Introduction to Corporate Finance

PRESENT BY ZAID BIN MUZAMMIL SYED SAULAT JAWAID

UNIVERSITY OF KARACHI

DEPARTMENT OF STATISTICS
Corporate Finance

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Introduction to Corporate Finance

Corporate Finance addresses the following three questions: 1. What long-term investments should the firm engage in? 2. How can the firm raise money for the required investments? 3. How much short-term cash flow does a company need to pay its bills?
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Corporate Finance

The Balance-Sheet Model of the Firm

Total Value of Assets: Total Firm Value to Investors:

Current Assets

Current Liabilities
Long-Term Debt

Fixed Assets 1 Tangible 2 Intangible

Shareholders Equity
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Corporate Finance

The Balance-Sheet Model of the Firm

The Capital Budgeting Decision
(Investment Decision) Current Assets

Current Liabilities
Long-Term Debt

Fixed Assets 1 Tangible 2 Intangible

What longterm investments should the firm engage in?

Corporate Finance

Shareholders Equity
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The Balance-Sheet Model of the Firm

The Capital Structure Decision
(Financing Decision) Current Assets

Current Liabilities
Long-Term Debt

How can the firm raise the money for the required Fixed Assets investments? 1 Tangible
2 Intangible

Shareholders Equity
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Corporate Finance

The Balance-Sheet Model of the Firm

The Net Working Capital Investment Decision
(Financial Decision) Current Assets
Net Working Capital

Current Liabilities
Long-Term Debt

Fixed Assets 1 Tangible 2 Intangible

How much shortterm cash flow does a company need to pay its bills?
Corporate Finance

Shareholders Equity
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Capital Structure
The value of the firm can be thought of as a pie. The goal of the manager is to increase the size of the pie.
70%50% 25% 30% DebtDebt Equity

The Capital Structure 50% 75% decision can be viewed as Equity how best to slice up a the pie. If how you slice the pie affects the size of the pie, then the capital structure decision matters.
Corporate Finance

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The Firm and the Financial Markets

Firm
Invests in assets (B) Firm issues securities (A) Retained cash flows (F) Short-term debt

Financial markets

Current assets Fixed assets

Cash flow from firm (C)

Dividends and debt payments (E)

Taxes (D)

Long-term debt
Equity shares

Ultimately, the firm must be a cash generating activity.

Government
Corporate Finance

The cash flows from the firm must exceed the cash flows from the financial markets.
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Financial Markets
Primary Market
When a corporation issues securities, cash flows from investors to the firm. Usually an underwriter is involved

Secondary Markets
Involve the sale of used securities from one investor to another. Securities may be exchange traded or trade over-thecounter in a dealer market.
Corporate Finance

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Financial Markets

Firms

Stocks and Bonds Money Bob

Investors securities Sue

money
Primary Market Secondary Market

Corporate Finance

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Investment Environment

Corporate Finance

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Two Elements of Investment: Time and Risk

InvestmentActivities that sacrifice present consumption for future (uncertain) rewards. Riskless Investment: (1) the asset is default-free. (2) the maturity of the asset matches the investment horizon of the investor.
$100 $110 10%

represented by dollar returns

represented by the rate of return

Riskless Investment deals with the time value of money

Corporate Finance

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Risky Investment and Capital Budgeting

Pt 1 Pt D t 1 Holding Period Rate of Return rt+1 Pt
$140 $130 $100 $100 $90 $80 40% 30% 0% -10% -20%

The Capital Budgeting Decision => How to choose investment projects?

Corporate Finance

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Capital Structure :Debt and Equity

The basic feature of a debt is that it is a promise by the borrowing firm to repay a fixed dollar amount of by a certain date. The shareholders claim on firm value is the residual amount that remains after the debtholders are paid. If the value of the firm is less than the amount promised to the debtholders, the shareholders get nothing.

Corporate Finance

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Debt and Equity as Options

Payoff to debt holders If the value of the firm is more than $F, debt holders get a maximum of $F. $F Payoff to shareholders If the value of the firm is less than $F, share holders get nothing.

$F Value of the firm (X)

$F Value of the firm (X)

If the value of the firm Debt holders are promised $F. is more than $F, share If the value of the firm is less than $F, they holders get everything get the whatever the firm if worth. above $F. Algebraically, the bondholders Algebraically, the shareholders claim is: Min[$F,$X] claim is: Max[0,$X $F] Corporate Finance 1-14

Combined Payoffs to Debt and Equity

Combined Payoffs to debt holders and shareholders If the value of the firm is less than $F, the shareholders claim is: Max[0,$X $F] = $0 and the debt holders claim is Min[$F,$X] = $X.

The sum of these is = $X Payoff to shareholders $F

If the value of the firm is more than Payoff to debt holders $F, the shareholders claim is: Max[0,$X $F] = $X $F and the $F debt holders claim is: Value of the firm (X)
Min[$F,$X] = $F. The sum of these is = $X

Debt holders are promised $F.

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Corporate Governance
Separation of Ownership and Control

Board of Directors Debtholders Shareholders Management

Assets

Debt Equity
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Asymmetric Information and Agency Costs

There is asymmetric information between shareholders and managers. How to induce managers to act in the shareholders interests ?
The shareholders can devise contracts that align the incentives of the managers with the goals of the shareholders. The shareholders can monitor the managers behavior.

(Agency Cost) This contracting and monitoring is costly.

Corporate Finance

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