BF3201

Corporate
Finance &
Strategy
Lecture 1
• The Big Picture

• Objective of Corporate
Finance

• Corporate Governance
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Objectives of Course
Ø To give you the capacity to understand the theory and
apply, in real world situations, the techniques that have
been developed in corporate finance.
Ø To give you the big picture of corporate finance so that
you can understand how things fit together.
Ø Finance is both an art and a science.
– Theories and models make finance scientific
– But finance theories do not predict with 100% accuracy
– Application of finance is an art
Ø To help you graduate and find a job!

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The Big
Picture
Corporate Finance - What is it?

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What is Corporate Finance?
Ø Every decision that a business makes has financial
implications, and any decision which affects the finances
of a business is a corporate finance decision.
Ø Defined broadly, everything that a business does fits
under the rubric of corporate finance.

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Objective of Corporate Finance
Ø Singular objective: Maximizing value of the firm
Ø As a result of this singular objective, we can
– Choose the “right” investment decision rule to use
– Determine the “right” mix of debt and equity
– Examine the “right” amount of cash that should be returned to the
owners of a business and the “right” amount to hold back as a cash
balance

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 The Objective of Corporate Finance is
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Universal
Ø Every business, small or large, public or private, US or emerging
market, has to make investment, financing and dividend
decisions.
Ø The objective in corporate finance for all of these businesses
remains the same: maximizing value.
Ø Constraints and challenges can vary across firms, the objective
do not change.
– Public vs private firms?
– Developed vs emerging market firms?

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The Big Picture and 3 First Principles

Maximize the value of the business (firm)

The Investment Decision The Financing Decision The Dividend Decision

Invest in assets that earn a Find the right kind of debt If you cannot find investments
return greater than the for your firm and the right that make your minimum
minimum acceptable hurdle mix of debt and equity to acceptable rate, return the cash
rate fund your operations to owners of your business

The hurdle rate The return How much How you choose
should reflect the The optimal The right kind
should relfect the cash you can to return cash to
riskiness of the mix of debt of debt
magnitude and return the owners will
investment and and equity matches the
the timing of the depends upon depend whether
the mix of debt maximizes firm tenor of your
cashflows as welll current & they prefer
and equity used value assets
as all side effects. potential dividends or
to fund it. investment buybacks
opportunities

L 2, 3, 4 L 5, 6, 7 L8 L9
L 10

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And it will be applied…

Disney Bookscape
Sector: Entertainment Sector: Book Retail
Incorporated in: US Incorporated in: US
Operations: Multinational Operations: New York
Size: Large market cap Other: Privately owned

Vale
Deutsche Bank
Sector: Mining/Metals
Sector: Bank/ Investment Bank
Incorporated in: Brazil
Incorporated in: Germany
Operations: Multinational Applied Corporate Finance Operations: Multinational
Size: Large market cap
Size: Large market cap
Other: Government stake
Other: Regulated

Tata Motors Baidu

Sector: Automotive Sector: Online Search
Incorporated in: India Incorporated in: Cayman Isl
Operations: Multinational Operations: China
Size: Mid market cap Size: Mid market cap
Other: Family Group Other: Shell company (VIE)

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The Objective
of Corporate
Finance
• Maximize stock price

• What can go wrong? Role of corporate governance

• Other objectives?

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The Objective in Decision Making
Ø In traditional corporate finance, the objective in decision
making is to maximize the value of the firm. PV of future CFs
Ø 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.

Assets Liabilities
Existing Investments Fixed Claim on cash flows
Generate cashflows today Assets in Place Debt Little or No role in management
Includes long lived (fixed) and Fixed Maturity
short-lived(working Tax Deductible
capital) assets

Expected Value that will be Growth Assets Equity Residual Claim on cash flows
created by future investments Significant Role in management
Perpetual Lives
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 For share price maximization to work,
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we need…
STOCKHOLDERS

Maximize
stockholder
wealth
Bondholder
Interests are
protected
BONDHOLDERS/ Managers SOCIETY
LENDERS No social costs or all
costs can be
Markets are traced to firm
efficient and
assess effect on
value

FINANCIAL MARKETS

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What can go wrong?
STOCKHOLDERS

Maximize
Managers put
stockholder
their interests
wealth
above stockholders
Bondholder
Bondholders
Interests are
protected
get ripped off
BONDHOLDERS Managers SOCIETY
No
Somesocial costs
social or cannot
costs all costsbe
Markets
Marketsaremake can be to firm
traced
efficient
mistakesand
or do traced to firm
assess effect
not have on
enough
Value
information to
assess value

FINANCIAL MARKETS

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I. Stockholder vs. Management
ØIn theory:
The stockholders have significant control over
management.
ØThe two mechanisms for disciplining management are the
annual meetings and the board of directors.
– Stockholders who are dissatisfied with managers can express their
disapproval at the annual meetings, and can use their voting power
at the meeting to keep managers in check.
– The board of directors plays its true role of representing
stockholders and acting as a check on management.

