Corporate Finance - Introduction

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What is Corporate Finance about?

Financial Decisions made by Corporations. Three broad areas of financial decision making: Investment Decisions Financing Decisions Dividend Decisions

Investment Decisions
Firms have scarce resources which must be allocated among competing uses. Resources may be used for :
Revenue Generating Cost Saving Projects Strategic Decisions Introduction of a New Product Line Replacing old equipment with new equipment Which markets to enter Acquisition of other companies

While taking Investment Decisions, we measure the Benefits (Returns) from the proposed Investment projects and compare with Minimum Acceptable Hurdle rate to decide acceptance or rejection.
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Investment Decisions (Contd.)

Minimum Acceptable Hurdle rate should be set so as to reflect: Risk profile of the project (Higher hurdle rate for riskier projects), and Financing mix of the project
Projects with different Risk Profiles

16% 9%

Less Risky

More Risky
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Investment Decisions (Contd.)

Investment Decisions are concerned with: Establish Minimum Acceptable Hurdle Rate appropriate to the investment proposal Measuring Benefits (Returns) from the investment proposals, Comparing benefits with minimum acceptable hurdle rate in order to accept (or reject) the project.

Invest in assets that earn a return greater than the minimum acceptable hurdle rate

Financing Decisions
How should firms raise Financial resources required? Businesses can broadly raise funds either through: Owners Fund (Equity) Borrowed Funds (Debt) Financing Decision involves : Finding a mix between Debt & Equity (Capital Structure), and Type of Instrument Long Term Vs. Short Term, Fixed Rate Vs. Floating Rate, Straight Vs. Convertible, Domestic Markets Vs. International Markets.

Choose the financing mix that maximizes the value of the projects taken and matches the assets being financed.
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Dividend Decisions
Dividend is any reward by the firm to its shareholders. Firms have to decide about what to do with the surplus generated by the firm i.e.: Reinvest into the business (Plough back) , or Distribute as Dividend (reward the shareholders) Amount of Dividend (Dividend Payout) Stability of Dividend (Trend) Form Cash Share Repurchase

Dividend Decisions (Contd.)

Trade-off between retention & distribution is to be made. When the firm is small and has attractive investment opportunities, profits are retained and reinvested. At a later stage in a firms life cycle when the funds generated is greater than the investment requirements, that the firm has to decide about ways of returning excess cash to the owners.

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

Objective of the Firm

How do we judge the correctness of these decisions? Any decision (Investment, Financing, or Dividend) that increases the value is considered good and which reduces the value is considered as poor. Thus the basic objective of Financial Management is:

to maximise the value of the firm

Value of the firm is, therefore, dependent on Firms Investment, Financing & Dividend Decisions.

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Linking Financial Decisions with Firms Objective

Hurdle Rate should reflect the riskiness of investment and the mix of Debt & Equity used to fund it. Returns should reflect the magnitude and timing of cash flows along with the side effects The right kind of debt that matches the tenure of assets financed Optimal Mix of Debt & Equity maximizes the firms value How much cash you can return depends upon current & potential investment opportunities How you choose to return cash to the owners will depend whether they prefer dividends or buybacks

Investment Decision
Invest in assets that earn a return greater than the minimum acceptable hurdle rate

Financing Decision
Choose the financing mix that maximizes the value of the projects taken , and matches the assets being financed.

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

Maximize the value of the Firm

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What is Firm Value?

Maximization of Value of the Firm
Debt holders can protect themselves contractually.

Maximization of Shareholders Value

Maximization of Stock Price of the Firm

Stock price is an observable & real measure of stockholder wealth.

