Corporate Finance

Prof. Swati Dhawan

INTRODUCTION TO
‘CORPORATE FINANCE’
In this session we shall
cover:
• Meaning and scope of corporate
finance
• Decision areas of a finance manager
• Objective of maximization of
shareholders’ wealth vis-à-vis profit
maximization
• Concept of agency theory
Basic issues of finance
• Any business,
whether new or
existing, big or
small, having any
structural form,
varying in terms of
industry, product,
service, location
etc. would be
dealing with
Basic issues of finance
• Where to raise the funds from?
• Where to deploy / invest the funds?
• How much of the profits to be
retained and what portion to be
distributed in form of dividend?
• Whether the funds are being
effectively used in the day to day
operations?
 Balance sheet
LAIBILITIES SIDE ASSETS SIDE

Shareholder funds Long term assets

Other long term liabilities Current assets

Current liabilities
Value of the firm

V = f (I, F, D), WC
Mgt
Here,
V: Value of the firm
I: Investment decision
F: Financing decision
Objective of Corporate Finance

• To maximize the value of the firm or

shareholders’ wealth
• This would be done through various
types of decisions (by a finance
manager)
– Investment decisions
– Financing decisions
– Dividend decisions
– WC management
Investment decisions
• Allocation of funds in various assets
• Risk profile of choices made to be considered
• Investments decisions reflected on the assets side
of the balance sheet

Capital budgeting decisions

Investment evaluation criteria
Determining cash flows
Risk analysis in capital budgeting
Cost of capital
Financing decisions
• Sources of raising finance
• Choosing from a wide variety of institutions and
markets
• Internal source of finance – Retained earnings
• Conventional sources of raising finance vs. Modern
sources of raising finance
• Reflected on the liabilities side of balance sheet

Capital structure theories

EBIT-EPS analysis
Leverage analysis
Dividend decisions
• Finance manager has to strike a balance
between the amount of earnings to be
retained and the amount to be paid to
shareholders as dividend
• Reflected on the liabilities side of the
balance sheet

Factors affecting dividend

Dividend theories
Forms of dividend
Working capital
management
• The finance manager shall be
ongoingly engaged in looking at how
to manage the working capital
effectively striking a balance between
liquidity and profitability.

Cash Management
Inventory Management
Receivables Management
Other important areas
• Risk and return
• Portfolio theory
• Corporate restructuring
Inter-relationship between
activities

Investment: Company decides to take on a large

number of attractive investment projects

Finance: Company will need to raise finance in

order to take up projects

Dividend: If finance is not available from external

sources, dividends may be reduced in order to
increase internal financing
Inter-relationship between
activities
Dividends: Company decides to pay higher levels of
dividend to its shareholders

Finance: Lower level of retained earnings available for

investment meaning that company may have to resort to
external sources

Investment: If finance not available from external

sources, the company may have to postpone future
investment projects
Inter-relationship between
activities
Finance: Company finances itself using more expensive
sources, resulting in higher cost of capital

Investment: Due to a higher cost of capital, the number

of projects attractive for the company decreases

Dividend: The company’s ability to pay dividends in the

future will be adversely affected
Why value maximization as
an objective?
• What’s wrong with ‘profit
maximization’ as an objective?
• How is value maximization going to
be different from profit maximization?
 Customers

Governmen
Suppliers
t

CORPORATE
AND ITS
STAKEHOLD
Banks / ERS
Researcher
Financial
s
institutions

Employees
Owners / /
investors manageme
nt
Stakeholders with varying
objectives
• Varying objectives:
– Maximization of profits
– Maximization of market share
– Maximization of ROI
– Beating the competition
– Minimization of costs
– Good product quality and service levels

None provide a unfailing framework for

financial decision making.
Stakeholders with varying
objectives
• Limitations of different objectives:
– Ignore the viewpoint of other stakeholders
– Are non-quantifiable
– Do not account for risk
– Not based on cash flows
– Does not account for TVM

The only objective that stands the

rigorous test is MAXIMISATION OF
SHAREHOLDERS’ WEALTH!
Advantages of ‘Value
maximization’
as an objective
• stands the rigorous test taking into
account the expectations of different
stakeholders
• Based on Cash flows
• Accounts for TVM
• Accounts for risk
Agency problem
• As per the agency theory, there exists a principal-
agent relationship between the shareholders and
management
• The finance manager (representing management)
acts on behalf of the shareholders and ideally
should be taking actions consistent to maximizing
the value of the firm

• Why does agency exist?

– When managers are clearly not
acting in the best interests of the
shareholders
Agency problem
• Factors contributing to the problem of agency:
– Divergence of ownership and control
– Goals of management differ from that of owners
– Asymmetry of information

• Conflict between shareholders and debt holders

– Shareholders have a preference for higher risk
projects when compared to debt holders
– Return of shareholders is unlimited whereas loss
is limited to the value of their shares
– Risk of failure also borne by debt holders but
their return is not unlimited
Agency problem
• This possibility of conflict between the
interests of shareholders and
management is referred to as
AGENCY PROBLEM and gives rise to
AGENCY COSTS.
• AGENCY COST is a type of internal
cost that arises from and must be
paid to an agent acting on behalf of
the principal
Dealing with agency
problem
Monitoring
and control
costs

Incentives
Dealing with agency problem
• Monitoring the actions of management
– Independently audited financial statements
– Additional reporting requirements
– Use of external analysts

• Costs of monitoring to be weighted against benefits accruing

there from

• Free ride: Small shareholders would allow large shareholders,

who would be more keen to monitor managerial actions, to
incur bulk of monitoring costs while reaping the benefits
there from

