Corporate Financial Policy and Shareholders Return

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Corporate Financial Policy and Shareholders Return Page 1

CHAPTER 1: SUMMARY

Competitor, or peer, firms play a central role in shaping a variety of

corporate policies ranging from executive compensation to product

market strategy. However, most research on corporate financial

policy assumes that firms choose their capital structures

independently of their peers. That is, researchers typically assume

that a firm's capital structure is determined by a function of its

marginal tax rate, expected deadweight loss in default, information

environment, or incentive conflicts among claimants. Thus, the role

for competitor firms' behavior in affecting corporate capital structures

is often ignored, or at most an implicit one through its unmeasured

impact on these firm specific determinants.

Corporate liquidity comes at a cost, however, since interest earned

on corporate cash reserves is often taxed at a higher rate thaninterest earned by individuals. Furthermore, cash may provide funds

for managers to invest in projects that offer non-pecuniary benefits

but destroy shareholder value.

Firms that face greater financing constraints, especially those with

valuable investment opportunities, the marginal value of cash should

be higher than for firms that can easily raise additional capital. While

financial constraints are often associated with information

asymmetries between firms and capital providers, they can be

thought of as tantamount to higher transactions costs in accessing


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external capital. In such a context, an additional dollar of internal

funds enables a constrained firm to avoid these higher costs of

raising funds, thereby, rendering additional internal funds relatively

more valuable.


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CHAPTER 2: INTRODUCTION

Financial Management is nothing but management of the limited

financial resources the organization has, to its utmost advantage.

Resources are always limited, compared to its demands or needs.

This is the case with every type of organisation. Proprietorship or

limited company, be it public or private, profit oriented or even non-

profitable organisation.

2.1 Finance function importance

In general, the term Finance is understood as provision of funds as

and when needed. Finance is the essential requirement sine qua

non of every organisation.

Required Everywhere: All activities, be it production, marketing,

human resources development, purchases and even research and

development, depend on the adequate and timely availability of

finance both for commencement and their smooth continuation to

completion. Finance is regarded as the life-blood of every business

enterprise.

Efficient utilization More Important: Finance function is the most

important function of all business activities. The efficient management

of business enterprise is closely linked with the efficient management

of its finances. The need of finance starts with the setting up of

business. Its growth and expansion require more funds. The funds

have to be raised from various sources. The sources have to be

selected keeping in relation to the implications, in particular, risk

attached. Rising of money, alone, is not important. Terms and


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conditions while raising money are more important. Cost of funds is

an important element. Its utilization is rather more important. If funds

are utilised properly, repayment would be possible and easier, too.

Care has to be exercised to match the inflow and outflow of funds.

Needless to say, profitability of any firm is dependent on its cost as

well as its efficient utilization.

2.2 Financial management

The term financial management has been defined, differently, by

various authors. Some of the authoritative definitions are given below:

Financial Management is concerned with the efficient use of an

important economic resource, namely, Capital Funds Solomon

Financial Management is concerned with the managerial decisions

that result in the acquisition and financing of short-term and long-term

credits for the firm

Phillioppatus

Business finance is that business activity which is concerned with

the conservation and acquisition of capital funds in meeting financial

needs and overall objectives of a business enterprise Wheeler

Financial Management is the process of financial-decisions. There

are three types of financial decisions:

Financing Decisions: such decisions involve estimating the

requirement of funds, deciding about leverage, evaluating various

sources of finance and finally raising the finance in such a way

that the cost of capital is minimum and the risk is at optimum level.


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Investment Decisions: such decisions involve investments in

working capital and fixed assets and evaluating the projects under

consideration. The management should be guided by getting the

maximum return by keeping the risk at optimum level.

Dividend Decisions: such decisions involve the consideration of

profit, liquidity, shareholder requirements, tax aspect and need of

the funds for reinvestment purposes. The management has to

decide about retaining the funds for further investment plans

without compromising the various income requirements of

innumerable shareholders.

The aim of a company is to create value for its shareholders.

Although the other stake holders are also important, the shareholder

is the most important stakeholder. The overall objective of the

financial Management is to apply the financial management policies

and principles for maximizing the wealth of the shareholders in the

long run. This can be achieved by maximizing the EPS and keeping

the risk at optimum levels.

The shareholders expect a rate of return based on the risk they

perceive. By maximizing their wealth we mean providing better than

the return they expect. How can a company earn more than the

return the shareholders and other stake holders expect in a hard-core

competitive arena? The answer is that this can be achieved by

creating a sustainable competitive advantage through exploiting the

market imperfections tapping the opportunities and identifying the

possible threats in advance. Also all the market players do not have


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same expectations and risk perception and it is here the financial

Management blooms i.e. they create value for shareholders through

appropriate level of trading on equity.

2.3 Nature of financial management

Financial management refers to that part of management activity,

which is concerned with the planning and controlling of firms financial

resources. Financial management is a part of overall management.

All business decisions involve finance. Where finance is needed, role

of finance manager is inevitable. Financial management deals with

raising of funds from various sources, dependant on availability and

existing capital structure of the organization. The sources must be

suitable and economical to the organization. Emphasis of financial

management is more on its efficient utilization, rather than raising of

funds, alone. The scope and complexity of financial management has

been widening, with the growth of business in different diverse

directions. As business competition has been increasing, with agreater pace, support of financial management is more needed, in a

more innovative way, to make the business grow, ahead of others.

2.4 Aims of finance function

The following are the aims of finance function:

Acquiring Sufficient and Suitable Funds: The primary aim of finance

function is to assess the needs of the enterprise, properly, and

procure funds, in time. Time is also an important element in meeting

the needs of the organization. If the funds are not available as and

when required, the firm may become sick or, at least, the profitability


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of the firm would be, definitely, affected. It is necessary that the funds

should be, reasonably, adequate to the demands of the firm. The

funds should be raised from different sources, commensurate to the

nature of business and risk profile of the organization. When the

nature of business is such that the production does not commence,

immediately, and requires long gestation period, it is necessary to

have the long-term sources like share capital, debentures and long

term loan etc. A concern with longer gestation period does not have

profits for some years. So, the firm should rely more on the

permanent capital like share capital to avoid interest burden on the

borrowing component.

Proper utilization of Funds:Raising funds is important, more than that

is its proper utilization. If proper utilization of funds were not made,

there would be no revenue generation. Benefits should always

exceed cost of funds so that the organization can be profitable.

Beneficial projects only are to be undertaken. So, it is all the more

necessary that careful planning and cost-benefit analysis should be

made before the actual commencement of projects.

Increasing Profitability: Profitability is necessary for every

organization. The planning and control functions of finance aim at

increasing profitability of the firm. To achieve profitability, the cost of

funds should be low. Idle funds do not yield any return, but incur cost.

So, the organization should avoid idle funds. Finance function also

requires matching of cost and returns of funds. If funds are used

efficiently, profitability gets a boost.