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Corporate Form of Organisation

Main Features Separation of Ownership & Management Legal Person Limited Liability of shareholders Shareholders are distinct from the company

Owners (Shareholders)

Agents (Top Management)

Level-I Management

Level-II Management : Level-V Management

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Agency Problem
Shareholders appoint agents (Management) to conduct the business of the company. As agents, the management should take decisions to maximize shareholders wealth. Shareholders delegate decision-making authority to Management hoping that agents will act in shareholders best interests. However, in actual practice, the objectives of the management may differ from those of the shareholders. Managers may take decisions in their own interest rather than in the interest of the shareholders. This problem of management (agents) not acting in the interests of their principals (shareholders) is called the Agency Problem.
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Why Agency Problem?

Divergence of ownership and control: Those who own the company (shareholders) do not manage it, but appoint agents (management) to run the company on their behalf. Difference in Objectives of Management & Shareholders: Managers are likely to maximize their own wealth rather than the wealth of shareholders. Asymmetry of information: Management, as a consequence of running the company on a day-to-day basis, has access to inside information while shareholders receive annual reports which may themselves be manipulated by the management.

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Resolving Agency Problem

Jensen & Meckling (1976) suggested methods to deal with agency problem which encourage goal congruence between shareholders & managers. Monitor the actions of the Management: Audit of Financial statements by independent Auditors; Shadowing of Senior Managers; Employment of External Analysts. Incentives to Managers: Stock options; Bonus ; Perquisites & Punishments Both methods involve costs- an inevitable result of the separation of ownership and control of a company. Lower the control, lower chances of managers behaviour being consistent with the shareholders, higher the Agency costs. Agency costs-(a) when managers do not attempt to maximizes firm value , and (b) shareholders incur cost to monitor managers.
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Financial System
-An Overview

Financial System : An Overview

In any economy there are two types of economic units: Surplus Units, and Deficit Units. Surplus Units: Units whose Consumption and planned Investments are less than their Incomes. (C+I < Y) Such units have surplus savings and look for avenues to invest their surplus savings. Deficit Units: Units whose Consumption and planned Investments are more than their Incomes. (C+I > Y) Such units have negative savings and need to borrow funds. A system through which the savings of Surplus Units are transferred to Deficit Units is called the Financial System.

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Financial System
Provide Funds Receive Funds

Financial System

Suppliers of Funds
Financial Markets Financial Institutions Financial Instruments & Services

Users of Funds

Buy Securities

Issue Securities

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Financial System (Contd.)

Financial System consists of the following three components, which facilitate the transfer of funds : Financial Markets Provides a mechanism through which funds flow from surplus units to deficit units Centres that provide the facility of buying & selling of financial claims Financial Institutions Organisations which channelise funds from Surplus Units to Deficit Units thereby act as mobilisers & depositories of savings, and creators of credit. E.g.:Commercial Banks, Insurance Cos. Mutual Funds, Developmental Financial Institutions, NBFCs Financial Instruments Claims of the lenders of funds over the funds lent to the borrowers.
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Financial System - Defined Financial system refers to a set of complex, interlinked markets, institutions, instruments and services in the economy which facilitate the transfer and allocation of funds efficiently and effectively.

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Classification of Financial Markets

Maturity of Claim Seasoning of Claim Nature of Claim Money Market Capital Market Primary Market Secondary Market Debt Market Equity Market Spot Market Timing of Delivery Organisational Structure Forward/Futures Market Exchange Traded Market Over-the-Counter Market
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Financial Markets Capital & Money Markets

Money Markets: Deal (trade) in debt securities of maturities of one year and less. Economic entities with excess funds for short durations lend (buy short-term instruments) to economic entities which face shortage of funds for short duration (sell short-term instruments). Money Market Instruments:
Treasury Bills (T-Bills) Call/Notice Money Repurchase Agreements (Repos) Commercial Bills of Exchange Commercial Papers (CPs) Certificates of Deposit (CDs)

No physical location, but an Over-the-Counter (OTC) Market; trades are conducted via telephones, wire transfers, and 23 Computer trading.

