Session 1

Introduction to Corporate Finance

Reading : Chapter 1 of Textbook
Instructor: Prof. Nivedita Sinha
General Information
 Instructor : Dr. Nivedita Sinha (Ph.D/FPM Finance, IIMB; Assistant
Prof. (IIMC – 2012-2015, WSB-2015-2016), BE Electrical, NIT Surat)
 Office : 1st floor
 email: nivedita.sinha@nmims.edu
 All slides will be available on LMS (Blackboard)
What is Corporate Finance/or a
Corporate Finance decision?
Corporate Finance is the study of the relationship between business
decisions and the value of the firm

Any decision in a business which has financial implications is a

Corporate Finance decision
The Traditional Balance Sheet Model of
the firm
Assets Liabilities

Current
Current Assets Net
Liabilities
Working
Capital
Long term debt
Fixed Assets
1. Tangible FA
2. Intangible FA Shareholders’
equity
 The Financial view of the firm

*Reference book : Applied Corporate Finance by A.Damodaran. Courtesy:A.Damodaran

What are Corporate Finance
decisions?

Capital Budgeting decision/Investment decision : Process of

making and managing expenditures on long lived assets

 Financing decision: How should the firm raise money - issue of

debt or equity ?

 Dividend decision: Whether to pay dividends or to reinvest

Any examples?
 Capital Budgeting decisions

http://in.reuters.com/article/vedanta-res-plc-capex-idINKBN13Q4CI
Capital Budgeting decisions
Financing decisions

http://economictimes.indiatimes.com/markets/bonds/reliance-communications-plans-to-raise-500-million-through-offshore-bond-
issue/articleshow/55736281.cms?prtpage=1
 Financing decisions

http://economictimes.indiatimes.com/industry/auto/news/apollo-tyres-logistics-arm-plans-100-million-fundraising-from-
pes/articleshow/55648117.cms?prtpage=1
Dividend decisions

http://www.thehindu.com/business/Industry/Tata-Sons-doled-out-hefty-dividends-even-as-profit-fell/article16441907.ece
Corporate Finance – Big picture

*Reference book : Applied Corporate Finance by A.Damodaran Courtesy:A.Damodaran

Is Corporate Finance only for
corporations?....only for publicly traded
companies???
Corporate Finance is Universal

Every business, small or large, public or private, has to make

investment and financing decisions

What are different legal forms of organizing firms?

 Legal forms of organizing firms

Sole • Unlimited liability

Proprietorship • Personal Tax on Profits

• Unlimited liability
Partnership • Personal Tax on Profits

• Limited Liability
Corporation • Corporate Tax on Profits +
Personal Tax on Dividends*

* In India additional income tax is payable @ 15% of the dividend distributed. This dividend is exempt
in the hands of the shareholders. Dividends above 10 lakhs p.a. to attract extra 10% tax in the hands of
shareholders
 Legal forms of organizations- A
comparison
Corporation Partnership

Easy exchange of shares. Secondary Subject to substantial restrictions. No

Liquidity
trading market available trading market

Limited partners may have some voting

Voting rights Usually one vote per share rights; General Partner have exclusive
control

Corporate income is taxable and

Taxation* Personal taxes on partnership profits
dividends to shareholders is taxable

Reinvestment and dividend All profits are distributed to partners

Broad latitute
payout generally

General partners may have unlimited

Liability Limited liability , Limited partners have limited
liability

Continuity of existence May have perpetual life Limited life

* In India shareholders are exempt to pay tax on dividends

Corporations in India pay a dividend distribution tax @15%. Dividends above 10 lakhs p.a. to attract extra 10%
tax in the hands of shareholders
 Objective of Corporate Finance
 Maximize value of the firm

Maximize shareholder wealth

 Maximize the current value per share of the existing stock, if the
stock is being traded and markets are viewed to be efficient
 Maximize the market value of the existing owners’ equity
The few underlying assumptions for the
Objective to hold
Stockholders

Monitoring by having
control over the
managers through
hire/fire, board meetings.
Is the board effective
enough?
Lend money
Bondholders
Protect bondholder’s
interest
Reveal information
honestly and on time. Do
they? Information
asymmetry
Maximize stockholder’s wealth.
Do they? Are the interests of the
managers aligned to the interests of the
shareholders. Agency relationship
Significant social
Managers costs Society
Costs can/cannot be
traced to firm
Markets are efficient
Financial
Markets
Agency relationship
 Agency relationship
Owners are principal
Managers are agents

The managers of the firm are essentially agents of shareholders.

They are appointed for running the firm in the shareholders’ best
interests.

However shareholders have little opportunity to assess whether the

managers are acting in the shareholders’ best interests.

This is the Principal –Agent agency relationship when the ownership is

diverse and responsibility of running the business lies with the managers.

What are the Agency costs if the interests of the managers are not
aligned to that of the shareholders?
 Agency costs
A) the costs incurred if the agent uses the company's resources for his
own benefit; or

B) the cost of techniques that principals use to prevent the agent from
prioritizing his interests over the shareholders'.
 Certain ways to align managers to
shareholders’ interests
Supervision by Board of Directors

Threat of hostile take-overs

Subject managers to review by specialists

Internal competition for top level jobs that are appointed by the boards
of directors.

 Contracts can be carefully constructed to be incentive compatible.

Financial incentives such as stock options

 There is a market for managerial talent—this may provide market

discipline to the managers—they can be replaced.
 Information asymmetry
Managers control the release of information to the public

 There is evidence that

 they suppress information, generally negative information
they delay the releasing of bad news
 bad earnings reports
 other news

 They sometimes reveal fraudulent information

 How to enforce full disclosure of information and credible information

– is through regulations
 Market efficiency
Weak form : Prices of traded assets (stocks) in the market reflect all
historical publicly available information

 Semi –strong form : Prices reflect all historical and new public
information. (Prices change instantly with new publicly available
information)

 Strong form: Prices reflect all historical, public and private (insider)
information
Cash Flow between firms and financial
markets

Firm issues securities (A)

Invests
Retained
in assets cash flows (F) Financial
Firm
(B)
markets
Short-term debt
Current assets Cash flow Dividends and Long-term debt
Fixed assets from firm (C) debt payments (E)
Equity shares

Taxes (D)

The cash flows from the

Ultimately, the firm must
Government firm must exceed the cash
be a cash generating activity.
flows from the financial
markets.
Accounting Profit versus Cash flows
Income statement Year
ending Dec 31
Sales $1000,000
Costs $900000
Profit $100000

Cash Flows
Cash inflow $0
Cash outflow -$ 900000
Cash -$900000

Value creation will depend on whether and when the company receives
$1 million
 Timing of Cash flows

Year New Product A New Product B

(CF) (CF)
0 $ -10,000 $ -10,000
1 0 4000
2 0 4000
3 0 4000
4 16,000 4000

Present Value of CF have to be calculated to decide which product to go for.

A $ received today is worth more than a $ received next year.
 Riskiness of Cash flows

Company A Company B

Recession $75000 0

Normal $100,000 $150,000

Boom $125,000 $200,000

You do not know which state of the economy will

occur and hence cash flows which you forecast are not
certain ; they are risky.