Maximising Firms Value: The ultimate aim of finance function is

maximizing the value of the firm, which is reflected in wealth


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maximization of shareholders. The market value of the equity shares

is an indicator of the wealth maximization.

2.5 Functions of finance

Finance function is the most important function of a business.

Finance is, closely, connected with production, marketing and other

activities. In the absence of finance, all these activities come to a halt.

In fact, only with finance, a business activity can be commenced,

continued and expanded. Finance exists everywhere, be it

production, marketing, human resource development or undertaking

research activity. Understanding the universality and importance of

finance, finance manager is associated, in modern business, in all

activities as no activity can exist without funds. Financial Decisions or

Finance Functions are closely inter-connected. All decisions mostly

involve finance. When a decision involves finance, it is a financial

decision in a business firm. In all the following financial areas of

decision-making, the role of finance manager is vital. We can classify

the finance functions or financial decisions into four major groups:

1. Investment Decision or Long-term Asset mix decision

2. Finance Decision or Capital mix decision

3. Liquidity Decision or Short-term asset mix decision

4. Dividend Decision or Profit allocation decision

Investment Decision

Investment decisions relate to selection of assets in which funds are

to be invested by the firm. Investment alternatives are numerous.

Resources are scarce and limited. They have to be rationed and


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discretely used. Investment decisions allocate and ration the

resources among the competing investment alternatives or

opportunities. The effort is to find out the projects, which are

acceptable. Investment decisions relate to the total amount of assets

to be held and their composition in the form of fixed and current

assets.Both the factors influence the risk the organisation is

exposed to. The more important aspect is how the investors perceive

the risk. The investment decisions result in purchase of assets.

Assets can be classified, under two broad categories:

Long-term investment decisions: The long-term capital decisions are

referred to as capital budgeting decisions, which relate to fixed

assets. The fixed assets are long term, in nature. Basically, fixed

assets create earnings to the firm. They give benefit in future. It is

difficult to measure the benefits as future is uncertain. The investment

decision is important not only for setting up new units but also for

expansion of existing units. Decisions related to them are, generally,

irreversible. Often, reversal of decisions results in substantial loss.

When a brand new car is sold, even after a day of its purchase, still,

buyer treats the vehicle as a second-hand car. The transaction,

invariably, results in heavy loss for a short period of owning. So, the

finance manager has to evaluate profitability of every investment

proposal, carefully, before funds are committed to them.

Short-term investment decisions: The short-term investment

decisions are, generally, referred as working capital management.

The finance manger has to allocate among cash and cash

equivalents, receivables and inventories. Though these current


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assets do not, directly, contribute to the earnings, their existence is

necessary for proper, efficient and optimum utilization of fixed assets.

Finance Decision

Once investment decision is made, the next step is how to raise

finance for the concerned investment. Finance decision is concerned

with the mix or composition of the sources of raising the funds

required by the firm. In other words, it is related to the pattern of

financing. In finance decision, the finance manager is required to

determine the proportion of equity and debt, which is known as

capital structure. There are two main sources of funds, shareholders

funds (variable in the form of dividend) and borrowed funds (fixed

interest bearing). These sources have their own peculiar

characteristics. The key distinction lies in the fixed commitment.

Borrowed funds are to be paid interest, irrespective of the profitability

of the firm. Interest has to be paid, even if the firm incurs loss and this

permanent obligation is not there with the funds raised from the

shareholders. The borrowed funds are relatively cheaper compared

to shareholders funds, however they carry risk. This risk is known as

financial risk i.e. Risk of insolvency due to non-payment of interest or

non-repayment of borrowed capital. On the other hand, the

shareholders funds are permanent source to the firm. The

shareholders funds could be from equity shareholders or preference

shareholders. Equity share capital is not repayable and does not

have fixed commitment in the form of dividend. However, preference

share capital has a fixed commitment, in the form of dividend and is

redeemable, if they are redeemable preference shares. Barring a few


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exceptions, every firm tries to employ both borrowed funds and

shareholders funds to finance its activities. The employment of these

funds, in combination, is known as financial leverage. Financial

leverage provides profitability, but carries risk. Without risk, there is

no return. This is the case in every walk of life! When the return on

capital employed (equity and borrowed funds) is greater than the rate

of interest paid on the debt, shareholders return get magnified or

increased. In period of inflation, this would be advantageous while it

is a disadvantage or curse in times of recession.

Return on equity (ignoring tax) is 20%, which is at the expense of

debt as they get 7% interest only. In the normal course, equity would

get a return of 15%. But they are enjoying 20% due to financing by a

combination of debt and equity. The finance manager follows thatcombination of raising funds which is optimal mix of debt and equity.

The optimal mix minimizes the risk and maximizes the wealth of

shareholders.


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Liquidity Decision

Liquidity decision is concerned with the management of current

assets. Basically, this is Working Capital Management. Working

Capital Management is concerned with the management of current

assets. It is concerned with short-term survival. Short term-survival is

a prerequisite for long-term survival. When more funds are tied up in

current assets, the firm would enjoy greater liquidity. In consequence,

the firm would not experience any difficulty in making payment of

debts, as and when they fall due. With excess liquidity, there would

be no default in payments. So, there would be no threat of insolvency

for failure of payments. However, funds have economic cost. Idle

current assets do not earn anything. Higher liquidity is at the cost of

profitability. Profitability would suffer with more idle funds. Investment

in current assets affects the profitability, liquidity and risk. A proper

balance must be maintained between liquidity and profitability of the

firm. This is the key area where finance manager has to play

significant role. The strategy is in ensuring a trade-off between

liquidity and profitability. This is, indeed, a balancing act and

continuous process. It is a continuous process as the conditions and

requirements of business change, time to time. In accordance with

the requirements of the firm, the liquidity has to vary and in

consequence, the profitability changes. This is the major dimension of

liquidity decision working capital management. Working capital

management is day to day problem to the finance manager. His skills

of financial management are put to test, daily.


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Dividend Decision

Dividend decision is concerned with the amount of profits to be

distributed and retained in the firm.

Dividend: The term dividend relates to the portion of profit, which is

distributed to shareholders of the company. It is a reward or

compensation to them for their investment made in the firm. The

dividend can be declared from the current profits or accumulated

profits. Which course should be followed dividend or retention?

Normally, companies distribute certain amount in the form of

dividend, in a stable manner, to meet the expectations of

shareholders and balance is retained within the organisation for

expansion. If dividend is not distributed, there would be great

dissatisfaction to the shareholders. Non-declaration of dividend

affects the market price of equity shares, severely. One significant

element in the dividend decision is, therefore, the dividend payout

ratio i.e. what proportion of dividend is to be paid to the shareholders.

The dividend decision depends on the preference of the equity

shareholders and investment opportunities, available within the firm.