• Incorporation of clauses in managerial contracts in

form of:
– Constraints
– Incentives
– Punishments
Dealing with agency problem
• Monitoring the actions of management
– Independently audited financial statements
– Additional reporting requirements
– Use of external analysts

• Costs of monitoring to be weighted against benefits accruing

there from

• Free ride: Small shareholders would allow large shareholders,

who would be more keen to monitor managerial actions, to
incur bulk of monitoring costs while reaping the benefits
there from

• Incorporation of clauses in managerial contracts in

form of:
– Constraints
– Incentives
– Punishments
Dealing with agency problem
• Performance related pay (in form of bonuses and
profit sharing)

• Executive stock option scheme

Quick Recap
• Financial managers are responsible for making decisions
about raising (financing decision), allocating funds
(investment decision) and how much to distribute to
shareholders (dividend decision)
• While objectives such as profit maximization, social
responsibility and survival represent important supporting
objectives, the main objective in corporate finance is
maximization of shareholders’ wealth
• A financial manager can maximize the company’s value by
making sound investment, financing and dividend decisions
• Managers do not always act in the best interest of
shareholders, giving rise to ‘agency problem’
• Monitoring and performance related benefits are two
potential ways to optimize managerial behavior
• Due to difficulties associated with monitoring, incentives
such as performance related pay and Employee stock option
plans can be adopted
Inter-relationship between activities

Investment: Company decides to take on a large number of

attractive investment projects

Finance: Company will need to raise finance in order to take up

projects

Dividend: If finance is not available from external sources,

dividends may be reduced in order to increase internal
financing
Inter-relationship between activities

Investment: Company decides to take on a large number of

attractive investment projects

Finance: Company will need to raise finance in order to take up

projects

Dividend: If finance is not available from external sources,

dividends may be reduced in order to increase internal
financing
Inter-relationship between activities

Investment: Company decides to take on a large number of

attractive investment projects

Finance: Company will need to raise finance in order to take up

projects

Dividend: If finance is not available from external sources,

dividends may be reduced in order to increase internal
financing
Why value maximization as an
objective?
• What’s wrong with ‘profit maximization’
as an objective?
• How is value maximization going to be
different from profit maximization?
 Customers

Suppliers Government

CORPORATE
AND ITS
STAKEHOLDE
Banks / RS
Financial Researchers
institutions

Employees /
Owners /
managemen
investors
t
Stakeholders with varying objectives

• Varying objectives:
– Maximization of profits
– Maximization of market share
– Maximization of ROI
– Beating the competition
– Minimization of costs
– Good product quality and service levels

None provide a unfailing framework for

financial decision making.
Stakeholders with varying objectives

• Varying objectives:
– Maximization of profits
– Maximization of market share
– Maximization of ROI
– Beating the competition
– Minimization of costs
– Good product quality and service levels

None provide a unfailing framework for

financial decision making.
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Advantages of ‘Value maximization’
as an objective
• stands the rigorous test taking into
account the expectations of different
stakeholders
• Based on Cash flows
• Accounts for TVM
• Accounts for risk
Agency problem
• As per the agency theory, there exists a principal-agent
relationship between the shareholders and
management
• The finance manager (representing management) acts
on behalf of the shareholders and ideally should be
taking actions consistent to maximizing the value of
the firm

• Why does agency exist?

– When managers are clearly not
acting in the best interests of the
shareholders
Agency problem
• As per the agency theory, there exists a principal-agent
relationship between the shareholders and
management
• The finance manager (representing management) acts
on behalf of the shareholders and ideally should be
taking actions consistent to maximizing the value of
the firm

• Why does agency exist?

– When managers are clearly not
acting in the best interests of the
shareholders
Agency problem
• This possibility of conflict between the
interests of shareholders and
management is referred to as AGENCY
PROBLEM and gives rise to AGENCY
COSTS.
• AGENCY COST is a type of internal cost
that arises from and must be paid to an
agent acting on behalf of the principal
Dealing with agency problem

Monitoring
and control
costs

Incentives
Dealing with agency problem
• Monitoring the actions of management
– Independently audited financial statements
– Additional reporting requirements
– Use of external analysts

• Costs of monitoring to be weighted against benefits accruing there

from

• Free ride: Small shareholders would allow large shareholders, who

would be more keen to monitor managerial actions, to incur bulk
of monitoring costs while reaping the benefits there from

• Incorporation of clauses in managerial contracts in form

of:
– Constraints
– Incentives
– Punishments
Dealing with agency problem
• Monitoring the actions of management
– Independently audited financial statements
– Additional reporting requirements
– Use of external analysts

• Costs of monitoring to be weighted against benefits accruing there

from

• Free ride: Small shareholders would allow large shareholders, who

would be more keen to monitor managerial actions, to incur bulk
of monitoring costs while reaping the benefits there from

• Incorporation of clauses in managerial contracts in form

of:
– Constraints
– Incentives
– Punishments
Dealing with agency problem

Monitoring
and control
costs

Incentives
Quick Recap
• Financial managers are responsible for making decisions about
raising (financing decision), allocating funds (investment decision)
and how much to distribute to shareholders (dividend decision)
• While objectives such as profit maximization, social responsibility
and survival represent important supporting objectives, the main
objective in corporate finance is maximization of shareholders’
wealth
• A financial manager can maximize the company’s value by
making sound investment, financing and dividend decisions
• Managers do not always act in the best interest of shareholders,
giving rise to ‘agency problem’
• Monitoring and performance related benefits are two potential
ways to optimize managerial behavior
• Due to difficulties associated with monitoring, incentives such as
performance related pay and Employee stock option plans can be
adopted
Thanks!