Chapter One

An Overview of Corporate Finance

Chapter Outline
1.1
1.2
1.3
1.4
1.5
1.6
1.7
1.8

What is Corporate Finance?

Decisions in Corporate Finance.
Distinction between Corporate Finance, Public Finance & Private Finance.
Functions of a Financial Manager.
Goals of a Firm.
Forms of Business Organization.
Agency Theory.
Financial Intermediary.

1.1 What is Corporate Finance?

Figure 1.1 Corporate Finance.

Corporate finance is the broad heading given to the process of transacting and managing certain activities of
companies, including the raising of funds and the realization of value through a sale or listing. These include
raising funds for the purpose of financing existing activities; developing new activities or investing in new
fixed assets, buying other companies or businesses and selling the whole or part of companies, or even selling
certain specific assets. Corporate Finance addresses the following three questions:
1.
2.
3.

What long-term investments should the firm engage in?

How can the firm raise the money for the required investments?
How much short-term cash flow does a company need to pay its bills?

Corporate finance is the area of finance dealing with monetary decisions that business enterprises make and
the tools and analysis used to make these decisions. The primary goal of corporate finance is to maximize
shareholder value. 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.

1.2 Decisions in Corporate Finance.

Figure: 1.2 Decisions in Corporate Finance.

The discipline can be divided into long-term and short-term decisions and techniques. Capital investment
decisions are long-term choices about 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, short term
decisions deal 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).
(A) 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.
o

o
o

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 in consideration of risk.
These projects must also be financed appropriately.
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.

I. The Investment Decision

Management must allocate limited resources between competing opportunities (projects) in a
process known as capital budgeting. Making this investment, or capital allocation, decision requires
estimating the value of each opportunity or project, which is a function of the size, timing and
predictability of future cash flows.

Project Valuation: In general, each project's value will be estimated using a discounted
cash flow (DCF) valuation, and the opportunity with the highest value, as measured by the
resultant net present value (NPV) will be selected (applied to Corporate Finance by Joel
Dean in 1951; see also Fisher separation theorem, John Burr Williams#Theory). This

requires estimating the size and timing of all of the incremental cash flows resulting from
the project. Such future cash flows are then discounted to determine their present value
(see Time value of money). These present values are then summed, and this sum net of the
initial investment outlay is the NPV.
The NPV is greatly affected by the discount rate. Thus, identifying the proper discount rate
often termed, the project "hurdle rate" is critical to making an appropriate decision.
The hurdle rate is the minimum acceptable return on an investmenti.e. the project
appropriate discount rate. The hurdle rate should reflect the riskiness of the investment,
typically measured by volatility of cash flows, and must take into account the projectrelevant financing mix. Managers use models such as the CAPM or the APT to estimate a
discount rate appropriate for a particular project, and use the weighted average cost of
capital (WACC) to reflect the financing mix selected. (A common error in choosing a
discount rate for a project is to apply a WACC that applies to the entire firm. Such an
approach may not be appropriate where the risk of a particular project differs markedly
from that of the firm's existing portfolio of assets.)
In conjunction with NPV, there are several other measures used as (secondary) selection
criteria in corporate finance. These are visible from the DCF and include discounted
payback period, IRR, Modified IRR, equivalent annuity, capital efficiency, and ROI.
Alternatives (complements) to NPV include Residual Income Valuation, MVA / EVA (Joel
Stern, Stern Stewart & Co) and APV (Stewart Myers).

Valuing Flexibility: In many cases, for example R&D projects, a project may open (or close)
various 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 modelled, 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 valuation
(ROV); 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 modelled 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 branches (i.e. actions) corresponding to the highest
value path probability weighted; (3) this path is then taken as representative of project
value.
ROV 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 Scholes 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.)

Quantifying uncertainty: Given the uncertainty inherent in project forecasting and

valuation, analysts will wish to assess the sensitivity of project NPV to the various inputs
(i.e. assumptions) to the DCF model. In a typical sensitivity analysis the analyst will vary
one key factor while holding all other inputs constant, ceteris paribus. The sensitivity of
NPV to a change in that factor is then observed, and is calculated as a "slope": NPV /
factor. For example, the analyst will determine NPV at various growth rates in annual
revenue as specified (usually at set increments, e.g. -10%, -5%, 0%, 5 %....), and then
determine the sensitivity using this formula. Often, several variables may be of interest,
and their various combinations produce a "value-surface", (or even a "value-space",)
where NPV is then a function of several variables.
Using a related technique, analysts also run scenario based forecasts of NPV. Here, a
scenario comprises a particular outcome for economy-wide, "global" factors (demand for
the product, exchange rates, commodity prices, etc...) as well as for company-specific
factors (unit costs, etc...). As an example, the analyst may specify various revenue growth
scenarios (e.g. 0% for "Worst Case", 10% for "Likely Case" and 20% for "Best Case"),
where all key inputs are adjusted so as to be consistent with the growth assumptions, and
calculate the NPV for each. Note that for scenario based analysis, the various combinations
of inputs must be internally consistent (see discussion at Financial modeling), whereas for
the sensitivity approach these need not be so. An application of this methodology is to
determine an "unbiased" NPV, where management determines a (subjective) probability
for each scenario the NPV for the project is then the probability-weighted average of the
various scenarios.
A further advancement which "overcomes the limitations of sensitivity and scenario
analyses by examining the effects of all possible combinations of variables and their
realizations is to construct stochastic or probabilistic financial models as opposed to the
traditional static and deterministic models as above. For this purpose, the most common
method is to use Monte Carlo simulation to analyze the projects NPV. This method was
introduced to finance by David B. Hertz in 1964, although it has only recently become
common: today analysts are even able to run simulations in spreadsheet based DCF
models, typically using a risk-analysis add-in, such as @Risk or Crystal Ball. Here, the cash
flow components that are (heavily) impacted by uncertainty are simulated,
mathematically reflecting their "random characteristics". In contrast to the scenario
approach above, the simulation produces several thousand random but possible outcomes,
or trials, "covering all conceivable real world contingencies in proportion to their
likelihood; see Monte Carlo Simulation versus What If Scenarios. The output is then a
histogram of project NPV, and the average NPV of the potential investment as well as its
volatility and other sensitivities is then observed. This histogram provides information
not visible from the static DCF: for example, it allows for an estimate of the probability that
a project has a net present value greater than zero (or any other value).
Continuing the above example: instead of assigning three discrete values to revenue
growth, and to the other relevant variables, the analyst would assign an appropriate
probability distribution to each variable (commonly triangular or beta), and, where
possible, specify the observed or supposed correlation between the variables. These
distributions would then be "sampled" repeatedly incorporating this correlation so as
to generate several thousand random but possible scenarios, with corresponding
valuations, which are then used to generate the NPV histogram. The resultant statistics
(average NPV and standard deviation of NPV) will be a more accurate mirror of the
project's "randomness" than the variance observed under the scenario based approach.
These are often used as estimates of the underlying "spot price" and volatility for the real
option valuation as above; see Real options valuation: Valuation inputs. A more robust

