Applied Corporate Finance. Unit 1

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1 Applied Corporate Finance Unit 1

2 Introduction to Corporate Finance Principles of Corporate Finance real world focus Objectives in Decision making Choosing the right objective Classical Objective Maximize Stock prices Alternatives to Stock Price Maximization The Limits of Corporate Finance

3 Disclaimer The contents of this course are inspired by Prof Aswath Damodaran s course on Applied Corporate Finance. The examples and contents have been suitably modified for the students at RVS IMSR. We would however thank Prof Damodaran for making his material available on the web for all learners. Some of the slides used have the content from Prof. Damodaran s slides.

4 What is Corporate Finance? Everything that a business does, has financial implications. Thus any decision that affects the financials of a business is a Corporate Finance Decision.

5 What is Corporate Finance? There are three major decision points in Corporate Finance The Investment Decision The Financing Decision The Dividend Decision

6 What is Corporate Finance? The Investment Decision Resources in any business are limited, while opportunities unlimited. The decision to deploy these resources is the investment decision The Financing Decision Where do we raise money from for the investments? What should be the debt and equity mix 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?

7 The View of a Firm Assets Assets in Place Growth Assets Liabilities Debt Equity

8 The View of a Firm Assets Liabilities Assets that the company has already invested into Assets in Place Debt Fixed Claim on cash flows, usually with fixed maturity Expected Value to be created from growth via investments Growth Assets Equity Residual Claim on cash flows, usually perpetual

First Principles Maximize the value of the business (firm) The Investment Decision Invest in assets that earn a return greater than the minimum acceptable hurdle rate The Financing Decision Find the

cash to owners of your business The hurdle rate should reflect the riskiness of the investment and the mix of debt and equity used to fund it.

9 First Principles Maximize the value of the business (firm) The Investment Decision Invest in assets that earn a return greater than the minimum acceptable hurdle rate The Financing Decision Find the right kind of debt for your firm and the right mix of debt and equity to fund your operations The Dividend Decision If you cannot find investments that make your minimum acceptable rate, return the cash to owners of your business The hurdle rate should reflect the riskiness of the investment and the mix of debt and equity used to fund it. The return should reflect the magnitude and the timing of the cashflows as welll as all side effects. The optimal mix of debt and equity maximizes firm value The right kind of debt matches the tenor of your assets How much cash you can return depends upon current & potential investment opportunities How you choose to return cash to the owners will depend on whether they prefer dividends or buybacks Source: Applied Corporate Finance, Aswath Damodaran

10 Questions Discuss the major decision points in Corporate Finance. What are growth Assets?

11 Applied Corporate Finance Unit 1

12 The Objective in Decision Making In traditional corporate finance, the objective in decision making is to maximize the value of the firm. A more specific objective is to maximize stockholder wealth. When the stock is traded and markets are viewed to be efficient, the objective is to maximize the stock price.

13 The Objective in Decision Making Assets Liabilities Assets that the company has already invested into Assets in Place Debt Fixed Claim on cash flows, usually with fixed maturity Expected Value to be created from growth via investments Growth Assets Equity Residual Claim on cash flows, usually perpetual

14 The Criticism Many critics believe that the objective of maximizing stock prices is not in cohesion with employee welfare For example, when some companies announce job cuts, or fire employees, stock prices jump because of rationalization of costs. Another criticism is that to maximize stock prices, you will have to care less about customer satisfaction. There is also criticism that in a bid to maximize stock prices, the company will care less about society in general.

15 The Support Companies which are successful over the longer run are likely to have happy employees, and happy customers. In the longer run, it s difficult to have a successful company that does not care about employees and customers. Companies which do not care about society also face bans, penalties etc in the long run, which reduce shareholder wealth. So to maximize shareholder wealth, the company will have to follow best practices according to the society. Finally, fuzzy objectives do not work. We have to be clear in stating the objective of the success of a company. Stock prices work well there, since they give instantaneous feedback. It is also most easily observable and constantly updated.

