Basic Concepts of Corporate Finance

1. Introduction to corporate finance
Presented by
Maksudul Huq Kanan

2. CORPORATE FINANCE
Corporate finance involves the financial
management of a corporation’s assets and
corporate financing decisions.
1. Financial Management of Assets
•Capital budgeting decisions, including the
analysis of asset, investment, acquisition and
replacement proposals.
•Credit (accounts receivable) policy
•Cash management

3. CORPORATE FINANCE (Cont..)
2. Corporate Financing Decisions
 Managing capital structure: the ratio of debt
and equity
 Raising new equity capital either through profit
retention or new share issues
 Dividend policy
 Borrowing decisions and liability Management

4. CORPORATE FINANCE (Cont..)
Corporate Finance addresses the following
three questions:
1. What long-term investments should the firm
engage in?
2. How can the firm raise the money for the
required investments?
3. How much short-term cash flow does a
company need to pay its bills?

5. Main tasks of corporate finance
• Capital budgeting: the process of planning
and managing a firm’s long-term
investments ⇒ fixed assets.
• Example: deciding whether or not to open a new
restaurant.
• Capital structure: the mixture of debt and
equity maintained by the firm ⇒ S-T and L-
T debt and equity.
• Working capital management: a firm’s short-
term assets and liabilities ⇒ current assets
and current liabilities.

6. The Balance-Sheet Model of the Firm
Current
Assets
Fixed Assets
1 Tangible
2 Intangible
Shareholders
’ Equity
Current
Liabilities
Long-Term
Debt

7. The Capital Budgeting Decision
Current
Assets
Fixed Assets
1 Tangible
2 Intangible
Shareholders
’ Equity
Current
Liabilities
Long-Term
Debt
What long-term
investments
should the firm
choose?

8. The Capital Structure Decision
Crrent Assets
Fixed Assets
1 Tangible
2 Intangible
Shareholders
’ Equity
Current
Liabilities
Long-Term
Debt
How can the
firm raise the
money for the
required
investments?

9. The Net Working Capital Decision
Crrent Assets
Fixed Assets
1 Tangible
2 Intangible
Shareholders
’ Equity
Current
Liabilities
Long-Term
Debt
How much
short-term cash
flow does a
company need
to pay its bills?
Net
Working
Capital

10. 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 pie.
The Capital Structure decision
can be viewed as how best to
slice up the pie.
If how you slice the pie affects the size of the pie,
then the capital structure decision matters.
70% Debt 30% Equity

11. Hypothetical Organization Chart

12. Modern form of firms
 Corporation: a business created as a distinct legal
entity composed of one or more individuals or
entities, e.g., IBM.
– Separation of control (shareholders) and management
(professionals).
– Ownership can be easily transferred.
– Limited liability.
– Double taxation.
– Rather expensive to form.
– Agency problems.

13. Who make the decisions?
 Owners (typically in small businesses).
 Professional managers.

14. Financial managers
 Frequently, financial managers try to address
these tasks.
 The top financial manager within a firm is
usually the Chief Financial Officer (CFO).
– Treasurer – oversees cash management, credit
management, capital expenditures and financial
planning.
– Controller – oversees taxes, cost accounting,
financial accounting and data processing.

15. Possible goals of financial
management
 Survive
 Beat the competition
 Maximize sales
 Maximize net income
 Maximize market share
 Minimize costs
 Maximize the value of (stock) shares

16. The “appropriate” goal of financial
management
 Maximize the (fundamental or economic) value of
(stock) shares is the right goal.
 Why? Shareholders own shares. Managers, as
agents, ought to act in a way to benefit
shareholders; i.e., to enhance the value of the
shares.
 A limitation of this goal is that value is not directly
observable.

17. The Firm and the Financial Markets

18. Corporate Securities as Contingent Claims
on Total Firm Value
 The basic feature of a debt is that it is a
promise by the borrowing firm to repay a
fixed amount by a certain date.
 The shareholder’s claim on firm value is the
residual amount that remains after the debt
holders are paid.
 If the value of the firm is less than the
amount promised to the debt holders, the
shareholders get nothing.

19. Value vs. price
 The value of shares are not observable. In contrast,
the price of shares can be observable.
 If one believes that share price is an accurate/good
estimate of share value, the appropriate goal would
be to maximize the price of shares.
 This belief/assumption is, however, questionable.
 But investors care about stock price, and that stock
price performance is very important to the tenure of
managers.

20. Value maximization and sustainability
 Business sustainability: often viewed as
managing the triple bottom line - a process
by which companies manage their
economic/financial, ecological, and social
opportunities and risks.
 Sustainability and value maximization are
somewhat different.

21. 3 aspects of sustainability
 Economic/financial – here is more about
economic viability and profitability, and not
directly about value maximization.
 Ecological – reaching your financial goals
should not impose burden on the current
natural environment.
 Social – reaching your financial goals should
not damage the well-being of the society
(employees, etc.).

22. Shareholders and other stakeholders
– Customers
– Suppliers
– Employees (human capital and assets)
– Creditors (bondholders, banks, debtholders)
– Government: tax and regulations
– Community (local / global)
– Owner/shareholder

23. Separation of Ownership and Control
Board of Directors
Management
Assets
Debt
Equity
Shareholders
Debtholders

24. The agency problem
 Agency relationship:
– Principals (citizens) hire an agent (the president) to
represent their interest.
– Principles (stockholders) hire agents (managers) to run the
company.
 Agency problem:
– Conflict of interest between principals and agents.
– This occurs in a corporate setting whenever the agents do
not hold 100% of the firm’s shares.
– The source of agency problems is the separation of
(owners’) control and management.

