PROJECT REPORT

Submitted in partial fulfillment of the requirements for the award of two year full time, POST GRADUATE DIPLOMA IN MANAGEMENT
By

Syed Nisar Husain PGDM/10-12/B/113 (IILM CMS) Under the guidance of

Mr. P.K Agarwal Professor (Accounts and Finance) IILM-CMS

Integrated Institute for Learning and Management College of Management Studies 16-17, Knowledge Park 2, Greater Noida

Declaration
I hereby declare that the project entitled Corporate Finance and its Scope is submitted in partial fulfillment of my PGDM course 2010-12 was carried out with sincere intention of benefiting the organization. To the best of my knowledge it is an original piece of work done by me and it has neither been submitted to any other organization nor published at anywhere before. The findings and conclusions expressed in this report are genuine, authentic and are for academic purpose. Any resemblance to earlier research work is purely coincidental.

Name: Syed Nisar Husain Date: 31st March 2012 Signature

Acknowledgement
Whatever we do and whatever we achieve during the course of our limited life is just not done only by our own efforts, but by efforts contributed by other people associated with us indirectly or directly. I thank all those people who contributed to this from the very beginning till its successful end. I acknowledge my gratitude to Mr. P.K Agarwal (Professor- Finance, IILM-CMS), for his extended guidance, encouragement, support and reviews without whom this project would not have been a success.

Table of Content

Sr. No. 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13.

Topic Introduction Structure of Corporate Finance What is Corporate Finance Relationship with other areas Corporate Finances in India International Businesses in India Indian Businesses Sources of raising funds Types of Finances Game Theory Agency cost of free cash flow and corporate finances The Role of debt in motivating organizational efficiency Conclusion

Page No. 6-7 8 9-13 14 15 16-17 18 19-20 21-23 24-27 28-29 30-31 32-34

CORPORATE FINANCE: A COMPARATIVE STUDY

Introduction to the Topic

Corporate finance dealing with financial decisions business enterprises make and the tools and analysis used to make these decisions. The primary goal of corporate finance is to maximize corporate value while managing the firm's financial risks. Although it is in principle different from managerial finance which studies the financial decisions of all firms, rather than corporations alone, the main concepts in the study of corporate finance are applicable to the financial problems of all kinds of firms. In July 1999, Carleton "Carly" Fiorina assumed the position of CEO of Hewlett-Packard (HP). Investors were pleased with her view of HP's future: She promised 15 percent annual growth in sales and earnings, quite a goal for a company with five consecutive years of declining revenue. Ms. Fiorina also changed the way HP was run. Rather than continuing to operate as separate product groups, which essentially meant the company operated as dozens of mini companies, Ms. Fiorina reorganized the company into just two divisions. In 2002, HP announced that it would merge with Compaq Computers. However, in one of the more acrimonious corporate battles in recent history, a group led by Walter Hewlett, son of one of HP's cofounders, fought against the merger. Ms. Fiorina ultimately prevailed, and the merger took place. With Compaq in the fold, the company began a two-pronged strategy. It would compete with Dell in the lower-cost, more commodity-like personal computer segment and with IBM in the more specialized, high end computing market. Unfortunately for HP's shareholders, Ms. Fiorina's strategy did not work out as planned, and in February 2005, under pressure from HP's board of directors, Ms. Fiorina resigned her position as CEO. Evidently, investors also felt a change in direction was a good idea; HP's stock price jumped almost seven percent the day the resignation was announced. Understanding Ms. Fiorina's rise from corporate executive to chief executive officer, and finally, ex-employee, takes us into issues involving the corporate form of organization, corporate goals, and corporate control. The discipline can be divided into long-term and short-term decisions and techniques. Capital investment decisions are long-term choices about
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which projects receive investment, whether to finance that investment with equity or debt, and when or whether to pay dividends to shareholders. On the other hand, the short term decisions can be grouped ". This subject deals with the short-term balance of current assets and current liabilities; the focus here is on managing cash, inventories, and short-term borrowing and lending (such as the terms on credit extended to customers). The terms corporate finance and corporate financier are also associated with investment banking. The typical role of an investment bank is to evaluate the company's financial needs and raise the appropriate type of capital that best fits those needs.

Structure of Corporate Finance

MAXIMIZE THE VALUE OF THE BUSINESS (FIRM)

The Investment Decision Invest in assets that earn a return greater that the minimum acceptable hurdle rate 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 cash flows as well as all side effects 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 Financing Decision Find the right kind of debt for your firm and the right mix of debt and equity to fund your operations

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 on current and potential investment opportunities

How you choose to return cash to the owners will depend on whether they prefer dividends or buybacks

