Corporate

Finance
Ross
Westerfield
Jaffe
Eight Edition
Sabeeh Ullah, IBMS

What Is Finance?
Finance is the study of how and under what
terms savings (money) are allocated
between lenders and borrowers.
Finance is distinct from economics in that it
addresses not only how resources are
allocated, but also under what terms and
through what channels resources are
allocated.

Financial contracts or securities occur

whenever funds are transferred from issuer
to buyer.
Sabeeh Ullah, IBMS

The Study of Finance

The study of finance requires a basic
understanding of:
securities
corporate Law
financial institutions and markets

Sabeeh Ullah, IBMS

What is Corporate
Finance?
Corporate Finance is the study of decisions that firms

make.
Every decision that a business makes has financial

implications, and any decision which affects the finances

of a business is a corporate finance decision.

Sabeeh Ullah, IBMS

Corporate Decision

Sabeeh Ullah, IBMS

The Three Major Decisions

in
Corporate
Finance
The Investment decision
Where do you invest the scarce resources of your

business?
What makes for a good investment?

The Financing decision

Where do you raise the funds for these investments?
Generically, what mix of owners money (equity) or
borrowed money(debt) do you use?
The Dividend Decision
How much of a firms funds should be reinvested in the

business and how much should be returned to the

owners?
Sabeeh Ullah, IBMS

Principles of Corporate
Finance
Investment Principle:
Invest in projects that yield a return greater than the minimum

acceptable hurdle rate.

The hurdle rate should be higher for riskier projects and reflect the
financing mix used - owners funds (equity) or borrowed money
(debt)
Returns on projects should be measured based on cash flows
generated and the timing of these cash flows; they should also
consider both positive and negative side effects of these projects.

The Financing Principle:

Choose a financing mix that minimizes the hurdle rate and matches

the assets being financed.

Is there an optimal financing mix and, if so, what is it?
Debt is beneficial as long as the marginal benefits exceed the
marginal costs
Sabeeh Ullah, IBMS

Principles of Corporate
Finance
The Dividend Principle: If there are not
enough investments that earn the hurdle rate,
return the cash to stockholders.
How much of the cash flows generated by the

firms assets should be reinvested?

How much of the cash flows should be returned
to stockholders?

Sabeeh Ullah, IBMS

The Objective of the Firm

The objective in corporate finance is to maximize the

value of the firm

How do we measure the value of the firm?
Historical or book value of firms assets not a good
choice
Market value of firms assets is preferred. This is
determined by the cash flows that the firms assets are
expected to generate and the uncertainty of these
cash flows

Sabeeh Ullah, IBMS

The Classical Viewpoint

Van Horne: "In this book, we assume that the objective

of the firm is to maximize its value to its stockholders"

Brealey & Myers: "Success is usually judged by value:
Shareholders are made better off by any decision which
increases the value of their stake in the firm... The secret
of success in financial management is to increase value."
Copeland & Weston: The most important theme is that
the objective of the firm is to maximize the wealth of its
stockholders."
Brigham and Gapenski: Throughout this book we
operate on the assumption that the management's
primary goal is stockholder wealth maximization which
translates into maximizing the price of the common
stock.

Sabeeh Ullah, IBMS

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The Objective in Decision

Making

In traditional corporate finance, the objective in

decision making is to maximize the value of the
firm.
A narrower 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.
All other goals of the firm are intermediate ones
leading to firm value maximization, or operate
as constraints on firm value maximization.
Sabeeh Ullah, IBMS

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Why traditional corporate

financial
theory
focuses
on
Stock price is easily observable and constantly
updated (unlike otherstockholder
measures of performance,
maximizing
which may not be as easily observable, and
certainly not updated as frequently).
wealth.

If investors are rational (are they?), stock prices

reflect the wisdom of decisions, short term and
long term, instantaneously.
The objective of stock price performance provides
some very elegant theory on:
how to pick projects
how to finance them
how much to pay in dividends
Sabeeh Ullah, IBMS

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The Classical Objective

Function
STOCKHOLDERS
Hire&fire
managers
Board
AnnualMeeting
BONDHOLDERS

LendMoney

Maximize
stockholder
wealth

Managers

Protect
bondholder
Interests
Reveal
information
honestlyand
ontime

NoSocialCosts
SOCIETY
Costscanbe
tracedtofirm

Marketsare
efficientand
assesseffecton
value

FINANCIALMARKETS

Sabeeh Ullah, IBMS

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The Modified Objective

Function
For publicly traded firms in reasonably efficient markets,

where bondholders (lenders) are protected:

Maximize Stock Price: This will also maximize firm value
For publicly traded firms in inefficient markets, where
bondholders are protected:
Maximize stockholder wealth: This will also maximize firm
value, but might not maximize the stock price
For publicly traded firms in inefficient markets, where
bondholders are not fully protected
Maximize firm value, though stockholder wealth and
stock prices may not be maximized at the same point.
For private firms, maximize stockholder wealth (if lenders
are protected) or firm value (if they are not)
Sabeeh Ullah, IBMS

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The Agency Cost Problem

The interests of managers, stockholders, bondholders and society

can diverge. What is good for one group may not necessarily for
another.
Managers may have other interests (job security, incentives,
compensation) that they put over stockholder wealth
maximization.
Actions that make stockholders better off (increasing dividends,
investing in risky projects) may make bondholders worse off.
Actions that increase stock price may not necessarily increase
stockholder wealth, if markets are not efficient or information is
imperfect.
Actions that makes firms better off may create such large social
costs that they make society worse off.
Agency costs refer to the conflicts of interest that arise between all
of these different groups.
Sabeeh Ullah, IBMS

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The Agency Relationship

An agency relationship exists when one party, the

Principal, contracts another party, the agent, to perform

some service on the Principals behalf.
Examples
Employer and Employee
Shareholders and managers
Regulators and regulated
Politicians and civil servants
Note that there can be multi-agent and multi-principal
relationships

Sabeeh Ullah, IBMS

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The problem
Agents do not perform for the principals because they

have conflicting objectives.

Examples
The objectives of politicians may be electoral success
not maximising the public interest for the minimum
taxpayers.
Employees may be interested in maximising their
income for the minimum effort rather than the
maximum effort required by their employer.

Sabeeh Ullah, IBMS

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