16 Stock Prices give fast feedback

17 Can we have another objective? Firms can always focus on a different objective function. Examples would include maximizing earnings maximizing revenues maximizing firm size maximizing market share maximizing EVA Note the impact of these functions. Most of them seem to be means rather than ends. To the extent these objectives fit in to the longer term value of the company, they work well. For example, if you give away services for free, you will make a market share, but how will you continue the business example Air Deccan If your idea is maximization of market share, there is a huge cost attached to it Flipkart, e-commerce

18 So we return to our objective function Stock Holders Hire & fire managers - Board - Annual Meeting Maximize stockholder wealth Bond Holders Lend Money Protect bondholder Interests Managers No Social Costs All costs can be traced to firm Society Source: Applied Corporate Finance, Aswath Damodaran Reveal information honestly and on time Financial Markets Markets are efficient and assess effect on Value

19 But in reality things can go wrong Stock Holders Have little control over managers Managers put their interests over stockholders Bond Holders Lend Money Bondholders are not protected. Managers High Social Costs Some costs cannot be traced to firm Society Do not reveal information correctly Markets are not efficient and make mistakes Source: Applied Corporate Finance, Aswath Damodaran Financial Markets

20 Examples Stockholders having little control over managers Bondholders are left unprotected Provide misleading information to markets, or markets react incorrectly to information Huge societal costs

21 Examples

22 Examples Source:

23 Questions Discuss why stock price maximization is the best objective function to have Discuss how relationships in the objective function for corporate finance can go wrong

24 Applied Corporate Finance Unit 1

25 Stockholders vs Managers Ideally, the stockholders can control the managers in theory in the following 2 ways A Board of Directors is working on behalf of the shareholders to ensure that managers act in the best interest of the shareholders The stockholders can act during the annual general meeting of companies, and use their voting rights to ensure that managers act in their best interests.

26 Stockholders vs Managers Ideally, the stockholders can control the managers in theory in the following 2 ways A Board of Directors is working on behalf of the shareholders to ensure that managers act in the best interest of the shareholders The stockholders can act during the annual general meeting of companies, and use their voting rights to ensure that managers act in their best interests. However, in real life this may not work.

27 Stockholders vs Managers Some of the reasons this may not work is The Board of Directors is made up of shareholders who are related to the management. After all, who chooses the Board of Directors? In most cases, the promoter is also the management, and why would they want to have a Board overseeing everything they do. Most small stockholders do not go the Annual Meetings Annual meetings are also tightly scripted and controlled events, making it difficult for outsiders and rebels to bring up issues that are not to the management s liking

28 Stockholders vs Managers The problems with the Board of Directors is The Board of Directors is made up of shareholders who are related to the management. The CEO is the head of the Board, so the Board cannot make a decision that overrules the CEO The compensation committee and audit committee are also appointed by the management in many cases (one of the ways management can work against the shareholders is by fixing high salary for management, thereby reducing profits for shareholders) The Directors serve on multiple companies, reducing the amount of time they can spend on one company.

29 Stockholders vs Managers One of the easiest and quickest ways for the management to take away money from shareholders is to go for an expensive acquisition. Time and again we have examples when companies go overboard while making an acquisition, only to lose money later.

30 Stockholders vs Managers Great Offshore acquisition by Bharati Shipyard Source:

31 Great Offshore acquisition by Bharati Shipyard Stockholders vs Managers

32 Great Offshore acquisition by Bharati Shipyard Stockholders vs Managers

33 Stockholders vs Bondholders In theory: there is no conflict of interests between stockholders and bondholders. In practice: Stockholder and bondholders have different objectives. Bondholders are concerned most about safety and ensuring that they get paid their claims. Stockholders are more likely to think about upside potential

34 Stockholders vs Bondholders So how can managers work against the bondholders A huge dividend or buyback may take cash out of the firm, making it riskier. This could be against the best interest of the bondholders When a firm takes riskier projects than those agreed to at the outset, lenders are hurt. Lenders base interest rates on their perceptions of how risky a firm s investments are. If stockholders then take on riskier investments, lenders will be hurt. It is in the benefit of stockholders to take excessive risks they get paid to do so, and have limited liability. But not so for bondholders

35 Stockholders vs Bondholders So how can managers work against the bondholders A huge dividend or buyback may take cash out of the firm, making it riskier. This could be against the best interest of the bondholders When a firm takes riskier projects than those agreed to at the outset, lenders are hurt. Lenders base interest rates on their perceptions of how risky a firm s investments are. If stockholders then take on riskier investments, lenders will be hurt. It is in the benefit of stockholders to take excessive risks they get paid to do so, and have limited liability. But not so for bondholders

