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Corporate Finance ICorporate Finance I

IntroductionIntroduction

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What corporate finance is about?What corporate finance is about?

Corporate Finance I (this course)Corporate Finance I (this course)

What a firm’s managers should do in order to maximize What a firm’s managers should do in order to maximize the wealth of its shareholders?the wealth of its shareholders?

How to select projects, given the available funds (investment How to select projects, given the available funds (investment decisions)decisions)

What is the optimal way to raise capital (financing decisions) and What is the optimal way to raise capital (financing decisions) and pay back to the shareholders (payout decisions)pay back to the shareholders (payout decisions)

How do firms cope with agency problems, i.e. ensure How do firms cope with agency problems, i.e. ensure that managers do not behave opportunistically? that managers do not behave opportunistically? (introductory level)(introductory level)

How do firms cope with information asymmetries How do firms cope with information asymmetries between them and the market? (introductory level)between them and the market? (introductory level)

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Corporate Finance II (Module 4)Corporate Finance II (Module 4)Financial Contracting and Corporate GovernanceFinancial Contracting and Corporate Governance

How do firms cope with agency problems and How do firms cope with agency problems and information asymmetries? (advanced)information asymmetries? (advanced)How to write financial contracts so that the manager and How to write financial contracts so that the manager and various investors are provided optimal incentives?various investors are provided optimal incentives?Incomplete contracts view: allocation of control is Incomplete contracts view: allocation of control is important!important!Transfers of corporate control (takeovers)Transfers of corporate control (takeovers)Law and Finance: how institutions affects ownership and Law and Finance: how institutions affects ownership and control allocation in firms and their ability to raise control allocation in firms and their ability to raise external finance – key to financial developmentexternal finance – key to financial development

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Structure of the courseStructure of the course

Investment decisions (capital budgeting)Investment decisions (capital budgeting): which projects to select: which projects to select Shoud we fund this R&D project? close/reopen the plant? acquire this Shoud we fund this R&D project? close/reopen the plant? acquire this

company?company?

Criterium: maximizing shareholders’ return (Discounted Cash Flows)Criterium: maximizing shareholders’ return (Discounted Cash Flows) How to discount cash flows?How to discount cash flows? Taking into account risk and uncertaintyTaking into account risk and uncertainty

Financing decisions (capital structure)Financing decisions (capital structure): how to raise capital for : how to raise capital for implementing projectsimplementing projects

How much debt and equity should we issue (if at all)?How much debt and equity should we issue (if at all)?I.e. what is the optimal capital structure?I.e. what is the optimal capital structure?

Criterium: minimizing the cost of capital for a firmCriterium: minimizing the cost of capital for a firm Effect of taxesEffect of taxes Effect of costs of financial distressEffect of costs of financial distress Effect of agency problems (what if managers behave opportunistically?)Effect of agency problems (what if managers behave opportunistically?) Effect of information asymmetries (what if the market undervalues our Effect of information asymmetries (what if the market undervalues our

company?)company?)

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Effect of capital structure on capital budgeting and Effect of capital structure on capital budgeting and valuation of a firmvaluation of a firm

Payout policyPayout policy Should we pay back our shareholders now? How much?Should we pay back our shareholders now? How much? Should we pay out if we need cash for investment?Should we pay out if we need cash for investment? Dividends or stock repurchase?Dividends or stock repurchase? How will the market react if we reduce/increase dividend this How will the market react if we reduce/increase dividend this

year?year?

Going public (IPO)Going public (IPO) Why do firms go public?Why do firms go public? How does the market prices IPOs? How does the market prices IPOs? What happens to the company after IPO?What happens to the company after IPO?

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The The Stakeholder SocietyStakeholder Society View: View: Managers should take care of all stakeholders, not only shareholders!

Should managers maximize Should managers maximize shareholder wealth?shareholder wealth?

Managers

Shareholders

Lenders

Workers

Society (consumers, environment, etc…)

Capital

Capital

Labor

May put their interests above shareholders

May shift wealth from lenders to shareholders

May fire workers, underinvest in safety on the job, …

Externalities

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Shareholder value position:Shareholder value position:

Managers

Shareholders

Lenders

Workers

Society (consumers, environment, etc…)

Capital

Capital

Labor

May put their interests above shareholders

May shift wealth from lenders to shareholders

May fire workers, underinvest in safety on the job, …

Externalities

Protected by contracts, exit options and regulation

Residual claimants

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Shareholder value position:Shareholder value position:

There are no inherent conflicts between There are no inherent conflicts between shareholders and other parties and society shareholders and other parties and society (stakeholders)(stakeholders) All other parties can protected by contracts and exit All other parties can protected by contracts and exit

optionsoptionsCreditors have a fixed claim, collateral, covenants, convertibility Creditors have a fixed claim, collateral, covenants, convertibility provisionsprovisionsWorkers are protected by a union, have an agreed wage, a Workers are protected by a union, have an agreed wage, a severance pay, outside opportunities (labor market)severance pay, outside opportunities (labor market)