25. Agency costs
 Direct costs: (1) unnecessary expenses,
and (2) monitoring costs.
 Indirect costs. For example, a manager
may choose not to take on the optimal
investment. She/he may prefer a less risky
project so that she/he has a higher
probability keeping her/his tenure.

26. Managerial incentives
 Managerial goals are frequently different
from shareholders’ goals.
– Expensive perks.
– Survival.
– Independence.
 Growth and size (related to compensation)
may not relate to shareholders’ wealth.

27. Corporate governance
 Compensation:
– Incentives ($$$, options, threat of dismissal, etc.) used to
align management and stockholder interests.
 Corporate control:
– Managers may take the threat of a takeover seriously and
run the business in the interest of shareholders.
 Pressure from other stakeholders (e.g., CalPERS, a
powerful corporate police).

28. Ethics
 Managers are expected to behave in an ethical
manner.
 The province of ethics is to sort out what is good and
bad.
 But, what is the criterion or guideline for doing so?
 Philosophers came up with some criteria, but none
of them makes sorting out what is good and bad an
easy task.

29. Do Shareholders Control Managerial
Behaviour?
 Shareholders vote for the board of directors, who in
turn hire the management team.
 Contracts can be carefully constructed to be
incentive compatible.
 There is a market for managerial talent—this may
provide market discipline to the managers—they can
be replaced.
 If the managers fail to maximize share price, they
may be replaced in a hostile takeover.

30. Financial Institutions, Financial Markets, and
the Corporation
LoansFinancial
intermediaries
DepositsFunds
suppliers
Funds
demanders
Financial
intermediaries
Funds
suppliers
Funds
demanders
 Financial Institutions
Indirect finance
Direct Finance

31. Financial markets
Money versus Capital Markets
• Money Markets
– For short-term debt instruments
• Capital Markets
– For long-term debt and equity

32. Financial markets
 Primary versus Secondary 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.

33. Financial markets
Firms
Investors
Secondary Market
SueBob
Stocks and
Bonds
Money
Primary Market

34. Overview of Corporate Securities
Common stock (equity)
 Cash Flows: Receives all corporate payouts,
after every other claimant has been paid.
Payments to the equity holders are called
dividends.
 Larger firms have their common stock traded
on stock exchange. There investors can
purchase and sell shares.

35. Overview of Corporate Securities
Common stock (equity)
 Tax Status:
Individuals- Dividends arc taxed as "ordinary income" (just
like wage income). Capital Gains have historically been
taxed at a rate below that of ordinary income. (A
shareholder who purchases a share of stock for 520, and
sells it for $22, realizes a $2 capital gain.)
Company - Payments to equity are not tax deductible from
corporate profit.
 Corporate Rights: Can hire and fire management, its voting
power allows its owners to control corporate decision
making.

36. Overview of Corporate Securities
Preferred stock
 Cash Flows: The firm agrees to give the
holder of this security a set dividend every
period (for example 52.25 per quarter per
share).
 Like common stock, preferred stock may be
traded on a stock exchange. There investors
can purchase and sell shares.

37. Overview of Corporate Securities
Preferred stock
 Tax Status: Same as common stock.
Individuals- Dividends arc taxed as "ordinary income" (just
like wage income). Capital Gains have historically been
taxed at a rate below that of ordinary income.
Company - Payments to equity are not tax deductible from
corporate profit.
 Corporate Rights: Paid before common equity, but after
all other claimants. Generally, cannot vote. If the
company fails to make a payment preferred
stockholders cannot force any immediate action,.

38. Overview of Corporate Securities
 Corporate Debt (Bonds)
Cash Flows: First in line for payment. Contracts
require a fixed coupon payment every 6 months. At
maturity the firm then pays $1000 which equals the
face value of the bond.
Larger firms have their bonds traded on a major bond
exchange. There investors can purchase and sell
bonds.

39. Overview of Corporate Securities
 Corporate Debt (Bonds)
 Tax Status:
Individuals - Coupon payments are taxed as "ordinary income"
(just like wage income).
Capital Gain - The difference 'between what an investor pays for
the bond and its price when sold. If the investor hold the bond to
maturity then the difference between the purchase price and the
face amount is considered a capital gain.
Company - Payments to debt are tax deductible.
Corporate Rights: When the firm misses a payment the
bondholders have the right to force a bankruptcy proceeding. In
principle this allows them to take over the company.

40. Overview of Corporate Securities
 Types of Debt
a. Maturity
1. Funded. any debt repayable in more than One year.
2. Unfunded. debt repayable in less than one year.
b. Repayment provisions.
1. Sinking fund. The company contributes money to
the fund which then repurchases the bonds.
2. Call options give the firm the right to repurchase
"the debt at a specified price. (Usually, cannot do this
for at least 5 years.)

41. Overview of Corporate Securities
 Types of Debt
c. Seniority
1. Senior Debt: Paid prior to all other claimants.
2. Subordinate Debt: Paid after the senior debt holders.
3. Secured Debt: Can claim the asset used as security
if payments are not satisfied. A lease agreement is
essentially the same as secured debt.

42. Overview of Corporate Securities
 Types of Debt
d. Rates
1. Floating rate: the interest rate is tied to some variable in
the economy.
2. Fixed rate: the interest rate is fixed throughout the life of
the loan.
e. Default risk
1. Junk bonds: A low rated bond, with a high probability that
the firm will not meet its contractual repayment obligations.
2. Investment grade: A highly rated bond, low probability of
default.

43. Overview of Corporate Securities
 Types of Debt
f. Hybrid Security:
Convertible bonds can be exchanged for stock at a
specified price, at the lender's option.
g. Placement:
1. Publicly placed debt is sold to the general public and
traded in the open market.
2. Privately placed security is purchased by large
institutions and either not traded at all or traded only
among large institutions.

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