A higher rate of dividend, beyond the market expectations, increases

the market price of shares. However, it leaves a small amount in the

form of retained earnings for expansion. The business that reinvests

less will tend to grow slower. The other alternative is to raise funds in

the market for expansion. It is not a desirable decision to retain all the

profits for expansion, without distributing any amount in the form of

dividend. There is no ready-made answer, how much is to be


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distributed and what portion is to be retained. Retention of profit is

related to

Reinvestment opportunities available to the firm.

Alternative rate of return available to equity shareholders, if they

invest themselves.

2.6 Corporate finance

Corporate finance is the field of finance dealing with financial

decisions that business enterprises make and the tools and analysis

used to make these decisions. The primary goal of corporate financeis to maximize corporate value while managing the firm's financial

risks. Although it is in principle different from managerial finance

which studies the financial decisions of all firms, rather than

corporations alone, the main concepts in the study of corporate

finance are applicable to the financial problems of all kinds of firms.

The discipline can be divided into long-term and short-term decisions

and techniques. Capital investment decisions are long-term choices

about which projects receive investment, whether to finance that

investment with equity or debt, and when or whether to pay dividends

to shareholders. On the other hand, short term decisions deal with

the short-term balance of current assets and current liabilities; the

focus here is on managing cash, inventories, and short-termborrowing and lending (such as the terms on credit extended to

customers).


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The terms corporate finance and corporate financier are also

associated with investment banking. The typical role of an investment

bank is to evaluate the company's financial needs and raise the

appropriate type of capital that best fits those needs. Thus, the terms

corporate finance and corporate financier may be associated with

transactions in which capital is raised in order to create, develop,

grow or acquire businesses.

The field of corporate finance has undergone a tremendous mutation

in the past twenty years. A substantial and important body of

empirical work has provided a clearer picture of patterns of corporate

financing and governance, and of their impact for firm behavior and

macroeconomic activity. To the extent that financial claims returns

depend on some choices such as investments, these choices, in the

complete market paradigm are assumed to be contractible and

therefore are not affected by moral hazard. Furthermore, investors

agree on the distribution of a claims returns; that is, financial markets

are not plagued by problems of asymmetric information. The key

issue for financial economists is the allocation of risk among investors

and the pricing of redundant claims by arbitrage.


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2.7 Role of finance in corporate strategy

The role of finance is obviously greater in financing decisions.

Finance plays a major role in formulating the financing strategy,

evaluating the alternatives, and monitoring the outcomes. The

objective of the financing strategy is to raise capital at the lowest cost,

which in turn increases shareholder value. At first glance, it might

appear that these decisions are the purview of the CFO and others

need not get involved in them. However, just as operating decisions

have an impact on financing policies, so financing decisions can

affect operating strategies. For example, a company whose financing

decisions have led it into too much debt might not have the financial

flexibility to raise capital quickly enough for needed growth. Or, on a


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positive note, a company whose financial policies include good risk

management might be able to create a competitive advantage for

itself by offering products that limit customer risk as well. Therefore, a

general manager with a clear understanding of financial policies can

leverage them to create value for shareholders. The role of finance in

performance evaluation is identical to its role in operating decisions:

valuation and monitoring.


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CHAPTER 3: FINANCIAL POLICY

In the simplest terms, financial policy relates to two key choices that

firms make:

How much of their capital structure to support by debt, rather than

equity

How much of their earnings to retain for use as internal equity

finance, rather than distributing dividends and raising new equity in

the market.

A portfolio consisting of a little risky equity and a lot of safe debt

should have the same value as a second portfolio with a lot of less

risky equity and a little safe debt if the underlying risk of the two

portfolios is comparable. We should go beyond terms like debt and

equity to consider the characteristics of the claims themselves. Over

the years, this lesson has been emphasized by the evolution of

financial instruments such as leases, which may act as substitutes fordebt, and options, the valuation of which can, once again, be

understood by constructing comparable portfolios with and without

options and requiring that they have the same value.

A challenge to analyzing the impact of taxation on firm decisions,

though, is that the tax system is based in large part on formal labels,

and only indirectly on underlying asset characteristics. Thus, equity

faces one set of tax rules and debt another, often more favorable, so

special rules are needed regarding the treatment of the risky debt that

more closely resembles equity. Equity repurchases are treated more


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favorably than are dividends but, again; restrictions exclude from this

favorable treatment share redemptions that too closely resemble

dividends. Evaluating the impact of taxes on firm behavior requires

that we understand the rules that apply in distinguishing among

different types of assets. Financial policy decisions often amount to

choosing the optimal trade-off between distortions to financial policy

and the tax benefits such distortions generate. Indeed, a major tax

avoidance activity consists of trying to improve this trade-off,

constructing assets and transactions to permit corporations to

characterize their financial decisions in a manner most favorable from

the tax standpoint. The impact of taxation, then, depends not only on

the tax system itself, but also on where the tax systems definitional

lines are drawn and how well they can be moved through tax

avoidance activity.

3.1 Corporate Strategy

Value creation is at the heart of corporate strategy.

Strategies are means to ends. Corporate Strategy is supposed to be

the means by which an organization achieves and sustains success.

It is about enabling an organization to achieve and sustain superior

overall performance and returns. It involves the activities of:

Defining and refining the corporate vision, mission and objectives

Problem identification

Alternatives generation

Evaluation/selection


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It is a core responsibility of the top management including CEO, CFO

and the Directors.

There are three levels of corporate strategy:

(i) Corporate level,

(ii) Business level, and

(iii) Functional level.

Corporate (Top) level managers decide what businesses to invest.

Decisions regarding the sources of funds and their allocation are also

taken at this level. This level strategy focuses on two dimensions:

Growth

Liquidity

Growth dimension refers to growth in sales, growth in assets and

growth of growth opportunities. The top level managers would need

to plan what types of growth strategies suit their market orientation.

They will need to effectively choose the optimal growth strategy from

the various alternatives like expansion into existing businesses,

diversification into new businesses, modes of growth, internal

development, acquiring firms, and collaborative ventures. Liquidity

refers to level of cash flows required to the business efficiently.

Business level strategy lays down the ways in which a company

would seek to attain competitive advantage through effective

positioning. Forming a successful business strategy involves creating

a first-rate competitive strategy. It concerns strategic decisions about

choice of products, quality of products, meeting needs of customers,


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gaining advantage over competitors, exploiting or creating new

opportunities etc. The strategy needs to be frequently reviewed

against prevailing external and internal environment Functional level

strategies are those strategies that are initiated by support centers of

an organization like human Relations department, IT department. To

be competitively superior to other firms, functional level managers

strategize to attain superior efficiency, superior quality, superior

customer responsiveness, and superior innovation.


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CHAPTER 4: CORPORATE FINANCIAL POLICIES

Corporate financial policy determines how the corporation will invest

its funds (the investment decision), how the corporation will obtain

money to purchase assets (the financing decision), and what it will do

with its net income (the dividend decision). These three types of

decisions are made in concert to maximize the value of the firm.