Monte Carlo model would include the possible occurrence of risk events (e.g., a credit
crunch) that drive variations in one or more of the DCF model inputs.
II. The Financing Decision
Achieving the goals of corporate finance requires that any corporate investment be financed
appropriately. The sources of financing are, generically, capital self-generated by the firm and capital
from external funders, obtained by issuing new debt and equity (and hybrid- or convertible
securities). As above, since both hurdle rate and cash flows (and hence the riskiness of the firm) will
be affected, the financing mix will impact the valuation of the firm (as well as the other long-term
financial management decisions). There are two interrelated considerations here:

Management must identify the "optimal mix" of financingthe capital structures that results
in maximum value. (See Balance sheet, WACC, Fisher separation theorem; but, see also the
Modigliani-Miller theorem.) 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 share ownership, control and earnings. The cost of equity is also
typically higher than the cost of debt (see CAPM and WACC) - which is, additionally, a
deductible expense - and so equity financing may result in an increased hurdle rate which may
offset any reduction in cash flow risk.

Management must attempt to match the long-term financing mix to the assets being financed
as closely as possible, in terms of both timing and cash flows. Managing any potential asset
liability mismatch or duration gap entails matching the assets and liabilities respectively
according to maturity pattern ("Cash flow matching") or duration ("immunization"); managing
this relationship in the short-term is a major function of working capital management, as
discussed below. Other techniques, such as securitization, or hedging using interest rate- or
credit derivatives, are also common. See Asset liability management; Treasury management;
Credit risk; Interest rate risk.

Much of the theory here falls under the umbrella of 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.
However economists have developed a set of alternative theories about financing decisions. One of
the main alternative theories of how firms make their financing decisions is the Pecking Order
Theory (Stewart Myers), 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. Also, Capital structure substitution theory hypothesizes that
management manipulates the capital structure such that earnings per share (EPS) are maximized. 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 of the more
recent innovations in this are from a theoretical point of view is the Market timing hypothesis. This
hypothesis, inspired in the behavioral finance literature, states that firms look for the cheaper type of
financing regardless of their current levels of internal resources, debt and equity.
III. The Dividend Decision
Whether to issue dividends, and what amount, is calculated mainly on the basis of the company's
unappropriated profit and its earning prospects for the coming year. The amount is also often
calculated based on expected free cash flows i.e. cash remaining after all business expenses, and
capital investment needs have been met.
If there are no NPV positive opportunities, i.e. projects where returns exceed the hurdle rate, then
finance theory suggests management must return excess cash to shareholders as dividends. This is
the general case, however there are exceptions. For example, shareholders of 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. Today, it is generally accepted that dividend policy is value neutral i.e. the
value of the firm would be the same, whether it issued cash dividends or repurchased its stock (see
Modigliani-Miller theorem).

(B) 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. In general this is as follows: 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 (i.e. short term) 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.

Decision criteria: Working capital is the amount of capital which is readily available to an
organization. That is, working capital is the difference between resources in cash or readily
convertible into cash (Current Assets), and cash requirements (Current Liabilities). As a result,
the decisions relating to working capital are always current, i.e. short term, decisions. In addition
to time horizon, working capital decisions differ from capital investment decisions in terms of
discounting and profitability considerations; they are also "reversible" to some extent.
(Considerations as to Risk appetite and return targets remain identical, although some
constraints such as those imposed by loan covenants may be more relevant here). Working
capital management decisions are therefore not taken on the same basis as long term decisions,
and working capital management applies different criteria in decision making: the main
considerations are (1) cash flow / liquidity and (2) profitability / return on capital (of which cash
flow is probably the most important).

The most widely used measure of cash flow is the net operating cycle, or cash
conversion cycle. This represents the time difference between cash payment for raw
materials and cash collection for sales. The cash conversion cycle indicates the firm's
ability to convert its resources into cash. Because this number effectively corresponds to
the time that the firm's cash is tied up in operations and unavailable for other activities,
management generally aims at a low net count. (Another measure is gross operating
cycle which is the same as net operating cycle except that it does not take into account
the creditors deferral period.)
In this context, the most useful measure of profitability is Return on capital (ROC). The
result is shown as a percentage, determined by dividing relevant income for the 12
months by capital employed; Return on equity (ROE) shows this result for the firm's
shareholders. As above, firm value is enhanced when, and if, the return on capital,
exceeds the cost of capital. ROC measures are therefore useful as a management tool, in
that they link short-term policy with long-term decision making.

