LESSON ONE: INTRODUCTION TO CORPORATE FINANCE

1.0 Lesson Learning Outcomes

By the end of this lesson, the learner should be able to;

i. State the various functions and decisions made by a finance manager.

ii. Explain the goals and objectives of a firm.

iii. Explain the types of agency conflicts in a corporate firm.

iv. Examine the types of agency problem resolutions.

v. Discuss the risk-return trade-off in companies.

1.1 Introduction

Finance is the art and science of managing money.

Finance is concerned with decisions about money or more specifically cash flows.

It is vital to note that finance decisions deal with how businesses, governments and individuals

raise and use money. Businesses have to deal with decisions such as whether to invest in a

project, financing of projects, working capital requirements and dividend payout.

Governments have to deal with decisions on raising public revenue and how to undertake public

spending while individuals have to make decisions on whether to borrow in order to buy a car or

a home, which investment to undertake – is it stocks, bonds, real estate or other investments, how

much to spend today etc.

The main functions of finance include;

1. To intelligently allocate capital to long term assets (Investment Decision)

2. When, where and how should a business acquire funds (Financing Decision)

3. To invest sufficient funds in current assets in order to avoid insolvency (Liquidity

Decision)

4. Whether to distribute all/part of the profits to the shareholder or retain all/part of the

profits (Dividend Decision)

1.1.1 Functions of a Finance Manager

Forecasting and Planning – the finance manager should work with other managers as they lay

the plans that will improve the future outlook of the firm.

Making Investment and Financing Decisions – it involves the finance manager deciding on

which specific assets to acquire in order to enhance expansion of the business and the best way

to finance those assets – is it by debt or equity.

Coordination and Control – the finance manager should interact with other managers to ensure

that the firm is operating efficiently and effectively. Therefore the finance manager makes it

clear that all business decisions made have a financial implication which should be considered by

all managers.

Dealing with the Financial Markets – the finance manager must deal with the money and

capital markets since it involves where the funds are raised, where the firm’s securities are traded

and where the investors are rewarded.

1.2 Objectives of the Firm

Firms have certain objectives that they aim to achieve such as shareholder wealth maximization

and stakeholder satisfaction. For quite a long time American based firms have aimed to attain

shareholder wealth maximization while continental Europe based firms have aimed at

stakeholder satisfaction. Below are points to consider in the pursuit of shareholder wealth

maximization;

Managerial Incentives to maximize Shareholder Wealth

Shareholders own the firm and elect a board of directors who then appoint the management team.

Management in turn should operate in the best interests of shareholders. These interests range

from decisions that maximize the value of the shares owned, dividends to be paid, etc.

Social Responsibility

It is the concept that businesses should be actively concerned with the welfare of the society at

large. Should firms operate strictly in their shareholders’ interests or are firms also responsible

for the welfare of their employees, customers, and the communities in which they operate?

Stock Price Maximization and Social Welfare

If a firm attempts to maximize its stock price, is that good or bad for the society?

Note that stock price maximization requires efficient, low cost production plants that produce

high quality goods and services at the lowest possible cost. Also stock price maximization

requires the development of products that clients want and need, so the profit motive leads to
new technology, new products, etc. Finally, stock price maximization requires efficient service,

adequate stocks of merchandise and well located business premises.

1.3 Agency Relationships

In large firms the owners (shareholders) are not involved in the day to day operations hence they

allow the managers to make decisions as to how firms are managed. The shareholders want the

managers to make decisions that are consistent with the goal of wealth maximization. However

manager interests can conflict with shareholder interests hence creating the agency problem.

An agency relationship exists when one or more individuals (principals) hire another person

(agent) to perform a service and delegate decision making authority to that agent. In firms key

agency relationships exist between shareholders and managers; and between shareholders and

creditors.

1.4 Agency Problem

Agency problem is a potential conflict of interest between either the shareholders and the

manager or shareholders and creditors (debtholders).