ØIn Practice: Neither mechanism is as effective in

disciplining management as theory posits. Why?

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 The Annual Meeting as a disciplinary
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venue
ØThe power of stockholders to act at annual meetings
is diluted
– Most small stockholders do not go to meetings because the
cost of going to the meeting exceeds the value of their
holdings.
– In Singapore 2016, on average 58% of shares are voted in AGMs
– Clustering of AGM on certain dates and in far off areas
– Evasive shareholder meetings
– For large stockholders, the path of least resistance, when
confronted by managers that they do not like, is to vote with
their feet.

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Other Voting Issues
Ø Plurality voting versus Majority voting when electing directors
Ø Voting rights – Many companies have dual class shares
– Facebook example, See also Facebook’s DEF 14A
– What are the reasons for and against dual class shares?
Ø Founders as majority shareowner
– Fahlenbrach (2009): Founder CEOs on average holds 11% of shares compared to 2% in
other firms
Ø Stockholders with competing interests
– Government ownership?
Ø Cross-holdings
– Chaebols in Korea, Keiretsus in Japan
Ø Different types of Institutional investors
– Passive institutional investors versus active institutional investors such as hedge funds,
private equity firms, etc
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The Independent Director
ØNASDAQ: An “independent director” is one who is not an
executive officer or employee of the listed company, and
who, in the opinion of the board of directors, has no
relationship which would interfere with the exercise of
independent judgment in carrying out the responsibilities
of a director.
ØAre the directors truly independent?
– Powerful CEOs are more likely to appoint directors who are socially-
connected to themselves (Fracassi and Tate 2012)
– Boards with a high proportion of directors appointed by the CEO
performs worse (Coles, Daniel, and Naveen 2014)

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 Board of directors as a disciplinary
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mechanism
ØDirectors are busy
– Own full-time job
– Sit on multiple boards
ØLack expertise and/or information to question management
ØLack of independence from management
– May be nominated by CEO
– May be socially connected to the CEO
– May be insiders
– Served for very long
ØNot sufficiently incentivized
– Hold little shares in the company
ØCEO chairs the board of directors as the chairman
– Control the meetings and likely the flow of information to the rest of the
board

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 When managers and shareholders are
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not aligned… (Additional)
1. Fight off takeovers that may increase shareholder value
• Greenmail: The (managers of ) target of a hostile takeover buy out
the potential acquirer's existing stake, at a price much greater
than the price paid by the raider, in return for the signing of a
'standstill' agreement.
• Golden Parachutes: Provisions in employment contracts, that
allows for the payment of a lump-sum or cash flows over a period,
if managers covered by these contracts lose their jobs in a
takeover.
• Shark Repellents: Anti-takeover amendments are also aimed at
dissuading hostile takeovers
o E.g., Supermajority requirements for approvals of mergers

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 When managers and shareholders are
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not aligned… (Additional)
2. The quickest and perhaps the most decisive way to
impoverish stockholders is to overpay on a takeover.
• Many mergers do not work.
o Stock prices of bidding firms decline on the takeover announcements a
significant proportion of the time.
o Post-merger operating and stock return performance also languish
over the long-term

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When managers and shareholders are
not aligned… (Additional)
3. Overpayment to CEOs: Are their pay justified?
• Yes!
• No!

4. CEOs do not work hard enough to maximize shareholder

wealth

ØAnd many more issues…..

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What can go wrong?
STOCKHOLDERS

Managers put
their interests
above stockholders

Bondholders
get ripped off
BONDHOLDERS Managers SOCIETY
Some
No social
social costs
costs or cannot
all costsbe
Markets
Marketsaremake traced
can be to firm
efficient
mistakesandor do traced to firm
assess effect
not have on
enough
Value
information to
assess value

FINANCIAL MARKETS

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II. Stockholders vs. Bondholders
ØIn theory:there is no conflict of interests between
stockholders and bondholders
– Bondholders include all lenders (including banks)
– Therefore, what is good for shareholders should be good for lenders
ØIn practice: What can go wrong?
– What does bondholder like?
– What does shareholder like?