4.1 Investment Decision

Financial policy begins with the investment decision---if the companycannot identify profitable investments, it will not need to raise funds.

In deciding whether to invest in an asset, a company will value the

cash flows it projects the asset will earn, net of the cost of the asset.

Because the cash flows will be received over time, the company has

to account for the time value of money and the riskiness of the cash

flows. It does so by "discounting" the cash flows at a "discount" or

"hurdle" rate.

4.2 Discount Rates

Discount rates have two components: one reflects the current riskless

interest rates (normally taken to be the rate of return on Treasury

bonds, termed Rf) and the other reflects the riskiness of the business.

The "risk premium," or the difference between the discount rate and

the riskless rate, also has two components: the required risk premium

on the market as a whole (termed Rm) and the co-movement of the


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company's returns with the returns on the market as a whole (termed

beta).

4.3 Financing Decision

There are two types of financing decisions made by corporations:

how to fund asset purchases and how to fund the daily operations. In

terms of funding daily operations, firms often operate on lines of

credit from banks or other financial institutions and may issue short-

term commercial paper. In terms of funding asset purchases, firms

generally go to 'the market,' and issue either corporate bonds orequity securities.

4.4 Long-Term Debt and Equity

Corporations do not directly issue corporate bonds and equity

securities; rather, these issues are "underwritten" by investment

banks. The banks are responsible for setting interest rates for bonds

and prices for stocks and are responsible for the actual selling of the

securities. The investment banks are generally responsible for

purchasing any of the issue that cannot be sold at the announced

price.

4.5 Long-Term Debt

Corporate bonds tend to be long-term instruments (30 years is not

uncommon) and pay interest rates that are above those paid by the

U.S. Treasury. Corporate bonds are "rated" by agencies such as

Moody's in terms of their riskiness: a bond rated Aaa is safer than a


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bond rated Baa, which is safer than one rated Bbb. The better the

rating on the bond, the lower will be the required interest rate, all

other things equal.

4.6 Equity

There are two types of equity securities: common stock and preferred

stock. Common stock represents an ownership share in the

corporation. Common shareholders have a right to vote at

shareholder meetings and may or may not receive dividends from the

company. The value of their shares will fluctuate depending on thefortunes of the company and the economy a whole. Preferred stock is

non-voting stock on which dividends are paid at a contractual rate

and may be convertible into common stock.

4.7 Dividend Decision

Companies can do two things with their net income: invest it in the

business or pay it to shareholders. Monies that are reinvested in the

business are termed "retained earnings." Companies can pay money

to shareholders in two ways: they can pay dividends, or they can

repurchase stock from shareholders. Some companies are known for

paying consistent dividends, whereas other companies pay no

dividends.


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CHAPTER 5: THEORIES

5.1 Efficient Market Theory

The efficient market hypothesis holds that a market is efficient if it is

impossible to make economic profits by trading on available

information. Cowles (1933) documents the inability of forty-five

professional agencies to forecast stock price changes. Other early

work in the field by statisticians such as Working (1934), Kendall

(1953), and Osborne (1959; 1962) document that stock and

commodity prices behave like a random walk, that is, stock price

changes behave as if they were independent random drawings. This

means that technical trading rules based on information in the past

price series cannot be expected to make above-normal returns.

Samuelson (1965) and Mandelbrot (1966) provide the modern

theoretical rationale behind the efficient markets hypothesis thatunexpected price changes in a speculative market must behave as

independent random drawings if the market is competitive and

economic trading profits are zero. They argue that unexpected price

changes reflect new information. Since new information by definition

is information that cannot be deduced from previous information, new

information must be independent over time. Therefore, unexpected

security price changes must be independent through time if expected

economic profits are to be zero. In the economics literature, this

hypothesis has been independently developed by Muth (1961).

Termed the rational expectations hypothesis, it has had a dramatic


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impact on macroeconomic analysis. The efficient markets hypothesis

is perhaps the most extensively tested hypothesis in all the social

sciences. An important factor leading to the substantial body of

empirical evidence on this hypothesis is the data made available by

the establishment of the Center for Research in Security Prices

(CRSP) sponsored by Merrill Lynch at the University of Chicago. The

center created accurate computer files of monthly closing prices,

dividends, and capital changes for all stocks on the New York Stock

Exchange since 1926 and daily closing prices of all stocks on the

New York and American stock exchanges since 1962 [Lorie and

Fisher (1964) describe the basic data and its structure.] Consistent

with the efficient markets hypothesis, detailed empirical studies of

stock prices indicate that it is difficult to earn above-normal profits by

trading on publicly available data because it is already incorporated

insecurity prices. Fama (1970; 1976) provides reviews of the

evidence. However the evidence is not completely one-sided; see, for

example, Jensen (1978), who provides a review of some anomalies.

If capital markets are efficient, then the market value of the firm

reflects the present value of the firms expected future net cash flows,

including cash flows from future investment opportunities. Thus the

efficient markets hypothesis has several important implications for

corporate finance. First, there is no ambiguity about the firms

objective function: managers should maximize the current market

value of the firm. Hence management does not have to choose

between maximizing the firms current value or its future value, and

there is no reason for management to have a time horizon that is too

short. Second, there is no benefit to manipulating earnings per share.


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Management decisions that increase earnings but do not affect cash

flows represent wasted effort. Third, if new securities are issued at

market prices which reflect an unbiased assessment of future

payoffs, then concern about dilution or the sharing of positive net

present value projects with new security holders is eliminated. Fourth,

security returns are meaningful measures of firm performance. This

allows scholars to use security returns to estimate the effects of

various corporate policies and events on the market value of the

corporation. Beginning with the Fama, Fisher, Jensen and Roll (1969)

analysis of the effect of stock splits on the value of the firms shares,

this empirical research has produced a rich array of evidence to

augment positive theories in corporate finance.

5.2 Portfolio Theory

Prior to Markowitz (1952; 1959), little attention was given to portfolio

selection. Security analysis focused on picking undervalued

securities; a portfolio was generally taken to be just an accumulation

of these securities. Markowitz points out that if risk is an undesirable

attribute for investors, merely accumulating predicted winners is a

poor portfolio selection procedure because it ignores the effect of

portfolio diversification on risk. He analyzes the normative portfolio

question: how to pick portfolios that maximize the expected utility of

investors under conditions where investors choose among portfolios

on the basis of expected portfolio return and portfolio risk measured

by the variance of portfolio return. He defines the efficient set of

portfolios as those which provide both maximum expected return for a

given variance and minimum variance for a given expected return.


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His mean-variance analysis provides formal content to the meaning

of diversification, a measure of the contribution of the covariance

among security returns to the riskiness of a portfolio, and rules for the

construction of an efficient portfolio. Portfolio theory implies that the

firm should evaluate projects in the same way that investors evaluate

securities. For example, there are no rewards or penalties per se

associated with corporate diversification. (Of course, diversification

could affect value by affecting expected bankruptcy costs and thus

net cash flows.)

