance
• Investment Decisions.
• Long-term Investment (Capital-Budgeting) Decision.
• Short-term Investment (Working Capital) Decisions.
• Financing Decisions.
• Dividend Decisions
• Profit maximisation
• Wealth Maximisation

Assessment
• Questions
• Quiz
• Case 1

What is Corporate Finance?

It is that sub-division of finance that encompasses how corporations raise funds through a
variety of sources, how much proportion of it being raised through each source and how it
invests these funds. Corporate Finance is also referred as Financial Management and Business
Finance.
According to Weston and Brigham, “Financial Management is an area of financial decision-
making, harmonizing individual and enterprise goals”.
J.F. Bradley defines financial management as “The area of the business management devoted
to a judicious use of capital and a careful selection of sources of capital in order to enable a
spending unit to move in the direction of reaching its goals.”
Thus, Corporate Finance can be described as the study the decisions that every firm has to
make, but what is a firm? It is used to mean any business, large or small, privately run or
publicly traded, and engaged in any kind of operation – manufacturing, retail or service. Thus,
both Boeing and the bookstore are firms.
Consider first what they have in common. Both businesses own assets that currently generate
earnings. Boeing, for instance, owns a large number of plants that manufacture its commercial
aircraft, and it owns the technology that goes in to these planes. The small bookstore owns
both the retail space where it operates and the books that it has in that space. In addition, both
businesses hope to keep investing in the future, to grow and prosper. When we talk about value
of the firm, we are referring to the value of both categories of investments – investments already
made and investments yet to be made.
To finance these assets, firms can raise money from two sources. First, they can borrow the
money from a bank or other lenders. We categorize this type of financing as debt.
Alternatively, they can use the funds of the owner or owners of the businesses. We term these
funds equity. The term equity in the context of an Indian Company is also referred as
Shareholders’ Funds/Net Worth/Proprietors Funds.
Again, there is a distinction between Boeing and small bookstore. Boeing, being a publicly
traded firm, can issue stock(shares) and bonds in financial markets to raise equity and debt.
The small bookstore, being a private business, has fewer options. The owner can invest his or
her own savings in the business, which would be equity, or borrow from the bank, which would
be debt. While much of what corporate finance has to say applies to both, there are differences
in the way in which we apply the theory in each. The generic view of the firm can be seen in
the figure below.

Figure 1.1 – A SIMPLE VIEW OF A FIRM

 Assets Liabilities
Existing Investments
generate cashflows
DEBT - Borrowed
today -
Money
INVESTMENTS
ALREADY MADE

Expected Value that

will be created by
future investments - EQUITY - Owner's
INVESTMENTS YET funds
TO BE MADE

Corporate Finance thus, basically seeks to enhance the wealth of the shareholders. This is done
by short, medium and long-term planning and the implementation of these plans. Chief
activities in corporate finance range from Investment of Capital, Raising of Funds, Acquiring
Assets and some good number of times acquiring other business which help them grow in
value.
For example, companies have resorted to the inorganic growth route for their growth and
expansion. Companies like Hindustan Unilever Ltd are now a combined entity of sorts which
have hitherto acquired Brooke Bond Lipton India Ltd in the year 1996, Pond’s India Ltd in the
year 1998 and the latest among which is merger of GSK Consumer Healthcare with itself in
2020.

Umpteen number of companies illustrate about Corporate Finance and its Applications. Both
in the Indian and Global Context, we find that there are well-established and well-reputed
companies which have made good corporate finance decisions. In the Indian context,
companies like Infosys, Wipro, Bajaj Auto Ltd, Cipla Ltd, Dabur India Ltd, Hindustan Unilever
Ltd are those which are successful in the long-term and have added a lot of value to the
shareholders. One of the important reasons they could add value to the shareholders was
because of their successful ability to manage their finances well, i.e., to make effective financial
decisions from time to time.
 Financial decisions in a firm:
We can classify all the financial decisions into three major groups:
1. Investment Decisions.
a. Long-term Investment (Capital-Budgeting) Decision.
b. Short-term Investment (Working Capital) Decisions.
2. Financing Decisions.
3. Dividend Decisions.

1.2.1. Investment Decisions:

Investment Decisions relate to the determination of total amount of assets to be held in the firm,
the composition of these assets and the business risk complexions of the firm as perceived by
its investors. Proper investment of funds is very necessary to achieve the goal of wealth
maximization.