The resolution of the agency problem of shareholders vs managers can be done in several ways

such as;
Managerial Compensation – it is a method used to motivate managers to operate in a manner

consistent with stock price maximization by tying managers’ compensation to the firm’s

performance.

The Threat of Firing – nowadays shareholders have the clout to influence a firm’s operations

especially when there is poor performance they can remove the mangers from office unlike many

years ago when shareholding was widely fragmented.

Shareholder Intervention – this involves large shareholders especially the institutional

shareholders, routinely monitoring firms to ensure that the managers are pursuing the goal of

wealth maximization. If it is determined that action is needed to realign management decisions

with the interests of the investors, these institutional investors exercise their influence by making

suggestions to be voted on in the AGM.

The Threat of Takeovers – that threat is eminent when a firm’s stock is undervalued relative to its

potential mainly due to poor management. In a hostile takeover, the managers of the acquired

firm are fired and those who decide to stay essentially lose the power they had before the

acquisition. Hence managers have the incentive to take actions that maximize stock prices.

1.5 Risk-return Trade-off

Financial decisions incur different degree of risk. The decision to invest money in government

bonds has less risk since the interest is known and the risk of default is very minimal. However if
you decide to invest money in shares you would incur more risk since the return is not certain.

Thus you can expect a lower return from government bonds and higher returns from shares.

The greater the risk, the greater the expected returns.

Financial decisions of the firm are guided by the risk-return trade-off. These decisions are

interrelated and jointly affect the market value of its shares by influencing return and risk of the

firm. The relationship between return and risk can be expressed as follows;

Return = Risk-free rate + Risk premium

Risk-free rate is the rate obtained from a default risk-free government security while risk

premium is the payment for the additional amount of risk investors take when purchasing risky

securities.

E-tivity 1.1 – Introduction to Corporate Finance

Numbering, pacing and 1.1
sequencing
Title Introduction to Corporate Finance
Purpose The purpose of this e-tivity is to enable you to explain the
functions of a finance manager and the agency problem in
companies.
Brief summary of overall task Watch video on agency conflicts in companies.
Spark

Individual task (a) Using bullet points explain the role of the finance
manager in raising funds and allocating funds?
(b) While using relevant examples, discuss the agency problems
that have faced companies in Kenya in the recent past.
Interaction begins a) Explain the risk-return tradeoff in firms.
b) Explain while giving relevant examples, agency conflicts
between creditors and shareholders.
Do this in discussion forum 1.1
E-moderator interventions 1 Ensure that learners are focused on the contents and context
of discussion.
2 Stimulate further learning and generation of new ideas.
3 Provide feedback on the learning progress.
4 Close the e-tivity
Schedule and time This task should take one and a half hours
Next Efficient Market Hypothesis
ASSESSMENT QUESTIONS

1. Highlight some examples of agency problems between shareholders and managers.

a. The rapid expansion of Uchumi Supermarket in 2004-2006 led by management in

conflict with shareholder wealth maximization
b. Fraud allegations on top managers of CMC holdings Ltd in 2011 leading to the
suspension of trading of the CMC shares at NSE
c. Conflicts of interest among board members at East African Portland Cement Ltd a few
years ago
d. The case of Imperial Bank and Chase Bank leading to their receivership
e. The case of Kenya Airways where the top managers adopted the Mawingu Expansion
project then subsequently affecting shareholder value due to its lack of financial
sustainability.

2. Discuss what constitutes agency costs?

These are costs incurred by a principal as a result of the agency problem. These may include
costs incurred when the agent uses the company resources for their own benefit or costs
incurred by the principal in preventing the agent from taking up their personal interests at the
expense of shareholder interests.

REFERENCE MATERIALS

Brealey, R., Myers, S., & Allen, F. (2020). Principles of Corporate Finance. 13th Ed. McGraw

Hill.

Brigham, E.F. & Houston, J.F. (2017). Fundamentals of Financial Management. 15th Ed.

