Chapter 1: Introduction to corporate finance

Corporate FinanceRoss, Westerfield & Jaffe

Main tasks of corporate finance• Capital budgeting: the process of planning

and managing a firm’s long-term investments fixed assets.

• Capital structure: the mixture of debt and equity maintained by the firm S-T and L-T debt and equity.

• Working capital management: a firm’s short-term assets and liabilities current assets and current liabilities.

Cash flows between the firm and the financial markets

SOURCE: Hillier, Ross, Westerfield, Jaffe and Jordan, 2010, Corporate Finance: European Edition, McGraw-Hill, Figure 1.3

Modern form of firms• Corporation: a business created as a distinct legal entity

composed of one or more individuals or entities, e.g., IBM.– Separation of control (shareholders) and management

(professionals).– Ownership can be easily transferred.– Limited liability.– Double taxation.– Rather expensive to form.– Agency problems.

Financial managers

• Frequently, financial managers try to address these tasks.

• The top financial manager within a firm is usually the Chief Financial Officer (CFO).– Treasurer – oversees cash management, credit

management, capital expenditures and financial planning.

– Controller – oversees taxes, cost accounting, financial accounting and data processing.

Value vs. price• The value of shares are not observable. In contrast, the price

of shares can be observable. • If one believes that share price is an accurate/good estimate

of share value, the appropriate goal would be to maximize the price of shares.

• This belief/assumption is, however, questionable.• But the previous slide (Home Depot ex-CEO), nevertheless,

showed that investors care about stock price, and that stock price performance is very important to the tenure of managers.

Role of The Financial Manager

Financial

managerFirm's

operations

Financial

markets

(1) Cash raised from investors(2) Cash invested in firm

(3) Cash generated by operations(4a) Cash reinvested

(4b) Cash returned to investors

(1)(2)

(3)

(4a)

(4b)

DECISIONS MADE BY THE FINANCIAL MANAGER

• Investment decisions

• Financing decisions

• Capital structure decisions

• Dividend policy decisions

• Short-term financial management decisions

• While accountancy plays an important role within corporate finance, the fundamental problem addressed by corporate finance is economic, i.e. how best to allocate the scarce resource of capital.

• Aim of Financial Manager is the optimal allocation of the scarce resources available to them.

Aim of Financial Manager

• Financial managers are responsible for making decisions about raising funds (the financing decision), allocating funds (the investment decision) and how much to distribute to shareholders (the dividend decision).

• The high level of interdependence existing between these decision areas should be appreciated by financial managers when making decisions

• Can you think how these decisions may be inter-related?

Role of The Financial Manager

Interrelationship b/w Investment, Financing & Dividend Decisions

Investment: Company decides to take on a large number of attractive new investment projects

Finance: Company will need to raise finance in order to take up projects

Dividends:If finance is not available from external sources, dividends may need to be cut in order to increase internal financing.

Dividends: Company decides to pay higher levels of dividend to its shareholders

Finance: Lower level of retained earnings available for investment means company may have to find finance from external sources.

Investment: If finance is not available from external sources than company may have to postpone future investment projects.

Finance: Company finances itself using more expensive sources, resulting in a higher cost of capital.

Investment: Due to a higher cost of capital the number of projects attractive to the company decreases.

Dividends: The company’s ability to pay dividends in the future will be adversely affected.

THE GOAL OF THE FIRMTHE GOAL OF THE FIRM• Maximizing shareholders’ wealth, ie

– maximizing the share price

– maximizing the value of the equity

– maximizing the value of the firm• Managers may not share the same goals as

shareholders– this is called an agency problem

• Amount and share of national income which is paid to the

owners of business

• A situation where output exceeds input, that is the value

created by the use of resources is more than the total of the

input resources

• Investment, financing and dividend policy decisions of a firm

should be oriented to the maximization of profits

• A yardstick by which economic performance can be judged

• Ambiguity- Has no precise connotation and is a vague and ambiguous concept

• Timing of Benefit- Ignores the differences in the time pattern of the benefits received from investment proposals or courses of action

• Quality of Benefit- ignores the quality aspect of benefits associated with a financial course of action

• Also known as value maximization or net present worth maximization, it is almost universally an accepted goal of a firm

• The managers should take decisions that maximize the shareholders' wealth or generates a net present value

•Net present value is the difference between present

value of the benefits of a project and present value of its

costs

•Equivalent to stock price maximization

• Based on the concept of cash flows generated by the

decision rather than accounting profit

• Considers time value of money

• It may not be suitable to present day business activities

• It is the indirect name of the profit maximization

• Creates ownership-management controversy

• Management alone enjoy certain benefits

• Can be activated only with the help of the profitable

position of the business concern

The agency problem• Agency relationship:

– Principals (citizens) hire an agent (the president) to represent their interest.