What is Corporate Finance

Suppose you decide to start a firm to make tennis balls. To do this, you hire managers to buy raw materials, and you assemble a workforce that will produce and sell finished tennis balls. In the language of finance, you make an investment in assets such as inventory, machinery, land, and labor. The amount of cash you invest in assets must be matched by an equal amount of cash raised by financing. When you begin to sell tennis balls, your firm will generate cash. This is the basis of value creation. The purpose of the firm is to create value for you, the owner. The value is reflected in the framework of the simple balance sheet model of the firm. Following Factor have to be consider before making the Corporate Finance. Capital investment decisions Capital investment decisions are long-term corporate finance decisions relating to fixed assets and capital structure. Decisions are based on several inter-related criteria. (1) Corporate management seeks to maximize the value of the firm by investing in projects which yield a positive net present value when valued using an appropriate discount rate. (2) These projects must also be financed appropriately. (3) If no such opportunities exist, maximizing shareholder value dictates that management must return excess cash to shareholders (i.e., distribution via dividends). Capital investment decisions thus comprise an investment decision, a financing decision, and a dividend decision. Valuing flexibility In many cases, for example R&D projects, a project may open or close) paths of action to the company, but this reality will not typically be captured in a strict NPV approach. Management will therefore (sometimes) employ tools which place an explicit value on these options. So, whereas in a DCF valuation the most likely or average or scenario specific cash flows are discounted, here the flexible and staged nature of the investment is modeled, and hence "all" potential payoffs are considered. The difference between the two valuations is the "value of flexibility" inherent in the project. The two most common tools

are Decision Tree Analysis (DTA) and Real options analysis (ROA); they may often be used interchangeably: DTA values flexibility by incorporating possible events (or states) and consequent management decisions. (For example, a company would build a factory given that demand for its product exceeded a certain level during the pilot-phase, and outsource production otherwise. In turn, given further demand, it would similarly expand the factory, and maintain it otherwise. In a DCF model, by contrast, there is no "branching" - each scenario must be modeled separately.) In the decision tree, each management decision in response to an "event" generates a "branch" or "path" which the company could follow; the probabilities of each event are determined or specified by management. Once the tree is constructed: (1) "all" possible events and their resultant paths are visible to management; (2) given this knowledge of the events that could follow, and assuming rational decision making, management chooses the actions corresponding to the highest value path probability weighted; (3) this path is then taken as representative of project value. See Decision theory: Choice under uncertainty. ROA is usually used when the value of a project is contingent on the value of some other asset or underlying variable. (For example, the viability of a mining project is contingent on the price of gold; if the price is too low, management will abandon the mining rights, if sufficiently high, management will develop the ore body. Again, a DCF valuation would capture only one of these outcomes.) Here: (1) using financial option theory as a framework, the decision to be taken is identified as corresponding to either a call option or a put option; (2) an appropriate valuation technique is then employed - usually a variant on the Binomial options model or a bespoke simulation model, while Black Sholes type formulae are used less often; see Contingent claim valuation. (3) The "true" value of the project is then the NPV of the "most likely" scenario plus the option value. (Real options in corporate finance were first discussed by Stewart Myers in 1977; viewing corporate strategy as a series of options was originally per Timothy Luehrman, in the late 1990s.) The Financing Decision Achieving the goals of corporate finance requires that any corporate investment be financed appropriately. As above, since both hurdle rate and
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cash flows (and hence the riskiness of the firm) will be affected, the financing mix can impact the valuation. Management must therefore identify the "optimal mix" of financingthe capital structures those results in maximum value. (See Balance sheet, WACC, Fisher separation theorem; but, see also the Modigliani-Miller theorem.). The sources of financing will, generically, comprise some combination of debt and equity financing. Financing a project through debt results in a liability or obligation that must be serviced, thus entailing cash flow implications independent of the project's degree of success. Equity financing is less risky with respect to cash flow commitments, but results in a dilution of ownership, control and earnings. The cost of equity is also typically higher than the cost of debt (see CAPM and WACC), and so equity financing may result in an increased hurdle rate which may offset any reduction in cash flow risk. Management must also attempt to match the financing mix to the asset being financed as closely as possible, in terms of both timing and cash flows. One of the main theories of how firms make their financing decisions is the Pecking Order Theory, which suggests that firms avoid external financing while they have internal financing available and avoid new equity financing while they can engage in new debt financing at reasonably low interest rates. Another major theory is the Trade-Off Theory in which firms are assumed to trade-off the tax benefits of debt with the bankruptcy costs of debt when making their decisions. An emerging area in finance theory is right-financing whereby investment banks and corporations can enhance investment return and company value over time by determining the right investment objectives, policy framework, institutional structure, source of financing (debt or equity) and expenditure framework within a given economy and under given market conditions. One last theory about this decision is the Market timing hypothesis which states that firms look for the cheaper type of financing regardless of their current levels of internal resources, debt and equity. The Dividend Decision Whether to issue dividends, and what amount, is calculated mainly on the basis of the company's inappropriate profit and its earnings prospects for the coming year. If there are no NPV positive opportunities, i.e. projects where returns exceed the hurdle rate, then management must return excess cash to
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investors. These free cash flows comprise cash remaining after all business expenses have been met. This is the general case, however there are exceptions. For example, investors in a "Growth stock", expect that the company will, almost by definition, retain earnings so as to fund growth internally. In other cases, even though an opportunity is currently NPV negative, management may consider investment flexibility / potential payoffs and decide to retain cash flows; see above and Real options. Management must also decide on the form of the dividend distribution, generally as cash dividends or via a share buyback. Various factors may be taken into consideration: where shareholders must pay tax on dividends, firms may elect to retain earnings or to perform a stock buyback, in both cases increasing the value of shares outstanding. Alternatively, some companies will pay "dividends" from stock rather than in cash; see corporate action. Today, it is generally accepted that dividend policy is value neutral (see ModiglianiMiller theorem). Working capital management Decisions relating to working capital and short term financing are referred to as working capital management. These involve managing the relationship between a firm's short-term assets and its short-term liabilities. As above, the goal of Corporate Finance is the maximization of firm value. In the context of long term, capital investment decisions, firm value is enhanced through appropriately selecting and funding NPV positive investments. These investments, in turn, have implications in terms of cash flow and cost of capital. The goal of Working capital management is therefore to ensure that the firm is able to operate, and that it has sufficient cash flow to service long term debt, and to satisfy both maturing short-term debt and upcoming operational expenses. In so doing, firm value is enhanced when, and if, the return on capital exceeds the cost of capital.

