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CORPORATE FINANCE

By:- Agam Singh


MBA 4th Sem

© Professor Ho-Mou Wu Corporate Finance 1-1


Introduction to Corporate Finance

Corporate Finance addresses the following three questions:


1. What long-term investments should
the firm engage in?
2. How can the firm raise money for the
required investments?
3. How much short-term cash flow does
a company need to pay its bills?
(RWJ ch.1)

© Professor Ho-Mou Wu Corporate Finance 1-2


The Balance-Sheet Model of
the Firm
Total Value of Assets: Total Firm Value to Investors:

Current
Liabilities
Current
Assets Long-Term
Debt

Fixed Assets
1 Tangible Shareholders’
2 Intangible Equity

© Professor Ho-Mou Wu Corporate Finance 1-3


The Balance-Sheet Model of
the FirmThe Capital Budgeting Decision
(Investment Decision) Current
Liabilities
Current
Assets Long-Term
Debt

Fixed Assets What long-


term
1 Tangible investments Shareholders’
2 Intangible should the Equity
firm engage
in?
© Professor Ho-Mou Wu Corporate Finance 1-4
The Balance-Sheet Model of
the Firm
The Capital Structure Decision
(Financing Decision) Current
Liabilities
Current
Assets Long-Term
How can the firm Debt
raise the money
for the required
Fixed Assets
investments?
1 Tangible Shareholders’
2 Intangible Equity

© Professor Ho-Mou Wu Corporate Finance 1-5


The Balance-Sheet Model of
the Firm
The Net Working Capital Investment Decision
(Financial Decision) Current
Liabilities
Current
Net
Assets Working Long-Term
Capital Debt

How much short-


Fixed Assets
term cash flow
1 Tangible does a company
need to pay its Shareholders’
2 Intangible bills? Equity

© Professor Ho-Mou Wu Corporate Finance 1-6


Capital Structure
The value of the firm can
be thought of as a pie.
The goal of the manager is
to increase the size of the 70%50%30%
25%
pie. DebtDebt
Equity
The Capital Structure 50%
75%
decision can be viewed as Equity
how best to slice up a the
pie.
If how you slice the pie affects the size of the
pie, then the capital structure decision
matters.
© Professor Ho-Mou Wu Corporate Finance 1-7
The Firm and the Financial
Markets
Firm Firm issues securities (A) Financial
markets
Invests
Retained
in assets cash flows (F)
(B)
Short-term debt
Current assets Cash flow Dividends and Long-term debt
Fixed assets from firm (C) debt payments (E)
Equity shares

Taxes (D)

The cash flows from


Ultimately, the firm
the firm must exceed
must be a cash Government
the cash flows from
generating activity.
the financial markets.
© Professor Ho-Mou Wu Corporate Finance 1-8
Financial Markets
 Primary Market
When a corporation issues securities, cash
flows from investors to the firm.
Usually an underwriter is involved
 Secondary Markets
Involve the sale of “used” securities from
one investor to another.
Securities may be exchange traded or trade
over-the-counter in a dealer market.

© Professor Ho-Mou Wu Corporate Finance 1-9


Financial Markets

Stocks and
Investors
Bonds
Firms securities
Money Bob Sue
money

Primary Market
Secondary
Market

© Professor Ho-Mou Wu Corporate Finance 1-10


Investment Environment
Financial Markets
Short term Financial Long term Financial Institutions
Institutions Loans Financial Instruments
(Banks)
CD’s $
$

Consumers Firms real investment


(Savers) (Spenders)

Financial Markets
$ Stocks &
Stocks & $
Primary Bonds
Bonds
exchange market
$
ownership
Secondary
market

© Professor Ho-Mou Wu Corporate Finance 1-11


Two Elements of Investment: Time and Risk
Investment=Activities that sacrifice present consumption for
future (uncertain) rewards.
Riskless Investment: (1) the asset is default-free.
(2) the maturity of the asset matches the
investment horizon of the investor.
$100 10%
$110
represented by dollar returns represented by the rate of return
Riskless Investment deals with the time value of money

© Professor Ho-Mou Wu Corporate Finance 1-12


Risky Investment and
Capital Budgeting
Pt + 1 − Pt + D t + 1
Holding Period Rate of Return rt+1= Pt
$140 40%

$130 30%
$100 $100 0%
$90 -10%
$80 -20%

The Capital Budgeting Decision => How to choose investment


projects?

© Professor Ho-Mou Wu Corporate Finance 1-13


Capital Structure :Debt and
Equity
 The basic feature of a debt is that it is a
promise by the borrowing firm to repay a fixed
dollar amount of by a certain date.
 The shareholder’s claim on firm value is the
residual amount that remains after the
debtholders are paid.
 If the value of the firm is less than the amount
promised to the debtholders, the shareholders
get nothing.

© Professor Ho-Mou Wu Corporate Finance 1-14


Debt and Equity as
Options
Payoff to
debt holders
Payoff to
shareholders
If the value of the firm If the value of the
is more than $F, debt firm is less than $F,
holders get a share holders get
maximum of $F. nothing.
$F

$F $F
Value of the firm (X) Value of the firm (X)

Debt holders are promised If the value of the firm


$F. is more than $F, share
If the value of the firm is less than $F,
holders get everything
they get the whatever the firm if worth.
above $F.
Algebraically, the bondholder’s Algebraically, the shareholder’s
claim is: Min[$F,$X] claim is: Max[0,$X – $F]
© Professor Ho-Mou Wu Corporate Finance 1-15
Combined Payoffs to Debt and Equity
Combined Payoffs to debt holders If the value of the firm is less than
and shareholders $F, the shareholder’s claim is:
Max[0,$X – $F] = $0 and the debt
holder’s claim is Min[$F,$X] = $X.
The sum of these is = $X
Payoff to shareholders
$F
If the value of the firm is more than
Payoff to debt holders $F, the shareholder’s claim is:
Max[0,$X – $F] = $X – $F and the
$F debt holder’s claim is:
Value of the firm (X)
Min[$F,$X] = $F.
Debt holders are promised
$F. The sum of these is = $X

© Professor Ho-Mou Wu Corporate Finance 1-16


Corporate Governance
Separation of Ownership and Control

Board of Directors

Debtholders

Shareholders
Management

Debt
Assets
Equity

© Professor Ho-Mou Wu Corporate Finance 1-17


Asymmetric Information and
Agency Costs
 There is asymmetric information between
shareholders and managers.
 How to induce managers to act in the
shareholders’ interests ?
The shareholders can devise contracts that align
the incentives of the managers with the goals of
the shareholders.
The shareholders can monitor the managers
behavior.
 (Agency Cost) This contracting and
monitoring is costly.

© Professor Ho-Mou Wu Corporate Finance 1-18