5.3 Capital Asset Pricing Theory

Treynor (1961), Sharpe (1964), and Lintner (1965) apply the

normative analysis of Markowitz to create a positive theory of the

determination of asset prices. Given investor demands for securities

implied by the Markowitz mean-variance portfolio selection model and

assuming fixed supplies of assets, they solve for equilibrium security

prices in a single-period world with no taxes. Although total risk is

measured by the variance of portfolio returns, Treynor, Sharpe, and

Lintner demonstrate that in equilibrium an individual security is priced

to reflect its contribution to total risk, which is measured by the

covariance of its return with the return on the market portfolio of all

assets. This risk measure is commonly called an assets systematic

risk.

5.4 Option Pricing Theory

The capital asset pricing model provides a positive theory for the

determination ofexpected returns and thus links todays asset price


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with expected future payoffs. In addition, many important corporate

policy problems require knowledge of the valuation of assets which,

like call options, have payoffs that are contingent on the value of

another asset. Black and Scholes (1973) provide a key to this

problem in their solution to the call option valuation problem. An

American call option gives the holder the right to buy a stock at a

specific exercise price at any time prior to a specified exercise date.

They note that a risk-free position can be maintained by a hedge

between an option and its stock when the hedge can be adjusted

continuously through time. To avoid opportunities for riskless

arbitrage profits, the return to the hedge must equal the market risk-

free rate; this condition yields an expression for the equilibrium call

price. Black/Scholes note that if the firms cash flow distribution is

fixed, the option pricing analysis can be used to value other

contingent claims such as the equity and debt of a levered firm. In

this view the equity of a levered firm is a call option on the total value

of the firms assets with an exercise price equal to the face value of

the debt and an expiration date equal to the maturity date of the debt.

The Black/Scholes analysis yields a valuation model for the firms

equity and debt. An increase in the value of the firms assets

increases the expected payoffs to the equity and increases the

coverage on the debt, increasing the current value of both. An

increase in the face value of the debt increases the debtholders

claim on the firms assets, thus increasing the value of the debt, and

since the stockholders are residual claimants, reduces the current

value of the equity; An increase in the time to repayment of the debt

or in the risk less rate lowers the present value of the debt and


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increases the market value of the equity. An increase in the variance

rate or in the time to maturity increases the dispersion of possible

values of the firm at the maturity date of the debt. Since the debt

holders have a maximum payment which they can receive, an

increase in dispersion increases the probability of default, lowering

the value of the debt and increasing the value of the equity.

5.5 Agency Theory

Narrowly defined, an agency relationship is a contract in which one or

more persons engage another person to perform some service on

their behalf which involves delegating some decision-making

authority. Spence and Zeckhauser (1971) and Ross (1973) provide

early formal analyses of the problems associated with structuring the

compensation of the agent to align his or her incentives with the

interests of the principal. Jensen and Meckling (1976) argue that

agency problems emanating from conflicts of interest are general to

virtually all cooperative activity among self-interested individuals

whether or not it occurs in the hierarchical fashion suggested by the

principal-agency analogy. Jensen and Meckling define agency costs

as the sum of the costs of structuring contracts (formal and informal):

monitoring expenditures by the principal, bonding expenditures by the

agent, and the residual loss. The residual loss is the opportunity cost

associated with the change in real activities that occurs because it

does not pay to enforce all contracts perfectly. They argue that the

parties to the contracts make rational forecasts of the activities to be

accomplished and structure contracts to facilitate those activities. At

the time the contracts are negotiated, the actions motivated by the


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incentives established through the contracts are anticipated and

reflected in the contracts prices and terms. Hence, the agency costs

of any relationship are born by the parties to the contracting

relationship. This means that some individuals) can always benefit by

devising more effective ways of reducing them. Jensen and Meckling

use the agency framework to analyze the resolution of conflicts of

interest between stockholders, managers, and bondholders of the

firm.

The development of a theory of the optimal contract structure in a firm

involves construction of a general theory of organizations. Jensen

(1983) outlines the role of agency theory in such an effort. Fama

(1980) and Fama and Jensen (1983a; 1983b) analyze the nature of

residual claims and the separation of management and risk bearing in

the corporation and in other organization forms. They provide a

theory based on tradeoffs of the risk sharing and other advantages of

the corporate form with its agency costs to explain the survival of the

corporate form in large-scale, complex non-financial activities. They

also explain the survival of proprietorships, partnerships, mutuals,

and nonprofits in other activities. Since the primary distinguishing

characteristic among these organizational forms is the nature of their

residual or equity claims, this work addresses the question: What

type of equity claim should an organization issue? This question is a

natural predecessor to the question of the optimal quantity of debt

relative to equitythe capital structure issuethat has long been

discussed in finance. One factor contributing to the survival of the

corporation is the constraints imposed on the investment, financing,


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and dividend decisions of managers by what Manne (1965) calls the

market for corporate control. Jensen and Ruback (1983) argue that

this market is the arena in which alternative management teams

compete for the rights to manage corporate resources, with

stockholders playing a relatively passive role accepting or rejecting

competing takeover offers. In the last ten years, there has been

extensive examination of the stock price effects associated with

corporate takeovers through mergers, tender offers, and proxy fights.

The evidence indicates that successful tender offers produce

approximately 30 percent abnormal stock price performance in target

firms shares and 4 percent abnormal stock price performance in

bidding firms shares, while for mergers the numbers are 20 percent

and 4 percent.


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CHAPTER 6: FINANCIAL THEORY AND

CORPORATE POLICY

The central purpose of a corporation is to provide value for the

shareholders. Simply put, it is to make money. The discipline that

studies money, markets and their operation with an eye to practical

application is called finance. Thus, financial theory has a significant

impact on the decisions made by the leaders of corporations.

6.1 Finance

Accountants have been described as historians. They record how

much is spent, earned and invested. They sort, classify and organize.

However, what these actions mean, in a greater sense is not their

primary concern. Economists, on the other hand, are concerned with

the more general questions of how markets operate, why they

operate thus and what this means for individuals, businesses andnations. Financial professionals stand in the middle ground. While

they must stay in touch with the accounting and have a keen

understanding of the real-world operations of the firm, they also

attempt to understand the esoteric aspects of economic theory.

6.2 Theory

Because finance requires that decisions be made, as opposed to the

decisions' impact being recorded, predictions and estimations must

be made. However, unlike economics, which addresses such general

questions, finance professionals use theories, models and statistical


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tools to answer specific questions. An economist may ask the

question, "Is this industry expanding its operations, and if so, at what

rate?" The financial professional may use some of the same tools,

but is more likely to ask, "Should our company expand operations,

and if so, when?"