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Financial Risk Management Risk management is the process of measuring risk and then developing and implementing strategies to manage that risk. Financial risk management focuses on risks that can be managed ("hedged") using traded financial instruments (typically changes in commodity prices, interest rates, foreign exchange rates and stock prices). Financial risk management will also play an important role in cash management. This area is related to corporate finance in two ways. Firstly, firm exposure to business risk is a direct result of previous Investment and Financing decisions. Secondly, both disciplines share the goal of enhancing, or preserving, firm value. All large corporations have risk management teams, and small firms practice informal, if not formal, risk management. There is a fundamental debate on the value of "Risk Management" and shareholder value that questions a shareholder's desire to optimize risk versus taking exposure to pure risk. The debate links value of risk management in a market to the cost of bankruptcy in that market. Derivatives are the instruments most commonly used in financial risk management. Because unique derivative contracts tend to be costly to create and monitor, the most cost-effective financial risk management methods usually involve derivatives that trade on well-established financial markets or exchanges. These standard derivative instruments include options, futures contracts, forward contracts, and swaps. More customized and second generation derivatives known as exotics trade over the counter (OTC). Financial risk; Default (finance); Credit risk; Interest rate risk; Liquidity risk; Market risk; Operational risk; Volatility risk; Settlement risk; Value at Risk;.

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Relationship with other Areas in Finance

Investment Banking
Use of the term corporate finance varies considerably across the world. In the United States it is used, as above, to describe activities, decisions and techniques that deal with many aspects of a companys finances and capital. In the United Kingdom and Commonwealth countries, the terms corporate finance and corporate financier tend to be associated with investment banking - i.e. with transactions in which capital is raised for the corporation. These may include Raising seed, start-up, development or expansion capital Mergers, demergers, acquisitions or the sale of private companies Mergers, demergers and takeovers of public companies, including public-toprivate deals. Management buy-out, buy-in or similar of companies, divisions or subsidiaries - typically backed by private equity. Equity issues by companies, including the flotation of companies on a recognised stock exchange in order to raise capital for development and/or to restructure ownership. Raising capital via the issue of other forms of equity, debt and related securities for the refinancing and restructuring of businesses. Financing joint ventures, project finance, infrastructure finance, publicprivate partnerships and privatisations. Secondary equity issues, whether by means of private placing or further issues on a stock market, especially where linked to one of the transactions listed above. Raising debt and restructuring debt, especially when linked to the types of transactions listed above.

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Corporate Finance in India

This site provides comprehensive information on Corporate Finance India. It also focuses on types of services offered by Corporate Financing Community in India. The economic renaissance in the 1990s brought by liberation of Indian economy had a stupendous effect on the financial health of India. The Indian financial market which was previously insulated from foreign investors were thrown open for foreign investments. And with modern economic policies (at par with western countries) in operation large quantum of foreign direct investments FDI started to flow into the Indian market. The rise in business activities and its subsequent rise in financial activities led to the need of proper and accurate financing for corporate in India. Corporate Finance India provides businessman, investors and entrepreneurs with finance and advice for proper and risk free investments with an eye for maximum returns. Corporate Finance India community relies on ready-to-use data, projections and in formations on India's economy. The projections future movements of the financial market are based on information and data collected from daily activities of the finance market. Corporate Financiers in India advices their clients after taking into consideration financial environment of the market along with important decisions taken by the Government which, compliments the financial health of the country. Corporate Finance India focuses on the provision of corporate advice and funding for Indian companies who wish to take advantage of the liquidity of the Indian financial markets. Corporate Finance India provides the following services to the Indian Corporate Markets. Corporate Finance. "Debt and equity funding. Start up and Growth capital. Pre-IPO finance. Real Estate Sales and Acquisition. Company Sales and Acquisitions.