Management of Working Capital: Guided by the above criteria, management will use a
combination of policies and techniques for the management of working capital. These

policies aim at managing the current assets (generally cash and cash equivalents, inventories
and debtors) and the short term financing, such that cash flows and returns are acceptable.

Cash management. Identify the cash balance which allows for the business to meet
day to day expenses, but reduces cash holding costs.
Inventory management. Identify the level of inventory which allows for
uninterrupted production but reduces the investment in raw materials and
minimizes reordering costs and hence increases cash flow. (Note that "inventory"
is usually the realm of operations management: given the potential impact on cash
flow, and on the balance sheet in general, finance typically "gets involved in an
oversight or policing way".)
Debtors management. There are two inter-related roles here: Identify the
appropriate credit policy, i.e. credit terms which will attract customers, such that
any impact on cash flows and the cash conversion cycle will be offset by increased
revenue and hence Return on Capital (or vice versa); see Discounts and allowances.
Implement appropriate Credit scoring policies and techniques such that the risk of
default on any new business is acceptable given these criteria.
Short term financing. Identify the appropriate source of financing, given the cash
conversion cycle: the inventory is ideally financed by credit granted by the supplier;
however, it may be necessary to utilize a bank loan (or overdraft), or to "convert
debtors to cash" through "factoring".

1.3 Distinction between Corporate Finance, Public Finance & Personal Finance.
Public Finance is a branch of economics which deals with income and expenditure of government of a
country. The function of public authorities are simply revenue raising and revenue spending for covering the
cost of administration and defense in the days of early economists. But modern states have to perform
various functions to promote the welfare of the people. Therefore, the public finance includes the study of
financial administration as well as of financial control.
According to Professor Bastable, "public finance is a branch of economics which deals with income and
expenditure of public authorities or the state and their mutual relation as also with the financial
administration and control."
Public finance is used for the benefit of the people of an economy while the private finance is used for the
benefit of an individual or his family. Public finance and the private finance are differentiated as under:
Perspectives

Corporate Finance

Public Finance

Personal Finance

1) Definition.

The process of arranging the

funds & proper utilization of
those funds in a firm is called
corporate finance.

The functions related to

collecting funds for an
individual or a family need
is called personal finance.

2) Purpose.

Shareholders
maximization.

3) Security.

Collateral is required in case

of large borrowings.
If the firm fails to pay its
debts, it could be declared as
bankrupt by the court.
Mostly
from
domestic
sources.
Firm can borrow from
financial institutions or can
issue financial securities to
finance the business.
On the basis of income,
expenses are allocated.

Arrangements of funds &

proper utilization of those
funds for purpose of the state
& local government is the
function of public finance.
Maximization
of
social
development & welfare of
peoples.
No collateral is required for
borrowings.
Government will never face
bankruptcy.

4) Insolvency.

5) Sources of Fund.
6) Modes of Finance.

7) Adjustment between
income & expense.

wealth

Both
the
domestic
&
international sources.
Government may finance by
collecting
tax,
duty
&
borrowings from local &
international institutions.
On the basis of expenses, the
sources of incomes are

For personal consumption

& maximizing wealth.
Collateral is required in
case of borrowings.
If the person fails to pay his
debts, it could be declared
as bankrupt by the court.
Mainly
from
domestic
sources.
Purely depends on his
personal
income
or
borrowings.
On the basis of income,
expenses are allocated.

8) Equality in income &

expense.

Firm always plans to increase

its income over expense.

9) Sectors of income &

expense.

Compare the government, the

sectors of income generation
& sources of fund are limited.
It can borrow from local
financial institutions & can
sell bonds & debentures.

10) Ability to Borrow.

11) Budgeting.

12) Tax System.

13) Confidentiality.

Although not mandatory, but

mostly budget is prepared by
the large firms.
It pays income tax to the
government.
Sometime, firm has to
maintain confidentiality in
case of financing.

identified.
Equality is not always
necessary. Government may
face budget deficit also.
The sectors of income
generation & sources of fund
are quite large.
It can borrow from both the
local & international financial
institutions
&
foreign
government also.
Government has to prepare
budget every year.
Government collects tax from
the firms & the peoples.
Not necessary to maintain
confidentiality.

Equality is must since

individual can not raise his
income willingly.
Compare the business &
government, the sources of
fund are minimum.
Can borrow only from
domestic sources.

Its not an obligation to

prepare budget.
Individual has to pay
income tax.
Essential
to
maintain
confidentiality of income &
expense.

1.4 Functions of Financial Manager.

Figure 1.3 Functions of a Financial Manager.

The main objective of the Finance Manager is to manage funds in such a way so as to ensure their optimum
utilization and their procurement in a manner that the risk, cost and control considerations are properly
balanced in a given situation. To achieve the objective the Finance Manager performs the following functions
in the following areas:a) Forecasting and Planning
The need to estimate/forecast the requirement of funds for both the short term (working
capital requirements) and the long term purpose (capital investments).
Forecasting the requirements of funds involves the use of budgetary control and longrange planning
b) Financing Decision
Helps to decide what type of Capital structure the company needs to have re: whether
these funds would be raised re: from loans/borrowings or from internal source(share
capital)
To raise sufficient long term funds to finance fixed assets and other long term investments
and to provide for the needs of working capital
c) Investment Decision
In projects using the various capitals budgeting tools like Payback method, accounting rate
of return, internal rate of return, net present value.

