CF Lecture 1

CorporateCorporate Finance Finance

Eight EditionEight Edition

Ross

Westerfield

Jaffe

Sabeeh Ullah, IBMS 1

What Is Finance?• Finance is the study of how and under what terms

savings (money) are allocated between lenders and borrowers.• Finance is distinct from economics in that it

addresses not only how resources are allocated, but also under what terms and through what channels resources are allocated.

• Financial contracts or securities occur whenever funds are transferred from issuer to buyer.

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The Study of Finance• The study of finance requires a basic understanding

of:• securities• corporate Law• financial institutions and markets

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What is Corporate Finance?Corporate Finance is the study of decisions that firms

make.

Every decision that a business makes has financial

implications, and any decision which affects the finances

of a business is a corporate finance decision.


Corporate Decision


The Three Major Decisions in Corporate FinanceThe Investment decision

Where do you invest the scarce resources of your business?

What makes for a good investment?The Financing decision

Where do you raise the funds for these investments?Generically, what mix of owner’s money (equity) or

borrowed money(debt) do you use?The Dividend Decision

How much of a firm’s funds should be reinvested in the business and how much should be returned to the owners?


Principles of Corporate FinanceInvestment Principle: Invest in projects that yield a return greater than the minimum

acceptable hurdle rate. The hurdle rate should be higher for riskier projects and reflect

the financing mix used - owners’ funds (equity) or borrowed money (debt)

Returns on projects should be measured based on cash flows generated and the timing of these cash flows; they should also consider both positive and negative side effects of these projects.

The Financing Principle: Choose a financing mix that minimizes the hurdle rate and

matches the assets being financed. Is there an optimal financing mix and, if so, what is it? Debt is beneficial as long as the marginal benefits exceed the

marginal costsSabeeh Ullah, IBMS 7

Principles of Corporate FinanceThe Dividend Principle: If there are not

enough investments that earn the hurdle rate, return the cash to stockholders.How much of the cash flows generated by the

firm’s assets should be reinvested?How much of the cash flows should be returned

to stockholders?


The Objective of the FirmThe objective in corporate finance is to maximize the

value of the firmHow do we measure the value of the firm?

Historical or book value of firm’s assets not a good choice

Market value of firm’s assets is preferred. This is determined by the cash flows that the firm’s assets are expected to generate and the uncertainty of these cash flows


The Classical ViewpointVan Horne: "In this book, we assume that the

objective of the firm is to maximize its value to its stockholders"

Brealey & Myers: "Success is usually judged by value: Shareholders are made better off by any decision which increases the value of their stake in the firm... The secret of success in financial management is to increase value."

Copeland & Weston: The most important theme is that the objective of the firm is to maximize the wealth of its stockholders."

Brigham and Gapenski: Throughout this book we operate on the assumption that the management's primary goal is stockholder wealth maximization which translates into maximizing the price of the common stock.


The Objective in Decision MakingIn traditional corporate finance, the objective

in decision making is to maximize the value of the firm.

A narrower objective is to maximize stockholder wealth. When the stock is traded and markets are viewed to be efficient, the objective is to maximize the stock price.

All other goals of the firm are intermediate ones leading to firm value maximization, or operate as constraints on firm value maximization.


Why traditional corporate financial theory focuses on maximizing stockholder wealth.Stock price is easily observable and constantly

updated (unlike other measures of performance, which may not be as easily observable, and certainly not updated as frequently).

If investors are rational (are they?), stock prices reflect the wisdom of decisions, short term and long term, instantaneously.

The objective of stock price performance provides some very elegant theory on:how to pick projectshow to finance themhow much to pay in dividends


The Classical Objective FunctionSTOCKHOLDERS

Maximizestockholder wealth

Hire & firemanagers- Board- Annual Meeting

BONDHOLDERSLend Money

ProtectbondholderInterests

FINANCIAL MARKETS

SOCIETYManagers

Revealinformationhonestly andon time

Markets areefficient andassess effect onvalue

No Social Costs

Costs can betraced to firm


The Modified Objective FunctionFor publicly traded firms in reasonably efficient markets,

where bondholders (lenders) are protected:Maximize Stock Price: This will also maximize firm value

For publicly traded firms in inefficient markets, where bondholders are protected:Maximize stockholder wealth: This will also maximize

firm value, but might not maximize the stock priceFor publicly traded firms in inefficient markets, where

bondholders are not fully protectedMaximize firm value, though stockholder wealth and

stock prices may not be maximized at the same point.For private firms, maximize stockholder wealth (if lenders

are protected) or firm value (if they are not)


The Agency Cost ProblemThe interests of managers, stockholders, bondholders and

society can diverge. What is good for one group may not necessarily for another.Managers may have other interests (job security, incentives,

compensation) that they put over stockholder wealth maximization.

Actions that make stockholders better off (increasing dividends, investing in risky projects) may make bondholders worse off.

Actions that increase stock price may not necessarily increase stockholder wealth, if markets are not efficient or information is imperfect.

Actions that makes firms better off may create such large social costs that they make society worse off.

Agency costs refer to the conflicts of interest that arise between all of these different groups.


The Agency RelationshipAn agency relationship exists when one party, the

Principal, contracts another party, the agent, to perform some service on the Principal’s behalf.

Examples Employer and Employee Shareholders and managers Regulators and regulated Politicians and civil servants

Note that there can be multi-agent and multi-principal relationships


The problemAgents do not perform for the principals because they

have conflicting objectives.Examples

The objectives of politicians may be electoral success not maximising the ‘public interest’ for the minimum taxpayers.

Employees may be interested in maximising their income for the minimum effort rather than the maximum effort required by their employer.


CF Lecture 1

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