Three Questions Addressed by the Study of

Finance:
1. What long-term investments should the firm undertake?
(capital budgeting decisions)
2. How should the firm fund these investments? (capital
structure decisions)
3. How can the firm best manage its cash flows as they
arise in its day-to-day operations? (working capital
management decisions)
 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.
 The Goal of the Financial Manager
 The goal of the financial manager must be consistent with the
mission of the corporation.
 What is the generally accepted mission of a corporation?

 To maximize firm value

 Corporate Financial Decisions, Firm Value and
Equity Value
 Value of the assets of the firm is determined by the cash flows
(CFs) that these assets are expected to generate and the
uncertainty of these CFs
 Expectation would change from day to day as new information
comes out about the firm and the macro environment- Market
Value of firm
 Value of the firm= Value of the equity in firm+ Value of the debt
 Value is determined not only by how well it manages its existing
assets but how well it invest in new assets
 Investors base expectations about firms future on the quality of
firms projects (investment decisions) and the amount of earnings it
reinvests (dividend decision)
OBJECTIVES of FINANCIAL MANAGEMENT…???

 Survive

 Avoid financial distress and bankruptcy

 Beat the competition
 Maximise Sales or Market Share
 Minimize costs
 Maintain steady earnings growth
 Maximize profits
 Why Profit Maximisation?
 For any business firm, the natural objective is Profit Maximisation and as such can
be pursued to guide financial decisions of a finance manager. This objective has the
following advantages:
 It is a well understood objective.
 It achieves sustainability for a firm as without profits, none can sustain itself for long.
 Profit is also considered as a yardstick of efficiency.
 In a free and competitive market, profit is the best driving and motivating force behind all economic
decisions.
 The theory of ‘Invisible Hand’ that ensures optimum allocation of resources for a society in a free
and competitive market also depends upon the objective of Profit Maximisation.
 It is an objective that is compatible with society’s objective as well as firm’s objective
Disadvantages of Profit Maximisation
– as an objective
 Profit is a vague term as it means so many things to different people that finance manager fails to
appreciate which profit should be maximised. Should it be profit to all stakeholders or profit to only
owners; before tax or after tax; short-term profits or long-term profits; total profits or per share profits;
operating profit or net profit; Accounting profit or Economic profit; and profit reported to shareholders or
profit reported to tax authorities?

 This objective ignores risk and uncertainty attached with profit. If a firm is earning huge profits at a very
high degree of risk, then it may be dangerous for the very existence of the firm in the periods to come?
For instance, should a finance manager divert funds to speculative activities and maximise the profits
of a firm?

 It ignores the time value of money as it does not make a distinction between profits received in future
and at present. Also, it ignores the timings when the costs are incurred and when the profits are
earned.

 Profit Maximisation objective concentrates only on the profitability aspects of various decisions but
ignores the financing decisions that are involved in them. As such, it fails to ignore the costs and the
risks involved in financing decisions that are important.
 Other Objectives
 Profit after tax (PAT) Maximisation
 Earning per share (EPS) Maximisation
These two are having more or less same disadvantages as the objective of
Profit Maximization has.
 Sales Maximisation
 Market Share Maximisation
………………??????????
 Goal of Financial Management
 Management employed by owners hence we need to ask:
From the shareholders perspective, what is a good financial
management decision?
 Assuming shareholder buy stock to gain financially….good
financial management decision increases the value of the
stock
 Hence the goal of financial management is to
maximise the current value per share of the existing
stock
 Corporate Finance can hence be described as study of
relationship bw business decisions, cash flows and the
value of the stock in business
 Firm’s Wealth Maximisation
 This objective also means to maximize the
STAKEHOLDERS’ WEALTH.

 According to it, the finance manager should decide the

things in such a manner that the wealth that would be
claimed by all the stakeholders - creditors, lenders,
employees, society, shareholders, etc. - should be
maximum.
Shareholders Wealth/ Value Maximisation
 Creation of shareholders’ Value in fact takes care of PROFIT,
SUCCESSFUL MARKETING STRATEGIES, HAPPY
CREDITORS and LENDERS.
 Ensuring balances among the objectives of the various stakeholders
is not a practical objective to be achieved.
 Since managers are accountable to the shareholders and they
employ them, managers should work for the maximum benefits of
the shareholders.
 Shareholders’ value consists of dividend payments and the market
value of shares. They both are accurately observable in case of listed
companies.
Shareholders Wealth/ Value Maximisation: contd.
 If we assume that stock markets are efficient then the valuation of
the shares reflects the fundamentals and risk involved of a
company. Thus, market provides a suitable measure to judge the
performance and hence, an objective worth pursuing.