As indicated before, long-term investment decision is referred to as the capital budgeting and
the short-term investment decision as working capital management.

Capital budgeting is the process of making investment decisions in capital expenditure. These
are expenditures, the benefits of which are expected to be received over a long period of time
exceeding one year. The finance manager has to assess the profitability of various projects
before committing the funds. The investment proposals should be evaluated in terms of
expected profitability, costs involved and the risks associated with the projects. The investment
decision is important not only for the setting of new units but also for the expansion of present
units, replacement of permanent assets, research and development project costs, and
reallocation of funds, in case, investments made earlier do not fetch result as anticipated earlier.
For example, Tata Nano Factory was initially started at Singur in West Bengal, but it had to be
shifted to Sanand in Gujarat later due to resistance from the Bengali Community, so the funds
didn’t yield desired results in West Bengal, had to be re-allocated including loss of a good
amount and additional investment of funds in the factory new factory opened in Gujarat.

Short-term investment decisions, on the other hand, relate to the allocation of funds among
current assets, prominently comprising cash and cash equivalents, receivables(debtors) and
inventories(stocks). There must be fine balance between high and low levels of these assets.
Excessive levels of such assets, stock, for example, if it stocked in excess, it would block up
much funds which may not turnover into cash quickly, leading to liquidity problem. On the
 other hand, if inadequate stocks are held, it would lose out on customers and forego
profitability, thus, there should be a balance or a trade-off between high and low levels of
current assets, viz., stock, debtors and cash balances. Optimum level of these assets need to be
maintained which ensures higher profitability, proper liquidity and sound structural health of
the organization.

1.2.2. Financing Decisions:

Since, firms regularly make new investments, the needs for financing and financial decisions
are ongoing. Hence, a firm will be continuously planning for new financial needs. The
Financial Decisions are not only concerned with how best to finance new assets, but also
concerned with the best overall mix of financing for the firm. The debt-equity ratio should be
fixed in such a way that it helps in maximizing the profitability of the concern. The raising of
more debt will involve fixed interest liability and dependence of funds through equity will
bring permanent funds to the business but the shareholders will expect higher rates of earnings.
The financial manager has to strike a balance between various sources so that the overall
profitability of the concern improves. If the capital structure/financing decision is able to
minimise the risk and raise the profitability, then the market prices of the shares will go up
maximising the wealth of shareholders.

For example, Narayana Murthy of Infosys, has inculcated a philosophy of zero debt(long-term)
right from its inception. The company’s balance sheet therefore shows zero long-term debt
and huge shareholders’ funds.

1.2.3. Dividend Decision:

The third major decision relates to the disbursement/payment of profits back to investors who
supplied capital to the firm. The term dividend refers to that part of profits of a company which
is distributed among its shareholders. It is the reward of shareholders for investments made by
them in the share capital of the company. The dividend decision is concerned with the quantum
of profits to be distributed among the shareholders in each financial year. A decision must be
taken whether all the profits are to be distributed, to retain all the profits in business or to keep
a part of profits in the business and distribute others among shareholders. Higher rates of
dividend may raise the market price of shares and thus, maximize the wealth of shareholders.
The firm should also consider the question of dividend stability, stock dividend (bonus shares)
and cash dividend.
 Most of the companies, particularly the listed companies, resort to regular dividends with
different variants. However, companies which enjoy the trust of the investment community
may not necessarily pay regular dividends. For example, there are a few companies like Lupin
Laboratories Ltd which have not paid dividends consistently, however, they have ploughed
back the profits for the company’s growth and expansion across the world in a profitable
manner. Its share prices nevertheless increased in the long-term.

Goals of corporate finance/objectives of financial management:

The main objective of a business is to maximize the owner’s economic welfare. This
objective can be achieved by:
1) Profit Maximization, and
2) Wealth Maximization.

