Corporate Finance

1. Introduction

Summary
I.

The Financial Paradigma of the Firm

II. The Corporation and the Financial System

III. Financial Instruments and the Securitization of Assets and Capital of the
Corporation

MIF/ME/MIM 2014/2015: Corporate Finance/Financial Management

I. The Financial Paradigm of the Firm

The main objective of the corporation

Value creation

MIF/ME/MIM 2014/2015: Corporate Finance/Financial Management

I. The Financial Paradigm of the Firm

Value creation
Can the financial function creat value on its own?
YES
Any financing operation allowing for a reduction in the firms average cost of
capital will create value on its own;

However,
It is also very important that the financial function helps the firm as a whole to
create value, namely by meeting the requirements allowing the firm to implement
all investment projects with a positive NPV.

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I. The Financial Paradigm of the Firm

Value creation
What type of value? How can we measure value?
The objective in conventional corporate financial theory is to maximize the
value of the firm
Aswath Damodaran, Corporate Finance, Theory and Practice (2nd Edition)

The goal of financial management is to maximize the value of the existing

owners equity
Ross, Westerfield and Jaffe, Corporate Finance (9 thEdition)

Are these objectives compatible? Can the firm adopt more than one objective?
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I. The Financial Paradigm of the Firm

Value creation
What type of value? How can we measure value?
Remember that the firm is composed of
Investments

Fixed Assets

FCFi
A
i
i 1 (1 r )

di
i
i 1 (1 rs )

Financing

Equity
Entreprise or firm
value

1. Tangible
2. Not tangible

Debt

Working Capital

Current Assets

MIF/ME/MIM 2014/2015: Corporate Finance/Financial Management

Short-term
Liabilities

Ci
N

i
(1 rd ) n
i 1 (1 rd )

I. The Financial Paradigm of the Firm

Value creation
What type of value? How can we measure value?
Take into consideration the actual reality of the activity of the firm
Shareholders

Creditors

Because creditors cannot

control management, they
will be exposed to the risk of
wealth
expropriation
by
managers or shareholders.

Shareholders have little control

over managers, who thus might
place their own interests above
shareholders interests.

Managers

Managers
might
manipulate
information
in
order
to
misinform the markets. Markets
can also be wrong.

Financial Markets
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Firms might jeopardize the

interests of society as a whole
and those costs might be
difficult to allocate to firms
(e.g. pollution).

Society

Agency conflicts
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I. The Financial Paradigm of the Firm

Value creation
What type of value? How can we measure value?
Can the firm adopt more than one objective?
It is not at all convenient, because contradictory objectives might give way to
difficulties in making the best decisions
The existence of a single objective favours clear decision making, because
decisions will be taken to maximize the achievement of the chosen objective
The objective
Must be clear, rather than ambiguous

Maximize growth? Measured by which variable?

It must be measurable on a periodic basis and in an objective way

Maximize client satisfaction?

It must not originate costs for other groups or entities

Maximize sales (a tobacco company). One way to do it would be to intensify advertising

addressed to the youth. It might represent relevant losses for society.

MIF/ME/MIM 2014/2015: Corporate Finance/Financial Management

I. The Financial Paradigm of the Firm

Value creation
What type of value? How can we measure value?
Objective: Maximize enterprise Value
(Subject to complying with the ethical values related to the costs that
might be imposed on society by meeting this objective)

Reduction or elimination of conflicts

between the firm/management and
society.

If conflicts of interest between shareholders and managers and

between shareholders and creditors are eliminated or at least
minimized.

Objective: Maximize shareholders Wealth

If managers do not attempt to cheat or manipulate the markets and
markets are efficient.

Objective: Maximize stock Prices

MIF/ME/MIM 2014/2015: Corporate Finance/Financial Management

I. The Financial Paradigm of the Firm

Value creation
What type of value? How can we measure value?
Even though the main objective of the firm is to maximize enterprise
value, value creation may be measured by changes in stock prices,

providing that:
Managers act in the interest of shareholders and adopt the objective of maximizing
stock prices;
Creditors are protected against the risk of wealth expropriation by shareholders;
Managers do not manipulate information and do not succeed in cheating the
markets (efficient markets);
Management decisions do not impose costs (externalities) on society.

Briefly: providing that agency conflicts are minimized.

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I. The Financial Paradigm of the Firm

Value creation
Advantages of adopting the objective of stock price maximization:
Stock prices are the best observable figure amongst all other alternative
measures (in the case of listed companies).
Contrary to net profits or sales, stock prices reflect permanently up-dated
information.

Stock prices reflect the long-term effects of company decisions.

Stock prices are the true measure of shareholders wealth.

They allow for the choice of models to select the best investment projects
for the company and their best financing structure, and facilitate empirical

testing of those models.

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I. The Financial Paradigm of the Firm

Value creation

Objective: Maximizing Enterprise Value

How?
Investment Decisions

Financing Decisions

Dividend Decisions

Invest in assets offering a

return higher than the
required rate of return
[hurdle rate].

Find the optimal capital mix

to finance investments and
the nature of debt which
better meets the needs of
the corporation.

Return to shareholders any

cash exceeding investments
offering a return higher
than the expected rate of
return.

The hurdle rate

must reflect the
investment risk
and the
financing mix.

The return on
the asset must
take into
consideration
the amount and
timing of cashflows

The optimal mix

of equity and
debt maximizes
enterprise value

The nature of
debt depends
on the
characteristics
of the
enterprise
assets

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How much cash

to return will
depend on
present and
future
investment
opportunities

Dividend policy
will depend on
shareholders
preference for
cash or stock
dividends.

