Introduction
to
Corporate Finance
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Contact Details and Office Hours
Professor Madhu VEERARAGHAVAN (MVR)
Director and T.A. Pai Chair Professor of Finance
T.A. PAI MANAGEMENT INSTITUTE
Phone: +91-820-270 1020
Email: madhuveeraraghavan@tapmi.edu.in
Alternate Email: director@tapmi.edu.in
Author Profile: http://ssrn.com/author=329972
Office hours: I will hold virtual office hours commencing next week.
Please contact Parimala HEGDE or Sowmya KAMATH on 1009 or
1430 for appointment.
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Some Fundamental Concepts
What is Corporate Finance?
What is the role of a financial manager?
Goals of financial management
Agency problem
Role of financial markets
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What is Corporate Finance?
Corporate finance is the study of ways to answer three questions.
•
Investment Decision
•
Financing Decision
•
Dividend Decision
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Role of a Financial Manager
Role of a financial manager is to answer these three questions.
•
What assets should we buy (real and financial)?
•
How do we fund the acquisition of the assets?
•
What dividends should be paid to the shareholders?
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Investment Decision
The investment decision also called the capital budgeting
decision starts with the identification of investment
opportunities. The investment opportunities are referred to as
capital investment projects.
The financial manager’s job is to identify promising projects
and decide how much to invest in each project.
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Financing Decision
The financial manager’s second major task is to raise capital for the firm to meet
its investments and operations.
Note that firms can finance through equity or debt. The mix of long-term debt and
equity financing is called capital structure.
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Financial Manager
Financial manager can be defined as anyone responsible for a
significant corporate investment or financing decision (Treasurer,
Controller, CFO etc).
The CFO is responsible for financial policy and corporate planning.
Typically, the CFO oversees the treasurers and controllers.
Treasurer is responsible for financing cash management and
relationships with banks and other financial institutions.
In essence, the treasurer is responsible for cash management, raising
capital and banking relationships.
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Financial Manager
Controllers have responsibilities for budgeting, accounting and taxes
whereas CFOs oversee the treasurer and controller and sets the overall
financial strategy.
In particular, controllers are responsible for preparation of financial
statements, accounting and taxation issues.
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Financial Manager
Chief Financial Officer
Treasurer
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Controller
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Shareholders Wealth Maximisation Model (SWMM)
Although there are different financial goals such as survival,
maximising profits, minimising costs etc. the most important goal is
to maximise the wealth of the owners.
The term wealth indicates maximising the value of the shares.
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SWM Model (Contd)
As a manager you should take decisions that increase share price.
An effective financial manager is one who makes decisions that
increase the current value of the company’s shares and consequently
the wealth of its stockholders.
Managers who ignore this objective are likely to be replaced.
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Profit Versus Wealth Maximisation
What is the difference between maximising profits and maximising
wealth?
Profit maximisation ignores three important issues:
(1) Cash flows
(2) Timing of returns
(3) Risk
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Profit Versus Wealth Maximisation
• Note that the value of an asset depends on the magnitude of the cash flows that
the asset is expected to generate. Value will be greater if cash flows are larger.
• Timing of cash flows is also important because of time value of money. In
short, the value of an asset is greater when cash flows are received sooner.
• If future cash flows are risky then we are not certain what the outcome will be
and it is possible that the actual cash flows can be less than the expected cash
flows. Remember rational investors dislike risk so the value of an asset is
greater when the risk of cash flows is lower.
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Profit Maximisation
Three reasons.
• Note that a firm can increase it’s current year profits by cutting back
on maintenance etc. but shareholders may not welcome this if
profits are damaged in future years.
• You can increase profits by cutting this year’s dividend and
investing the freed-up cash in the firm.
• Profits can be calculated in different ways using different sets of
accounting rules.
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Agency Problems
• Control of a corporation lies in the hands of managers (agents for stockholders)
who are not the owners of the corporation.
• Large corporations have millions of shareholders and not all can be involved in
management. The goal of managers is to maximise the wealth of the owners.
Anyone with a financial interest in the firm is a stakeholder. Also, note that
owner-managers have no conflicts of interest in their management of the
business.
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Agency Problems (Contd)
• When managers place their personal goals ahead of the corporate
goals, we are bound to experience agency problem.
• In short, agency issue is the conflict between personal goals and
corporate goals.
