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An overview of Corporate Financeby Binam Ghimire

Learning Objectives

Concept, Scope and Significance Key Decisions in Corporate Finance Agency problem Appreciate Business Ethics and social

Responsibilities

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Finance: What is it?

Finance as a resource Finance as a discipline

Monetary means of financing assets of an entity

Collection and allocation of resources

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Specialised areas of finance

Personal

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Specialised areas of finance

Public

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Specialised areas of finance

Securities and investment

6Source: London Evening Standard, 18 May 2011

Specialised areas of finance

Institutional

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Source: The Telegraph, 29th July 2011

Specialised areas of finance

International Finance

Table from Bringham and Huston (2002, p. 7)

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£, $, €, ¥, %

Corporate Finance

?

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The Corporate Firm

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? ??

Sole Proprietorship

Business is owned and run by one person Typically have few, if any, employees Advantages: Easy to create Disadvantages: Unlimited personal liability, No

separation between the firm and the owner, Limited life, Difficult to transfer ownership

Partnership

Similar to a sole proprietorship, but with more than one owner

Income is taxed at the personal level All partners have unlimited personal liability The partnership ends with the death or

withdrawal of any single partner General and limited partner

The Corporation

AKA: JSC, PLC, LLC, Corporation,

The Corporation

A legal entity separate from its owners Has many of the legal powers individuals have

such as the ability to enter into contracts, own assets, and borrow money …

Source: www.bizstats.com

The Corporation

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Several advantages: Limited liability, ease of ownership transfer and unlimited life. These give the corporation an enhanced ability to raise cash, However

Starting is more complicated than others: Articles of associations and a set of bylaws, and one great disadvantage is

_ _ _ _ _ e _ _ x_ _ _ _ n

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Corporation Partnership

Liability

Perpetuity

Taxation

Voting Rights

Liquidity/ sale of share

Dividend

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Corporation Partnership

Liability No Limited: noGeneral: yes

Perpetuity Yes No

Taxation Double: corporate income and dividends to shareholders

Partnerships is not taxed, partners are on their partnership profit

Voting Rights One vote per share, vote to elect director

Some by limited partners, general are active in managing and operating

Liquidity/ sale of share

Yes – common stock can be listed in exchange and traded

There is usually no established trading market

Dividend Not bound legally Generally no retention i.e. distribute all

Corporate Finance: Concept

Corporate finance: Finance for the corporate or beyond?

limited to management of funds?

Sell - Cash - Value

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Corporate Finance: concept

Corporate Finance deals with:Determining value of a Corporate EntityAdding Value to a Corporate EntityThe Value of X is what X is worth now at time t.Making the best decision when that decision

involves a consideration or an opportunity cost and the cost of consideration may be higher or lower given time t

This is part of strategy

Corporate Finance: the concept

Strategy is how an organization achieves her long term objectives through re-configuration of her resources in

response to a changing external business environment

to achieve competitive advantage in order to satisfy stakeholder’s objectives

Corporate Finance: the concept

Corporate Finance is the: The Reconfiguration of Resources The study of the external changing Business

Environment Definition of what stakeholder’s Financial

objectives are Gaining of competitive advantage

The Three Key Corporate Finance Decisions

Investment Decisions concerned with whether to undertake capital expenditure projects or not

Financing Decisions concerned with the collection of funds from appropriate sources

Managerial Decisions concerned with dividend, working capital and other decisions at management level

Investment Decisions

The Investment Decisions of a Firm are taken using the various investment appraisal techniques which we will study

This techniques are tools which work well if applied properly

They have various decision criteria's and can be very effective if used by the right kind of managers

While they can cause a loss of corporate value if used wrongly

Investment Decisions

The process of making and managing expenditures on long-lived assets: Capital budgeting/ Investment appraisal

Financing Decision

The Financing Decision if informed by the Target Capital Structure desired by the firm

The cost of capital the firm has to bear The sources of finance available to her

Financing Decision

The sources of finance available can be current and long term

Long term debt and equity falls in capital structure

Cost of capital explains about the cost associated with such components of debt and equity capital

Managerial Decisions

How large should the firm grow? How Much Dividend Should be Paid and How

Much profit should be retained for growth? How fast should this growth be? How should the firm manage its receivables and

payables? e.g. Should the firm grant credit to a customer?

The Role of The Financial Manager

Organisational Chart of a Typical Corporation

Financial

Manager

Firm's

operations Investors

(1)(2)

(3)

4

5Real assets

Financial Manager’s Roles

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4. Cash

reinvested

2. Cash invested in the firm’s

operations

3. Cash generated by the firm’s operations

5. Cash returned to

investors

1. Cash raised by selling financial assets to

investors

Goals of a firm

Profit Maximisation vs. Wealth MaximisationAccounting conceptZero dividendTime value of benefitsQuality of benefitsModern business environmentWho are the shareholders?Conflict of interest among stakeholders of a

firm

The Three Different Views of the Firm

The Investment Vehicle Model of the Firm The Accounting Model of the Firm Set of Contracts Model of the Firm

The Investment Vehicle Model of the Firm

The Firm

Investment Decisions

Financing Decisions

Corporate Financial Management

Financial Markets and Intermediaries Investments

Three Main Areas of Finance:

TheWorld

Exchange of Money and Real Assets

Investors

FinancialIntermediaries

FinancialMarkets

Exchange of Money and

Financial Assets

The Accounting Model of the Firm

The Financing Decision

Current LiabilitiesAccounts PayableCurrent Debt

Long-Term Liabilities

Long-Term Bank DebtBonds

Shareholder’s Equity

Common StockRetained Earnings

The Investment Decision

Current AssetsCashMarketable SecuritiesAccounts ReceivableInventory

Total Fixed AssetsTangible Fixed AssetsIntangible Fixed Assets

Net Working Capital =CA - CL

Set of Contracts Model of the Firm

PreferredStockholders

Managers

Firm

CommonStockholders

Communities

Creditors

Governments

Customers

Suppliers

Society

Banks

Environment

Bondholders

Employees

Managers and Owners

The Wall Street Journal Survey of CEO Compensation

http://www.businessinsider.com/25-most-overpaid-ceos-2010-10#18-news-corp-rupert-murdoch-8

Agency Problem: Responsibility for the financial manager

Agency TheoryMichael C. Jensen and William H. Meckling

propounded this theory in 1976 Principal and Agent Management and Shareholders, Creditors and

shareholders

Agency Problem: Responsibility for the financial manager

Manager owns less than 100% of the company Agency Problem Agency Cost (Monitoring, Structuring and

opportunity costs)

Agency Problem

Owners of Corporations cannot manage them

Personally

They have to employ Directors to Manage their Businesses on

their Behalf

These Directors May not carry out the

management to the standard expected of

them

They may do it but to their own advantage or

at a higher cost

Shareholders have to pay the Directors and

these is part of Agency Cost

Because of Breakdown of Trust, Shareholders

have to employ Auditors to Vouch the Stewardship Report of

Directors

All theses add up and the management of the Agent Principal Relationship with its attendant cost to the

Principals is the Agency Cost

Agency Problem/cost: How to reduce?

Managerial compensation plan (e.g. performance stock)

Direct Intervention by shareholders Threat of firing Threat of takeover (e.g. hostile takeover, M&A)

Stakeholder Theory

Who are these

Stakeholder? Stakeholders identification Models

To what Extent Should Companies take them into

consideration? Stakeholders Mapping

What if what is good for one stakeholder is Bad for Another?

Satisficing

What if What is good for stakeholders is viewed as

unethical? Moral Frameworks and Guidelines

A Stakeholder is someone who can affect or be

affected by the operations of an organization as it

seeks to meet its corporate objectives

Business Ethics

Ethics: The study of right and wrong “in action” Making a business decision can involve ethical

dilemmas

An Ethical Dilemma?

Choice to be made Implicates competing values, rights, & goals Potential harm to decision maker? Potential harm to others? “Ripple effect:” long-term, far reaching

implications of decision to be made.

How to Resolve Ethical Dilemmas in Business

Identify relevant facts Identify relevant issue(s) Identify primary stakeholders Identify possible solutions Evaluate each possible solution Compare and assess consequences Decide on solution Take action

Additional Approaches to Ethical Decision Making

Five Question Approach (Tucker) Moral Standards Approach (Velasquez) Pastin’s Approach

Practical Approaches to Ethics

Five Question Approach (Tucker) Evaluate each alternative on:

Profitability (shareholders)Legality (society at large)FairnessImpact on the rights of stakeholdersImpact on sustainable development

(environment)

Tuckers Five QuestionsIs it profitable?Is it fair?Is it legal?Is it right?Is it sustainable?

Practical Approaches to Ethics

Practical Approaches to Ethics

Moral Standards Approach (Velasquez) Is the decision:

Of net benefit to societyFair to all stakeholders (fair distribution of

benefits and burdens)Consistent with each person’s rights

Practical Approaches to Ethics

Pastin’s approach (Pastin)Ground rule ethics (organization/individual

rules and values)End-point ethics (greatest net good for all

concerned)Rule ethics (determine ethical boundaries to

take into account – impingement of rights) Social contract ethics (how to move

boundaries)

Consider This: “You and John”

You are the manager for Tesco. You recently fired John, a sales clerk, after John punched a customer during a dispute in the store. John admitted this after the customer complained.

Lisa, manager of your competitor, Asda, calls you to tell you that John has applied for a job at Asda, and to ask you whether John is “good with customers.”

What will you reply to Lisa?

Legal Vs. Ethical: “You and John”

Action Legal/Illegal Ethical/Unethical

Tell the Truth

Lie

No Comment

Other

Corporate Social Responsibility

Milton Friedman's argument

There is one and only one responsibility of business: to use its resources and energy in activities designed to increase its profit so long as it stays within the rule of game and engages in open and free competition, without deception and fraud.

Source: The New York Times Magazine, September 13, 1970, The New York Times Company.

Corporate Social Responsibility

This is Davis and Blomstrom (1971) Iron Law ofResponsibility

An iron law of responsibility which states that in the long-term those who do not use power in a manner that society considers responsible will tend to lose it.

Source: Davis, K. and Blomstrom, R. (1971) Business, Society and Environment. Social Power and Social Response, 2nd edition, New York, McGraw-Hill. Davis, K. (1973) The case for and against Business assumptions of Social Responsibilities, The Academy of Management Journal, 16, 2, 312-322

Corporate Social Responsibility

Gray, Owen and Adams (1996) described society as a series of social contracts between members of society and society itself.

Corporate Social Responsibility

Gray, Owen and Adams (1996)

1.Pristine Capitalist, 2.Expedient, 3.Social contract, 4.Social Ecologists, 5.Socialists, 6.Radiacal Feminists, 7.Deep Ecologists

Corporate Social Responsibility

Different approachesSocial ObstructionSocial ObligationSocial ResponseSocial Contribution

Charity Principle Stewardship Principle

Discussion

Sarbanes-Oxley Act (2002), USA

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Discussion

Ethics & Management Objectives Does value maximization justify unethical

behavior?

Enron exampleWorldCom exampleAIG example

Careers in Finance

Discuss

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Thank You