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Introduction to Corporate Finance

Introduction to Corporate Finance www.livecampus.in Ankur Garg 1

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Learning objectives

What is finance? What is corporate finance? Boo k, market, an d intr ins ic values Forms of business organizations Financial goals of the corporation Separation of ownership and control Risk and investor attitudes toward risk

Separation of ownership and control Risk and investor attitudes toward risk www.livecampus.in Ankur Garg 2

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What is finance?

A foremost concept in finance concerns how individuals interact in order to a ll ocate resources (capita l) an d/or sh i ft consumption across time by borrowing or investing .

If you receive Rs 10 million today then what decision would you make regarding consumption and investment?

Suppose you spend (consume) Rs 100,000 now.

This leaves you with Rs 900 ,000 . You can postpone consumption to future time periods by investing the Rs 900,000 today.

On the other hand, what if you have Rs20,000 but need to consume Rs30, 000 . You can borrow the Rs10, 000 and pay it back in a future period along with the interest.

the Rs10 , 000 and pay it back in a future period along with the interest.

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What is corporate finance?

Ever y decision that a business makes has financial implications, and any decision which affects the finances of a business is a corporate finance decision.

Defined broadly, everything that a business does fits under the rubric of corporate finance .

, everything that a business does fits under the rubric of corporate finance . www.livecampus.in Ankur

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The Three Major Decisions in Corporate Finance

The Allocation decision

Where do you invest the scarce resources of your business?

What makes for a good investment?

The Financing decision

Where do you raise the funds for these investments?

Generi ca ll y, wh at m i x o f owner ’s money (equ it y) or borrowed money(debt) do you use?

The Dividend Decision

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

be reinvested in the business and how much should be returned to the owners? www.livecampus.in Ankur

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Two examples of common corporate fi nanc i al d eci s i ons

A firm must spend Rs10 million for the required assets if a proposed project is approved. Important issues are:

Should the project be accepted or rejected? What do investors demand as a (minimum acceptable) project rate of return?

What are the project’s forecasted future cash flows? How risky are these forecasted cash flows?

Where will the Rs10 million come from, i.e., what mix of equity and d e bt financ ing sh ou ld b e use d?

If a firm has Rs20 million of cash flow, but needs reinvest Rs12 million , what should be done with the remaining Rs8 million of cash.

Pay it out as a dividend or repurchase some stock?

Rs8 million of cash. – Pay it out as a dividend or repurchase some stock? www.livecampus.in

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Example of common investments type fi nanc i al d eci s i ons

A mutual fund mana ger that mana ges a fund with Rs10 billion portfolio receives an additional Rs100 million in cash from new investors.

Which stocks or bonds to purchase?

How will any proposed new investments affect the expected return and risk of the overall portfolio?

new investments affect the expected return and risk of the overall portfolio? www.livecampus.in Ankur Garg 7

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Forms of business organization

Sole proprietorship

Partnership

Corporation

Most large firms are organized as corporations .

Advantages: unlimited life, easy transfer of ownership (stock), limited liability for owners, relative ease of raising capital, and can use stock for acquisitions

Disadvantages: Double taxation of earnings, cost of set up and report filing, and issues relating to the separation of ownership and control

Hy brid forms; Limited Liabilit y Corp orations ( LLC ), S Corp orations , etc., firms having characteristics of the three forms above.

), S Corp orations , etc., firms having characteristics of the three forms above. www.livecampus.in Ankur

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Book versus Market values

The book value of an asset is determined based on accounting rules.

The book value is at best a rough approximation of the asset ’s replacement cost.

The market value of an asset is that investors are willing to pay today for stocks and bonds in order to recei ve a ri s ky stream of f uture expected cas h fl ows.

Market values are forward looking.

Stocks and bonds rep resent claims on the f uture cash flows that a firm’s assets generate.

rep resent claims on the f uture cash flows that a firm’s assets generate. www.livecampus.in Ankur

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Book versus market values

Market value of a firm

Assets

Liabilities + Equity

Market value of the asset’s earning power (as a going concern)

Mkt. value of debt

Mkt. value of equity

earning power (as a going concern) Mkt. value of debt Mkt. value of equity www.livecampus.in Ankur

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Book versus market values

The Book value of a firm often contrasts sharply with the Market value.

Assets

Liabilities + Equity

P hysica l assets at historical book value

Boo k d ebt

Book equity

Equity P hysica l assets at historical book value Boo k d ebt Book equity www.livecampus.in

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Book versus market values: a hypothetical exampl e

A firm beg ins with Rs2000 of debt and Rs4000 of equity in order to purchase Rs6000 of assets. These become the original accounting book values.

In contrast, Market values are based on today ’s expectations of future performance, i.e., what cash amounts are expected to be paid out and the perception of ris k. Assume the following:

Investors are willing to pay Rs2000 for the bonds.

