Unit: 1

Goals and Governance of the Firm

1.1Corporate Finance
1.2Corporate Financial Decisions
1.3Investment Decision
1.4Financing Decision
1.5Corporation

Introduction

Corporations invest in real assets, which generate cash inflows and income. Some of the
assets are tangible assets such as plant and machinery; others are intangible assets such
as brand names and patents.
Corporations finance these assets by borrowing, by retaining and reinvesting cash flow,
and by selling additional shares of stock to the corporations shareholders.
A large corporation may have hundreds of thousands of shareholders. These shareholders
differ in many ways, such as their wealth, risk tolerance, and investment horizon. They
usually endorse the same financial goal: they want the financial manager to increase the
value of the corporation and its current stock price.
The corporation can either invest in new assets or it can give the cash back to the
shareholders, who can then invest that cash in the financial markets. Financial managers
add value whenever the company can earn a higher return than shareholders can earn for
themselves. The shareholders investment opportunities outside the corporation set the
standard for investments inside the corporation. Financial managers therefore refer to the
opportunity cost of the capital that shareholders contribute to the firm.

1.1 Corporate Finance

Every decision made in a business has financial implications, and any decision that involves
the use of money is a corporate financial decision. Defined broadly, everything that a
business does fits under the rubric of corporate finance.
A) Meaning:
Finance plays a very important role in making an organisation successful and it is a starting
point of every business activity. Finance is regarded as science as well as an art. It is the
soul of every business and basic requirement for starting and running business. Business
finance is the lifeblood of business.
B) Definitions:
1) Bonneville and Deway :
Business finance consists of the raising, providing, managing of all the money, capital or
funds of any kind to be used in connection with the finance.
2) Guthmann and Dougall :
Business finance can be broadly defined as the activity concerned with planning, raising
and administering of funds used in the business.

C) Features of Corporate Finance:

1) Financial Activity :
Corporate finance is a financial activity. It includes planning, raising, investing and
monitoring the finance of the company.
2) Raising the Finance :
Corporate finance includes raising (collecting) finance for the company. Finance can be
collected through shares, debentures, bank loans, etc. It is very difficult for new
companies to collect finance because the investors do not have confidence in new
companies.
3) Investing the Finance :
Corporate finance also includes investing (using) the finance. The finance is used to
achieve the objectives of the company. It is used to purchase fixed assets.
4) Objective Oriented :
Corporate finance is objective oriented. That is, it is used to achieve the objectives of the
company.
5) Types of Finance :
There are two types of corporate Finance, viz., fixed capital and working capital.

1.1 Corporate Finance

C) Features of Corporate Finance:

6) Relationship with other Departments :
Corporate finance has a close relationship with all other departments in the company, i.e.
Production Department, Marketing Department, etc.
7) Dynamic in Nature :
Corporate finance is dynamic in nature. It goes on changing according to the changes in
environment, circumstances, times, etc.
8) Requires proper Planning and Control :
Corporate finance requires proper planning and control. Planning is required to collect
finance from the investors. It is also required for investing the finance.
9) Managing Finance is an Art and Science :
Managing finance is an Art because it requires human skills and judgement. It is a Science
because it follows a systematic approach.
10)Legal Requirements :
There are many legal requirements for corporate finance. The company has to take
permission, from the Controller of Capital Issues, for collecting finance from the public.
11) Important part of Business Management :
Finance is required for all business activities. It is required for promoting business. It is
required for conducting the business smoothly. It is required for expansion, diversification,
modernization, replacement of assets, etc.

