Corporate Finance

Course Instructor : Suresh Herur

 Reference Books


 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


Principles of Managerial Finance

- Lawrence Gitman

Financial Management
- Prasanna Chandra

Financial Management
- I M Pandey


 Financial Services
 - Nalini Tripathy

Sources of Financial Information:
The following sources apart from CMIE- PROWESS have extensive
information about corporate world, economy and markets.

ØGovernment-owned Websites: Securities and Exchange Board of

India (SEBI), Reserve Bank of India (RBI)

ØStock Exchange Websites: National Stock Exchange (NSE), and

Bombay Stock Exchange (BSE)

ØFinancial Magazine/Newspaper Websites: Business Standard,

Hindu Business Line, Financial Express, Business Today, Economic
Times, Economist, etc.

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

Sharekhan, iInvestor, CRISIL, CMIE, CapitalIdeasOnline, ICICIMarkets
Recommended readings (Revision)
ØQuick reading of Chapter 10 & 11 (Shareholders’ equity
and Financial statement analysis) of the text “Financial
accounting – Narayanaswamy”
Ø
ØPick up an Annual report of any company and have a clear
understanding of the elements of the annual report and briefly
analysethe financial reports of the company for the latest year.
Ø
ØHave an understanding of the various Accounting standards & their
relevance (www.icai.org)
Course coverage (CF-1)
 Time value of money
 Valuation of Bonds / stocks
 Capital Budgeting
 Financial markets in India

 Risk & returns
 Cost of capital
 Capital structure, Leverage
 Dividend policy
 CF – 2 :Course coverage

Working Capital Management

qManagement of receivables
qManagement of Cash
qManagement of Inventories
Short term Lending & Borrowing
Leasing

International Finance
Derivatives
Valuation models
Merger & acquisitions
  Evaluation scheme:


Quizzes/ assignments/
 presentations / case analysis - 30%


Mid term exam - 30%


End term exam - 40%

 Introduction to
Corporate Finance
What is corporate finance?
Every decision that a business makes has
financial implications, and any decision which
affects the finances of a business is a
corporate finance decision.

Three Major Decisions
in Corporate Finance
The Allocation decision
 Where do you invest the scarce resources of your
business?
 What makes for a good investment?

The Financing decision

 Where do you raise the funds for these investments?
 What mix of owner’s money (equity) or borrowed
money(debt) do you use?

The Dividend Decision

 How much of a firm’s funds should be reinvested in the
business and how much should be returned to the
owners?
The Capital Budgeting Decision
Current
Liabilities
Current Assets
Long-Term
Debt

Fixed Assets
What long-term
1 Tangible investments Shareholders’
should the firm Equity
2 Intangible choose?
The Capital Structure Decision

Current
Liabilities
Current Assets
Long-Term
Debt
How should the
firm raise funds
for the selected
Fixed Assets investments?
1 Tangible Shareholders’
2 Intangible Equity
Short-Term Asset Management
Current
Liabilities
Current Assets
Net
Working Long-Term
Capital Debt

Fixed Assets How should

short-term assets
1 Tangible be managed and
financed? Shareholders’
2 Intangible Equity
 Capital Structure
The value of the firm can be
thought of as a pie.
The goal of the manager is to 70%50%30%
25%
increase the size of the pie. DebtDebt
Equity

The Capital Structure 75%

50%
Equity
decision 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.
The Firm and the Financial Markets

Firm Firm issues securities (A) Financial

markets
Invests
in assets Retained
cash flows (F)
(B)
Short-term debt
Current assets Dividends and Long-term debt
Cash flow debt payments
Fixed assets from firm (C) Equity shares
(E)

Taxes (D)

The cash flows from the

Ultimately, the firm must
firm must exceed the
be a cash generating
Government cash flows from the
activity.
financial markets.
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 on
cash flows generated and the timingof these cash
flows; they should also consider both positive
and negative side effects of these projects.
First Principles of Corporate Finance
Choose a financing mix that minimizes the
hurdle rate and matches the assets being
financed.
If there are not enough investments that earn the
hurdle 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
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.
 Characteristics of a
Good 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 a
tobacco company defines its objective to be revenue
growth.
Good Objective Function
 Which is a good objective function?
 Maximize profit?

 Minimize costs?

 Maximize market share?

 Maximize shareholder wealth?

The Objective in Decision Making
 In traditional corporate finance, the objective in
decision making is to maximize the value of the
firm.
 A narrower objective is to maximize stockholder
wealth. When the stock is traded and markets are
viewed to be efficient, the objective is to maximize
the stock price.
 All other goals of the firm are intermediate ones
leading to firm value maximization, or operate as
constraints on firm value maximization.
Why focus on maximizing stock prices ?
 Stock price is easily observable and constantly
updated (unlike other measures of performance, which may
not be as easily observable, and certainly not updated as
frequently).

