Introduction to
Corporate Finance
Financial Policy and Planning
Outline
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Meaning of Financial Management
Meaning of Corporate Finance
Significance
Goal of a Firm
Motivating Management
Meaning of Corporate Finance
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Corporate finance can be defined as a body
of knowledge that deals with the following
three issues:
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What long-term strategic investments a firm should
undertake?
What long-term strategic financing alternatives that a firm
should use to raise capital to finance its long-term strategic
investments?
How much short-term cash flow does a company need to
ensure smooth day-to-day operations of the firm?
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Long-term strategic investments decisions are also
known as the capital budgeting decisions of the firm.
Long-terms strategic financing decisions involve a
decision on
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mix of debt and equity financing for the company and are
known as capital structure decisions
Dividend policy decisions also fall into this category.
Management of short-term cash flows relates to
working capital management.
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The above-mentioned three issues are discussed
and analyzed within the basic framework of time
value of money and principles of risk and return.
Moreover, financial statements analysis helps the
management in moving towards the right path in the
interests of the shareholders.
Thus, we can define corporate finance as a study of
the principles, policies, and institutions that shape
corporate financial decisions
Why Financial Management is an
Important?
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There are financial implications of virtually all
business decisions and non-financial executives
must know enough finance to work these
implications into their own specialized analyses
Lack of understanding of basic principles of finance
may have disastrous implications for a firm
Eastern Airline filed for bankruptcy partially due to
lack of understanding of financial implications of its
decisions.
Goal of Firm in a Corporate
Form of Organization
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Separation of ownership from management in a company form of
organization
Owners (shareholders) elect the management (board of
directors)
Management is in an agency relationship to shareholders
Given that management is managing the firm on behalf of the
shareholders, what should be the goal of a firm?
 Should it be maximization of sales revenue?
 Should it be minimization of costs?
 Should it be maximization of employee welfare?
 Should it be maximization of society welfare?
 Should it be maximization of customer satisfaction?
Goal of a Firm?
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The overall goal should be maximization of
owners’ welfare
It also means maximization of shareholder
wealth
Shareholder wealth is maximized through
market price per share maximization
It is also consistent with maximization of
profits at a given level of risk
How to Ensure the Management
Acts in Shareholders’ Interest?
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Managerial Incentives
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Performance-based Incentive Plans
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Executive Stock Option Plans
Performance Shares
Direct Intervention by Shareholders
The Threat of Firing
The Threat of Hostile Takeover
Performance-based incentive
Plans
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Firms are increasingly linking managerial compensation to the
firm’s performance by instituting performance-based incentive
plans
Stock options allow management to purchase pre-designated
number of shares at some time in the future at a predetermined
price.
The stock options will have value only if the market price of the
stock rises above the exercise price of the option.
This serves as an incentive to the management to take actions
that would ensure growth of stock price through comparison with
competitors.
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Performance shares are shares of stock given to executives on
the basis of performance as defined by objective measures such
as earnings per share, return on assets, return on equity, and so
forth.
Managerial performance may also be judged in a relative sense
Other methods of motivating top management:
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Kodak requires its top executives to invest one to four times the base salary in
Kodak shares
GM requires top executives to hold GM common stock equivalent in market
value to the manager’s annual salary
Xeros, Union Carbide, and Hershey Foods also require top executives to invest
in the common stock of the firm
http://www.forbes.com/2005/04/20/05ceoland.html
Direct Intervention by
Shareholders
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Direct intervention more easy now with institutional
ownership of shares
Shareholders being the ultimate owners can force
management to act in their best interests or risk
losing the job
Lockheed’s CEO Daniel Tellep had to adopt
shareholders’ proposals that made the company an
attractive target for takeover.
This resulted in Lockheed Martin in 1995.
Institutional investors who owned 46% stake played
a key role.
Threat of Firing
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Of course, shareholders can remove the
existing management by voting them and
with institutional investors this threat has
become a reality.
American Express, Goodyear, GM, IBM,
Apple have lost their CEOs at some point due
to shareholders’ unhappiness
Threat of Hostile Takeover
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Hostile takeover is a takeover of a firm against the
wishes of existing management.
Hostile takeovers are most likely to occur when a
firm’s stock is undervalued relative to its potential
due to poor management.
RJR Nabisco was the target of hostile takeover by
KKR group
IBM initial bid for Lotus Development Corporate was
hostile
Oracle bid for Peoplesoft
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Can management prevent hostile takeovers?
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