6.3 Overlap

If the distinction between finance and economics is a matter of scale,

then it is only natural that there exists some overlap between the

disciplines and indeed, some of the most esteemed names infinancial theory are great economists. John Maynard Keynes, William

Sharpe and Oskar Morgenstern were responsible for innovations like

the capital asset pricing model and modern portfolio theory. However,

these scholars are almost universally referred to as economists, not

financial theorists.

6.4 Impact on Policy

While financial theory, like all theory, is imperfect, it does provide

rational guidance for dealing with uncertainty. For example, analysts

may regard the company's stock price as too low. This may lead the

directors of the corporation to purchase shares of the stock from

shareholders, allowing the firm to retain more of its profits as it would

not have to pay dividends on shares that it repurchased. Another

possibility would be theorists predicting significant changes in the

interest rates demanded by credit markets. The corporation may then

hasten, or delay, obtaining needed credit lines.


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6.5 Problems

The greatest challenge to financial theory is the reliance on reason.

While objective assessment of measurable facts and application of

proven formulas may seem unassailable, as Publius Syrus said

"Everything is worth what its purchaser will pay for it." Pricing models,

market statistics and economic data may be invaluable for providing

predictions, but sometimes a particular product, company or brand

name may fall into fashion or out of favor for reasons that may be

apparent only in retrospect or forever remain inscrutable.


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CHAPTER 7: FINANCIAL OBJECTIVES OF

CORPORATE FINANCE THEORY

Corporate finance theory takes specific models and applies them to

specific corporate finance decisions. By and large, these decisions

have financial goals, but occasionally, there are other types of goals

as well, such as good community relations. Nevertheless, corporate

finance theory has several specific goals in mind relative to both the

structure of the firm as well as the returns on assets.

7.1 Rational Choice

Rational Choice is the main model of finance theory. It is the basic,

"classical model" that holds a firm seeks to maximize its return on

capital. In this case, the financial goal is very clear: profit

maximization through direct methods and indirect methods, such as

increasing market share. This model sees the firm as a unified entityand the financial goals are calculated with this in mind.

7.2 Control

Firms have different centers of control. Stockholders, managers,

labor unions, creditors and investors all have interests and different

levers of power to use and manipulate. In this model, the final idea is

to satisfy these different interests and hence, the financial goal is

really about spreading earnings to as many different centers of power

as possible. While this remains a part of rational choice, it is a highly

decentralized version of the approach that spreads out who is doing


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the choosing over many factors. In this model, the firm is not a unified

entity.

7.3 Debt

More specific is the creation of an optimal debt/equity ratio. The

financial goal here is to maximize the tax benefits of debt financing,

while maintaining strong growth in equity. Investors do not like to see

huge debt, but the real goal here is to see how capital is performing.

If capital is performing well and cash flow is growing, then the debt

can be carried and hence, it is not an issue for investors. The basicbalance is the final goal: to use enough debt to finance projects

cheaply while maintaining solid cash flows.

7.4 Expansion

In any set of investment decisions, one additional goal is the option to

expand. A decision might come down to issuing dividends on stock

versus reinvesting that cash in expansion projects to increase cash

flow and the ability to carry debt. This might be termed an indirect

model of rational choice, since it sees cash flow as the result of good

decisions over time, not an immediate need to satisfy stockholders

and investors.


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CHAPTER 8: SHAREHOLDER VALUE CREATION

Creating shareholder value is the key to success in today's

marketplace. There is increasing pressure on corporate executives to

measure, manage and report the creation of shareholder value on a

regular basis. In the emerging field of shareholder value analysis,

various measures have been developed that claim to quantify the

creation of shareholder value and wealth.

More than ever, corporate executives are under increasing pressure

to demonstrate on a regular basis that they are creating shareholder

value. This pressure has led to an emergence of a variety of

measures that claim to quantify value-creating performance.

Creating value for shareholders is now a widely accepted corporate

objective. The interest in value creation has been stimulated by

several developments.

Capital markets are becoming increasingly global. Investors can

readily shift investments to higher yielding, often foreign,

opportunities.

Institutional investors, which traditionally were passive investors,

have begun exerting influence on corporate managements to

create value for shareholders. Corporate governance is shifting, with owners now demanding

accountability from corporate executives. Manifestations of the

increased assertiveness of shareholders include the necessity for


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executives to justify their compensation levels, and well-publicized

lists of under performing companies and overpaid executives.

Business press is emphasizing shareholder value creation in

performance rating exercises.

Greater attention is being paid to link top management

compensation to shareholder returns.

Defining Shareholder Value and Wealth Creation

From the economist's viewpoint, value is created when management

generates revenues over and above the economic costs to generatethese revenues. Costs come from four sources: employee wages and

benefits; material, supplies, and economic depreciation of physical

assets; taxes; and the opportunity cost of using the capital.

Under this value-based view, value is only created when revenues

exceed all costs including a capital charge. This value accrues mostly

to shareholders because they are the residual owners of the firm.

Shareholders expect management to generate value over and above

the costs of resources consumed, including the cost of using capital.

If suppliers of capital do not receive a fair return to compensate them

for the risk they are taking, they will withdraw their capital in search of

better returns, since value will be lost. A company that is destroying

value will always struggle to attract further capital to finance

expansion since it will be hamstrung by a share price that stands at a

discount to the underlying value of its assets and by higher interest

rates on debt or bank loans demanded by creditors.


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Wealth creation refers to changes in the wealth of shareholders on a

periodic (annual) basis. Applicable to exchange-listed firms, changes

in shareholder wealth are inferred mostly from changes in stock

prices, dividends paid, and equity raised during the period. Since

stock prices reflect investor expectations about future cash flows,

creating wealth for shareholders requires that the firm undertake

investment decisions that have a positive net present value (NPV).

Although used interchangeably, there is a subtle difference between

value creation and wealth creation. The value perspective is based

on measuring value directly from accounting-based information with

some adjustments, while the wealth perspective relies mainly on

stock market information. For a publicly traded firm these two

concepts are identical when (i) management provides all pertinent

information to capital markets, and (ii) the markets believe and have

confidence in management.

8.1 Approaches for measuring shareholder value:

8.1.1 Marakon Approach:

Marakan Associates, an international management-consulting firm

founded in1978, has done pioneering work in the area of value-based

management. This measure considers the difference between the

ROE and required return on equity (cost of equity) as the source of

value creation. This measure is a variation of the EV measures.

Instead of using capital as the entire base and the cost of capital for

calculating the capital charge, this measure uses equity capital and


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the cost of equity to calculate the capital (equity) charge.

Correspondingly, it uses economic value to equity holders (net of

interest charges) rather than total firm value.

According to Marakan model shareholder wealth creation is

measured as the difference between the market value3 and the book

value of a firm's equity. Thee book value of a firm's equity, B,

measures approximately the capital contributed by the shareholders,

whereas the market value of equity, M, reflects how productively the

firm has employed the capital contributed by the shareholders, as

assessed by the stock market. Hence, the management creates

value for shareholders if M exceeds B, decimates value if m is less

than B, and maintains value is M is equal to B.