Corporate Finance India focus has been on entrepreneurial clients, whether individuals or businesses, and on providing funding and investment in entrepreneurial businesses. Corporate Finance India offers a complete solution to its clients objectives through market research. Corporate Finance India companies have an extensive network of investors and funding institutions and group of corporate associates.
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International Business in India

The current scenario for 'International Business in India' is more than heartening. With stupendous growth of more than 7% annually, improvement and stabilization of relations with neighboring countries and record setting rise of its stock indexes, India continues to grab international attention. It is destination of opportunity with its high-potential workforce and burgeoning middle class and as an increasingly dynamic competitor. India being a multi-cultural, multi-lingual and multi-religion state, it is not advisable to formulate a uniform business strategy. The eastern part of the country is known as the 'land of the intellectuals' and is regarded as the cultural hub of the country. The southern part is known for its technology acumen and western part is the commercial-capital of the country. The north is where the political power sits and operates the country. International Business Opportunity in India ' exists in areas like Information Technology and Electronics Hardware. Telecommunication. Pharmaceuticals and Biotechnology. R&D. Banking, Financial Institutions and Insurance & Pensions. Capital Market. Chemicals and Hydrocarbons. Infrastructure. Agriculture and Food Processing. Retailing. Logistics. Manufacturing. Power and Non-conventional Energy.

Sectors like Health, Education, Housing, Resource Conservation & Management Group, Water Resources, Environment, Rural Development, Small and Medium Enterprises (SME) and Urban Development are untapped and offer huge scope. With highest numbers of technical, medical, business management graduates and highest numbers of PhDs coupled with an energetic English speaking mass India offers 'services' with 50-70% less cost from their western counterparts. For 'International Business in India' bodies
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like CII, FICCI and different Chambers of Commerce provides a variety of business facilitation services by Closely working with Government and business promotion organizations in India and the respective partner countries. Also hosts high-level Government dignitaries and help build close working relationships between Governments and business organizations. It also exchanges business delegations, joint task forces and identifies bilateral business co-operation potential and makes suitable policy recommendations to Governments. With opportunities galore for' International Business in India' the trend is mind boggling. India International Business' community along with Indian Domestic Business community is steadily emerging as the Knowledge Capital of the world. The World Bank and different rating organizations have forecast that at 7-8% of Economic growth, she will be worlds second largest economy by 2050.

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Indian Businesses
Indian Businesses are slowly shifting their base from agriculture major industrialization. Numerous types of Businesses in India coming up. As India is developing the Iron & Steel Businesses in India, IT Businesses in India, Indian Businesses in Travel &I "tourism, Indian Businesses in Business Process Outsourcing, Food Business market in India, Soft Drinks Businesses in India and various other types of businesses are coming to the forefront and taking the center stage. The marketplace for Indian Businesses is quite varied including industries in the field of Agriculture & Forestry, Automobiles, Business Services, Chemicals, Computers, Construction, Education, Electrical, Electronics, Engineering/ Machinery, Entertainment, Import & Export, Fashion & Advertising, Food Processing, Government of India Websites, Immigration, India Neighborhood, Intelligence, International, IT/ITes, Minerals & Metals, Packaging & Paper, Real Estate in India, Regional Portals, Travel & Tourism and many others. The scope of doing business in India has grown in its magnitude. Some of the major companies in the IT sector are Wipro, Tata Consultancy Services, Infosys Technologies, HCL ltd, Satyam Computer Services, Cognizant Technology Solutions, Patni Computers, BFL MphasiS, Polaris, i-flex, IBM, Hewlett-Packard and Accenture. In general the major Indian Businesses are the Tatas, Birlas, Ambanis and many more. The Government has played a major role in the transformation of the Indian Business scenario in India. The major changes initiated by the Government for the betterment of the Indian Businesses are in the form of macroeconomic reforms, tax reforms, finance reforms and freeing of capital markets, reforms in the regulation of business firms, revitalization of the Indian private sector, removal of exchange controls and convertibility, trade reforms, and foreign direct investment. The Foreign companies are showing massive interest in the Indian Businesses. The number of Businesses in India has increased at an impressive rate. More and more foreign companies are having their branches in India. They are either holding hands with the Indian Businesses by entering into a partnership with them or they are building up their own offices in India. The 'future of Indian Businesses looks bright and assuring.

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Sources of Raising Finance

When a company is growing rapidly, for example when contemplating investment in capital equipment or an acquisition, its current financial resources may be inadequate. Few growing companies are able to finance their expansion plans from cash flow alone. They will therefore need to consider raising finance from other external sources. In addition, managers who are looking to buy-in to a business ("management buy-in" or "MBI") or buyout (management buy-out" or "MBO")a business from its owners, may not have the resources to acquire the company. They will need to raise finance to achieve their objectives. There are a number of potential sources of finance to meet the needs of a growing business or to finance an MBI or MBO: Family and friends Business angels Clearing banks (overdrafts, short or medium term loans) Factoring and invoice discounting Hire purchase and leasing Merchant banks (medium to longer term loans) Venture capital Existing shareholders and directors funds