 Assets management policies are to be laid down regarding the various items of current
assets like accounts receivable by coordinating with the sales personnel, inventory with
production
d) Dividend Decision
Taking into consideration, earnings trend, share market price trend, fund requirement for
future growth, cash flow situation and others.
Financial negotiation
Plays a very important role in carrying out negotiations with the various financial
institutions, banks and public depositors for raising funds on favorable terms
e) Cash Management
The finance manager needs to ensure the supply of adequate, timely and cheap fund to the
various parts of the organization
That there is no excessive cash idling around
f) Evaluating financial performance
To need to constantly review the financial performance of the various units of
organization generally in terms of ROI (return on investment. Such review assists
management in seeing how the funds have been utilized in the various divisions and what
can be done to improve it.
g) Dealing with relevant parties in the Financial Markets
Where the company is a listed entity, the need to interact with the Stock Exchange
To deal with money markets and capital markets for financing or investment of idling
funds
To foster relationships with bankers, investors, underwriters of equity and bond issuances
and other government regulatory bodies.

1.5 Goals of a Firm.

Figure 1.4 Goals of a Firm.

The core goals of a company are:
a) Stockholder wealth maximization.
b) Profit maximization.
c) Managerial reward maximization.
d) Behavioral goals.
e) Social responsibility.
Modern managerial finance theory operates on the assumption that the primary goal of the firm is to
maximize the wealth of its stockholders, which translates into maximizing the price of the firms common
stock.
a) Profit Maximization is basically a single-period or short-term goal which is usually interpreted
to mean the maximization of profits within given a given period of time. A firm may maximize its
profits at the expense of its long-term profitability & still realize this goal.

b) Stockholder Wealth Maximization is along-term goal, since stockholders are interested in

future as well as present profits. This concept is preferred because it considers:

Wealth for the long term,

Risk or uncertainty,
The timing of returns, &
The stockholders return.

The disadvantages of profit maximization as a goal are:

Emphasizes the short term.
Ignores risk or uncertainty.
Ignores the timing of returns.
Require immediate resources.
The strengths of wealth maximization as a goal are:

Emphasizes the long term.

Recognizes risk.
Recognizes the timing of returns.
Consider stockholders return.

Figure 1.5 Factors affecting Stock Prices.

c) Managerial Reward Maximization: Since the manager of a firm plays the vital role in
controlling the manpower & thus responsible in maximizing the profit of the firm, so the firm will
always treat the managerial position separately. That's why, through stock option plan, firms
allocate a good portion of shares to its managers to minimize agency problem.
d) Behavioral Goals: This indicates the perception of a firm to its employees, customers, & all
other stakeholders. Differences in perception towards stakeholders result the goodwill of the
firm & its acceptability in the market. The benefits & offering good working environment to its
employees, providing post & after-sales service to its customers, paying proper taxes to the
government all indicate a positive perception of a firm.
e) Social Responsibility: It doesnt mean charity. Beyond the regular duties of a firm, what are the
additional services the firm is providing to the society, to the nation, is the part of CSR. With
those CSR activities, both the firm & the society will be equally benefited.

10

1.6 Forms of Business Organization.

Figure 1.6 Types of Business Organization in UK.

Sole Proprietorships
1.
2.
3.
4.

5.

The most common form of business ownership; also the simplest and older.
There are no legal distinctions that separate a sole proprietors status as an individual from her or his
status as a business owner.
Common in all industries, however concentrated in certain industries, such as repair shops, small
retail outlets, service and providers.
Offer advantages, such as:
I. easy to form and dissolve
II. management flexibility
III. the owner retains the right to all profits after payment of personal income tax
IV. owners are motivated to maximize efficiency because of their individual stake in profits
V. minimal legal requirements for entering and exiting, such as:
registering the business or trade name
obtaining necessary licenses
special insurance may be required in some cases
However, have disadvantages, including:
i. the owners financial liability for all debts of the business
ii. the owners personal funds and borrow he or she can borrow limit the financial
resources of the business
iii. the owner must handle a wide range of management and operational tasks
iv. the sole proprietorship lacks long-term continuity when the owner dies, retires, or
changes personal interest, the company ends
v. this aspect of lack of continuity can make potential customer leery about making major
purchases

Partnerships
An association of two or more persons who operate a business as co-owners by voluntary legal agreement.
This organizing alternative was the traditional form for professionals, such as physicians, lawyers and
dentists. Today, most of these individuals have switched to other organizing forms to limit their personal
liability.
Advantages include:
a. easy to form
b. legal requirements are simply registering the name and obtaining necessary licenses and
applicable insurance same as with sole proprietorship
c. offers expanded financial capabilities increasing access to borrowing funds
d. professionals have the opportunity to combine areas of expertise, skills, and knowledge
Disadvantages include:
a. unlimited financial liability by the owners
b. each partner bears full responsibility for any debts

11

c.
d.
e.
f.
g.

each is legally liable for actions of the other partners

if one partner wants to leave the other partner may have to purchase the remaining portion of the
company, or risk sale to someone else
the partner who wants out is confined because an individual perhaps the other current owner
needs to be found to purchase portion owned by partner who wants to leave
upon death of one partner, a new partnership must be formed and the estate of the deceased is
entitled to a share of the firms value
life insurance coverage for each partner will limit this disadvantage, however, the cost is often
prohibitive

In some states, partners can minimize risks by organizing as a limited liability partnership limiting the
liability of each partner to the value of her or his investments in the company.