Cengage Learning.

Ross, S., Westerfield, J. & Jordan, F. (2018). Corporate Finance. 12th Ed. McGraw-Hill, Irwin.
LESSON TWO: EFFICIENT MARKET HYPOTHESIS

2.0 Lesson Learning Outcomes

By the end of this lesson, the learner should be able to;

i. State the types of an efficient market.

ii. Explain the forms of efficient market hypothesis.

iii. Explain the observations on perfectly efficient markets.

iv. Examine the various market efficiency test results.

v. Discuss the implications of efficient market hypothesis.

2.1 Market Efficiency

The topic of market efficiency continues to be a matter of intense debate in the investment

community. In order to understand and participate in this debate, one must understand the

concept of market efficiency. A reasonable goal of government policy is to encourage the

establishment of allocationally efficient markets, in which the firms with the most promising

investment opportunities have access to the needed funds. However, in order for markets to be

allocationally efficient they need to be both internally and externally efficient. In an externally

efficient market, information is quickly and widely disseminated thus allowing each security’s

price to adjust rapidly in an unbiased manner to new information so that it reflects investment

value. On the other hand, an internally efficient market is one in which brokers and dealers

compete fairly so that the cost of transacting is low and the speed of transacting is high.
2.2 Random Walks and the Efficient Market Hypothesis

In 1953 Maurice Kendall attempted to examine the proposition that the behaviour of stock

market prices over time could indicate a trend or pattern. However, he was surprised to find that

he could not predict patterns in stock prices since the prices seemed to move randomly. They

were likely to go up as they were to go down in any day regardless of past performance.

Therefore, economists over the years have arrived at a consensus that the random price

movements indicate a well functioning or efficient market.

In summary we need to take note of the following definition of terms;

Efficient Market Hypothesis (EMH) is the hypothesis that prices of securities fully reflect

available information about securities.

Random Walk is the notion that stock price changes are random and unpredictable.

Market Efficiency – a market is efficient with respect to a particular set of information if it is

impossible to make abnormal profits by using this set of information to formulate buying and

selling decisions.

2.3 The Versions/Forms of EMH

In an efficient market a set of information is fully and immediately reflected in market prices. A

common description of market efficiency is given by Eugene Fama as follows;

 Weak Form EMH – the assertion that stock prices already reflect all information

contained in the history of past trading.

 Semi-strong Form EMH – the assertion that stock prices already reflect all publicly

available information.
  Strong Form EMH – the assertion that stock prices reflect all relevant information

including inside information.

2.3.1 Observations on Perfectly Efficient Markets

There are fascinating observations made about perfectly efficient markets as shown below;

1. Investors should expect to make a fair return on their investment.

2. Markets will be efficient only if enough investors believe that they are not efficient.

3. Publicly known investment strategies cannot be expected to generate abnormal returns.

4. Some investors will display impressive performance records.

5. Professional investors should fare no better in picking securities than ordinary investors.

6. Past performance is not an indicator of future performance.

2.3.2 Observations on Perfectly Efficient Markets with Transaction Costs

There are observations made by Sanford Grossman and Joseph Stiglitz on how transaction costs

affects the efficient market model. The observations are as follows;

1. In a world where it costs money to analyse securities, analysts will be able to identify

mispriced securities.
2. Investors will do just as well using a passive investment strategy where they simply buy the

securities in a particular index and hold onto that investment.

2.4 Testing for Market Efficiency

The common tests conducted to determine the level of market efficiency are as follows;

2.4.1 Event Studies

They are conducted to see how fast security prices actually react to the release of information.

Event studies are really joint tests as they simultaneously involve tests of the asset pricing

model’s validity and tests of market efficiency.

2.4.2 Looking for Patterns

This involves investigating whether there are patterns in security price movements attributable to

something other than what one would expect. Securities can be expected to provide a rate of

return over a given period of time in accordance with an asset pricing model. In recent years, a

large number of these patterns have been identified and labelled as empirical regularities or

market anomalies. For example, the January effect, Friday effect, etc.