A key consideration in choosing the source of new business finance is to strike a balance between equity and debt to ensure the funding structure suits the business. The main differences between borrowed money (debt) and equity are that bankers request interest payments and capital repayments, and the borrowed money is usually secured on business assets or the personal assets of shareholders and/or directors. A bank also has the power to place a business into administration or bankruptcy if it defaults on debt interest or repayments or its prospects decline. In contrast, equity investors take the risk of failure like other shareholders, whilst they will benefit through participation in increasing levels of profits and on the eventual sale of their stake. However in most circumstances venture capitalists will also require more complex investments (such as preference shares or loan stock) in additional to their equity stake. The
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overall objective in raising finance for a company is to avoid exposing the business to excessive high borrowings, but without unnecessarily diluting the share capital. This will ensure that the financial risk of the company is kept at an optimal level. Business Plan Once a need to raise finance has been identified it is then necessary to prepare a business plan. If management intends to turn around a business or start a new phase of growth, a business plan is an important tool to articulate their ideas while convincing investors and other people to support it. The business plan should be updated regularly to assist in forward planning. There are many potential contents of a business plan. The European Venture Capital Association suggests the following: Profiles of company founders directors and other key managers; Statistics relating to sales and markets; Names of potential customers and anticipated demand; Names of, information about and -assessment of competitors; Financial information required to support specific projects (for example, major capital investment or new product development); Research and development information; Production process and sources of supply; Information on requirements for factory and plant; Regulations and laws that could affect the business product and process protection (patents, copyrights, trademarks).

The challenge for management in preparing a business plan is to communicate their ideas clearly and succinctly. The very process of researching and writing the business plan should help clarify ideas and identify gaps in management information about their business, competitors and the market.

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TYPES OF FINANCE
A brief description of the key features of the main sources of business finance is provided below. Venture Capital Venture capital is a general term to describe a range of ordinary and preference shares where the investing institution acquires a share in the business. Venture capital is intended for higher risks such as start up situations and development capital for more mature investments. Replacement capital brings in an institution in place of one of the original shareholders of a business who wishes to realise their personal equity before the other shareholders. There are over 100 different venture capital funds in the UK and some have geographical or industry preferences. There are also certain large industrial companies which have funds available to invest in growing businesses and this 'corporate venturing' is an additional source of equity finance. Grants and Soft Loans Government, local authorities, local development agencies and the European Union are the major sources of grants and soft loans. Grants are normally made to facilitate the purchase of assets and either the generation of jobs or the training of employees. Soft loans are normally subsidised by a third party so that the terms of interest and security levels are less than the market rate. There are over 350 initiatives from the Department of Trade and Industry alone so it is a matter of identifying. Which sources will be Appropriate in each case. Invoice Discounting and Invoice Factoring Finance can be raised against debts due from customers via invoice discounting or invoice factoring, thus improving cash flow. Debtors are used as the prime security for the lender and the borrower may obtain up to about 80 per cent of approved debts. In addition, a number of these sources of finance
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will now lend against stock and other assets and may be more suitable then bank lending. Invoice discounting is normally confidential (the customer is not aware that their payments are essentially insured) whereas factoring extends the simple discounting principle by also dealing with the administration of the sales ledger and debtor collection.

Hire Purchase and Leasing Hire purchase agreements and leasing provide finance for the acquisition of specific assets such as cars, equipment and machinery involving a deposit and repayments over, typically, three to ten years. Technically, ownership of the asset remains with the lessor whereas title to the goods is eventually transferred to the hirer in a hire purchase agreement. Loans Medium term loans (up to seven years) and long term loans (including commercial mortgages) are provided for specific purposes such as acquiring an asset, business or shares. The loan is normally secured on the asset or assets and the interest rate may be variable or fixed. The Small Firms Loan Guarantee Scheme can provide up to 250,000 of borrowing supported by a government guarantee where all other sources of finance have been exhausted. Bank Overdraft An overdraft is an agreed sum by which a customer can overdraw their current account. It is normally secured on current assets, repayable on demand and used for short term working capital fluctuations. The interest cost is normally variable and linked to bank base rate. Completing the Finance-raising Raising finance is often a complex process. Business management need to assess several alternatives and then negotiate terms which are acceptable to the finance provider. The main negotiating points are often as follows: Whether equity investors take a seat on the board. Votes ascribed to equity investors. Level of warranties and indemnities provided by the directors. Financier's fees and costs.

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During the finance-raising process, accountants are often called to review the financial aspects of the plan. Their report may be formal or informal, an overview or an extensive review of the company's management information system, forecasting methods and their accuracy, review of latest management accounts including working capital, pension funding and employee contracts etc. This due diligence process is used to highlight any fundamental problems that may exist

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Game Theory Application for Corporate Finance