1.2 Corporate Financial Decision

A) Concept of Corporate Financial Decisions:

To carry on business, a corporation needs an almost endless variety of real assets. These
assets do not drop free from a blue sky; they need to be paid for. To pay for real assets, the
corporation sells claims on the assets and on the cash flow that they will generate. These
claims are called financial assets or securities. Take a bank loan as an example. The bank
provides the corporation with cash in exchange for a financial asset, which is the
corporations promise to repay the loan with interest. An ordinary bank loan is not a security,
however, because it is held by the bank and not sold or traded in financial markets. Take a
corporate bond as a second example. The corporation sells the bond to investors in exchange
for the promise to pay interest on the bond and to pay off the bond at its maturity. The bond
is a financial asset, and also a security, because it can be held by and traded among many
investors in financial markets. Securities include bonds, shares of stock, and a dizzying variety
of specialized instruments.
The investment decision also involves managing assets already in place and deciding
when to shut down and dispose of assets if profits decline. The corporation also has to
manage and control the risks of its investments. The financing decision includes not just
raising cash today but also meeting obligations to banks, bondholders, and stockholders that
contributed financing in the past. For example, the corporation has to repay its debts when
they become due. If it cannot do so, it ends up insolvent and bankrupt. Sooner or later the
corporation will also want to pay out cash to its shareholders.

1.2 Corporate Financial Decision

B) Nature of Financial Decisions:

The nature of financial decisions would be clear while understanding the operation of a firm.
At the very outset, the promoter makes an appraisal of various investment proposals and
selects one or more of them, depending upon the net benefit derived from each as well as
on the availability of funds. When a particular project is selected or the area of operation is
finalised, the requirements for long-term assets as well as current assets are determined, and
accordingly, the quantum and the sources of finance are sorted out.

1)
2)
3)
4)

Selection of investment proposals, known as the investment decision;

Determination of working capital requirements, known as the working capital decision;
Raising of funds to finance the assets, known as the financing decision;
Allocation of profits for dividend payment, known as the dividend decision.

These four decisions form the subject matter of corporate finance, although financial tools,
such as financial analysis, planning and control instruments that facilitate the above
decisions are also an integral part of the theme of corporate finamial management.

1.2 Corporate Financial Decision

C) Types of Corporate Financial Decisions:

1) Investment Decision/ Capital Budgeting Decision:
The investment decision, which is also known as capital budgeting, is concerned with the
selection of an investment proposal / proposals and the investment of funds in the
selected proposal or proposals.
2) Financing Decision:
All functions of a company need to be paid for one way or another. It is up to the finance
department to figure out how to pay for them through the process of financing. There
are two ways to finance an investment: using a company's own money or by raising
money from external funders.
3) Dividend Decision :
Dividend decision is the third major financial decision. The financial manager must decide
whether the firm should distribute all profits, or retain them, or distribute a portion and
retain the balance. Like the debt policy, the dividend policy should be determined in
terms of its impact on the shareholders value.
4) Working Capital Decision:
The working capital decision takes into account the management of current asses and
current liabilities. The management of current assets involves a couple of issues. The first
being the size of current assets, or in other words, what the size of cash holdings, shortterm marketable securities, account receivables and inventory should be.

1.2 Corporate Financial Decision

D) Objectives of Corporate Financial Decisions:

Long-term Decisions
1) Long-term Decisions :
This includes capital investment decisions like viability
assessment of projects,
financing it through equity and/or debt,
pay dividend or reinvest the profit.

2) Short-term Decisions :
These are also called working capital
management decisions which try to strike
a balance between current assets such as
cash, inventories, etc and current liabilities
i.e. a companys debts/obligations
impending for less than a year.

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1.2 Corporate Financial Decision

E) Factors Influencing Corporate Financial Decisions:

Nature and Size ofMicroeconomic Factors the

Enterprise

Macroeconomic Factors
The State of the Economy

1.2 Corporate Financial Decision

E) Factors Influencing Corporate Financial Decisions:

a) Microeconomic Factors:
1) Nature and Size of the Enterprise:
If a firm is engaged in manufacturing operations or in the provision of public utility
services, its investment in fixed assets is large and hence the capital structure has a large
share of long-term capital.
2) Risk:
Risk is another important factor that influences financial decisions. The greater the risk,
the higher the discount factor and this in turn considerably influences the investment
decision.
3) Liquidity Position;
The third factor influencing financial decisions is the liquidity position. Since dividend is
normally paid out of cash, firms with a sound liquidity position adopt a liberal dividend
policy.
4) Attitude of the Management:
Last factor is the managements attitude. A conservative finance manager will attach
greater importance to liquidity rather than to the profitability.