Society can be protected by regulationSociety can be protected by regulation Shareholders are residual claimantsShareholders are residual claimants

Max {shareholder value} Max {shareholder value} ~~ Max {aggregate welfare} Max {aggregate welfare}

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But contracts and regulation are But contracts and regulation are imperfectimperfect

Unprotected creditorsUnprotected creditors ““Asset substitution” problem. By choosing more risky Asset substitution” problem. By choosing more risky

projects shareholders transfer wealth from creditors to projects shareholders transfer wealth from creditors to themselvesthemselves

Paying too much dividendsPaying too much dividends Issuing new debt to new creditorsIssuing new debt to new creditors

Unprotected workers.Unprotected workers. If labor markets are rigid being laid off is very costly If labor markets are rigid being laid off is very costly

(e.g. in France)(e.g. in France)

Unprotected society.Unprotected society. E.g. regulators can be corruptE.g. regulators can be corrupt Who regulates multinationals?Who regulates multinationals?

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Example: announcement of leveraged Example: announcement of leveraged buyout of RJR Nabisco in 1988buyout of RJR Nabisco in 1988(from Damodaran’s “Corporate Finance”)(from Damodaran’s “Corporate Finance”)

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Yet few more arguments in defense Yet few more arguments in defense of shareholder valueof shareholder value

Maximizing shareholder value is not necessarily Maximizing shareholder value is not necessarily incompatible with treating other stakeholders wellincompatible with treating other stakeholders well

Treating employees well, having good reputation in relationships Treating employees well, having good reputation in relationships with creditors, consumers can eventually benefit shareholderswith creditors, consumers can eventually benefit shareholders

Measurement issue.Measurement issue. If financial markets are efficient, stock price provides a perfect If financial markets are efficient, stock price provides a perfect

estimate of shareholder wealth – easy to objectively assess the estimate of shareholder wealth – easy to objectively assess the manager’s performance.manager’s performance.

In contrast, performance in the provision of positive externalities In contrast, performance in the provision of positive externalities to other stakeholders is ill-defined and unverifiable.to other stakeholders is ill-defined and unverifiable.

Objection: financial markets are imperfect Objection: financial markets are imperfect stock price stock price is not a good measure.is not a good measure.Still concentrating on one task – shareholder Still concentrating on one task – shareholder welfarewelfare – is – is desirable due to the benefits of “focused missions”desirable due to the benefits of “focused missions”

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So what is the right objective for a So what is the right objective for a manager?manager?

For publicly traded firms in reasonably efficient markets, and if stakeholders are protected:

Maximize stock price.

For publicly traded firms in inefficient markets (or for private firms), and if stakeholders are protected:

Still maximize stockholder wealth. This might not maximize the stock price.

When stakeholders are not fully protected (by contracts or regulation)

The answer is unclear. Tradeoff: benefits of focus and objective measure of performance (stock price if markets are efficient) vs. accounting for externalities imposed on other stakeholders.

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What is Corporation?What is Corporation?

USUS Российский эквивалентРоссийский эквивалент

Sole ProprietorshipSole Proprietorship Частный предприниматель Частный предприниматель (ПБОЮЛ)(ПБОЮЛ)

PartnershipPartnership generalgeneral limitedlimited

ТовариществоТоварищество полноеполное коммандитное (на вере)коммандитное (на вере)

Limited Liability CompanyLimited Liability Company ОООООО

CorporationCorporation ОАООАО

Forms of business organizationForms of business organization

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In contrast to other forms, Corporation is a legally defined artificial being (judicial person or legal entity), separate from its owners, implying it can

possess property, protected by the US constitution from seizure (like an ordinary person)

enter contracts acquire assets incur obligations… Owners of a corporation are not

responsible for its obligation; neither is a corporation is responsible for obligations of its owners!

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EasyComplex and costlyEase of setting up

Virtually noSubstantialDisclosure requirements

Generally all cash flow must be distributed to partners

Broad latitude on payout decisions

Reinvestment and dividend payout

A Comparison of Partnership and CorporationA Comparison of Partnership and Corporation

Taxes only on distributions to partners.

Double (on firm’s income and distributions to sh-s)

Taxation

Limited lifePerpetual lifeContinuity

Subject to substantial restrictions.

Shares can easily be exchanged.

Transfer of ownership

General partners may have unlimited liability. Limited partners enjoy limited liability.

Limited liabilityLiability

PartnershipCorporation

Ultimate advantage of Corporation is the ability to raise large amounts of money

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Types of U.S. FirmsTypes of U.S. Firms

Source: www.bizstats.comSource: www.bizstats.com

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Corporation StructureCorporation StructureShareholder (Principals)•Elect/fire Directors and sometimes the CEO•Vote on most important decisions (e.g. large

transactions, amendments to the charter)

Managers (Agents)Day-to-day management. Ideally should maximize firm value

Board of Directors•Define strategy•Monitor and control managers•Sometimes elect/fire CEO

Capital Return