Corporate Finance:

“Any decisions made by a Business that affect its

finances”

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Firm Objectives
Objective Function

Maximise the value of the firm

Analysis Tools
How to achieve?

Accounting
Statement
Increase Maximise
Growth return to
Profit
Present shareholder
Value
 Acquisition  Operating  Dividend
Risk and efficiency payout
 Investment
return new  Increase  Improve
models project sales retained
earning
 Diversificat  Maintain
Option ion working
capital
pricing  Expansion
model  Proper
capital
structure

Investment Financing Dividend

Decision Decision Decision
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Cash Flows between the Firm and the Financial
Markets

Firm issues securites (A)

Firm invests Financial markets

in assets (B) Retained cash flows (E)

Short-term debt
Current assets Cash flow Dividends and Logn-term debt
Fixed assets From firm (C) Debt payments (F) Equity shares

Taxes
Total value of assets Total value of the firm
to investors in
the financial markets
Government
(D)

(A) Firm issues securities to raise cash (the financing decision)

(B) Firm invests in assets (capital budgeting)
(C) Firm’s operations generate cash flow
(D) Cash is paid to government as taxes
(E) Retained cash flows are reinvested in firm
(F) Cash is paid out to investors in the form of interest and dividends

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An Introduction to Corporate Finance

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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.

 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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The Classical Objective Function

STOCKHOLDERS

Hire & fire managers Maximize 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 time on value

FINANCIAL MARKETS

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What can go wrong?

STOCKHOLDERS

Have little control Mangers put

over managers their interests
above stockholders

Significant
Lend Money
Social Costs
BONDHOLDERS MANAGERS SOCIETY
Bondholders
Some costs
can get
cannot be
ripped off
traced to firm

Delay bad
Markets make
news or
mistakes and
provide
can over react
misleading
information

FINANCIAL MARKETS

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The Counter Reaction

STOCKHOLDERS

1. More activist investors Mangers of poorly

2. Hostile takeovers run firms are put
on notice

Corporate Good
Protect themselves Citizen Constraint
BONDHOLDERS MANAGERS SOCIETY
1. Covenants
1. More Laws
2. New Types
2. Investor/
Customer Backlash

Firms are
Investors and
punished for
analysists become
misleading
more skeptical
markets

FINANCIAL MARKETS

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When traditional corporate financial theory
breaks down, the solution is:

 To choose a different mechanism for corporate governance

 To choose a different objective:

 To maximize stock price, but reduce the potential for conflict and breakdown:
• Making managers (decision makers) and employees into stockholders
• By providing information honestly and promptly to financial markets

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Choose a Different Objective Function
Firms can always focus on a different objective function. Examples would include
 Maximizing earnings
• Maximizing revenues
• Maximizing firm size
• Maximizing market share
• Maximizing EVA
•

The 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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Choose a Different Objective Function
The strength of the stock price maximization objective function is its internal self correction mechanism. Excesses on any of the linkages lead, if unregulated, to counter actions which

reduce or eliminated these excesses

In the context of our discussion


Managers taking advantage of stockholders has lead to a much more active market for corporate control
•
Stockholders taking advantage of bondholders has lead to bondholders protecting themselves at the time of the issue
•
Firms revealing incorrect or delayed information to markets has lead to markets becoming more “skeptical” and “punitive”
•
Firms creating social costs has lead to more regulations, as well as investors and customer backlashes
•

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First Principles
Invest in projects that yield a return greater than the minimum acceptable hurdle rate
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.
•
•

Choose a financing mix that minimizes the hurdle rate and matches the assets being financed.