Financial Markets Capital & Money Markets

Capital Markets Deal in long-term securities (equity and debt) having maturities of more than one year. Capital Market instruments include: Equity Shares Bonds/Debentures issued by Corporates, Public Sector Undertakings, Governments, Units of closed ended schemes of Mutual Funds

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Financial Markets - Primary & Secondary Markets

Primary Markets: Markets in which Users of funds raise resources through issue of new financial instruments. Also called New Issues Market. Fund users have new projects but do not have sufficient funds internally, hence they issue new securities in the Primary Market to raise additional funds. Intermediary between the user (Issuer) and the suppliers (Investors) which helps raise funds from the Primary Market Investment Banker (Merchant Banker). Funds may be raised thru Initial Public Offering (IPOs); Private Placements; Secondary Public Offerings/Follow-on Public Issue(FPO); Rights Issue (Seasoned Offerings).
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Financial Markets - Primary & Secondary Markets

Secondary Markets: Once the financial instruments have been issued in the Primary Market, they are traded (bought and sold) in the Secondary Market. Deals in existing financial claims (securities). Provides a centralised marketplace for buyers and sellers to trade efficiently (save on search costs). Trade takes place through a stock/securities broker. E.g.: National Stock Exchange (NSE); Bombay Stock Exchange (BSE); NYSE, LSE. Advantages: Investors can trade at market values (an indicator of companys performance) An active secondary market boosts the primary market.

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Functions of Financial System

Payment System: Banks play a pivotal role in the smooth functioning of the payments systems. Pooling of Funds: Businesses requires huge investments beyond the means of any one individual. Through the Financial System, the savings are mobilized and used to finance business enterprises. Transfer of Resources: A well-developed Financial System helps in the efficient allocation of resources into the most productive use in the business sector.

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Functions of Financial System (Contd.) Risk Management: Financial System provides various instruments for pooling, pricing & sharing of risks by way of: Hedging (Forward Cover); Diversification (Mutual Funds- pooling & sub-division of risks) Insurance (the Insured retains the economic benefit of ownership while laying off the possible losses). Price Information for Decentralised Decision-making: Interest rates and security prices help in Investment decisions by each individual unit Surplus Units would want to the Highest returns while the Deficit Units would want the Lowest Costs.

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Indian Financial System An Overview

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Regulatory Authorities Financial Markets

Securities & Exchange Board of India
Forward Markets Commission

Reserve Bank of India

Ministry of Finance (GOI)

Insurance Regulatory & Development Authority

Pension Fund Regulatory & Development Authority

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Reserve Bank of India (RBI)

Reserve Bank of India (RBI)

Developmental Financial Institutions (DFIs) All India: State Level: -IFCI -SFCs -IIBI -SIDCs -TFCI -IDFC -PFC -IRFC

Other Apex FIs

Commercial Banks Public Sector: -SBI Group -Nationalised Private Sector: -Indian -Foreign

RRBs/ Co-op. Banks

NBFCs

-NABARD -EXIM Bank -SIDBI -NHB

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Reserve Bank of India (RBI)

Central monetary authority in India Set up on April 1, 1935; became stateowned in 1949 Main Functions:
Note Issuing Authority Banker to the Government Bankers Bank(Lender of last resort) Regulator of Money & Credit Supervising Authority Exchange Control Authority Promotional Activities www.rbi.org.in
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Governor: Dr.D.Subbarao

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Other Apex (Refinancing) & Regulatory FIs

NABARD EXIM Bank 1982 1982 National Bank for Agriculture & Rural Development -Regulatory & Refinancing authority for RRBs. Export Import Bank of India -Refinancing authority for Exports/Imports. Small Industries Development Bank of India -Refinancing authority for SMEs. National Housing Bank -Regulatory & Refinancing authority for Housing Finance Companies

SIDBI

1988

NHB

1988

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Specialised FIs
IIBI 1997 Industrial Investment Bank of India formerly IRBI: Industrial Reconstruction Bank of India(1971) Tourism Finance Corporation of India Power Finance Corporation Ltd Indian Railway Finance Corporation Ltd Infrastructure Development Finance Corporation