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Agency Problems
Compensation plans also help managers maximise value. BMM cite Walt
Disney Corporation as an example where the CEO’s package had three
components – a base salary of $750,000, an annual bonus of 2-percent of
Disney’s net income above a threshold of normal profitability and a 10-year
option that allowed him to purchase 2 million shares for $14 per share.
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Managers and Interests of Shareholders
• Remember managers are agents of shareholders. Yes, they want managers to
maximise their wealth. Not at the cost of reputation.
• There are unwritten rules of behaviour. Think of frauds such as Bernie
Madoff’s Ponzi scheme
• Where did the money go? Who were the financial advisers?
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Financial Markets
• A market is the means through which the buyers and sellers are
brought together in order to discover prices.
• A financial market is a market where securities are issued and
traded. Note that for a corporation the stock market is the most
important financial market.
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Primary Versus Secondary Markets
• Primary market is a market where the original sale of debt and
equity securities takes place whereas in the secondary market the
securities are bought and sold after the original sale.
• The primary market transaction involves the company and the
buyers and the objective is to raise money for the company.
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Primary Versus Secondary Markets (Contd)
• The secondary market transaction does not involve the company unlike
primary markets. This is simply the means for transferring the ownership of
the securities. Trading takes place between the current and potential owners.
• The proceeds from the sale do not go to the issuing entity but to the current
owner.
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Fisher’s Separation Theorem (Contd)
• What is an NPV and how do we calculate the NPV of a project?
• NPV is the difference between the present value of the cash flows
generated by a project and the initial cash outlay.
• In particular, NPV can be defined as the difference between the PV
of the net cash flows discounted at the required rate of return and
the initial outlay of the investment.
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Net Present Value (NPV)
NPV can be calculated as follows:
Ct
NPV  
 C0
t
t 1 1  k 
n
where;
C0 is the initial cash outlay
Ct is the cash flow generated at time t
k is the required rate of return
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Net Present Value (NPV)
• Since NPV is based on project cash flows discounted to reflect the
time value of money it is known as a discounted cash flow method.
• We will discuss NPV, IRR and profitability index in the capital
budgeting session.
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Corporate Goals and Corporate Governance
We know that managers can best serve the interests of shareholders by
choosing positive NPV projects. The following can be used as an
mechanism to ensure that management pays attention to the value of a firm.
– Manager’s actions are subject to the scrutiny of the board of directors.
– Shirkers are likely to find they are ousted by more energetic managers.
– Financial incentives such as stock options
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Whose Company is it?
Views of 378 managers from 5 countries
3
Japan
97
17
Germany
22
France
78
71
29
United Kingdom
United States
76
24
0
The Shareholders
83
20
40
60
% of responses
All Stakeholders
07-12-2023
80
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100
120
Which is more important? Job security or shareholder
dividends?
Views of 399 managers from 5 countries
3
Japan
97
40
Germany
41
France
59
89
11
United Kingdom
United States
89
11
0
Dividends
60
20
40
60
80
% of responses
Job Security
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100
120
How are agency problems mitigated?
1. Legal and Regulatory Requirements: Note that managers have legal duty to act
in the interests of investors. For instance, in India the SEBI sets
out
standards to ensure consistency and transparency in reporting.
2. Good compensation plans
3. Board of Directors: BOD have an important duty – represent
shareholders.
Clause 40 of the listing agreements specify that listed companies in India should
have at least 50% independent directors.
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How are agency problems mitigated?
4. Monitoring: In addition to the BOD, managers are also monitored by security
analysts who give out investment recommendations.
5. Takeovers: Firms that fail to maximise value can be a target for takeovers.
6. Shareholder pressure can also help mitigate agency issues. They can elect
representatives to the board.
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What should be management’s primary objective?
• The primary objective should be shareholder wealth maximization,
which translates to maximizing the fundamental stock price.
– Should firms behave ethically? YES!
– Do firms have any responsibilities to society at large? YES!
Shareholders are also members of society.
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Is maximizing stock price good for society,
employees, and customers?
• Employment growth is higher in firms that try to maximize stock price. On
average, employment goes up in:
– firms that make managers into owners (such as LBO firms)
– firms that were owned by the government but that have been sold to
private investors
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Is maximizing stock price good? (Continued)
• Consumer welfare is higher in capitalist free market
economies than in communist or socialist economies.
• Fortune lists the most admired firms. In addition to high
stock returns, these firms have:
– high quality from customers’ view
– employees who like working there
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What three aspects of cash flows affect an
investment’s value?