Finance in general is concerned with how the savings of investors are allocated through financial markets and intermediaries to firms, who use them to fund their activities. Finance can broadly be broken down into two fields. The first is asset pricing, which is concerned with the decisions of investors. The second is corporate finance, which is concerned with the decisions of firms. This paper will focus on the latter field and how game theory can be used to explain certain behaviors that are regularly witnessed. Traditional financial thinking relies on assumptions of certainty, complete knowledge and market efficiency and in this context, financial decisions should be relatively straightforward. In the real world though, many times what is observed deviates greatly from what would be expected using traditional financial thinking. This paper will show how different game theory models can be used to more accurately explain observed financial decisions dealing with capital structure, corporate acquisitions and initial public offerings (IPOs). Game theory has made great strides in explaining many of the observed phenomena falling under corporate finance. One example is the capital structure decided upon by a firms management. Capital structure deals with the firms decision to raise funds through debt versus equity and what ratio of debt to equity should the firm maintain. Modigliani and Miller in 1958 showed that in perfect capital markets (i.e. no frictions and symmetric information) and no taxes a firm could not change its total value by altering its debt/equity ratio; thus capital structure is irrelevant. However in the real world, capital structure is carefully thought about by every company, and it is in fact not irrelevant because taxes do exist and capital markets are not perfect. In the United States, interest paid by a company is a tax-deductible expense. This tax shield creates an incentive to take on debt. Modigliani and Miller corrected their original model to include corporate income taxes showing that a firm could increase its equity, or shareholder value, by taking on debt and taking advantage of tax shields. Their model then showed all firms stood to gain the most if they were 100% debt financed; however this is not observed in reality. In fact, some companies and industries thrive with no debt at all. Different game theory models have been used to explain the actions of managers in determining their companys capital structure, the most influential deals with the signaling effects attributed to debt vs. equity financing. In 1984 Myers and Majluf

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developed a model based on asymmetric information that insists managers are better informed of the prospects of the firm than the capital markets. If management feels that the market is currently undervaluing its firms equity then it will be unwilling to raise money through an equity issue because it will be selling the stock at a discount. On the other hand, management might be eager to issue equity if it feels its stock is overvalued, because it will be selling its stock at a premium. Investors are not dull and will predict that managers are more likely to issue stock when they think it is overvalued while optimistic managers may cancel or defer issues. Therefore, when an equity issue is announced, investors will mark down the price of the stock accordingly. Thus equity issues are considered a bad signal; even companies with overvalued stock would prefer another option to raise money to avoid the mark down in stock price. Firms prefer to use less information sensitive sources of funds. This leads to the pecking order of corporate financing: Retained earnings are the most preferred, followed by debt, then hybrid securities such as convertible bond and lastly equity. Some industries by their nature support companies that finance most of their growth through retained earnings. Airlines however are an example of an industry that is characterized by its high debt level. In general, capital structure is similar within industries with differences resulting from weighing the benefits of a higher tax shield versus the benefits of the less information sensitive financial of retained earnings. A second application of game theory to capital structure is concerned with agency costs. In 1976 Jensen and Meckling described two kinds of agency problems in corporations: One between equity holders and bondholders and the other between managers and equity holders. The first arises because the owners of a levered firm have an incentive to take risks at the expense of debt holders. Stockholders of levered firms gain when business risk increases because they receive the surplus when returns are high but the bondholders bear the cost when default occurs. Bondholders value does not increase with the value of the firm, thus they would like the firm to take safe bets to minimize the risk of default. Equity holders on the other hand, receive whatever is leftover after paying back debt holders. They would like to see the upside potential of the company maximized and this occurs through taking on risky projects (higher returns are generated though greater risk taking.) It is obvious that there is a conflict of interest between equity holders desire for business risk and bondholders aversion to business risk. Financial managers
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who act strictly in the interests of shareholders will favor risky projects over safe ones. It is important to note that this agency cost does not occur in financially sound companies. It mainly occurs when the odds of default or high and equity holders feel they can make one last gamble to avoid bankruptcy and get a big payoff at the same time. An average payoff would not benefit the stockholders much when the company is near default because most of the payoff will be paid out to the debt holders. A financially sound company would not have this agency problem because equity holders stand to lose more from risky projects when the company is not in risk of going bankrupt, and thus want to avoid them along with bondholders. The second conflict arises when equity holders cannot fully control the actions of managers. This occurs when managers have an incentive to pursue their own interests rather than those of the equity holders. Executive compensation in the form of option contracts can create incentives for managers to make risky decisions in an attempt to gain the highest payoff from the call options. Higher risk increases the value of an option, but risk can also cause a stock price to take a nosedive. A manager with options is not hurt nearly as much as a worker with his/her retirement savings in a company whose stock plummets because of risky bets. Option contracts were meant to better align the interests of managers with stockholders, but it is obvious that this is not so easily achieved. Game theory can also be used to explain what is observed in the course of many corporate acquisitions. If markets are efficient then one would expect a company to pay fair value when acquiring another company; however in many instances the acquirer pays a large premium to buy the other company. In 1986 Shleifer and Vishny provide one explanation of this phenomenon, the free rider problem. One of the concepts behind efficient markets is the market for corporate control. The market for corporate control says that in order for resources to be used efficiently, companies need to be run by the most able and competent managers. One way to achieve this is through corporate acquisitions. Initial Public Offerings (IPOs) have long been known to provide a significant positive return in the initial days of trading. This occurrence directly conflicts with the theory of market efficiency because the companies should be fairly valued at their IPO and any return in the initial days should be minimal. In 1986 Rock explained that this phenomenon was due to adverse selection between informed buyers and uninformed buyers. The informed buyers know the true value of the stock and will only purchase shares at or
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below its true value. The implication of this is that the uninformed buyers will receive a high allocation of overpriced shares since they will be the only people in the market when the offering price is above the true value. Knowing this, uninformed buyers would be unwilling to purchase the stock; forcing the informed buyers to hold onto the stock because there is no one they can sell it to. Therefore, to induce the uninformed to participate they must be compensated for the overpriced stock they end up buying. One way to do this is to under-price the stock on average. This means that on average the uniformed will buy a stock that started out undervalued and thus they are still able to buy the stock at or below its true value. Since all investors know that an IPO will likely be under priced they all try to buy the stock as quick as possible creating a demand for the stock that results in substantial price gain in the initial days of trading. Another interesting implication of IPOs pointed out by Ritter in 1991 is the fact that while they experience high returns in the short run they typically under-perform the market in the long run. One argument for this behavior is that the market for IPOs is subject to fads and that investment banks underprice IPOs to create the appearance of excess demand. This leads to a high price initially but subsequently underperformance; therefore companies with the highest initial returns should have the lowest subsequent returns. There exists evidence of this in the long run. Game theory has been extremely useful in explaining certain financial decisions. This paper has only highlighted a few of the aspects where behavioral analysis has helped explained observed behavior. Specifically, game theory has helped explain the reasons companies might choose various capital structures and the agency costs between managers, equity holders, and debt holders. In addition, the existence of free rider problems and bidding wars in corporate acquisitions has been made clear through game theory applications. Lastly, IPOs exhibit behavior contrary to the efficient market theory, and game theory can be utilized to help show why this behavior occurs.