According to the Marakon model, the market-to-book values ratio is

function of thee return on equity, the growth rate of dividends, and

cost of equity.

For an all-equity firm, both EV and the equity-spread method will

provide identical values because there are no interest charges and

debt capital to consider. Even for a firm that relies on some debt, the

two measures will lead to identical insights provided there are no

extraordinary gains and losses, the capital structure is stable, and a

proper re-estimation of the cost of equity and debt is conducted.

A market is attractive only if the equity spread and economic profit

earned by the average competitor is positive. If the average


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competitor's equity spread and economic profit are negative, the

market is unattractive.

For an all-equity firm, both EV and the equity spread method will

provide identical values because there are no interest charges and

debt capital to consider. Even for a firm that relies on some debt, the

two measures will lead to identical insights provided there are no

extraordinary gains and losses, the capital structure is stable, and a

proper re-estimation of the cost of equity and debt is conducted.

A market is attractive only if the equity spread and economic profitearned by the average competitor is positive. If the average

competitor's equity spread and economic profit are negative, the

market is unattractive.

8.1.2 ALCAR approach

The Alcar group Inc. a management and Software Company has

developed an approach to value-based management which is based

on discounted cash flow analysis. In this framework, the emphasis is

not on annual performance but on valuing expected performance.

The implied value measure is akin to valuing the firm based on its

future cash flows and is the method most closely related to the

DCF/NPV framework.

With this approach, one estimates future cash flows of the firm over a

reasonable horizon, assigns a continuing (terminal) value at the end

of the horizon, estimates the cost of capital, and then estimates the

value of the firm by calculating the present value of these estimated


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cash flows. This method of valuing the firm is identical to that followed

in calculating NPV in a capital-budgeting context. Since the

computation arrives at the value of the firm, the implied value of the

firm's equity can be determined by subtracting the value of the

current debt from the estimated value of the firm. This value is the

implied value of the equity of the firm.

To estimate whether the firm's management has created shareholder

value, one subtracts the implied value at the beginning of the year

from the value estimated at the end of the year, adjusting for any

dividends paid during the year. If this difference is positive (i.e., the

estimated value of the equity has increased during the year)

management can be said to have created shareholder value.

The Alcar approach has been well received by financial analysts for

two main reasons:

It is conceptually sound as it employs the discounted cash flow

framework

Alcar have made available computer software to popularize their

approach

However, the Alcar approach seems to suffer from two main

shortcomings: (1) In the Alcar approach, profitability is measured in

terms of profit margin on sales. It is generally recognized that this is

not a good index for comparative purposes. (2) Essentially a verbal

model, it is needlessly cumbersome. Hence it requires a fairly

involved computer programme.


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8.1.3 McKINSEY approach:

McKinsey & Company a leading international consultancy firm has

developed an approach to value-based management which has been

very well articulated by Tom Copeland, Tim Koller, and Jack Murrian

of McKinsey & Company. According to them:

Properly executed, value based management is an approach to

management whereby the company's overall aspirations, analytical

techniques, and management processes are all aligned to help the

company maximize its value by focusing decision making on the keydrivers of value.

The key steps in the McKinsey approach to value-based

maximization are as follows:

Ensure the supremacy of value maximization

Find the value drivers Establish appropriate managerial processes

Implement value-based management philosophy

8.1.4 Economic value added

Consulting firm Stern Steward has developed the concept of

Economic Value Added. Companies across a broad spectrum of

industries and a wide range of companies have joined the EVA

badwagon. EVA is a useful tool to measure the wealth generated by

a company for its equity shareholders. In other words, it is a measure


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of residual income after meeting the necessary requirements for

funds.

Computation of EVA:

EVA is essentially the surplus left after making an appropriate charge

for capital employed in the business. It may be calculated by using

following equation.

EVA= Net operating profit after tax- Cost charges for capital

employed

EVA is net earnings in excess of the cost of capital supplied by

lenders and shareholders. It represents the excess return (over and

above the minimum required return) to shareholders; it is the net

value added to shareholders.

In the above formula Net operating profit after tax [NOPAT] is

calculated as follows:

NOPAT= PBIT (1-T)=PAT+INT (1-T)

Chief features of EVA Approach:

It is a performance measure that ties directly, theoretically as well

as empirically, to shareholder wealth creation. It converts accounting information into economic reality that is

readily grasped by non-financial managers. It is a simple yet

effective way of teaching business literacy to everyone.


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It serves as a guide to every decision from strategic planning to

capital budgeting to acquisitions to operating decisions.

It is an effective tool for investor communication.

It is closest in both theory and construct to the net present valueof

a project in capital budgeting, as opposed to the IRR.

Thevalue of a firm, in DCF terms, can be written in terms of the

EVA of projects in place and the present value of the EVA of future

projects.

8.1.5 The discount cash flow approach

The true economic value of a firm or a business or a project or any

strategy depends on the cash flows and the appropriate discount rate

(commensurate with the risk of cash flow). There are several

methods for calculating the present value of a firm or a

business/division or a project. In following pages we will discuss three

main methods that are mostly used under discount cash flow

approach.

The firstmethod uses the weighted average cost of debt and equity

(WACC) to discount the net operating cash flows. When the value of

a project with an estimated economic life or of a firm or business over

a planning horizon is calculated, then an estimate of the terminal

cash flows or value will also be made. Thus, the economic value of a

project or business is:

Economic Value=Present Value of net operating cash flows+ Present

value of terminal value


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The second method of calculating the economic value explicitly

incorporates the value created by financial leverage. The steps that

are involved in this method of estimation of the firm's total value are

as follows:

1. Estimate the firm's unlevered cash flows and terminal value

2. Determine the unlevered cost of capital

3. Discount the unlevered cash flows and terminal value by the

unlevered cost of capital.

4. Calculate the present value of the interest tax shield

discounting at the cost of debt.

5. Add these two values to obtain the levered firm's total value.

6. Subtract the value of debt from the total value to obtain the

value of the firm's shares.

7. Divide the value of shares by the number of shares to obtain

the economic value per share.

The third method to determine the shareholder economic value is to

calculate the value of equity by discounting cash flows available to

shareholders by the cost of equity. The present value of equity is

given as below:

Economic value of equity= Present value of equity cash flows+

Present value of terminal investment

8.1.6 Total shareholder return

Is it sufficient to access and analyze the corporate performance only

in capital markets? Is total return to shareholders (TRS) the best way


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to measure corporate performance? Is it always a true indicator of

corporate performance? Or is there something more to corporate

performance? In order to obtain an answer to these questions let us

try and understand what TRS is and what role does it play in a

corporate performance. TRS, as the name suggests, is a measure of

total returns earned by shareholders of a company during a given

period of time i.e. the sum total of appreciation in share price plus

dividends declared during the period. Given the objective of

maximization of shareholder returns, TRS is often assumed to be the

most significant parameter governing corporate performance but that

may not be the case.