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Examples of the conflict..
ØA dividend/buyback surge: 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.
ØRisk shifting: When a firm takes riskier projects than those
agreed to at the outset, lenders are hurt.
– Lenders base interest rates on their perceptions of how risky a firmʼs
investments are. If stockholders then take on riskier investments,
lenders will be hurt.
ØAdditional borrowings: If lenders do not protect
themselves, a firm can borrow more money and make all
existing lenders worse off.

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What can go wrong?
STOCKHOLDERS

Managers put
their interests
above stockholders

Bondholders
get ripped off
BONDHOLDERS Managers SOCIETY
Some
No social
social costs
costs or cannot
all costsbe
Markets make traced
can be to firm
mistakes or do traced to firm
not have enough
information to
assess value

FINANCIAL MARKETS

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III. Firm vs Financial Markets
ØIn theory: Financial markets are efficient. Managers
convey information honestly and and in a timely manner to
financial markets, and financial markets make reasoned
judgments of the effects of this information on '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.
è Stock price performance is a good measure of company
performance.
ØIn practice: There are some holes in the 'Efficient Markets'
assumption.

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 Managers control the release of
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information to the general public
ØOutright fraud: In some cases, firms release intentionally
misleading information about their current conditions and
future prospects to financial markets.
– Examples of recent fraud?

ØInformation management (timing and spin): Information

(especially negative) is sometimes suppressed or delayed
by managers seeking a better time to release it.
– Strategic news releases in equity vesting months

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 Evidence that managers delay bad
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news?

DO MANAGERS DELAY BAD NEWS?: EPS and DPS Changes- by

Weekday

8.00%

6.00%

4.00%

2.00%

0.00%

-2.00%

-4.00%

-6.00%
Monday Tuesday Wednesday Thursday Friday

% Chg(EPS) % Chg(DPS)

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Some critiques of market efficiency..
ØInvestor irrationality: The base argument is that
investors are irrational and prices often move for no
reason at all.
ØManifestations of irrationality
• Some believe that investors overreact to news, both good and
bad.
• Prices are manipulated by insiders.
• Investors are short-sighted, and do not consider the long-term
implications of actions taken by the firm
è Stock prices do not reflect the true fundamentals of the firm.
è Recent examples?
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What can go wrong?
STOCKHOLDERS

Managers put
their interests
above stockholders

Bondholders
get ripped off
BONDHOLDERS Managers SOCIETY
Some social costs cannot be
Markets make traced to firm
mistakes or do
not have enough
information to
assess value

FINANCIAL MARKETS

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IV. Firm vs Society
ØIn theory: All costs and benefits associated with a firmʼs
decisions can be traced back to the firm.
ØIn practice: Financial decisions can create social costs and
benefits.
– A social cost or benefit 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:
o creating employment in areas with high unemployment
o supporting development in poor cities
o creating access to goods in areas where such access does not exist

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Social Costs and Benefits
ØAre difficult to quantify
Ø They might not be known at the time of the decision.
– Example: Johns Manville Corporation was forced into bankruptcy in 1982
because of asbestos produced in the 1950s and 1960s.

ØEyes of the beholder: They are ‘person-specific’, since different

decision makers can look at the same social cost and weight
them very differently

èDifficult to account for when measuring firm value/ stock price

– WEF: Toward Common Metrics and Consistent Reporting of
Sustainable Value Creation
– CFA Global ESG Disclosure Standards for Investment Products

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 Given so much issues, should we
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choose a different objective function?
ØFirms can always focus on a different objective function.
Examples would include
• maximizing earnings
• maximizing revenues What can go wrong?
• maximizing firm size
• maximizing market share
• cater to the welfare of all stakeholders
ØThe key thing to remember is that these are intermediate
objective functions.
• To the degree that they are correlated with the long term health
and value of the company, they work well.
• To the degree that they do not, the firm can end up with a disaster
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Market-based system is still the best…
ØThe strength of the stock price maximization objective
function is its internal self-correction mechanism.
– Market-based systems are ruthless and quick to correct mistakes
ØIn the context of our discussion,
– managers taking advantage of stockholders has led to an increase in
shareholder activism and more responsive boards.
– stockholders taking advantage of bondholders has led to
bondholders protecting themselves at the time of the issue.
– firms revealing incorrect or delayed information to markets has led
to markets becoming more “skeptical” and “punitive.”
– firms creating social costs has led to more regulations, as well as
investor and customer backlashes.
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However…
ØWhat if markets do not get it right? What if markets are
short-term focused? Or stock prices do not reflect long-
term value?
– Tying corporate financial decisions to stock price can sometimes lead
to bad decisions