Corporations
1. A legal organization with assets and liabilities separate from those of the owners
2. Often referred to as C corporations to distinguish them from other types of firms
3. Can be either small businesses or extremely large companies
4. U.S. and Canadian firms identify corporations with the initials Inc.; British firms use Ltd, an abbreviation for
limited; Australian firms use Pty. Ltd. Proprietary Limited
Advantages include:
a. the stockholders/owners have only limited financial risks if firm fails they lose only the money
they invested
b. this protection also applies to legal risk
c. they can draw upon the specialized skills of many employees, except if a small business
corporation
d. employees can develop even more specialized skills and specialize in their most effective tasks
e. gain access to expanded financial capabilities
Disadvantages include:
a. double taxation the corporation pays federal, state and local taxes, and then the owners have to
pay income tax on stock dividend earnings
b. the number of laws and regulations affecting corporations is much more complex

Types of Corporations
DomesticA firm is considered a domestic corporation in the state where it is incorporated
ForeignWhen company does business in a state other than the one where it has filed
incorporation papers, it is registered as a foreign corporation in each of those states
AlienA firm incorporated in one nation that operates in another is known as an alien
corporation where it operates

Differences between Corporation & Partnership

1-17

A Comparison of Partnership
and Corporations
Corporation

Partnership

Liquidity

Shares can easily be

exchanged.

Subject to substantial
restrictions.

Voting Rights

Usually each share gets

one vote

Taxation

Double

General Partner is in
charge; limited partners
may have some voting
rights.
Partners pay taxes on
distributions.

Reinvestment and
dividend payout

Broad latitude

All net cash flow is

distributed to partners.

Liability

Limited liability

Continuity

Perpetual life

General partners may

have unlimited liability.
Limited partners enjoy
limited liability.
Limited life

McGraw-Hill/Irwin
Corporate Finance, 7/e

2005 The McGraw-Hill Companies, Inc. All Rights Reserved.

Figure 1.7 A Comparison between Partnership & Corporation.

12

1.7 Agency Theory.

Figure 1.8 Agency Theory.

Agency theory suggests that the firm can be viewed as a nexus of contracts (loosely defined) between
resource holders. An agency relationship arises whenever one or more individuals, called principals, hire one
or more other individuals, called agents, to perform some service and then delegate decision-making
authority to the agents. The primary agency relationships in business are those (1) between stockholders and
managers and (2) between debtholders and stockholders. These relationships are not necessarily
harmonious; indeed, agency theory is concerned with so-called agency conflicts, or conflicts of interest
between agents and principals. This has implications for, among other things, corporate governance and
business ethics. When agency occurs it also tends to give rise to agency costs, which are expenses incurred in
order to sustain an effective agency relationship (e.g., offering management performance bonuses to
encourage managers to act in the shareholders' interests). Accordingly, agency theory has emerged as a
dominant model in the financial economics literature, and is widely discussed in business ethics texts.
Agency theory in a formal sense originated in the early 1970s, but the concepts behind it have a long and
varied history. Among the influences are property-rights theories, organization economics, contract law, and
political philosophy, including the works of Locke and Hobbes. Some noteworthy scholars involved in agency
theory's formative period in the 1970s included Armen Alchian, Harold Demsetz, Michael Jensen, William
Meckling, and S.A. Ross.

Conflicts between Managers and Shareholders

Agency theory raises a fundamental problem in organizationsself-interested behavior. A corporation's
managers may have personal goals that compete with the owner's goal of maximization of shareholder
wealth. Since the shareholders authorize managers to administer the firm's assets, a potential conflict of
interest exists between the two groups.

Self-Interested Behavior.
Agency theory suggests that, in imperfect labor and capital markets, managers will seek to
maximize their own utility at the expense of corporate shareholders. Agents have the ability
to operate in their own self-interest rather than in the best interests of the firm because of
asymmetric information (e.g., managers know better than shareholders whether they are
capable of meeting the shareholders' objectives) and uncertainty (e.g., myriad factors
contribute to final outcomes, and it may not be evident whether the agent directly caused a
given outcome, positive or negative). Evidence of self-interested managerial behavior
includes the consumption of some corporate resources in the form of perquisites and the
avoidance of optimal risk positions, whereby risk-averse managers bypass profitable
opportunities in which the firm's shareholders would prefer they invest. Outside investors
recognize that the firm will make decisions contrary to their best interests. Accordingly,
investors will discount the prices they are willing to pay for the firm's securities.

13

A potential agency conflict arises whenever the manager of a firm owns less than 100
percent of the firm's common stock. If a firm is a sole proprietorship managed by the owner,
the owner-manager will undertake actions to maximize his or her own welfare. The ownermanager will probably measure utility by personal wealth, but may trade off other
considerations, such as leisure and perquisites, against personal wealth. If the ownermanager forgoes a portion of his or her ownership by selling some of the firm's stock to
outside investors, a potential conflict of interest, called an agency conflict, arises. For
example, the owner-manager may prefer a more leisurely lifestyle and not work as
vigorously to maximize shareholder wealth, because less of the wealth will now accrue to the
owner-manager. In addition, the owner-manager may decide to consume more perquisites,
because some of the cost of the consumption of benefits will now be borne by the outside
shareholders.

Costs of Shareholder-Management Conflict.

