Corporate Finance (BBS III Year) Chapter: 1 (Introduction to Corporate Finance)

Chapter Outlines: Concept of Corporate Finance Finance in the Organizational Structure of the Firm Finance Functions Goals of Corporation Corporate Finance and Related Disciplines The Agency Problem Development of Corporate Finance 1. Concept of Corporate Finance Corporate finance basically deals with the procurement or acquisition of the required funds from the cost effective sources and utilize such funds productively creating the value for the organizations or firms. In other words, corporate finance is the managerial activity that ensures financing needs and options are met effectively and efficiently. Business finance, managerial finance, financial management are synonymous to corporate finance, however, the term business finance is narrow and traditional. During the early stage of industrialization in the United States and other European countries, the term business finance was in use. On passage of time, corporate finance came into use since the businesses now had the corporate structure. Traditionally, the business finance was focused only on assessing the requirements of funds and procuring it. However, the scope widened and the corporate finance now deals with the questions like what long term investment should be made? Where the firm will get the long term fund? How firm will manage its daily financial activities? And how the firm should compensate its shareholders and many more. 2. Finance in the Organizational Structure It is not possible for the shareholders to run their business or firm due to large number of shareholders in large companies. So, the shareholders elect the Board of Directors (BoD) which represents the interests of the shareholders in the company. BoD frames the policies, strategies, makes decision and appoints the management to run the company. Usually, the top management of the company is Chief Executive Officer (CEO) or Managing Directors. Likewise, the finance function of a company comes under the responsibility of the Chief Financial Officer (CFO) assisted by the Treasurer and the Controller. CFO directly reports to CEO and is responsible in making financial plans, policy making and making decisions. 3. Finance Functions There are two approaches of finance functions. The first approach is too narrow and traditional which relates to procurement or raising of funds. In other hand, second approach focuses on procurement of funds and their effective utilization. In addition, there are two types of finance function namely: a. Executive finance functions It requires the managerial abilities and skills to perform the executive finance functions. Executive function includes the planning, execution and control. Major executive functions are:

Investment Decision: Managers need to assess the benefits of the certain projects in order to decide whether or not to invest in such projects. It uses the capital budgeting techniques in which the net present value of the project is computed. Financing Decision: It deals with the source from where the required funds to be procured. It involves deciding upon needs and sources of funds and negotiation for external financing. The financial managers analyze the various options of financing like common stock, preferred stocks, bonds, commercial papers and bank loans etc. Decisions are made based on the cost effectiveness and the general market conditions. Dividend Decision: Dividend is return for the shareholders but not the obligation. The decision whether or not the dividend should be distributed are made by the financial managers based on various factors. The company may distribute all income as dividends, retain all income and distribute certain amount as dividends. While making such decisions, the financial managers need to analyze the available investment opportunities, practice of the company, legal requirements, expectation of the shareholders, profit condition of the company etc. Working Capital Decision: Working capital is needed to carry out the day to day or short term activities of the company. So, company maintains cash balance, bills and account receivables, inventory etc. This decision is also known as the current asset management. Since the working capital decision affects the profitability, liquidity and risks, the financial managers should make the acceptable trade-off between all these factors. For example, excessive holdings of current asset may reduce the profits since the cash holdings does not earn high returns and may be much less than the cost of capital.

b. Routine functions Routine or incidental finance function involves the activities that support the executive finance functions. It does not require the managerial skills and abilities rather it is clerical and usually performed by operating level employees. It involves lot of paper work and time. Some of the routine finance functions are: Supervision of cash receipts and disbursements and cash balances. Custody and safeguarding the valuable documents like securities, contracts, insurance policies etc. Record keeping of financial transactions and other details. Supervision of the fixed and current assets and report the management. 4. Goals of Corporation Goals are the desired end that any organization strives to achieve. It is the purposes for which various functions including finance function are carried out. Goals of an organization provide the guidelines for the decision making. Widely discussed financial goals of an organization are profit maximization and shareholders wealth maximization. a. Profit Maximization Under this goal, the projects or investments that increase profits are undertaken and the one with fewer profits are rejected. The managers select such projects and assets that are sure to increase the profits of the organization. The supporters of this goal argue that profit is test of economic efficiency, effective utilization of resources and represents the total welfare. However, the profit maximization goal is not free from criticisms which are as follows:

Ambiguity or Unclear: Profit maximization goal is unclear. It is not clear whether the after tax or before tax profit should be maximized, net profit or gross profit, earning per share or return on equity etc. So, this goal creates confusion in managerial decision makings. Ignores Time Value of Money: Benefits received earlier are better since it can be reinvested that can increase the terminal wealth of investments. However, the profit maximization considers the total value of the benefit or profits but not the timing of cash flows. Ignores the Quality of Benefits: If the benefits are certain, such benefits or profits are considered to be of quality. Profit maximization goal merely focuses on the amount of profit rather than its certainty or degree of risks associated with. Profit maximization goal some time may mislead the managers to select the projects with higher degree of risks. Unsuitable in Modern Business Environment: Traditionally businesses were family owned and self financed. But todays business are characterized by separate ownership and management and market oriented. It has various stakeholders which creates the unsuitability of profit maximization goal. Profit maximization is considered as unethical, unrealistic and difficult.