1.2 Corporate Financial Decision

E) Factors Influencing Corporate Financial Decisions:

b) Macroeconomic Factors:
1) The State of the Economy:
The state of the economy changes from time to time and the financial decisions of a firm
conform to these changes. When the economy is growing or proceeding towards
recovery, the finance manager should be eager to avail of investment opportunities. But
when the economy is facing a slump, the finance manager should proceed with care.

2) Governmental Policy:
Apart from the state of economy, governmental policy is no less significant in influencing
corporate financial decisions. State intervention or state regulation is found in almost all
countries, although its degree varies.

1.3 Investment Decision/ Capital Budgeting

The finance manager must carefully select best investment alternatives and consider the
reasonable and stable return from the investment. He must be well versed in the field of
capital budgeting techniques to determine the effective utilization of investment. The finance
manager must concentrate to principles of safety, liquidity and profitability while investing
capital.
A) Meaning:
Capital budgeting is the process of making investment decisions in the capital
expenditures. A progressive business firm always moves ahead, its fixed assets and other
resources continue to expand or there comes a need for expanding them. Capital
budgeting is actually the process of making investment decisions in capital expenditure or
fixed assets.
B) Definitions:
1) Charles T. Horngreen :
Capital budgeting is long term planning for making and financing proposed capital
outlays.
2) Lynch :
Capital budgeting consists in planning development of available capital for the purpose
of maximising the long term profitability of the concern.

.3 Investment Decision/ Capital Budgeting

C) Nature of Investment Decisions:

1) Allocation of Resources :
The capital budgeting is concerned with the allocation of their firms scarce financial
resources among the available market opportunities.
2) Current Outlays of Cash Resources :
The investment decisions involves a current outlay or series of outlays of cash resources
in return for an anticipated flow of future benefits.
3) Evaluation of expenditure Decision :
The system of investment decisions is employed to evaluate expenditure decisions which
involve current outlays but are likely to produce benefits over a period of time longer
than one year.
4) Capital Expenditure :
Capital expenditure management includes addition, disposition, modification and
replacement of fixed assets.
5) Determination of Destiny :
Investment decisions determine the future destiny of the company.
6) Not Easily Reversible :
Capital investment decisions, once made, are not easily reversible without much financial
loss to the firm.

3 Investment Decision/ Capital Budgeting

D) Significance of Investment Decision :

1) Large Investment :
Investment decisions involve large investment of funds. The funds available with the firm
are always limited and the demand for the funds far exceeds the resources.
2) Long-term Commitment of Funds :
The funds involved in capital expenditure are blocked in long-term investment. Longer
the time, greater the risk involved.
3) Irreversible in Nature :
Investments are most irreversible. When the decision for acquiring a permanent asset is
taken, it is very difficult to reverse that decision.
4) Complicated Investment Decisions :
The long-term investment decisions are more complicated in nature. The capital
budgeting decisions require an assessment of future events which are uncertain.
5) Long-term Effect on Profitability :
Investment decisions have a long-term and significant effect on the profitability of a
concern. Capital budgeting is of utmost importance to avoid over-investment or underinvestment in fixed assets.

4 Financing Decision

A) Introduction:
Financial management helps to take sound financial decision in the business concern.
Financial decision will affect the entire business operation of the concern. Because there is a
direct relationship with various department functions such as marketing, production
personnel, etc.

B) Meaning:
Financing decision is the decisions concerning the liabilities and stockholders' equity side of
the firm's balance sheet, such as a decision to issue bonds. The fundamental nature of
decision-making in finance is balancing the tension between maximizing profit and
minimizing risk. All of the decisions within the domain of financial management involve this
tension. Financial managers are responsible for investment of capital, which means they
must maximize returns with as little risk as possible. They must make decisions about
investment in the company itself, for capital acquisitions and research and development, for
example, always weighing the risk of affecting cash flow and profitability against the odds of
their internal investment decisions yielding profits.