36 Source: Stockholders vs Bondholders

37 Source: Stockholders vs Bondholders

38 Questions Explain how can managers work against the shareholders of the company. Give an example Explain how the objectives of shareholders and bondholders are different

39 Applied Corporate Finance Unit 1

40 Source: arati-abg-surge-on-great-offshore-open-offer.html Firms and Financial Markets

41 Firms and Financial Markets In theory: Financial markets are efficient. Managers convey information honestly and and in a timely manner to financial markets, and financial markets make reasoned judgments of the effects of this information on 'true value'. As a consequenceo A company that invests in good long term projects will be rewarded. o Short term accounting gimmicks will not lead to increases in market value. o Stock price performance is a good measure of company performance. In practice: There are some holes in the 'Efficient Markets' assumption.

42 Firms and Financial Markets Why is actual experience different? That is because sometimes the firms manage the information given out to markets (such as delay bad news) and sometimes they resort to give misleading or incorrect information. The second problem is with the investor reaction to news. There tends to be overreaction on either side. We have to be aware of such limitations. Finally, there seems to be evidence of insider trading that is, company insiders may trade on news before it is made public. This is however illegal.

43 Firms and Financial Markets However, what works in the favour of markets, is the following Fast reaction or overreaction to news is better than some other metrics which may not react to news at all. For example, a news of a merger will have no impact on any other metric like profits or sales in the immediate term. Also, someone has to make this judgement, on whether the news is good or bad. Markets may be imperfect, but they do this better than managers or governments.

44 Firms and Financial Markets And while markets are considered more short term in nature they are supposed to overreact to news, the following points tell that markets may be able to look beyond the short run 1. The market is able to value small and young companies, even though they may not have enough revenues or profits today. This shows that markets can look in the long run 2. Markets reaction to investments in R&D is usually good. Markets reaction to investments also points to the fact that they are able to look beyond the short term.

45 Firms and Society In theory: All costs and benefits associated with a firm s decisions can be traced back to the firm. In practice: Financial decisions can create social costs and benefits. A social cost or benefit is a cost or benefit that accrues to society as a whole and not to the firm making the decision. Environmental costs (pollution, health costs, etc..) Quality of Life' costs (traffic, housing, safety, etc.) Examples of social benefits include: creating employment in areas with high unemployment supporting development in inner cities creating access to goods in areas where such access does not exist

46 Firms and Society However, socials costs may be difficult to quantify For example what is the quantified impact on society on account of tobacco / cigarette smoking. How much of it would have happened even without ITC selling cigarettes? Have they actually increased it, or reduced it, since the user may have otherwise resorted to using unregulated tobacco sources. Eyes of the beholder: They are person-specific, since different decision makers can look at the same social cost and weight them very differently. Cannot know the unknown: The costs may not be known at the time of the decision. In other words, a firm may think that it is delivering a product that enhances society, at the time it delivers the product but discover afterwards that there are very large costs. For example nuclear power.

47 Tradition Corporate Finance Break Down Traditional corporate financial theory breaks down when Managers look at their interest first and firm interest later. Bondholders are not protected against shareholders Financial markets do not operate efficiently, and stock prices do not reflect the underlying value of the firm. Significant social costs can be created as a by-product of stock price maximization.

48 But in reality things can go wrong Stock Holders Have little control over managers Managers put their interests over stockholders Bond Holders Lend Money Bondholders are not protected. Managers High Social Costs Some costs cannot be traced to firm Society Do not reveal information correctly Markets are not efficient and make mistakes Source: Applied Corporate Finance, Aswath Damodaran Financial Markets

49 Self correcting mechanisms Stock Holders 1. More activist investors 2. Hostile takeovers Managers of poorly run firms are put on notice. Bond Holders Protect themselves New Bond Covenants Managers Corporate Good Citizen Constraints 1. More laws 2. Investor/Customer Backlash Society Firms are punished for misleading markets Investors and analysts become more skeptical Source: Applied Corporate Finance, Aswath Damodaran Financial Markets

50 Questions Explain what is the criticism of the relationship between the firm and the markets Explain why it is difficult to quantify the impact of the firm s business on the society.

What is Corporate Finance? Includes any decisions made by a business that affect its finances

1 Lecture I What is Corporate Finance? Includes any decisions made by a business that affect its finances Three major decisions: Investments: Where should a firm invest its (scarce) resources? - project