• Amount of expected cash flows (bigger is better)
• Timing of the cash flow stream (sooner is better)
• Risk of the cash flows (less risk is better)
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Free Cash Flows (FCF)
• Free cash flows are the cash flows that are available (or free)
for distribution to all investors (stockholders and creditors).
• FCF = sales revenues - operating costs - operating taxes required investments in operating capital.
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What is the weighted average cost of capital
(WACC)?
• WACC is the average rate of return required by all of the company’s
investors.
• WACC is affected by:
– Capital structure (the firm’s relative use of debt and equity as
sources of financing)
– Interest rates
– Risk of the firm
– Investors’ overall attitude toward risk
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What determines a firm’s fundamental, or
intrinsic, value?
Intrinsic value is the sum of all the future expected free cash
flows when converted into today’s dollars:
Value =
FCF1
+
(1 + WACC)1
FCF2
+…+
(1 + WACC)2
See “big picture” diagram on next slide.
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FCF∞
(1 + WACC)∞
Determinants of Intrinsic Value: The Big Picture
Sales revenues
− Operating costs and
taxes
−
Required investments in operating capital
Free cash flow
(FCF)
Value =
FCF2
FCF1
+
(1 + WACC)1 (1 + WACC)2
=
+ ...
+
FCF∞
(1 + WACC)∞
Weighted average
cost of capital
(WACC)
Market interest rates
Market risk aversion
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Firm’s debt/equity mix
Cost of debt
Cost of equity
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Firm’s business risk
Who are the providers (savers) and users
(borrowers) of capital?
• Households: Net savers
• Non-financial corporations: Net users (borrowers)
• Governments: U.S. governments are net borrowers, some
foreign governments are net savers
• Financial corporations: Slightly net borrowers, but almost
breakeven
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Cost of Money
• What do we call the price, or cost, of debt capital?
– The interest rate
• What do we call the price, or cost, of equity capital?
– Cost of equity = Required return = dividend yield + capital
gain
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What economic conditions affect the cost of money?
• Federal Reserve policies
• Budget deficits/surpluses
• Level of business activity (recession or boom)
• International trade deficits/surpluses
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What are some financial institutions?
•
•
•
•
•
Commercial banks
Investment banks
Savings & Loans, mutual savings banks, and credit unions
Life insurance companies
Mutual funds
– Exchanged Traded Funds (ETFs)
• Pension funds
• Hedge funds and private equity funds
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What are some types of markets?
• A market is a method of exchanging one asset (usually cash) for
another asset.
• Physical assets vs. financial assets
• Spot versus future markets
• Money versus capital markets
• Primary versus secondary markets
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Primary vs. Secondary Security Sales
• Primary
– New issue (IPO or seasoned)
– Key factor: issuer receives the proceeds from the sale.
• Secondary
– Existing owner sells to another party.
– Issuing firm doesn’t receive proceeds and is not directly
involved.
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How are secondary markets organized?
• By “location”
– Physical location exchanges
– Computer/telephone networks
• By the way that orders from buyers and sellers are matched
– Open outcry auction
– Dealers (i.e., market makers)
– Electronic communications networks (ECNs)
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Physical Location vs. Computer/telephone
Networks
• Physical location exchanges: e.g., NYSE, AMEX, CBOT, Tokyo Stock
Exchange
• Computer/telephone: e.g., Nasdaq, government bond markets, foreign
exchange markets
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Types of Orders
• Instructions on how a transaction is to be completed
– Market Order– Transact as quickly as possible at current
price
– Limit Order– Transact only if specific situation occurs. For
example, buy if price drops to $50 or below during the next
two hours.
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Auction Markets
• Participants have a seat on the exchange, meet face-to-face, and place
orders for themselves or for their clients; e.g., CBOT.
• NYSE and AMEX are the two largest auction markets for stocks.
• NYSE is a modified auction, with a “specialist.”
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Dealer Markets
• “Dealers” keep an inventory of the stock (or other financial asset) and place bid
and ask “advertisements,” which are prices at which they are willing to buy and
sell.
• Often many dealers for each stock
• Computerized quotation system keeps track of bid and ask prices, but does not
automatically match buyers and sellers.
• Examples: Nasdaq National Market, Nasdaq SmallCap Market, London SEAQ,
German Neuer Markt.
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Electronic Communications Networks (ECNs)
• ECNs:
– Computerized system matches orders from buyers and sellers and
automatically executes transaction.