– Principles (stockholders) hire agents (managers) to run the company.• Agency problem:

– Conflict of interest between principals and agents.– This occurs in a corporate setting whenever the agents do not hold

100% of the firm’s shares.– The source of agency problems is the separation of (owners’) control

and management.

Agency costs• Direct costs: (1) unnecessary expenses, such

as a corporate jet, and (2) monitoring costs.• Indirect costs. For example, a manager may

choose not to take on the optimal investment. She/he may prefer a less risky project so that she/he has a higher probability keeping her/his tenure.

Managerial incentives

• Managerial goals are frequently different from shareholders’ goals.– Expensive perks.– Survival.– Independence.

• Growth and size (related to compensation) may not relate to shareholders’ wealth.

Corporate governance• Compensation:

– Incentives ($$$, options, threat of dismissal, etc.) used to align management and stockholder interests.

• Corporate control:– Managers may take the threat of a takeover seriously and run the

business in the interest of shareholders.

• Pressure from other stakeholders (e.g., CalPERS, a powerful corporate police).

CORPORATE GOVERNANCECORPORATE GOVERNANCE

Board of Directors

Management

AssetsDebt

Equity

Shareholders

Debtholders

Separation of ownership and control

THE AGENCY PROBLEMTHE AGENCY PROBLEM• Separation of ownership and control

Berle & Means (1932), The Modern Corporation and Private Property

Asset ownership versus control

• The core issue – Managers are the agents of shareholders– Managers may act in their own self interest if the consequences are not severe enough

• Shareholders vs Management• Bondholders vs Shareholders

Corporate Governance Models

Shareholders

Main Bank Firm(management)

Shareholders

Firm(management)

Banks Employees

Frequently criticized as focusing onshort-term profitability rather thanlong-term growth

Frequently criticized for its lack of accountability to shareholders while focusing on the demands of too diffuse a group of stakeholders

Anglo-American Model “Impatient Capital”

Continental European Model “Patient Capital”

Corporate governance conflicts

Management

Controlling Minority shareholders shareholders

Corporate governance conflicts Type I agency problem: the conflict of interest

between managers and shareholders (the ‘classic’ agency problem)

Type II agency problem: when controlling shareholders are present, eg families, they may have an incentive to extract private benefits of control at the expense of minority shareholders

Mitigating the Agency Problem Internal control mechanisms Board of directors Audited financial statements Share value–based compensation Share ownership External control mechanisms Managerial labour market Market for corporate control Shareholder activism Corporate Governance codes (‘soft law’)

Corporate Governance dilemmas ...

• Remuneration policy (eg share-value based schemes) can align managerial interests with those of shareholders

• But excessive remuneration is one of the possible ways that managers can expropriate wealth from shareholders

• Maximisation of a company’s ordinary share price is used as a surrogate objective to that of maximisation of shareholder wealth.

Role of The Financial Manager

Ownership vs. Management

Difference in Information

• Stock prices and returns• Issues of shares and

other securities• Dividends• Financing

Different Objectives

• Managers vs. stockholders

• Top mgmt vs. operating mgmt

• Stockholders vs. banks and lenders

Agency & Corporate Governance

• Managers do not always act in the best interest of their shareholders, giving rise to what is called the ‘agency’ problem.

• A financial manager can maximise a company’s market value by making good investment, financing and dividend decisions

Agency & Corporate Governance

Customers

Shareholdersincluding institutions andprivate individuals Creditors

including banks, suppliersand bond holders

Management

Employees

THE COMPANY

Diagram showing the agency relationships that exist between the various stakeholders of a company

Agency & Corporate Governance• Agency is most likely to be a problem when there is a divergence

of ownership and control, when the goals of management differ

from those of shareholders and when asymmetry of information

exists.

• An example of how the agency problem can manifest itself within

a company is where managers diversify to reduce the overall risk

of the company, thereby safeguarding their job prospects.

• Shareholders could achieve this themselves by diversification.

Agency & Corporate Governance• Monitoring and performance-related benefits are two potential ways to

optimise managerial behavior and encourage ‘goal congruence’.

• Due to difficulties associated with monitoring, incentives such as

performance-related pay and executive share options can be a more

practical way of encouraging goal congruence.

• Institutional shareholders now own approximately 60 per cent of all UK

ordinary share capital. Recently, they have brought pressure to bear on

companies who do not comply with corporate governance standards.

Agency & Corporate Governance

• The problem of corporate governance has received a lot of attention

following a number of high profile corporate collapses and a plethora

of self-serving executive remuneration packages.

• In the UK, we have the example of Transport and Banking

• UK corporate governance systems have traditionally stressed internal

controls and financial reporting rather than external legislation.

• Corporate governance in the UK was addressed by the 1992 Cadbury

Report and its Code of Best Practice, and the 1995 Greenbury Report.