Investors are willing to pay Rs10,000 for the equity.

for the bonds. – Investors are willing to pay Rs10,000 for the equity. www.livecampus.in Ankur Garg

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Book versus market values for the hypot h etical exampl e

Book values of firm:

Assets

Liabilities + Equity

Rs6,000 physical assets

Rs2,000 Book debt

Rs4 , 000 Book equity

Market values of firm:

Rs4 , 000 Book equity • Market values of firm: www.livecampus.in Assets Liabilities + Equity

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Assets

Liabilities + Equity

Rs12,000 M.V. as a go i ng concern

Rs2,000 M.V. debt

Rs10,000 M.V. equity

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Intrinsic (fundamental) values

Market values are what investors are willin g to either buy or sell an asset for, based on investors’ expectations of future performance.

Market values are very often publicly observed, e. g., the transactions in the stock markets.

In contrast, intrinsic values are usually considered as private estimates of what something , e. g ., a common stock, is actually worth.

Intrinsic value is not something that you can prove.

I f ten ana l ysts are asked to va l ue IBM stock , t h en th ere wi ll likely be ten different intrinsic value estimates!

stock , t h en th ere wi ll likely be ten different intrinsic value estimates!

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Intrinsic (fundamental) values

Assume that a New York Stock Exchange listed firm has an equity market value of Rs10 billion.

However, those that mana ge the firm ( insiders ) believe the firm is actually worth Rs12 billion (intrinsic value), based on their private or inside forecasts of future cash flow performance.

For the most part, market prices are driven by public expectations and consensus, w hi l e intrinsi c va l ues represent private forecasts.

an d consensus, w hi l e intrinsi c va l ues represent private forecasts. www.livecampus.in

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Financial goals of the corporation

The primary financial goal is shareholder wealth maximization — a function of future cash flow and risk.

In reality, this is maximizing intrinsic value

For now we will assume that this is synonymous w i t h maximizing t h e market va lue , i. e ., stoc k price maximization.

Warren Buffett states that his goal is to max i m i ze Berkshire Hathaway s intrinsic value, and hopefully, the stock’s market value will be close to the intrinsic value.

and hopefully, the stock’s market value will be close to the intrinsic value. www.livecampus.in Ankur Garg

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and hopefully, the stock’s market value will be close to the intrinsic value. www.livecampus.in Ankur Garg

Stock price maximization is NOT profit or earni ngs max i mi zat i on ?

Market (and intrinsic) values are driven by risk and expectatons (forecasts) of future cash flows.

Earnings and other accounting profitability measures are not cash flows and have limited use in estimating financial values.

Some actions may cause an increase in reported earnings, yet cause the stock price to decrease (and vice versa).

in reported earnings, yet cause the stock price to d ecrease (and vice versa). www.livecampus.in Ankur

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Wealth maximization and societal welfare

Is the general welfare of society advanced when individual agents pursue wealth maximization?

Is intrinsic or market value maximization good or bad for societ y. Should firms behave ethicall y?

The following slide contains a quote is from Adam Smith ’s Inquiry into the Nature and Causes of the Wea lth of Nations , 1776.

Adam Smith believed that an economic system in which individual agents strive to increase their market value result s i n the most effi ci ent l evel o f genera l welfare, as it facilitates the allocation of resources to their most productive use.

as it facilitates the allocation of resources to their most productive use. www.livecampus.in Ankur Garg 18

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Agency relationships — the separation of owners hi p an d contro l

An a gency relationshi p exists whenever a princi pal (owner of a resource) hires an agent to act on their behalf. Examples are:

Citizen (principal) and elected official (agent)

Stockholder (principal) and corporate manager (agent)

Withi n a corporati on, agency rel ati ons hi ps exi st between:

Shareholders and managers

Shareholders and creditors

ps exi st between: – Shareholders and managers – Shareholders and creditors www.livecampus.in Ankur Garg 19

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Shareholders versus Managers

Managers are naturally inclined to act in their own best interests.

But the following factors affect managerial behavior:

Mana gerial com pensation plans

Direct intervention by shareholders

The threat of firing

The threat of corporate takeover

by shareholders – The threat of firing – The threat of corporate takeover www.livecampus.in Ankur Garg

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Shareholders versus Creditors

Shareholders (through managers) could take actions to maximize stock price that are detrimental to creditors, i.e., actions that result in a wealth transfer from creditors to stockholders.

In the long run, such actions will raise the cost of debt and ultimately lower the stock p rice.

actions will raise the cost of debt and ultimatel y lower the stock p rice. www.livecampus.in

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Factors that affect stock prices

As im plied in earlier slides , stock prices are a function of:

Projected cash flows to shareholders

Timing of the cash flow stream

Riskiness of the cash flows

shareholders – Timing of the cash flow stream – Riskiness of the cash flows www.livecampus.in Ankur

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Principles of Corporate Finance

Invest in projects that yield a return greater than the minimum acceptable h urdle rate .

The hurdle rate should be higher for riskier projects and reflect the financing mix used owners’ funds (equity) or borrowed money (debt)

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

Choose a financing mix that minimizes the hurdle rate and matches th e asset s b e ing fi nance d.

If there are not enough investments that earn the hurdle rate, return the cash to stockholders.

The form o f returns dividends an d stoc k b uy b ac ks will d epen d upon the stockholders’ characteristics.

Objective: Maximize the Value of the Firm

the stockholders’ characteristics . Objective: Maximize the Value of the Firm www.livecampus.in Ankur Garg 23

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