What corporate finance is about by qfc86623


									What corporate finance is about?
Corporate Finance I (this course)

What a firm’s managers should do in order to
maximize the wealth of its shareholders?
How to ensure that managers will do so?
How to ensure that firms (projects) are valued
correctly by the market (i.e. get finance on fair
Corporate Finance II (Module 4)

How to write financial contracts so that the
manager and various investors are provided
optimal incentives?
Incomplete contracts view: allocation of control
is important!
Transfers of corporate control (takeovers)
Law and Finance: how legal system affects
ownership and control allocation in firms and
their ability to raise external finance
Other theories of financial development
1. What a firm’s managers should do in order
 to maximize the wealth of its shareholders?
 Capital budgeting: which projects to select
     Shoud we fund this R&D project?
     Should we close/reopen the plant?
     Should we acquire this company?

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

 Capital structure: how to raise capital for implementing projects
     How much debt and equity should we issue (if at all)?
      I.e. what is the optimal capital structure?

  Criterium: minimizing the cost of capital for a firm
    Effect of taxes
    Costs of financial distress
    Agency and asymmetric information problems
Payout policy
   Should we pay back our shareholders now?
    How much?
   Dividends or stock repurchase?
   Should we pay out dividend if we need cash
    for investment?

Going public
   Why do firms go public (do IPOs)?
   Consequences of going public
2. How to ensure that managers will
  maximize shareholders’ wealth?
Is it actually the right objective? (Tirole)
If yes then the problem:
managers’ interests may diverge from
max. shareholder value
   Shirking
   Empire building
   Investing in “pet” projects   Agency problem
   Perquisites
   Self-dealing
Agency problem  difficult to raise
     funds (cost of capital↑)
 Simple example:
 Entrepreneur needs I to realize a project
 that brings E(R)=V > I
 Has no money  goes to the market to
 raise I
 But once the funds have been injected can
 “steal” non-verifiable x such that E(R)=V-x
 If V-x < I investors will refuse funding
             Solutions (partial)
Alignment through managerial compensation (stock-
based compensation, bonuses)
Market discipline
   Firms whose management do not maximize shareholder wealth
    are taken over
   Market for managerial talent (managers can be replaced)
Monitoring and bonding (credibly committing)
   Large shareholder monitoring
   Outside auditors
   Rating agencies
   Cross-listing abroad (for underdeveloped markets)
   Committing to high dividends (implications for payout policy)
   Providing shareholders with control rights
Using debt instead of equity. But (!) costs of debt
 implications for optimal capital structure
3. How to ensure that firms (projects) are
 valued correctly by the market (i.e. get
         finance on fair terms)?
Problem: asymmetric information
“Bad” managers want to pretend being good
If investors believe that the project is rather bad they
would agree to finance it only for high enough “promiced”
return (e.g. high face value of debt, or large share of
Two kinds of problems:
   Underinvestment (“lemons” problem). No projects are financed
   Overinvestment. Inefficient projects are financed (investors can’t
    distinguish between projects, but break-even on average)
Solution: signalling
   By ownership structure
   By leverage (i.e. implication for optimal capital structure)
Implication for dividend policy and IPOs
          Should managers maximize
             shareholder wealth?
     The concept of Stakeholder Society:
                                    May put their
                          Capital   interests above
Lenders                      Managers                       Society (consumers,
           May shift                     Externalities      environment, etc…)
           wealth from              May fire workers,
           lenders to      Labor    underinvest in safety
           shareholders             on the job, …

          Managers should take care of all stakeholders,
          not only shareholders!
     Shareholder value position:
                          Shareholders           Residual claimants
                                   May put their
                         Capital   interests above
Lenders                     Managers                       Society (consumers,
          May shift                     Externalities      environment, etc…)
          wealth from              May fire workers,
          lenders to      Labor    underinvest in safety
          shareholders             on the job, …


     Protected by contracts, exit options and regulation
      Shareholder value position:
  There are no inherent conflicts between
  shareholders and other parties and society
     All other parties can protected by contracts and exit
         Creditors have a fixed claim, collateral, covenants, convertibility
         Workers are protected by a union, have an agreed wage, a
         severance pay, outside opportunities (labor market)
     Society can be protected by regulation
     Shareholders are residual claimants

 Max {shareholder value} ~ Max {aggregate welfare}
But contracts and regulation are
Unprotected creditors
   “Asset substitution” problem. By choosing more risky
    projects shareholders transfer wealth from creditors to
   Paying too much dividends
   Issuing new debt to new creditors
Unprotected workers.
   If labor markets are rigid being laid off is very costly
    (e.g. in France)
Unprotected society.
   E.g. regulators can be corrupt
Example: increase in the financial
   leverage of RJR Nabisco
Yet few more arguments in defense
       of shareholder value
 Maximizing shareholder value is not necessarily
 incompatible with treating other stakeholders well
    Treating employees well, having good reputation in relationships
     with creditors, consumers can eventually benefit shareholders
 Measurement issue.
    If financial markets are efficient, stock price provides a perfect
     estimate of shareholder wealth – easy to objectively assess the
     manager’s performance.
    In contrast, performance in the provision of positive externalities
     to other stakeholders is ill-defined and unverifiable.
 Objection: financial markets are imperfect  stock price
 is not a good measure.
 Still concentrating on one task – shareholder welfare – is
 desirable due to the benefits of “focused missions”
So what is the right objective for a
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.
         What is Corporation?
      Forms of Business Organization (US)

The Sole Proprietorship
The Partnership
   General Partnership
   Limited Partnership
The Corporation

Advantages and disadvantages, evaluating by:
   Liquidity and Marketability of Ownership
   Liability
   Continuity of Existence
   Tax Considerations
   Ease of setting up
A Comparison of Partnership and Corporation
                        Corporation            Partnership

Liability               Limited liability      General partners may have
                                               unlimited liability. Limited
                                               partners enjoy limited
Transfer of ownership   Shares can easily be   Subject to substantial
                        exchanged.             restrictions.
Continuity              Perpetual life         Limited life

Taxation                Double                 Partners pay taxes on
Ease of setting up      Complex and costly     Easy

  Ultimate advantage of Corporation is the ability to
  raise large amounts of money
   Responsibilities of the Chief
     Financial Officer (CFO)
One of the three key people together with
Investment decisions           Financing decisions

• Large capital expendiures    • Capital structure
• Research and development     • Dividend policy
• Mergers and acquisitions     • Lease vs. borrow
• Working capital management   •…
           Balance Sheet model and the Two Key
              Functions of Corporate Finance
          The Investment Decision:   The Financing Decision:
                   Assets             Liabilities and Equity

             Current Assets                  Current Liabilities
                      Cash                   Accounts Payable
       Marketable Securities                 Short-Term Debt
       Account Receivables                   Product Warranties

                Fixed Assets                 Long-Term Liabilities
                   Buildings                 Long-Term Debt
                  Equipment                  Pension Obligations
                       Land                  Deferred Taxes

            Intangible Assets
                Brand Names
    Trademarks and Patents                  Equity
       Distribution Networks                Proceeds from Stock Sales
           Customer Loyalty                 Retained Earnings
Loyal and Skilled Work Force                Additional Paid-in Capital

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