1.3.1. Profit Maximization.

Earning of profits is the main aim of every economic activity. Profit is a measure of efficiency
of a business enterprise. Profits also serve as a protection against risks which cannot be insured.
The accumulated profits enable a business to face risks like fall in prices, competition from
other units, adverse government policies, etc.,

The following arguments are advanced in favour of profit maximization as the objective of a
business:
i) When profit-earning is the aim of business, then profit maximization should be
the obvious objective.
ii) Profitability is the barometer for measuring efficiency and economic prosperity
of a business enterprise.
iii) Economic and business conditions do not remain same at all the times. There
may be adverse business conditions like recession, depression, severe
competition, etc., A business will be able to survive under unfavourable
situation, only if it has some past earnings.
iv) A business should aim at maximization of profits for enabling its growth and
development.
v) Profitability is essential for fulfilling social goals.

However, profit maximization objective has been criticised on many grounds. A firm pursuing
the objective of profit maximization starts exploiting workers and the consumers. Hence, it is
 immoral and leads to a number of corrupt practices. Further, it leads to colossal inequalities
and lowers human values which are an essential part of an ideal social system.
Profit maximization has been rejected because of the following drawbacks too:
i) Ambiguity: The term ‘profit’ is vague. It means different things to different
people. Should we consider short-term profits or long-term profits? Does it
mean total profits or earnings per share? Should we take profits before tax or
after tax? Does it mean operating profit or profit available for shareholders?
ii) Ignores time value of money: It treats all earnings as equal though they occur
in different periods.
iii) Ignores risk factor: It does not take into consideration the risk of the prospective
earnings stream.
iv) Dividend Policy: The effect of dividend policy on the market price of shares is
also not considered in the objective of profit maximization. In case, earnings
per share is the only objective then an enterprise may not think of paying
dividend at all.

1.3.2. Wealth maximization:

It is considered as the most appropriate objective of an enterprises in managing its funds.
Financial theory asserts that wealth maximization is the single substitute for a stockholder’s
utility. When the firm maximises the stockholder’s wealth, the individual stockholder can use
this wealth to maximise his individual utility. It means that by maximizing stockholders’
wealth, the firm is operating consistently towards maximizing stockholders’ equity.

A stockholder’s current wealth in the firm is the product of the number of shares owned,
multiplied with the current stock price per share. The market price per share serves as a
performance index or a report card of its progress.
However, maximization of the market price of the shares should be in the long-run. It implies
a period long enough to reflect the normal market value of the shares irrespective of short-term
fluctuations.
Arguments in support of wealth maximization:
There are three compelling arguments in support of the goal of shareholder wealth
maximization, viz., legal, economic, and decisional.
From a legal point of view, managers, as agents of shareholders are expected to further the
interests of shareholders, who are their principals, as established in the Anglo-Saxon Law. As
Alfred Rappaport said, “In a market-based economy which recognizes the rights of private
property, the only social responsibility of business is to create value and do so legally and with
integrity.
The economic argument for maximizing shareholder wealth rests on the premise that the
pursuit of this goal serves the larger public interest by maximising social wealth. As Bennett
Stewart put it, “The quest for value drives scarce resources to their most productive uses and
their most efficient users. The more effectively resources are deployed, the more robust will
be the economic growth and the rate of improvement in our standard of living. Adam Sith’s
invisible hand ‘is at work at work when investors’ private gain is a public value”.
According to the decisional argument, for purposeful or rational behaviour, an organization
requires a single-valued objective function, because it is logically impossible to maximize in
more than one dimension. If a manager is told to maximize market share, current profits,
employment, future growth in profits, and something else, he cannot make a well-reasoned
decision. In effect, he will be left with no objective.

Class task:

Collect the latest annual reports of L & T and BHEL. Read the information given in the reports
including Director’s Report and the Chairman’s Statement and comment on both firm’s objective and

Chapter related Questions

1. Define the scope of financial management? What is the role of the financial manager
in today’s enterprise?
2. How is the role of a financial manager of a large company different from that of a
small and a medium-sized firm. Explain
3. Finance function, in addition to raising funds, is also concerned with production,
marketing and other functions within an enterprise whenever decisions are made
about the acquisition or disposal or diminution of assets. Explain.
4. What are the basic financial decisions? Explain.
5. “Profit maximization is not an operationally feasible criterion”. Do you agree?
Illustrate your views.
6. “In what ways is the wealth maximization objective superior to the profit
maximization objective”. Explain.
7. How should the finance function of an enterprise be organised? What functions does
the financial officer perform?
8. Should the titles of Controller and Treasurer be adopted under the Indian Context?
Would you like to modify their functions in view of the company practices in India?
Justify your answer.