 Also, the market takes into account the long-term view to

determine the share prices.

 This objective takes care of the time value of money.

 This objective provides an objective and well defined quantitative

yardstick for evaluating financial decisions.
 Why do we need a Unique Objective?
 Objective specifies what a decision maker is trying to accomplish
and by so doing, it provides measures that can be used to choose
bw alternatives
 It is the managers of the firm rather than the owners who make the
investment/ financial/dividend decisions
 If stock price maximisation is the objective, a manager choosing bw
2 alternatives will choose the one that increases stock price more
 If no objective is chosen there is no systematic way to make
decisions that every business will be confronted
 Multiple objectives will lead to chaos
 Costs of choosing the wrong objectives can be significant
 Characteristics of the “Right” Objective
 It should be clear and unambiguous
 Stock Price Maximisation- Stock prices are the most observable of all the
measures that can be applied to judge performance
 It comes with a clear and timely measure
 Stock Price Maximisation- in a market with rational investors, stock prices
reflect the long term effects of the firms decisions
 Stock prices real measure of stockholder wealth since stockholders can sell
their stock and receive the price right now
 It doesn’t create costs for other entities and groups
 Maximising stock prices can create costs for others (Agency Problem)
Why Stock Price Maximisation Works?
Stock Price Maximisation in an Ideal World
 Agency Considerations in Corporate Finance
 Agency relationship exists when one or more persons
(known as the principal) contracts with one or more
persons (the agent) to make decisions on their behalf.

 The Principal-Agent Relationship

Typically in a Corporation, there are what is called agents and
principals:
The Agent is the “person that acts,” whereas the Principal is the
person that receives the benefits from the actions.

 In a corporation, the managers are the agents and the

stockholders are the principal.
 Agency Considerations in Corporate Finance:
contd.
 Agency problems arise when there is conflict of interest between the
stockholders and the managers. Such problems are likely to arise more
when the managers have little or no ownership in the firm.
 Examples:
◦ Not pursuing risky project for fear of losing jobs, empire building, expensive perks
consumption.

 All else equal, agency problems will reduce the firm value.
 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.
Do Managers Act in the Stockholders' Interests
 How closely are management goals aligned with stockholders goals
(managerial compensation tied to financial performance, job
prospects)?
 Can managers be replaced if they do not pursue stockholders goals
(proxy fight, takeover)?
 Any checks and balances in system (Monitoring by way of- Reports,
Meetings, Auditors, board of directors, financial markets, bankers,
credit agencies)
 Regulatory supervision (SEBI Prohibition of Insider Trading
regulations 2015 and Clause 49 of listing agreement 2005-
improvement of corporate governance in all listed companies)

The above will help to reduce agency problems/costs.

Agency Problem and Stock Price Maximisation
Constrained Stock Price Maximisation
 Business Ethics
• Business ethics refers to the standards of conduct or
moral behaviour as applied to business practices.
• Fraud involves violating the law, whereas unethical
behavior involves breaching the code of ethics or moral
behaviour.
• In general, ethical behaviour and long-run profitability are
positively correlated.
• Given the subjective nature of ethics, in many cases the
choice between the ethics and profits is not
unambiguous.
 Corporate Social Responsibility
• The World Business Council: “Corporate social
responsibility is the continuing commitment by business
to behave ethically and contribute to economic
development while improving the quality of life of the
workforce and their families as well as the local
community and society at large.”

• While Hayek and Friedman argued that a business firm

should not swerve from its economic goal, many business
firms in practice do contribute to various social causes.
 Basic Axioms in Corporate Finance
 Money has time value/opportunity cost.
 Everyfinancial decision involves a trade-off
between RISK and RETURN.
 Market Prices reflect INFORMATION.
 Accounting Profit is not relevant profit concept for
financial decisions. Profits based on cashflows are
more relevant for Financial Decision-Making.
 Options have a VALUE.
 Economic Value Added
 Measure of Economic profit

 It is nothing but value created in excess of required

return of the company’s investors

 EVA= (Return on invested capital – Cost of capital) *

Capital Invested