If there are not enough investments that earn the hurdle rate, return the cash to stockholders.
The form of returns – dividends and stock buybacks – will depend upon the stockholders’ characteristics

•

Objective: Maximize the Value of the Firm

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The notion of a benchmark

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Models of Risk and Return

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Discount Rate - Concepts

 It is the required rate of return or the opportunity cost of funds

 It is not the capitalisation rate

 It is a function of the investment not the investor

 It has 3 basic components

• The “real” rate of return that investors expect for lending the money on a riskless basis
• Expected inflation
• Risk

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Discount Rate - Concepts

 Weighted Average Cost of Capital (“WACC”)

• Weighted average of all forms of capital:

• written as [ kb*(1-Tc)B/V + kp*P/V+ks*S/V]

• kb is pre-tax cost of debt

• kp is cost of preferred stock

• Ks is cost of equity

• B,P and S are market values of debt, preferred stock and equity; V is B+P+S

• If discounting Pre-tax cash flows, the pre-tax, as opposed to the post-tax cost should be used

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Discount Rate - Concepts

 Estimating cost of equity

• Risk and return models

• Capital Asset Pricing Model
• Arbitrage Pricing Model

• Dividend Growth model

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Discount Rate - Concepts

 More about CAPM

• Written as E(R)=Rf+β (E[Rm]-Rf)

• E(R) is the expected return and is ≈ ks

• Rf is the risk-free rate

∀ β is the measure of non-diversifiable risk

• (E[Rm]-Rf) is the market risk premium

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Discount Rate - Calculation

 Directly available from the market:

• The rate implicit in current market transactions for similar assets

• Use WACC of a listed enterprise that has a single asset (or a portfolio
of assets) similar in terms of service potential and risks to the asset
under review

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Discount Rate - Calculation

 When rate is not directly available from the market:

• Start with enterprise’s WACC and

• Adjust it to reflect the discount rate of the specific asset

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Financial Market

 Financial markets are forum for the exchange of financial products

 Exist to allow money and risk to be passed from those who have a surplus money to those who our surplus of money to those who have a requirement for
funds or capacity to accept risk for a potential reward.

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Simplified frame work of the financial market

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Financial Market Sector
Banking Sector
 In the simplest sense, the banking sector operates to accept deposits from individuals or organizations (depositors) with excess cash and to lend this money to
others (borrowers) who have a demand for it. The depositors are paid interest, typically at rates less than those charged to borrowers, and the borrowers are
charged at higher interest rates

Capital Market Sector

 A capital market is a market in which governments, banks, and companies can borrow or invest large amounts of money for medium-to long term periods. The
purpose of a capital market is to facilitate the flow of capital by making money available to those that need it (borrowers) from those who have available funds
(investors).

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Basic Banking Model

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Capital Markets

Primary Market


Secondary Market


Grey Market


Derivative Market


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Capital Markets
Primary Market


A new issue is the introduction or sale to the public of shares or bonds not previously quoted on an exchange. New issues are introduced in the primary market.

Secondary Market
The secondary market is the market in which new shares or bonds are subsequently traded.


Grey Market
The grey market is a highly speculative and, accordingly, risky market in which only a limited number of dealing houses and clients are actively involved. In essence, transactions in the grey market consist of the purchase and sale of instruments prior to their issue.


Derivatives Market
A derivative instrument is based upon an underlying security (and possibly upon underlying exchange rates, interest rates, commodities or indexes). It provides the owner with certain rights or obligations with regard to the underlying instrument. A derivative instrument may be used either for speculation or to reduce risks (to hedge) connected
 with the underlying instrument.

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Financial Statements

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Financial Statements – Balance Sheet

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Financial Statements – Balance Sheet

Balance sheet concerns

 Accounting liquidity

 Debt versus equity

 Value versus cost

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Financial Statements – Income Statement

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Financial Statements – Cash Flow

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Financial Statements – Financial Ratio

Financial Ratio

 Short term solvency (current ration, quick ratio)

 Activity (total asset turnover, receivable turnover, inventory turnover)

 Financial leverage (debt ratio, interest coverage)

 Profitability (profit margin, return on asset, return on equity)

 Value (price earning ratio, market to book value, etc.)

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