TFCI PFC IRFC IDFC

1989 1990 1986 1997

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Securities & Exchange Board of India (SEBI)

Securities & Exchange Board of India (SEBI)

Mutual Funds Public Sector: -UTI, SBI & Others Private Sector: -Indian -Foreign

Venture Capital Funds

Foreign Institutional Investors (FIIs)

Credit Rating Agencies

Capital Markets
-Stock Exchanges -Merchant Bankers -Underwriters -Stock Brokers -Custodians -Depositories/DP -FIIs -Investors

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Securities & Exchange Board of India (SEBI) Regulatory Authority to oversee & regulate the functioning of the Capital Markets in India. Set up in 1988 through an administrative order but became a statutory organization in 1992. Objective : to protect the interest of the investors & promote the development, regulate the securities market.
www.sebi.gov.in
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Chairman: Mr. UK Sinha

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Insurance Regulatory & Development Authority (IRDA)

Insurance Regulatory & Development Authority (IRDA)

Life Insurance

Non-Life Insurance

Public Sector -LIC Private Sector

Public Sector -GIC Private Sector

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Insurance Regulatory & Development Authority (IRDA) Regulatory authority to oversee & regulate the functioning of the Insurance sector in India. Set up in 1999. Objective : To protect the interests of the policyholders, to regulate, promote and ensure orderly growth of the insurance industry and for matters connected therewith or incidental thereto.
Chairman Mr.J. Hari Narayan

www.irda.gov.in
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Pension Fund Regulatory & Development Authority (PFRDA) Established by the Government of India on 23rd August 2003 Objective: to promote old age income security by establishing, developing and regulating pension funds, to protect the interests of subscribers to schemes of pension funds and for matters connected therewith or incidental thereto Chairman : Mr. Yogesh Agarwal
www.pfrda.gov.in
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Forward Markets Commission (FMC)

FMC is a regulatory authority for commodity futures market in India. Works under the administrative control of Ministry of Consumer Affairs, Food and Public Distribution, Government of India Chairman: Mr Ramesh Abhishek
Regional Exchanges 1 Bikaner Commodity Exchange Ltd., Bikaner 2 Bombay Commodity Exchange Ltd., Vashi 3 Chamber Of Commerce, Hapur 4 Central India Commercial Exchange Ltd., Gwalior 5 Cotton Association of India , Mumbai 6 East India Jute & Hessian Exchange Ltd., Kolkata 7 First Commodities Exchange of India Ltd., Kochi 8 Haryana Commodities Ltd., Sirsa 9 India Pepper & Spice Trade Association., Kochi 10 Meerut Agro Commodities Exchange Co. Ltd., Meerut 11 National Board of Trade, Indore 12 Rajkot Commodity Exchange Ltd.,Rajkot 13 Rajdhani Oils & Oilseeds Exchange Ltd., Delhi 14 Surendranagar Cotton Oil & Oilseeds Association Ltd., Surendranagar 15 Spices and Oilseeds Exchange Ltd. Sangli 16 Vijay Beopar Chamber Ltd., Muzaffarnagar National Exchanges 1 2 3 4 5 Multi Commodity Exchange of India Ltd. (MCX) National Commodity & Derivatives Exchange Ltd. (NCDEX) National Multi-Commodity Exchange of India Ltd. (NMCE) Indian Commodity Exchange Ltd. (ICEX) Ace Commodities & Derivatives Exchange Ltd.

www.fmc.gov.in
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Role of a Finance Manager

Funds raised invested in firms Real assets

Tangible Assets:
Plant & Equipments Building

Funds raised by selling Financial assets

Finance Manager
Funds reinvested Funds generated by firms operations Funds returned to investors

Financial Markets
Investors holding Financial assets

Intangible Assets:
Patents

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