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Agency Costs of Free Cash Flow and Corporate Finance

Corporate managers are the agents of shareholders, a relationship fraught with conflicting interests. Agency theory, the analysis of such conflicts, is now a major part of the economics literature. The payout of cash to shareholders creates major conflicts that have received little attention. Payouts to shareholders reduce the resources under managers control, thereby reducing managers power, and making it more likely they will incur the monitoring of the capital markets which occurs when the firm must obtain new capital. Financing projects internally avoids this monitoring and the possibility the funds will be unavailable or available only at high explicit prices. Managers have incentives to cause their firms to grow beyond the optimal size. Growth increases managers power by increasing the resources under their control. It is also associated with increases in managers compensation; because changes in compensation are positively related to the growth in sales. Competition in the product and factor markets tends to drive prices towards minimum average cost in an activity. Managers must therefore motivate their organizations to increase efficiency to enhance the problem of survival. However, product and factor market disciplinary forces are often weaker in new activities and activities that involve substantial economic rents or quasi rents. In these cases, monitoring by the firms internal control system and the market for corporate control are more important. Activities generating substantial economic rents or quasi rents are the types of activities that generate substantial amounts of free cash flow. Free cash flow is cash flow in excess of that required to fund all projects that have positive net present values when discounted at the relevant cost of capital. Conflicts of interest between shareholders and managers over payout policies are especially severe when the organization generates substantial free cash flow. The problem is how to motivate managers to disgorge the cash rather than investing it at below the cost of capital or wasting it on organization inefficiencies.
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The theory developed here explains 1) the benefits of debt in reducing agency costs of free cash flows, 2) how debt can substitute for dividends, 3) why diversification programs are more likely to generate losses than takeovers or expansion in the same line of business or liquidation-motivated takeovers, 4) why the factors generating takeover activity in such diverse activities as broadcasting and tobacco are similar to those in oil, and 5) why bidders and some targets tend to perform abnormally well prior to takeover.

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The Role of Debt in Motivating Organizational Efficiency

The agency costs of debt have been widely discussed, but the benefits of debt in motivating managers and their organizations to be efficient have been ignored. I call these effects the control hypothesis for debt creation. Managers with substantial free cash flow can increase dividends or repurchase stock and thereby pay out current cash that would otherwise be invested in low-return projects or wasted. This leaves managers with control over the use of future free cash flows, but they can promise to pay out future cash flows by announcing a permanent increase in the dividend. Such promises are weak because dividends can be reduced in the future. The fact that capital markets punish dividend cuts with large stock price reductions is consistent with the agency costs of free cash flow. Debt creation, without retention of the proceeds of the issue, enables managers to effectively bond their promise to pay out future cash flows. Thus, debt can be an effective substitute for dividends, something not generally recognized in the corporate finance literature. By issuing debt in exchange for stock, managers are bonding their promise to pay out future cash flows in a way that cannot be accomplished by simple dividend increases. In doing so, they give shareholder recipients of the debt the right to take the firm into bankruptcy court if they do not maintain their promise to make the interest and principal payments. Thus debt reduces the agency costs of free cash flow by reducing the cash flow available for spending at the discretion of managers. These control effects of debt are a potential determinant of capital structure. Issuing large amounts of debt to buy back stock also sets up the required organizational incentives to motivate managers and to help them overcome normal organizational resistance to retrenchment which the payout of free cash flow often requires. The threat caused by failure to make debt service payments serves as an effective motivating force to make such organizations more efficient.