ØManagers should first and foremost focus on long term

value
– Use stock price changes as feedback and judge whether the changes
are justified

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Summary
ØGoal of Corporation è Maximize firm value è Maximize
shareholder wealth è Maximize stock price
ØMaximize stock price will work well as a goal if
– Managers act in the best interest of shareholders
– Bondholders are protected
– Markets are efficient and have proper information to evaluate the
firm
– All social costs and benefits can be traced back to the firm

ØHowever, in reality, each of the above conditions can break

down

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 Reducing conflicts between shareholders
and managers – Stockholder backlash
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ØAt annual meetings, vocal stockholders have taken to expressing

their displeasure with incumbent management by voting against
their compensation contracts or their board of directors
ØShareholder activism

– Proxy contests that seeks to replace some of the directors, e.g., P&G vs
Trian
– Shareholder proposals asking for policy changes or disclosure on some
issue.
– Shareholders wanting to meet with a company’s executives or directors
to discuss their concerns and urge action. See “Behind the Scenes: The
Corporate Governance Preferences of Institutional Investors.”

è Mostly institutional investors such as Calpers and hedge funds

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Is activism useful?

Source: Bebchuk, Brav, and Jiang (2015) 37

What about other institutional
investors such as mutual funds?
ØInstitutional investors hold about 70% of all outstanding US
equities
– Have huge power to shift balance of power from managers to
shareholders

Blackrock engagement statistics

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 In response, boards are becoming
more effective (at least on paper!)
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Ø Boards have become smaller over time.

– Median size of a board has decreased from 16 to 20 in the 1970s to about 8 in recent years

Ø There are fewer insiders on the board

– After 2002, exchange listing rules require boards to have majority independent directors and some
of the major board committees to comprise of independent directors only

Ø Directors are increasingly compensated with stock and options in the company,
instead of cash.
Ø More directors are identified and selected by a nominating committee rather than
being chosen by the CEO of the firm.
– In 2007, 97% of boards had nominating committees; the comparable statistic in 1973 was 2%.

Ø Firms are restricting the number of board seats held by their directors

Ø Appointing lead independent directors to counter CEO as chairman

Ø Singapore’s Code of Corporate Governance

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 Reducing conflicts between bondholders and
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shareholders
Ø More restrictive covenants on investment, financing and dividend
policy have been incorporated into both private lending agreements
and into bond issues
Ø 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
Ø 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.
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The Financial Market Response
ØBetter information flow
– Analyst coverage of firms
– Media attention
ØAs investor access to information improves, it is becoming
much more difficult for firms to control when and how
information gets out to markets.
ØWhen firms mislead markets, the punishment is not only
quick but it is savage.

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The Societal Response
ØIf 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.
– Passage of SOX in 2002
– ESG reporting
– Carbon tax
ØFor firms catering to a more socially conscious clientele, the
failure to meet societal norms (even if it is legal) can lead to loss
of business and value.
– E.g., Starbucks; Asia Pulp and Paper
ØFinally, investors may choose not to invest in stocks of firms that
they view as socially irresponsible.
– BlackRock’s ESG initiative; Retail investments in ESG funds increasing
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The Counter Reaction
STOCKHOLDERS

1. More activist Managers of poorly

Investors run firms are put
2. More responsive on notice.
boards
Protect themselves Corporate Good Citizen Constraints
BONDHOLDERS Managers SOCIETY
1. Covenants 1. More laws
2. New Types 2. Investor/Customer Backlash
Firms are
punished Investors and
for misleading analysts become
markets more skeptical

FINANCIAL MARKETS

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The Modified Objective Function
ØFor publicly traded firms in reasonably efficient markets, where
bondholders (lenders) are protected:
• Maximize Stock Price: This will also maximize firm value
ØFor publicly traded firms in inefficient markets, where
bondholders are protected:
• Maximize stockholder wealth: This will also maximize firm value, but
might not maximize the stock price
ØFor publicly traded firms in inefficient markets, where
bondholders are not fully protected
• Maximize firm value, though stockholder wealth and stock prices may
not be maximized at the same point.
ØFor private firms, maximize stockholder wealth (if lenders are
protected) or firm value (if they are not)
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