Also as share price is a major determinant of TRS (returns by way of

dividends are relatively smaller in value), it is imperative to know what

does the share price reflect. A companys share price incorporates

expectations of future growth and returns. The share price is driven

by the difference between expected and actual performance and by

changes in expectations than by the current level of performance as

such. The implication of this is that actual performance is not

important but it is the perception of performance which holds the key.

As a result the companies that consistently meet performance

expectations but do not exceed them find it hard to deliver a high

TRS. While on other hand improvements in expectations of future

performance can lead to significant increase in the TRS. Thus to

achieve total returns consistently greater than the cost of equity

requires beating the expectations consistently. The expectation of


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future financial performance is similar to a treadmill. As performance

of an enterprise improves, the expectations rise and the treadmill

begin to turn quickly. The better the management performs, the more

the market expects from them. If the company is able to beat these

expectations, it accelerates the treadmill and therefore delivers

superior returns to shareholders.

But the question here is for how long a company can continue to beat

expectations? The better the performance, the higher the

expectations become. Achieving above-average returns thus requires

consistently beating the increasing expectations. As a result, simply

performing better than the peer group is neither sufficient nor

necessary to achieve higher capital market returns. For outstanding

companies, which have performed excellently over the years, the

marker expectations are very high and thus the treadmill is moving

faster than that for any other company. Continuously beating the

expectations would eventually become impossible and hence the

company might deliver only an ordinary return to shareholders. On

the other hand, for companies that are in the process of recovery, the

market expectations are minimal and the expectation treadmill is not

moving fast and hence only a marginal improvement in performance

may lead to significant increase in share price and consequently the

TRS.

For example1, over a five-year period ending Dec 2001, Sears (US

based Retailer) achieved a higher TRS as compared to Wal-Mart

stores (the largest fortune 500 company). Does that mean that Sears


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is creating more value or is performing better than Wal-Mart? No,

because during the same period the Market Value Added (MVA)2, a

better indicator of value creation, was higher for Wal-Mart than that of

Sears. To sum up, what the expectation treadmill concept holds is

that it is the delivery of surprises (as reflected by performance

exceeding the expectations) that produces higher or lower total

shareholder returns. Hence share price appreciation or TRS, though

is a good indicator of corporate performance it cannot be applied in

isolation for all companies in all situations. The performance in capital

market is therefore one of the parameters of corporate performance.

This has to be further reinforced or backed by performance of the

enterprise along key value drivers of a company such as return on

capital and growth

Source: McKinsey Quarterly

Market Value implies the total of Equity and Debt. MVA is the

difference between Market Value at the beginning of the period and

Market Value at the end of the period.

Total Shareholder Return (TSR) is a concept used to compare the

performance of different companies stocks and shares over time. It

combines share price appreciation and dividends paid to show the

total return to the shareholder. The absolute size of the TSR will vary

with stock markets, but the relative position reflects the market

perception of overall performance relative to a reference group.


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With Pricebegin = share price at beginning of period, Priceend = share

price at end of period, Dividends = dividends paid and TSR= Total

Shareholder Return, TSR is computed as

TSR= (Priceend Pricebegin + Dividends) / Pricebegin

What DoesTotal Shareholder Return - TSR Mean?

The total return of a stock to an investor (capital gain plus

dividends).

The internal rate of return of all cash flows to an investor during

the holding period of an investment.


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CHAPTER 9: INTER-RELATIONSHIP OF

FINANCIAL POLICY & SHAREHOLDERS RETURN

All the major functions or decisions Investment function, Finance

function, Liquidity function and Dividend function, are inter-related

and inter-connected. They are inter-related because the goal of all

the functions is one and the same. Their ultimate objective is only one

achievement of maximization of shareholders wealth or maximizing

the market value of the shares. All the decisions are also inter-

connected or inter-dependent also. Let us illustrate both these

aspects with an example.

Example: If a firm wants to undertake a project requiring funds, this

investment decision can not be taken, in isolation, without considering

the availability of finances, which is a finance decision. Both the

decisions are inter-connected. If the firm allocates more funds for

fixed assets, lesser amount would be available for current assets. So,

financing decision and liquidity decision are inter-connected. The firm

has two options to finance the project, either from internal resources

or raising funds, externally, from the market. If the firm decides to

meet the total project cost only from internal resources, the profits,

otherwise available for distribution in the form of dividend, have to be

retained to meet the project cost. Here, the finance decision has

influenced the dividend decision.


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So, an efficient financial management takes the optimal decision by

considering the implications or impact of all the decisions, together,

on the market value of the companys shares. The decision has to be

taken considering all the angles, simultaneously.


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CHAPTER 10: CONCLUSIONS

The finance profession has moved from a largely ad hoc, normatively

oriented field with little scientific basis for decision making to one of

the richest and most exciting fields in the economics profession.

Financial economics has progressed through its stage of policy

irrelevance propositions of the 1960s to a stage where the theory and

evidence have much useful guidance to offer the practicing financial

manager. The theory and evidence are now sufficiently rich that

sensible analysis of many detailed problems such as the valuation of

contingent claims, optimal bond indenture covenants, and a wide

range of contracting problems are emerging. Science has not as yet,

however, provided a satisfactory framework for resolving all problems

facing the corporate financial officer. Some of the more important

unresolved questions are how to decide on:

The level of the dividend payment The maturity structure of the firms debt instruments

The marketing of the firms securities (i.e., public versus privately

placed debt, rights versus underwritten offerings)

The relative quantities of debt and equity in the firms capital

structure

We expect the frontiers of knowledge in corporate finance to continue

to expand.

The shareholder value creation approach helps to strengthen the

competitive position of the firm by focusing on wealth creation. It

provides an objective and consistent framework of evaluation and


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decision-making across all functions, departments and units of the

firm. It can be easily implemented since cash flow data can be

obtained by suitably adapting the firm's existing system of financial

projection and planning. The only additional input needed is the cost

of capital. The adoption of the shareholder value creation approach

does require a change of the mind-set and educating managers

about the shareholders value approach and its implementation.


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CHAPTER 11: REFERENCES

A perspective on corporate financial policies Acharya, Viral V

The cash flow sensitivity Journal of

Finance

Does the source of capital affect capital structure? Review of

Financial Studies 19, 4579.

Tender offers and free cash flow The Financial

Review

The determinants of corporate liquidity Journal of

Financial and Quantitative Analysis

Determinants of corporate borrowing Journal of

Financial Economics

Financial Management Pandey I. M.

Financial Management Theory and Practice Chandra

Prasanna

www.Valuebasedmanagement.com

Corporate Financial Policy and Shareholders Return

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Transcript of Corporate Financial Policy and Shareholders Return