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Stock repurchases for debt or cash also has tax advantages. (Interest payments are tax deductible to the corporation, and that part of the repurchase proceeds equal to the sellers tax basis in the stock is not taxed at all.) Increased leverage also has costs. As leverage increases, the usual agency costs of debt rise, including bankruptcy costs. The optimal debt-equity ratio is the point at which firm value is maximized, the point where the marginal costs of debt just offset the marginal benefits. The control hypothesis does not imply that debt issues will always have positive control effects. For example, these effects will not be as important for rapidly growing organizations with large and highly profitable investment projects but no free cash flow. Such organizations will have to go regularly to the financial markets to obtain capital. At these times the markets have an opportunity to evaluate the company, its management, and its proposed projects. Investment bankers and analysts play an important role in this monitoring, and the markets assessment is made evident by the price investors pay for the financial claims. The control function of debt is more important in organizations that generate large cash flows but have low growth prospects, and even more important in organizations that must shrink. In these organizations the pressures to waste cash flows by investing them in uneconomic projects is most serious.

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CONCLUSION
Arguably, the role of a corporation's management is to increase the value of the firm to its shareholders while observing applicable laws and responsibilities. Corporate finance deals with the strategic financial issues associated with achieving this goal, such as how the corporation should raise and manage its capital, what investments the firm should make, what portion of profits should be returned to shareholders in the form of dividends, and whether it makes sense to merge with or acquire another firm. If the role of management is to increase the shareholder value, then managers can make better decisions if they can predict the impact of those decisions on the firm's value. By observing the difference in the firm's equity value at different points in time, one can better evaluate the effectiveness of financial decisions. A rudimentary way of valuing the equity of a company is simply to take its balance sheet and subtract liabilities from assets to arrive at the equity value. However, this book value has little resemblance to the real value of the company. First, the assets are recorded at historical costs, which may be much greater than or much less their present market values. Second, assets such as patents, trademarks, loyal customers, and talented managers do not appear on the balance sheet but may have a significant impact on the firm's ability to generate future profits. So while the balance sheet method is simple, it is not accurate; there are better ways of accomplishing the task of valuation. Another way to value the firm is to consider the future flow of cash. Since cash today is worth more than the same amount of cash tomorrow, a valuation model based on cash flow can discount the value of cash received in future years, thus providing a more accurate picture of the true impact of financial decisions. The primary goal of corporate finance is to maximize corporate value while managing the firm's financial risks. Although it is in principle different
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from managerial finance which studies the financial decisions of all firms, rather than corporations alone, the main concepts in the study of corporate finance are applicable to the financial problems of all kinds of firms. The distinction between cash and equity shareholders' equity is the sum of common stock at par value, additional paid-in capital, and retained earnings. Some people have been known to picture retained earnings as money sitting in a shoe box or bank account. But shareholders' equity is on the opposite side of the balance sheet from cash. In fact, retained earnings represent shareholders' claims on the assets of the firm, and do not represent cash that can be used if the cash balance gets too low. In this regard, one can say that retained earnings represent cash that already has been spent. Shareholder equity changes due to three things: net income or losses payment of dividends share issuance or repurchase. Changes in cash are reported by the cash flow statement, which organizes the sources and uses of cash into three categories: operating activities, investing activities, and financing activities. The primary goal of corporate finance is to maximize corporate value while managing the firm's financial risks. Although it is in principle different from managerial finance which studies the financial decisions of all firms, rather than corporations alone, the main concepts in the study of corporate finance are applicable to the financial problems of all kinds of firms. In the process of Corporate Finance the main factor plays an important role that is Financial Risk Management. It is the process of measuring risk and then developing and implementing strategies to manage that risk. Financial risk management focuses on risks that can be managed ("hedged") using traded financial instruments (typically changes in commodity prices, interest rates, foreign exchange rates and stock prices). Financial risk management will also play an important role in cash management.

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Financial decisions, the analysis and tools that are required to reach these conclusions is what corporation finance is all about. The objective of this is to improve the value of the company while simultaneously reducing any financial risks. In addition it oversees that the company gets maximum returns on whatever ventures they have invested in. Corporate finance can be categorized into short and long term decisions. Short term decisions like capital management deal with current liabilities and asset balance. This is basically management of cash, inventories and lending on a short term basis. The long term category deals with investments of capital in relation to projects and the techniques required to fund them. Corporate finance is also associated with investment banking. The investment banker is in charge of evaluating the different projects that are brought to the bank and making appropriate investment decisions. For the company to be able to achieve their objectives, they need to have a proper financial structure in place. It has to be able to accommodate the various financial options that are available. These sources could be a combination of equity and also debt. When a business or project is funded through equity, there is a lower risk in terms of the cash flow. The one done through debt is more of a liability to the company which needs to be assessed. This automatically affects the cash flow even if the project turns out to be a success. The company must try to equate the invest merge with the asset being financed as much as possible. When a company is adequately financed, it has enough in its reserves for any contingencies.

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