b. Shareholders Wealth Maximization (Stock Price Maximization) Wealth maximization goal is widely accepted that seeks to maximize the wealth or net worth of the shareholders. Shareholders wealth is maximized when an investment decision generates the positive net present value. Net present value is the difference between the present value of benefits and present value of costs. The company undertaking the financially viable projects sends good information in the market pushing up demand for the shares of that company and drives up the price as well. So, shareholders wealth maximization is also called stock price maximization. Some advantages of this goal as opposed to profit maximization are as follows: Clarity of Goal: Shareholder wealth maximization goal is clear since every decision are to be made based on evaluation of cash flows rather than accounting profit. Financial managers always try to make the cash flows to the shareholders as big as possible. Considers the Time Value of Money: This goal considers the cash flow and its present value. The cash flows received in earlier period can be reinvested. So, this goal takes concern of time value of money. Quality of Benefits: According to this goal, the cash flows with lower degree of risks are discounted with lower required rate of return while risky cash flows are subjected to higher required rate of return. It makes the difference in the net present value of the same project with equal cash flows. So, it is easier for managers to undertake the decisions. Reduces the Conflicts: Wealth maximization goal can serve the interest of multiple stakeholders of the company like owners or shareholders, employees, customers, creditors and society. Under this goal, company allocates the resources efficiently that help in producing high quality goods and services at competitive price. It serves the interest of the customers. In addition, the wealth maximization can be ensured only when employee are fairly compensated. Moreover, to allocate the benefit for shareholders, the company should first settle the claim of creditors.

5. Corporate Finance and Related Discipline Corporate finance derives various concepts and models from other different discipline especially from economics and accountancy. a. Relationship with Economics: Corporate finance is related with both the micro and macro economics. Corporate finance managers need to assess the macro economic factors like output, employment, labor market conditions, money supply, interest rates etc. in order to take certain financial decision. Likewise, the firm specific micro factors like demand and supply, profits, pricing theories etc are heavily related with micro economic concepts and theories. b. Relationship with Accountancy: Finance has quite close relationship with the accountancy. Accountants collects, records, prepares and presents the financial data while finance managers use such financial information in decision making process. c. Relationship with Quantitative Techniques and Statistics: Various financial models have been developed in recent time that requires a good deal of knowledge of quantitative techniques and statistics. Such quantitative and statistical tools are useful in solving complex financial problems. 6. The Agency Problem The agency problem is the conflict of interest between the principal and the agent of the company. The basic reason behind the agency problem is the separation between the ownership (Principals) and management (agents) of the company. Basically, the agency problem is severe between the shareholders and managers. However, the agency problems between the shareholders (through managers) and creditors are persistent. a. Agency Problem between Shareholders and Managers In practice, the top management of the company is concerned with their personal wealth, prestige, salary, job security, life style, fringe benefits etc. So, it is uncertain that managers will work in best interest of the shareholders which results in eroding the shareholders wealth. In addition, managers have tendency to increase the size of firms in order to avoid the hostile takeovers that increase the power, status and salaries of the managers. Managers may practice Poison Pill in which managers poses the company unattractive to be taken over and Greenmail in which the management go for stock repurchases to gain control of the company. The agency problem between the shareholders and the managers can be reduced by following ways: Managerial Compensation: Performance shares and Executive stock options may be provided to managers that motivate the managers to work in best interest of the shareholders. Better performing managers should be compensated well that creates the harmony in between the interest of shareholders and managers. However, financial viability of such compensation packages should be assessed. Direct Intervention by Shareholders: Controlling and institutional shareholders holding more than 5 percent shares can pass the resolution calling for the discussion during the Annual General Meeting. Likewise, extra ordinary general meetings can be called where the discussion are carried out to resolve the conflicts. Threat of Firing: Threat firing for poor performing managers can align managers to work in the best interest of shareholders since the firing deteriorates the career and the prestige of the managers. Threats of Hostile Takeovers: If the share price of company is undervalued and facing the crisis in terms of financial viability and management performance, there is always risk of hostile takeovers of such

companies. Hostile takeovers may punish the managers in the market and can be fired from job as well. So, managers may act in direction of shareholders interests. b. Agency Problem between Shareholders and Creditors When the managers make decisions to maximize the wealth of shareholders ignoring the interest of creditors, the conflict arises between the shareholders and the creditors. Shareholders seeks to increase their wealth using the debt borrowed from creditors while creditors always resists such decisions thinking that cannot participate in extra earning of the company i.e. the creditors do not entitle to extra income but they have to bear extra risks. Some ways by which the agency problem between the shareholders and creditors can be minimized are as follows: Risk Premiums for Creditors: If the company is planning to undertake the risky projects, the creditors need to be compensated with the higher risk premiums. Protective Terms and Covenants: Protective Terms can be provisioned in the indenture of the debts that restricts the company to undertake some risky activities. Such restrictions can be restructuring the capital structure, payment of dividend, sale of assets repurchase of shares, acquisition and merger etc.

7. Development of Corporate Finance Finance was the part of economics till late 1800s and emerged as the separate discipline during early 1900s. Industrialization in US and other European countries stimulated the need of corporate finance. The key financial issues were raising the new capital for formation of new business and expansion. Due to shortage of regulations and increased fraudulent activities during early period, investors were reluctant to invest in shares of the company. So, financial managers had to focus on legal aspects. (Outsiders Viewpoint) During the great depression 1930s, the focus shifted to the survival aspects rather than their expansion and modernization. Amendments in company law and regulation increased the investors confidence. Now, the finance was related with the day to day problems faced in the finance functions like fund analysis, planning and control. During 1950s various corporate finance theories and tools were developed that changed the emphasis to insiders viewpoint. After 1990s, two trends namely globalization and communication and technology restructured the finance functions. Multinational business finance emerged. Financial decision makings are made with the software and data based computer information systems. Today the corporate finance has become more analytical and quantitative. Development of capital structure theory, efficient market theory, capital budgeting technique, option pricing model, arbitrage pricing model etc.