Agency costs are defined as those costs borne by shareholders to encourage managers to
maximize shareholder wealth rather than behave in their own self-interests. The notion of
agency costs is perhaps most associated with a seminal 1976 Journal of Finance paper by
Michael Jensen and William Meckling, who suggested that corporate debt levels and
management equity levels are both influenced by a wish to contain agency costs. There are
three major types of agency costs: (1) expenditures to monitor managerial activities, such as
audit costs; (2) expenditures to structure the organization in a way that will limit
undesirable managerial behavior, such as appointing outside members to the board of
directors or restructuring the company's business units and management hierarchy; and (3)
opportunity costs which are incurred when shareholder-imposed restrictions, such as
requirements for shareholder votes on specific issues, limit the ability of managers to take
actions that advance shareholder wealth.
In the absence of efforts by shareholders to alter managerial behavior, there will typically be
some loss of shareholder wealth due to inappropriate managerial actions. On the other hand,
agency costs would be excessive if shareholders attempted to ensure that every managerial
action conformed with shareholder interests. Therefore, the optimal amount of agency costs
to be borne by shareholders is determined in a cost-benefit contextagency costs should be
increased as long as each incremental dollar spent results in at least a dollar increase in
shareholder wealth.

Mechanisms for Dealing with Shareholder-Manager Conflicts

There are two polar positions for dealing with shareholder-manager agency conflicts. At one
extreme, the firm's managers are compensated entirely on the basis of stock price changes.
In this case, agency costs will be low because managers have great incentives to maximize
shareholder wealth. It would be extremely difficult, however, to hire talented managers
under these contractual terms because the firm's earnings would be affected by economic
events that are not under managerial control. At the other extreme, stockholders could
monitor every managerial action, but this would be extremely costly and inefficient. The
optimal solution lies between the extremes, where executive compensation is tied to
performance, but some monitoring is also undertaken. In addition to monitoring, the
following mechanisms encourage managers to act in shareholders' interests: (1)
performance-based incentive plans, (2) direct intervention by shareholders, (3) the threat of
firing, and (4) the threat of takeover.
Most publicly traded firms now employ performance shares, which are shares of stock given
to executives on the basis of performances as defined by financial measures such as earnings
per share, return on assets, return on equity, and stock price changes. If corporate
performance is above the performance targets, the firm's managers earn more shares. If
performance is below the target, however, they receive less than 100 percent of the shares.
Incentive-based compensation plans, such as performance shares, are designed to satisfy
two objectives. First, they offer executives incentives to take actions that will enhance
shareholder wealth. Second, these plans help companies attract and retain managers who

14

have the confidence to risk their financial future on their own abilitieswhich should lead
to better performance.
An increasing percentage of common stock in corporate America is owned by institutional
investors such as insurance companies, pension funds, and mutual funds. The institutional
money managers have the clout, if they choose, to exert considerable influence over a firm's
operations. Institutional investors can influence a firm's managers in two primary ways.
First, they can meet with a firm's management and offer suggestions regarding the firm's
operations. Second, institutional shareholders can sponsor a proposal to be voted on at the
annual stockholders' meeting, even if the proposal is opposed by management. Although
such shareholder-sponsored proposals are nonbinding and involve issues outside day-today operations, the results of these votes clearly influence management opinion.
In the past, the likelihood of a large company's management being ousted by its stockholders
was so remote that it posed little threat. This was true because the ownership of most firms
was so widely distributed, and management's control over the voting mechanism so strong,
that it was almost impossible for dissident stockholders to obtain the necessary votes
required removing the managers. In recent years, however, the chief executive officers at
American Express Co., General Motors Corp., IBM, and Kmart have all resigned in the midst
of institutional opposition and speculation that their departures were associated with their
companies' poor operating performance.
Hostile takeovers, which occur when management does not wish to sell the firm, are most
likely to develop when a firm's stock is undervalued relative to its potential because of
inadequate management. In a hostile takeover, the senior managers of the acquired firm are
typically dismissed, and those who are retained lose the independence they had prior to the
acquisition. The threat of a hostile takeover disciplines managerial behavior and induces
managers to attempt to maximize shareholder value.

Stockholders versus Creditors: A Second Agency Conflict

In addition to the agency conflict between stockholders and managers, there is a second class of agency
conflictsthose between creditors and stockholders. Creditors have the primary claim on part of the firm's
earnings in the form of interest and principal payments on the debt as well as a claim on the firm's assets in
the event of bankruptcy. The stockholders, however, maintain control of the operating decisions (through the
firm's managers) that affect the firm's cash flows and their corresponding risks. Creditors lend capital to the
firm at rates that are based on the riskiness of the firm's existing assets and on the firm's existing capital
structure of debt and equity financing, as well as on expectations concerning changes in the riskiness of these
two variables.
The shareholders, acting through management, have an incentive to induce the firm to take on new projects
that have a greater risk than was anticipated by the firm's creditors. The increased risk will raise the required
rate of return on the firm's debt, which in turn will cause the value of the outstanding bonds to fall. If the risky
capital investment project is successful, all of the benefits will go to the firm's stockholders, because the
bondholders' returns are fixed at the original low-risk rate. If the project fails, however, the bondholders are
forced to share in the losses. On the other hand, shareholders may be reluctant to finance beneficial
investment projects. Shareholders of firms undergoing financial distress are unwilling to raise additional
funds to finance positive net present value projects because these actions will benefit bondholders more than
shareholders by providing additional security for the creditors' claims.
Managers can also increase the firm's level of debt, without altering its assets, in an effort to leverage up
stockholders' return on equity. If the old debt is not senior to the newly issued debt, its value will decrease,
because a larger number of creditors will have claims against the firm's cash flows and assets. Both the riskier
assets and the increased leverage transactions have the effect of transferring wealth from the firm's
bondholders to the stockholders.
Shareholder-creditor agency conflicts can result in situations in which a firm's total value declines but its
stock price rises. This occurs if the value of the firm's outstanding debt falls by more than the increase in the

