Week 1

Lecture 1 – SF

Introduction
 What is finance?
 Corporate finance is an area of finance dealing with financial
decisions business enterprises make and the tools and analysis
used to make these decisions.

 Corporate Financial Management deals with the decisions of a

firm related to investment, financing and dividend (Veshvanath)
 To carry on business, a firm invests in tangible assets like plant
and machinery, buildings, and intangible assets like goodwill
and patents. This comprises the investment decision

12/28/2017
 These assets don’t come free; one has to pay for
them, so a company needs to tap various sources of
funds including shares, bonds, bank loans. This
forms the financing decision

 The investment in assets generates revenues and

cash flows for a specific period of time. The
managers of the company can either retain cash with
the company for further investment or distribute to
the owners of the company—the shareholders. This
constitutes the dividend decision
 In short, a finance manager will be concerned with such
financial decisions as:
 Which investment/s should the company accept and what are
the financial implications of undertaking the same?

 How should the company finance those investments? What

should be the mix of owners’ contribution— equity and
borrowed funds, i.e., debt at any given point in time?

 How much of the income generated from operations should be

returned to shareholders in the form of dividends and how
much is to be retained for further investment?

12/28/2017
Financial decisions: Time perspective

 Capital investment decisions are long-term

choices about which projects receive
investment, whether to finance that investment
with equity or debt, and when or whether to pay
dividends to shareholders

 On the other hand, the short term decisions can be

grouped under the heading "Working capital
management".

 This subject deals with the short-term balance of

current assets and current liabilities;
 The focus here is on managing cash,
inventories, and short-term borrowing and
lending (such as the terms on credit extended
to customers).

12/28/2017
Objective of financial managers

 Corporate Finance theoreticians generally agree

that the objective of a firm is to maximize
wealth
 Whose wealth? whether it should be the wealth
of shareholders or the wealth of the firm, which
includes bondholders and preferred
stockholders
 Shareholder wealth maximization rule requires
managers to work towards a sustainable
increase in the price of the firm’s stock
12/28/2017
 Alternative to the above rule is to maximize
profit, social value, or growth of the firm
 The underlying assumption is that, an increase
in any of these proxies results in an increase in
the value of the firm (alternatively, shareholder
value)
 Maximize Profit? Increase sales, suppress
expenses, extract the last rupee from the
customer, pay the lowest possible price to
suppliers, pay less salaries to employees,
12/28/2017
 Can social responsibility be an objective?
 Businessmen are supposed to be socially
responsible
 But social welfare activities have conceptual
propblems? What is right or wrong, how much
to spend on social responsibility? Moreover,
what was considered moral 30 years ago could
be immoral now?

12/28/2017
 Can growth be an objective of a firm?
 Business in pakistan, india and south Korea are
dominated by family groups, and
conglomerates.
 Businesses groups in south Korea are called
chaebol, typically own 30—50 companies in all
key business areas; and the big five—Daewoo,
Samsung, Hyundai, LG, and SK—account for
20 percent of all borrowing and contribute to
almost 50 percent of GDP
12/28/2017
 Debt ratios at the top 30 chaebol are in the
range of 550 percent; they suck up a major
portion of the available credit and drive out
smaller businesses
 The chaebol understand only one language:
borrow to the hilt; focus on size and not profit;
focus on growth and not productivity; invest
aggressively and acquire companies
 Productivity in South Korea is about half that of
US levels
12/28/2017
 When earnings fall due to recession,
competition, or some such thing, these
companies will default on borrowings
 To summarize, growth, though important, need
not necessarily lead to an increase in
shareholder value

12/28/2017
 Do Firms Pursue Multiple Objectives?
 In a survey of management views on alternative
objectives, Porwal found in his sample that in 67
percent companies—with high profitability—the
first preference is given to the objective of
maximizing percent ROI and, in 33 percent
companies, the first preference is given to the
objective of maximizing aggregate earnings

12/28/2017
12/28/2017
Impediments to shareholder wealth maximization

 There could be potential conflict of interest

between shareholders and bondholders,
managers and shareholders, majority and
minority shareholders. So, maximizing wealth
of one group could be achieved at the expense
of other groups
 Shareholders vs Bondholders
 Managers vs Shareholders
 Shareholder vs Shareholder

12/28/2017
Conclusion

 The objective of a firm should not be to make

a profit or even maximize profit, increase
market share or sales, but to maximize
shareholders’ wealth
 But this should not be achieved at the expense
of other investor groups
 Financial markets are efficient to some extent,
they can see whether a firm is adding value or
not; this will be reflected in the share price of
the firm
12/28/2017
What is strategic financial management

 The identification of the possible strategies

capable of maximizing an organization's net
present value, the allocation of scarce capital
resources among the competing opportunities,
and the implementation and monitoring of the
chosen strategy so as to achieve stated
objectives

12/28/2017
 Goals of Corporation &
Role of financial
institutions and financial
markets
 What is a Corporation?
 Corporation
• A business organized as a separate legal entity owned by stockholders.
 Types of Corporations
• Public Companies[a company whose shares are traded freely on a stock
exchange].
• Private Corporations
• Limited Liability Corporations (LLC)[ LLC is the United States-
specific form of a private limited company. It is a business structure that
combines the pass-through taxation of a partnership or sole proprietorship
with the limited liability of a corporation

The principal difference between public and privately held companies is

that public companies have shares that can be publicly traded on a
stock market. A privately held company might become a publicly
held company by conducting an initial public offering, which is the
offering of shares of the company to the public
 Organizing a Business

 Types of Business Organizations

• Sole Proprietorships
• Partnerships
• Corporations
• Limited Liability Options
• Limited Liability Partnerships
• Limited Liability Corporations
• Professional Corporations
Organizing a Business
Sole
Proprietorship Partnership Corporation

Who owns the

The manager Partners Stockholders
business?

Are managers and

No No Usually
owners separate?

What is the owner's

Unlimited Unlimited Limited
liability?

Are the owner and

business taxed No No Yes
separately?
Corporate Structure

Sole Proprietorships
Unlimited Liability
Personal tax on profits
Partnerships

Limited Liability

Corporations Corporate tax on profits +

Personal tax on dividends
 Goals of The Corporation

 Shareholders desire wealth

maximization
 Do managers maximize
shareholder wealth?
 Mangers have many
constituencies “stakeholders”
 “Agency Problems” represent the
conflict of interest between
management and owners
 Goals of The Corporation

Ethics & Management Objectives

 Does value maximization justify unethical
behavior?
 Enron example
 WorldCom example
 Putnam example
 Agency Problem

Ownership vs. Management

Different Objectives
Difference in
 Managers vs.
Information
stockholders
 Stock prices and
 Top mgmt vs.
returns
operating mgmt
 Issues of shares and
 Stockholders vs.
other securities
banks and lenders
 Dividends
 Financing
 Agency Problem

 Agency Problems
• Managers, acting as agents for stockholders, may
act in their own interests rather than maximizing
value.

 Stakeholder
• Anyone with a financial interest in the firm.
 Goals of The Corporation

Agency Problem Solutions

1 - Compensation plans
2 - Board of Directors
3 - Takeovers
4 - Specialist Monitoring
5 - Legal and Regulatory Requirements