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I. The Financial Paradigm of the Firm

Value creation
Questions for which a CFO might have to provide an answer:
Invest 25 million euros in increasing production capacity or wait for one
year to observe market demand performance?

Implement or not a strategy of fixing:

commodity prices;

export exchange rates;

interest rate on loans?

How to finance the aggressive investment plan designed for the next three
years?

Implement or not a new management incentive scheme, based on

incentives to be decided upon?
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I. The Financial Paradigm of the Firm

Value creation
Questions for which a CFO might have to provide an answer:
To meet or not the demand of institutional investors for higher dividends?
Choose to offer stock dividends? Choose to offer stock repurchases?

There is a merger proposal by a big telecom company. What to do?

Is it in the best interest of shareholders?

What will be the reaction by foreign joint venture partners?

Should the company remain listed in the stock market?

Should capital structure be consolidated through an increase in equity?

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I. The Financial Paradigm of the Firm

Value creation
One could argue that value creation cannot ignore the conflicts of
interest (agency conflicts), the power basis, as a function of
ownership structure, as well as the environment of the financial

markets in which investment and financing operations will take

place;

Likewise, it can stated that the corporation is a nexus of contracts,

which constraint real world investment and financing decisions (and
make them more complex) .

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Summary
I.

O Paradigma Financeiro da Empresa

II. The Corporation and The Financial System

III. Os Instrumentos Financeiros e a Titulao de Activos e Capitais da

Empresa

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II. The Corporation and The Financial System

Financial
Markets

Exchange
of capital
& real
assets

Direct financing
Investment
decisions

Financing
decisions

Exchange of capital and financial assets

Indirect financing

Financial
Intermediaries

Corporate Finance
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Financial Markets and

Intermediaries

Investors

World

The Corporation

Financial
Assets
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II. The Corporation and The Financial System

A Classification of Financial Markets

Financial Markets

IMM

Money Market
(S-T)

Public Debt (Bills)

Libor rates (Euribor)

Yields

Treasure bills (T-bills)

Sort-term bank loans

Commercial paper

Commercial Paper
[Corporate Debt]

Capital Market
(L-T)

Repurchase agreements
(REPO)

Equity
(Stocks)

Common stocks
Preferred stocks

Debt
(Bonds)

Treasury bonds (T-bonds)

Corporate bonds (fixed rate &
float rate), zero-cupon

[Government & Corporate]

Hybrid

MIF/ME/MIM 2014/2015: Corporate Finance/Financial Management

Yields

Convertible bonds
Warrant bonds
Perpetual bonds

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II. The Corporation and The Financial System

Other important classifications of financial markets

Primary market vs. Secondary market

Cash market (spot market) vs. Futures market (derivatives)

Domestic market vs. Currency market

Domestic market vs. International market

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II. The Corporation and The Financial System

The financial system
Financial Institutions
Credit Institutions
Central
Bank

Auxiliary Institutions

Other Financial
Institutions

Banks

Other
Intermediaries

Brokers

Insurance Companies

Commercial
Banks

Leasing
Companies

Pension Funds

Savings
Banks

Factoring
Companies

Assets Management
Firms

Investment
Banks

Dealers

Information Services

Insurance Brokers

Mutual
Banks

Venture
Capital

Mutual Agro
Banks

Private Equity
Holding
Companies

Other

Other

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II. The Corporation and The Financial System

Financial institutions play a very important role
Intermediation of cash transfers (across space, across time, across
denominations);
Intermediation of financial operations; and

Intermediation in risk allocation (financial and non-financial risks)

They can thus contribute to market efficiency, but they are

nevertheless a source of transactions costs, one of market

inefficiencies.

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Summary
I.

O Paradigma Financeiro da Empresa

II. A empresa no Sistema Financeiro

III. Financial Instruments and The Securitization of Assets and Capital of

the Corporation

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III. Financial Instruments and The Securitization of

Assets and Capital of The Corporation

The securitization of financing contracts, as well as asset

securitization, grants:

Liquidity to the assets or to the rights represented by securities;

An objective basis for asset valuation (through market prices);
The benefit of regulation by market authorities and thus the

safeguard of the intrinsic quality of the assets;

An alternative financing solution, competing with bank financing;

The possibility of converting less liquid assets into cash.

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III. Financial Instruments and The Securitization of

Assets and Capital of The Corporation
Securitization
High growth in asset securitization operations in international
markets, a trend joined by a number of Portuguese Companies;
A very common solution amongst financial institutions:
It allows a conciliation of rapid business growth levels and of the assets
allocated to it with regulation requirements, namely those related with

solvency ratios;

It is a source of development of the financial markets, a driver of

financial innovation, and a factor of investment and financing

flexibility.

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 What is Corporate Finance?

Corporate finance encompasses all of

a firms decisions that have financial
implications
Aswath Damodaran, Corporate Finance, Theory and Practice (2nd Edition)

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 What is a firm? Why it exist?

The existence of the firm compensated for a critical flaw in the
price-setting mechanism:
Transaction costs, like the need to negotiate or draw up
contracts
Firms would exist when it was cheaper and easier to coordinate activity within a centrally planned organisation than
to spell out contract details for every step in the production
process.
Ronald Coase, cited by The Economist, One of the giants on 7 th September 2013 (5 days after his death)

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