15

value of the firm's common stock. If stockholders attempt to expropriate wealth from the firm's creditors,
bondholders will protect themselves by placing restrictive covenants in future debt agreements.
Furthermore, if creditors believe that a firm's managers are trying to take advantage of them, they will either
refuse to provide additional funds to the firm or will charge an above-market interest rate to compensate for
the risk of possible expropriation of their claims. Thus, firms which deal with creditors in an inequitable
manner either lose access to the debt markets or face high interest rates and restrictive covenants, both of
which are detrimental to shareholders.
Management actions that attempt to usurp wealth from any of the firm's other stakeholders, including its
employees, customers, or suppliers, are handled through similar constraints and sanctions. For example, if
employees believe that they will be treated unfairly, they will demand an above-market wage rate to
compensate for the unreasonably high likelihood of job loss.

Agency versus Contract

Although the notions of agency and contract are closely intertwined, some academics bristle at the suggestion
they are essentially the same. Specifically, they point out a number of unique features of agency versus
contractual relationships. There are two major sets of differences. First, agents are usually retained not for
any particular or discrete set of tasks, but for a broad range of activities, which may change over time, that are
consistent with basic objectives and interests set forth by the principals. In this instance principals must be
concerned to some degree about agents' personal attitudes, dispositions, and other characteristics that are
usually not a concern in contractual agreements. Principals hire out broad objectives to be fulfilled instead of
specific tasks. Second, in an agency relationship there is typically much less independence between agent and
principal than between contracting parties. Typically this also means that the principal-agent relationship is
more hierarchical and power-driven than a contractual relationship, and included in this power is greater
latitude for principals to reward, punish, and control agents.

Agency and Ethics

Since agency relationships are usually more complex and ambiguous (in terms of what specifically the agent
is required to do for the principal) than contractual relationships, agency carries with it special ethical issues
and problems, concerning both agents and principals. Ethicists point out that the classical version of agency
theory assumes that agents (i.e., managers) should always act in principals' (owners') interests. However, if
taken literally, this entails a further assumption that either (a) the principals' interests are always morally
acceptable ones or (b) managers should act unethically in order to fulfill their "contract" in the agency
relationship. Clearly, these stances do not conform to any practicable model of business ethics.
A familiar real-life example is large corporations' layoff dilemma. Conventional wisdom holds that investors
are rewarded when companies thin their employment rosters because operating costs are lowered, in theory
leading to greater profits. This expectation is often made explicit in news reporting surrounding a downsizing
episode; the reports highlight whether investors seem pleased or displeased with an announcement of a mass
layoff, and the often-stated assumption is that corporate management has undertaken the layoffs in part, if
not in whole, to please shareholders and enhance their wealth. In this instance it is obvious that shareholders'
interests are advanced to the detriment of at least one other constituency, namely the employees. In such
cases, observers question whether it is ethical to serve the principals' interests when those actions harm a
large number of people, and whether the benefits shareholders receive are commensurate with the harm
inflicted on the laid-off employees.
Along the same lines, others have noted that traditional agency theory makes little mention of what
obligations, moral or otherwise, principals have to their agents. The emphasis lies almost exclusively on what
agents should or must do for the principals, relying, in turn, on a vague assumption that principals will
compensate agents adequatelyeven more than adequatelyfor their services. Some ethics scholars argue
that principals have obligations as well. In the example above, some would argue that not only is it unethical
to harm employees to obtain improvements (often marginal) in shareowners' wealth, but also that the
shareholders have moral obligations directly to the employees as an extension of the ethical
employer/employee relationship (i.e., not to harm them arbitrarily, among other obligations). This ethical
problem is only complicated by the reality that, as noted above, principals are often institutions rather than
individuals.

16

Meanwhile, consistent with the conventional formulation of the theory, agents are seen as having ethical
duties to the principals. If managers act in self-interesta rather negative assumptionand it fails to serve
the best interests of the shareholders, they may, according to some views, have fallen short on their ethical
responsibilities.
In a larger sense, some see the traditional agency model as a simplistic, even deceptive, justification for
traditional economic power relationships, specifically that large wealth holders can extract concessions from
weaker economic beings. Certain scholars have argued that from a broader social perspective, there are many
kinds of principal-agent relations, and included among these is the fact that shareholders may be seen as
agents to managers, employees, and the broader society.
Do Shareholders Control Managerial Behavior?
When a conflict of interest exists between management & shareholders, who wins? There is no doubt that
ownership in large corporations is diffuse when compared to the closely held corporation. However, several
control devices used by shareholders bond management to the self-interest o shareholders:
1.
2.
3.

4.

Shareholders determine the membership of the board of directors by voting. Thus shareholders
control the directors, who in turn select the management team.
Contracts with management & arrangement for compensation, such as stock option plans, can be
made so that management has an incentive to pursue the goal of the shareholders.
If the price of a firms stock drops too low because of poor management, if the firm may be acquired
by another group of shareholders, by another firm, or by an individual. This is called a takeover. In a
takeover, the top management of the acquired firm may find themselves out of a job. This puts
pressure on the management to make decisions in the stockholders interests.
Competition in the managerial labor market may force managers to perform in the best interest of
stockholders.

1.8 Financial Intermediary.

Figure 1.9 Financial Intermediary.