2.4.3 Examining Performance

This involves examining the investment record of professional investors. Are more of them able

to earn abnormally high rates of return than one would expect in a perfectly efficient market?

Are more of them able to consistently earn abnormally high returns period after period than one

would expect in an efficient market? Therefore, the challenges faced in conducting such tests
because they require the determination of abnormal returns which then requires the

determination of ‘normal returns’.

2.5 Market Efficiency Test Results

Many tests have been conducted over the years where they have examined the extent or degree to

which security markets are efficient.

2.5.1 Weak-Form Tests

Early tests of weak-form market efficiency failed to find any evidence that abnormal profits

could be earned trading on information related to past prices. These tests mainly concluded that

technical analysis, which relies on forecasting security prices on the basis of past prices, was

ineffective. However, more recent studies have indicated that investors may overreact to certain

types of information, driving security prices temporarily away from their investment values.

Consequently, it may be possible to earn abnormal profits buying securities that have been

“oversold” and selling securities whose prices have been bid up excessively.

2.5.2 Semi-strong-Form Tests

The results of tests of semi-strong form market efficiency have been mixed. Most event studies

have failed to demonstrate sufficiently large inefficiencies to overcome transaction costs.

However, various market anomalies have been discovered where by securities with certain

characteristics or during certain time periods appear to produce abnormally high returns.
2.5.3 Strong-Form Tests

Generally, corporate insiders and securities exchange experts who have information not readily

available to the public have been shown to be able to earn abnormally high profits. Sometimes

these experts or analysts have direct access to private information and somehow they also

‘manufacture’ their own private information through their research efforts. Some studies have

indicated that certain analysts are able to discern mispriced securities but whether this ability is

due to skill or chance is debatable.

2.6 Implications of the EMH

Technical Analysis

Fundamental Analysis

Active vs. Passive Portfolio Management

Resource Allocation
E-tivity 2.1 – Efficient Market Hypothesis
Numbering, pacing and 2.1
sequencing
Title Efficient Market Hypothesis
Purpose The purpose of this e-tivity is to enable you to explain the
efficient market hypothesis and market efficiency tests.
Brief summary of overall task Watch video on EMH.

Spark

Individual task (a) Compare and contrast fundamental analysis and

technical analysis in stock trading.
(b) While using relevant examples, discuss the shortcomings of
EMH.
Interaction begins a) Discuss the application of EMH in Nairobi Securities
Exchange.
b) Explain while giving relevant examples, active and passive
portfolio management.
Do this in discussion forum 2.1
 E-moderator interventions 1. Ensure that learners are focused on the contents and context
of discussion.
2. Stimulate further learning and generation of new ideas.
3. Provide feedback on the learning progress.
4. Close the e-tivity
Schedule and time This task should take one and a half hours
Next Long-term Financing

ASSESSMENT QUESTIONS

1. Explain the concept of EMH while highlighting the various tests that can be done to ascertain

the EMH.

 EMH states that prices of securities fully reflect available information about securities. The
various tests on EMH range from weak-form tests, semi-strong form tests and strong-form
tests.

2. Suppose you observe that top managers make superior returns on investments in their

company stock.

i) Would that be a violation of weak-form market efficiency?

ii) Would it be a violation of strong-form market efficiency?

REFERENCE MATERIALS

Brealey, R., Myers, S., & Allen, F. (2020). Principles of Corporate Finance. 13th Ed. McGraw Hill.
Brigham, E.F. & Houston, J.F. (2017). Fundamentals of Financial Management. 15th Ed. Cengage
Learning.
Bodie, Z., Kane, A., & Marcus, A. (2018). Investments. 11th Ed. McGraw Hill.
Sharpe, W.F., Alexander, G.J., & Bailey, J.V. (2008). Investments. 6th Ed. New Delhi: PHI Learning.