CORPORATE FINANCE

FUNCTIONS AND GOALS

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 The domain
Every decision that a business makes has financial implications, and
any decision which affects the finances of a business is a corporate
finance decision.

Defined broadly, everything that a business does fits under the ambit
of corporate finance.

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 Determinants of Intrinsic Value: The Big Picture
Sales revenues

− Operating costs and taxes

− Required investments in operating capital

Free cash flow

=
(FCF)

FCF1 FCF2 FCF∞

Value = + ... + +
1
(1 + WACC) (1 + WACC) 2 (1+ WACC)∞

Weighted average
cost of capital
(WACC)

Market interest rates Cost of debt Firm’s debt/equity mix

Market risk aversion Cost of equity Firm’s business risk

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 The Three Major Decisions in Corporate Finance

FIRST
THE ALLOCATION DECISION

Where do you invest the scarce resources of your business?

What makes for a good investment?

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 The Three Major Decisions in Corporate Finance

SECOND
THE FINANCING DECISION

Where do you raise the funds for these investments?

What mix of owner’s money (equity) and borrowed money (debt) do

you use?

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 The Three Major Decisions in Corporate Finance

THIRD
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?

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 THE TRADITIONAL BALANCE SHEET

ASSETS LIABILITIES
Fixed Assets Current Liabilities

Current Assets Debt

Financial Investments Other Long-Term Liabilities

Intangible Assets Equity

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 ASSETS

Fixed Assets → Long-lived Real Assets

Current Assets → Short-lived Assets

Financial Investments → Investments in securities and assets of

other firms

Intangible Assets → Assets which are not physical, like patents and
trademarks
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 LIABILITIES
Current Liabilities → Short-term liabilities of the firm

Debt → Debt obligations of the firm

Other Liabilities → Other long-term obligations

Equity → Equity investment in the firm

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THE FINANCIAL VIEW OF THE FIRM

ASSETS LIABILITIES

Assets in place Debt

Growth Assets Equity

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 ASSETS
(Financial View)
Assets in place
 Existing Investments

 Generate cash flows today

 Includes long-lived (fixed) and short-lived (working capital) assets

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 ASSETS
(Financial View)
Growth Assets
 Expected value that will be created by future investments

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 LIABILITIES
(Financial view)
Debt
 Fixed claim on cash flows

 Little or no role in management

 Fixed Maturity

 Tax Deductible
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 LIABILITIES
(Financial view)
Equity
 Residual claim on cash flows

 Significant role in management

 Perpetual lives

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FIRST PRINCIPLES OF CORPORATE FINANCE

Invest in projects that

yield a return
greater than the
minimum acceptable hurdle rate

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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 timing of these cash flows;
they should also consider both positive and negative side effects of these
projects
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 Choose a
financing mix
that
minimises the hurdle rate
and
matches the assets being financed

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If there are not enough investments
that earn the hurdle rate,
return the cash to stockholders

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 The form of returns
– dividends and stock buybacks –
will depend upon
the stockholders’ characteristics

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All these will result in achieving the objective – which is to

Maximise firm’s profit?

Maximise market share?

Maximise firm value?

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 What determines a firm’s fundamental, or intrinsic, value?

Intrinsic value is the sum of all the future expected free cash flows when
converted into today’s currency:

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 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.

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 Why do we need an objective?

 If an objective is not chosen, there is no systematic way to make

the decisions that every business will be confronted with at some
point in time.

 A theory developed around multiple objectives of equal weight

will create a dilemma when it comes to making decisions.

 The costs of choosing the wrong objective can be significant.

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 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

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 It does not create costs for other entities or groups that erase firm-
specific benefits and leave society worse off overall.

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 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.

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 All other goals of the firm are intermediate ones leading to firm
value maximization, or operate as constraints on firm value
maximization.

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Why traditional corporate
financial theory often focuses on
maximizing stock prices as
opposed to firm value

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 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 (are they?), 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.

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 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

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 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.

 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.

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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

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Another Way of Presenting this is...

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