Financial intermediation consists of channeling funds between surplus and deficit agents A financial
intermediary is a financial institution that connects surplus and deficit agents. The classic example of a
financial intermediary is a bank that transforms bank deposits into bank loans. Through the process of
financial intermediation, certain assets or liabilities are transformed into different assets or liabilities.
As such, financial intermediaries channel funds from people who have extra money (savers) to those who do
not have enough money to carry out a desired activity (borrowers).

Functions Performed by Financial Intermediaries:

I. Maturity transformation: Converting short-term liabilities to long term assets (banks deal
with large number of lenders and borrowers, and reconcile their conflicting needs)
II. Risk transformation: Converting risky investments into relatively risk-free ones. (Lending to
multiple borrowers to spread the risk)

17

III. Convenience denomination: Matching small deposits with large loans and large deposits
with small loans
Advantages of Financial Intermediaries:
I. Cost advantage: over direct lending/borrowing
II. Market failure protection: The conflicting needs of lenders and borrowers are reconciled,
preventing market failure
Types of Financial Intermediaries
Banks
Building societies
Credit unions
Financial advisers or brokers
Insurance companies
Collective investment schemes
Pension funds

Self-Test Questions
1.1 What is meant by the term Corporate Finance?
1.2 Differentiate between the terms Corporate Finance, Public Finance & Personal Finance.
1.3 What are the fundamental financial decisions that must be made? Where does a decision concerning how
much to pay the stockholders fit into this framework?
1.4 Why is shareholder wealth maximization a proper goal for the firm? Is it a short-run or a long-run goal, &
why?
1.5 Contrast shareholder wealth maximization with profit maximization.
1.6 State & explain three objections to profit maximization as the goal of the firm.
1.7 Why might management pursue goals other than shareholder wealth maximization?
1.8 What are Agency Theory & Agency Costs?
1.9 How do shareholders control managerial behavior?
1.10 What are the mechanisms to deal with shareholders-manager conflict?

Mini Case
Assume that you recently graduated with a degree in finance and have just reported to work as an investment
advisor at the brokerage firm of Balik and Kiefer Inc. One of the firms clients is Michelle Della Torre, a
professional tennis player who has just come to the United States from Chile. Della Torre is a highly ranked
tennis player who would like to start a company to produce and market apparel that she designs. She also
expects to invest substantial amounts of money through Balik and Kiefer. Della Torre is very bright, and,
therefore, she would like to understand in general terms what will happen to her money. Your boss has
developed the following set of questions which you must ask and answer to explain the U.S. financial system
to Della- Torre.
A. Why is corporate finance important to all managers?
B.
(1) What are the alternative forms of business organization?
(2) What are their advantages and disadvantages?
C. What should be the primary objective of managers?
(1) Do firms have any responsibilities to society at large?
(2) Is stock price maximization good or bad for society?
(3) Should firms behave ethically?
D. What factors affect stock prices?
E. What factors determine cash flows?
F. What factors affect the level and risk of cash flows?
G. What are financial assets? Describe some financial instruments.

18

H. Who are the providers (savers) and users (borrowers) of capital? How is capital transferred between
savers and borrowers?
I. List some financial intermediaries.
J. What are some different types of markets?
K. How are secondary markets organized?
(1) List some physical location markets and some computer/telephone networks.
(2)Explain the differences between open outcry auctions, dealer markets, and electronic
communications networks (ECNs).
L. What do we call the price that a borrower must pay for debt capital? What is the price of equity capital?
What are the four most fundamental factors that affect the cost of money, or the general level of interest rates,
in the economy?
M. What is the real risk-free rate of interest (r*) and the nominal risk-free rate (rRF)? How are these two rates
measured?
N. Define the terms inflation premium (IP), default risk premium (DRP), liquidity premium (LP), and maturity
risk premium (MRP). Which of these premiums is included when determining the interest rate on (1) shortterm U.S. Treasury securities, (2) long-term U.S. Treasury securities, (3) short-term corporate securities, and
(4) long-term corporate securities? Explain how the premiums would vary over time and among the different
securities listed above.
O. What is the term structure of interest rates? What is a yield curve?
P. Suppose most investors expect the inflation rate to be 5 percent next year, 6 percent the following year,
and 8 percent thereafter. The real risk-free rate is 3 percent. The maturity risk premium is zero for securities
that mature in 1 year or less, 0.1 percent for 2-year securities, and then the MRP increases by 0.1 percent per
year thereafter for 20 years, after which it is stable. What is the interest rate on 1-year, 10-year, and 20-year
Treasury securities? Draw a yield curve with these data. What factors can explain why this constructed yield
curve is upward sloping?
Q. At any given time, how would the yield curve facing an AAA-rated company compare with the yield curve
for U.S. Treasury securities? At any given time, how would the yield curve facing a BB-rated company
compare with the yield curve for U.S. Treasury securities? Draw a graph to illustrate your answer.
R. What is the pure expectations theory? What does the pure expectations theory imply about the term
structure of interest rates?
S. Suppose that you observe the following term structure for Treasury securities:
Maturity
1 year
2 year
3 year
4 year
5 year

Yield
6.0%
6.2%
6.4%
6.5%
6.5%

Assume that the pure expectations theory of the term structure is correct. (This implies that you can use the
yield curve given above to back out the markets expectations about future interest rates.) What does the
market expect will be the interest rate on 1-year securities one year from now? What does the market expect
will be the interest rate on 3-year securities two years from now?
T. Finally, Della Torre is also interested in investing in countries other than the United States. Describe the
various types of risks that arise when investing overseas.

19