 If investors are rational , stock prices reflect the

wisdom 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.
Maximize stock prices
as the only objective function
 For stock price maximization to be the only objective
in 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.
Maximize stock prices
as the only objective function

 Markets are efficient; only then will stock prices

reflect stockholder wealth.
 There are no significant social costs; only then will
firms maximizing value be consistent with the
welfare of all of society.
The Classical Objective Function
STOCKHOLDERS

Hire & fire Maximize

managers stockholder
- Board wealth
- Annual Meeting

Lend Money No Social Costs

BONDHOLDERS Managers SOCIETY
Protect Costs can be
bondholder traced to firm
Interests
Reveal Markets are
information efficient and
honestly and assess effect on
on time value

FINANCIAL MARKETS
Financial Markets
Primary Market
 Issuance of a security for the first time

Secondary Markets
 Buying and selling of previously issued
securities (NSE / BSE)
Financial Markets

Stocks and Investors

Bonds
Firms securities
Money Bob Sue
money

Primary Market
Secondary
Market
The Agency Cost Problem
 The interests of managers, stockholders, bondholders
and society can diverge. What is good for one group
may not necessarily for another.
 Managers may have other interests (job security, perks,
compensation) that they put over stockholder wealth
maximization.
 Actions that make stockholders better off (increasing
dividends, investing in risky projects) may make
bondholders worse off.
The Agency Cost Problem

– Actions that increase stock price may not

necessarily increase stockholder wealth, if
markets are not efficient or information is
imperfect.
– Actions that make firms better off may create such
large social costs that they make society worse
off.
 Agency costs refer to the conflicts of interest that
arise between all of these different groups.
–
Managerial Goals
Managerial goals may be different from
shareholder goals
 Expensive perquisites
 Survival
 Independence
Increased growth and size are not necessarily
equivalent to increased shareholder wealth
Managing Managers

Managerial compensation
 Incentives can be used to align
management and stockholder interests
 The incentives need to be structured
carefully to make sure that they achieve
their intended goal
Corporate control
 The threat of a takeover may result in
better management
 Stockholder Interests vs.
Management Interests

Theory: The stockholders have significant control

over 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.
The Annual Meeting as a disciplinary venue
 The power of stockholders to act at annual meetings
is diluted by three factors
– Most small stockholders do not go to meetings because the
cost of going to the meeting exceeds the value of their
holdings.
– Incumbent management starts off with a clear advantage
when it comes to the exercising of proxies. Proxies that are
not voted becomes votes for incumbent management.
– For large stockholders, the path of least resistance, when
confronted by managers that they do not like, is to vote with
their feet.
Directors lack the expertise to ask the
necessary tough questions..

The CEO sets the agenda, chairs the meeting

and controls the information.
The search for consensus overwhelms any
attempts at confrontation.
Overpaying on takeovers
 The quickest and perhaps the most decisive way
to impoverish stockholders is to overpay on a
takeover.
 The stockholders in acquiring firms do not seem to
share the enthusiasm of the managers in these
firms. Stock prices of bidding firms decline on
the takeover announcements a significant
proportion of the time.
 Many mergers do not work, as evidenced by a
number of measures.
– The profitability of merged firms relative to their peer
groups, does not increase significantly after
mergers.
– An even more damning indictment is that a large
number of mergers are reversed within a few years,
Stockholders' objectives vs. Bondholders' objectives

Tata Corus
Nov 07,2006 Close: 497.35 High: 512.95
dealLow:
on495.00
Oct 22Open: 511.00 Volume: 1422075
Stockholders' objectives vs.
Bondholders' objectives
In theory: there is no conflict of interests
between 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 the
firm are hurt and stockholders may be
helped. This is because the firm becomes
riskier without the cash.
Stockholders' objectives vs.
Bondholders' objectives

 Taking riskier projects than those agreed to at

the outset: Lenders base interest rates on
their perceptions of how risky a firm’s
investments are. If stockholders then take on
riskier investments, lenders will be hurt.

 Borrowing more on the same assets: If lenders

do not protect themselves, a firm can borrow
more money and make all existing lenders
worse off.
Firms and Financial Markets
 In theory: Financial markets are efficient. Managers
convey information honestly and truthfully to financial markets,
and financial markets make reasoned judgments of 'true value'. As
a 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 'Efficient
Markets' assumption.
Managers control the release of
information to the general public
There is evidence that
 they suppress information, generally negative
information
 they delay the releasing of bad news
bad earnings reports
other news
 they sometimes reveal fraudulent information
Even when information is revealed to financial markets, the
market value that is set by demand and supply may
contain errors.

 Prices are much more volatile than justified by the

underlying fundamentals
– Eg. Market Crash in Jan 2008
 Financial markets overreact to news, both good and bad
 Financial 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.
Are Markets Short Sighted?
Some evidence that they are not..
 There are hundreds of start-up and small firms, with
no earnings expected in the near future, that raise
money on financial markets
 If the evidence suggests anything, it is that markets do
not value current earnings and cashflows enough
and value future earnings and cashflows too much.
– Low PE stocks are underpriced relative to high PE stocks
 The market response to research and development
and investment expenditure is generally positive
Firms and Society
 In theory: There are no costs associated with the firm
that cannot be traced to the firm and charged to it.
 In practice: Financial decisions can create social costs
and benefits.
– A social cost or benefit is a cost or benefit that accrues to
society 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 unemployment
 supporting development in under developed areas
The Bondholders’ defense against
Stockholder excesses
 More restrictive covenants on investment, financing and
dividend policy have been incorporated into both
private lending agreements and into bond issues
 New types of bonds have been created to explicitly
protect bondholders against sudden increases in
leverage or other actions that increase lender risk
substantially. Two examples of such bonds
– Puttable Bonds, where the bondholder can put the bond back
to the firm and get face value, if the firm takes actions that
hurt bondholders
– Ratings Sensitive Notes, where the interest rate on the notes
adjusts to that appropriate for the rating of the firm
The Bondholders’ Defense Against
Stockholder Excesses

More hybrid bonds (with an equity

component, usually in the form of a conversion
option or warrant) have been used. This
allows bondholders to become equity
investors, if they feel it is in their best
interests to do so.
The Societal Response
 If firms consistently flout societal norms
and create large social costs, the
governmental response (especially in a
democracy) is for laws and regulations to be
passed against such behavior.
Finally, investors may choose not to invest
in stocks of firms that they view as social
outcasts.
 e.g.. Tobacco firms and the growth of
“socially responsible” funds