cf intro Essay Example

cf intro Essay Example cf intro Essay cf intro Essay LBSlM-2013-1 *Term-II Introduction to Corporate Finance Some Recent Business News Reliance Industries declares 150% dividend India Nippon shareholders approve 7:10 bonus issue Introduction to Corporate Finance 2 What is Corporate Finance about? ? Financial Decisions made by Corporations. ? Financial decisions relate to: Where to invest the firms resources (Investment Decisions) How to raise resources for the firm (Financing Decisions) How to reward the owners of the business (Dividend Decisions) ? Corporate Finance provides answers to these issues. Investment Decisions ? Firms have scarce resources which must be allocated mong competing uses. ? Resources may be used for : Revenue Generating Cost Saving Projects Strategic Decisions Introduction of a New Product 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 Mini mum Acceptable Hurdle rate to decide acceptance or rejection. 4 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 Less Risky More Risky 5 ? 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 6 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 an optimal 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 a financing mix that matches the characteristics of assets being financed. 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) Forms: Cash Share Repurchase 8 Dividend Decisions (Contd. ) ? Trade-off between re tention distribution is to be made. When the firm is small and has attractive investment opportunities, profits are retained and reinvested. Ata later stage in a firms life cycle when the funds generated are greater than the investment requirements, the firm has to decide about ways of returning the excess cash to the owners. If there are not enough investments that earn the hurdle rate, return the cash to the owners. 9 Linking Financial Decisions with Firms Objective Investment Decision Financing Decision Dividend Decision Invest in assets that earn a return greater than the minimum acceptable hurdle rate Choose the financing mix that maximizes the value of the projects taken , and matches the assets being financed. If there are not enough investments that earn the hurdle rate, return the cash to the owners. Maximize the value of the Firm 10 Objective of the Firm ? How do we Judge the correctness of these decisions? ? The basic objective of Financial Management is: to maximise the value of the firm ? Any decision (Investment, Financing, or Dividend) that ncreases the value is considered good and which reduces the value is considered as poor. Value of the firm is, therefore, dependent on Firms Investment, Financing Dividend Decisions. 11 What is Firm Value? Maximization of Value of the Firm Maximization of Shareholders Value Maximization of Stock Price of the Firm Debt holders can protect themselves contractually. Stock price is an observable real measure of stockholder wealth. 12 Owners (Shareholders) Agents (Top Management) Main Features ? Separation of Ownership Management ? Legal Person ? Limited Liability of shareholders ? Shareholders are distinct from the company Level-I Management Level-II Management Level-V Management 13 Agency Problem ? Shareholders appoint agents (Management) to conduct the business of the company. ? As agents, the management should take decisions to maximize shareholders ? 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 hareholders. ? This pro blem of management (agents) not acting in the interests of their principals (shareholders) is called the Agency Problem. 4 ? 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 nside information while shareholders receive annual reports which may themselves be manipulated by the management. 5 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. ? Incenti ves to Managers: Stock options; Bonus ; Perquisites Punishments ? Both methods involve costs- an inevitable result of the separation of ownership and ontrol 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. Introduction to Corporate Finance 16 Financial System -An Overview Financial System : An Overview ? In any economy there are two types of economic units: Surplus Units, and Deficit Units. Investments are less than their Incomes. (C+l 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. Introduction to Corporate Finance 18 Provide Funds Receive Funds Suppliers of Funds Users ? Financial Markets ? Financial Institutions ? Financial Instruments Services Buy Securities Issue Securities 19 Financial System (Contd. ? Financial System consists of the following three components, which facilitate the ransfer of funds : Financial Markets 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. 20 Financial System Defined ? Financial system refers to a set of complex, interlinked markets, institutions, nstruments and services in the economy which facilitate the transfer and allocation of funds efficiently and effectively. 1 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 Structure ? Forward/Futures Market ? Exchange Traded Market ? Over-the-counter Market 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 Introductioncomputer trading. to Corporate Finance Capital Markets Deal in long-term securities (equity and debt) having maturities of more than one year.