– Low cost to transact
– Examples: Instinet (US, stocks, owned by Nasdaq); Archipelago
(US, stocks, owned by NYSE); Eurex (Swiss-German, futures
contracts); SETS (London, stocks).
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Over the Counter (OTC) Markets
• In the old days, securities were kept in a safe behind the
counter, and passed “over the counter” when they were sold.
• Now the OTC market is the equivalent of a computer bulletin
board (e.g., Nasdaq Pink Sheets), which allows potential
buyers and sellers to post an offer.
– No dealers
– Very poor liquidity
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Home Mortgages Before S&Ls
• The problems if an individual investor tried to lend money to an
aspiring homeowner:
– Individual investor might not have enough money to fund an
entire home
– Individual investor might not be in a good position to
evaluate the risk of the potential homeowner
– Individual investor might have difficulty collecting
mortgage payments
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S&Ls Before Securitization
• Savings and loan associations (S&Ls) solved the problems faced
by individual investors
– S&Ls pooled deposits from many investors
– S&Ls developed expertise in evaluating the risk of borrowers
– S&Ls had legal resources to collect payments from borrowers
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Problems faced by S&Ls Before Securitization
• S&Ls were limited in the amount of mortgages they could fund by the
amount of deposits they could raise
• S&Ls were raising money through short-term floating-rate deposits, but
making loans in the form of long-term fixed-rate mortgages
• When interest rates increased, S&Ls faced crisis because they had to pay
more to depositors than they collected from mortgagees
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Taxpayers to the Rescue
• Many S&Ls went bankrupt when interest rates rose in the
1980s.
• Because deposits are insured, taxpayers ended up paying
hundreds of billions of dollars.
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Securitization in the Home Mortgage Industry
• After crisis in 1980s, S&Ls now put their mortgages into “pools” and
sell the pools to other organizations, such as Fannie Mae.
• After selling a pool, the S&Ls have funds to make new home loans
• Risk is shifted to Fannie Mae
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Fannie Mae Shifts Risk to Its Investors
• Risk hasn’t disappeared, it has been shifted to Fannie Mae.
• But Fannie Mae doesn’t keep the mortgages:
– Puts mortgages in pools, sells shares of these pools to investors
– Risk is shifted to investors.
– But investors get a rate of return close to the mortgage rate, which is
higher than the rate S&Ls pay their depositor.
– Investors have more risk, but more return
• This is called securitization, since new securities have been created based on
original securities (mortgages in this example)
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Collateralized Debt Obligations (CDOs)
• Fannie Mae and others, such as investment banks, can also split
mortgage pools into “special” securities
– Some securities might pay investors only the mortgage interest,
others might pay only the mortgage principal.
– Some securities might mature quickly, others might mature later.
– Some securities are “senior” and get paid before other securities
from the pool get paid.
– Rating agencies give different
• Risk of basic mortgage is parceled out to those investors who want
that type of risk (and the potential return that goes with it).
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Other Assets Can be Securitized
• Car loans
• Student loans
• Credit card balances
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The Dark Side of Securitization
• Homeowners wanted better homes than they could afford.
• Mortgage brokers encouraged homeowners to take mortgages even thought
they would reset to payments that the borrowers might not be able to pay
because the brokers got a commission for closing the deal.
• Appraisers thought the real estate boom would continue and over-appraised
house values, getting paid at the time of the appraisal.
• Originating institutions (like Countrywide) quickly sold the mortgages to
investment banks and other institutions.
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The Dark Side (Continued)
• Investment banks created CDOs and got rating agencies to help design
and then rate the new CDOs, with rating agencies making big profits
despite conflicts of interest.
• Financial engineers used unrealistic inputs to generate high values for the
CDOs.
• Investment banks sold the CDOs to investors and made big profits.
• Investors bought the CDOs but either didn’t understand or care about the
risk.
• Some investors bought “insurance” via credit default swaps.
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The Collapse
• When mortgages reset and borrowers defaulted, the values of
CDOs plummeted.
• Many of the credit default swaps failed to provide insurance
because the counterparty failed.
• Many originators and securitizers still owned sub-prime
securities, which led to many bankruptcies, government
takeovers, and fire sales, including:
– New Century, Countrywide, IndyMac, Northern Rock, Fannie
Mae, Freddie Mac, Bear Stearns, Lehman Brothers, and
Merrill Lynch.
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Questions
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