1.4 Financing Decision

C) Nature of Financing Decision:

1.4 Financing Decision

C) Nature of Financing Decision:

1) Determine the Financing-mix:
The financing decision involves to decide when, where and how to acquire funds to meet
the firms investment needs. The central issue before the finance manager is to
determine the financing-mix or capital structure or leverage.
2) Financial Requirements Estimation:
But before the determination of capital structure, it involves the estimation about the
financial requirements correctly (both for long-period and short-period).
3) Deination of Appropriate Capital Structure:
The finance manager must strive to obtain the best financing mix or the optimum capital
structure for his or her firm. The firm's capital structure is considered to be optimum
when the market value of shares is maximised.
4) Raising the required Amount of Funds:
Once, the finance manager determines the best combination of debt and equity then he
or she must raise the appropriate amount through the best available sources.
5) It Covers two Inter-related Aspect:
The financing decision is concerned with the liabilities owned and stockholders' (owners')
equity (left) side of the company's balance sheet and covers two inter-related aspects: (a)
determination of an appropriate capital structure, and (b) raising the required amount of
funds.

CORporation

A) Introduction:
A corporation is a business or organization formed by a group of people, and it has rights and
liabilities separate from those of the individuals involved. It may be a nonprofit organization
engaged in activities for the public good; a municipal corporation, such as a city or town; or a
private corporation (the subject of this article), which has been organized to make a profit.

B) Meaning:
A corporation is a legal entity. In the view of the law, it is a legal person that is owned by its
shareholders. As a legal person, the corporation can make contracts, carry on a business,
borrow or lend money, and sue or be sued. One corporation can make a takeover bid for
another and then merge the two businesses. Corporations pay taxesbut cannot vote. A
corporation is owned by its shareholders but is legally distinct from them. Therefore the
shareholders have limited liability, which means that shareholders cannot be held personally
responsible for the corporations debts.

1.5 Corporation

C) Goals of Corporation:
a) Profit Maximization :
1) Ambiguity or Unclear:
Profit maximization goal is unclear. It is not clear whether the after tax or before tax
profit should be maximized, net profit or gross profit, earning per share or return on
equity etc. So, this goal creates confusion in managerial decision makings.
2) Ignores Time Value of Money:
Benefits received earlier are better since it can be reinvested that can increase the
terminal wealth of investments. However, the profit maximization considers the total
value of the benefit or profits but not the timing of cash flows.
3) Ignores the Quality of Benefits:
If the benefits are certain, such benefits or profits are considered to be of quality. Profit
maximization goal merely focuses on the amount of profit rather than its certainty or
degree of risks associated with. Profit maximization goal some time may mislead the
managers to select the projects with higher degree of risks.
4) Unsuitable in Modern Business Environment:
Traditionally businesses were family owned and self financed. But todays business are
characterized by separate ownership and management and market oriented. It has
various stakeholders which creates the unsuitability of profit maximization goal.

1.5 Corporation

C) Goals of Corporation:
b) Shareholders Wealth Maximization (Stock Price Maximization) :
Shareholders wealth maximization is also called stock price maximization. Some advantages
of this goal as opposed to profit maximization are as follows:
1.5 Corporation
C) Goals of Corporation:
b) Shareholders Wealth Maximization (Stock Price Maximization) :
1) Clarity of Goal:
Shareholder wealth maximization goal is clear since every decision are to be made based
on evaluation of cash flows rather than accounting profit. Financial managers always try
to make the cash flows to the shareholders as big as possible.
2) Considers the Time Value of Money:
This goal considers the cash flow and its present value. The cash flows received in earlier
period can be reinvested. So, this goal takes concern of time value of money.
3) Quality of Benefits:
According to this goal, the cash flows with lower degree of risks are discounted with
lower required rate of return while risky cash flows are subjected to higher required rate
of return. It makes the difference in the net present value of the same project with equal
cash flows. So, it is easier for managers to undertake the decisions.
4) Reduces the Conflicts:
Wealth maximization goal can serve the interest of multiple stakeholders of the company
like owners or shareholders, employees, customers, creditors and society. Under this
goal, company allocates the resources efficiently that help in producing high quality
goods and services at competitive price. It serves the interest of the customers.