Corporate Financing Decision (MFIN 641)

MBA Vth Term

Kathmandu University School of Management

Rajesh Sharma, PhD

Course Objective
• This course discusses the essential issues that a
manager needs to understand in order to improve
corporate financing decision in his/her company.

• Those issues include stock and bond valuation; risk,

return, and diversification; the cost of capital;
project evaluation; market efficiency; capital
structure; dividend policy; corporate value creation
and valuation; and mergers and acquisitions.
Learning Outcome
• This course aims to build intuition in finance beyond the nitty gritty of
accounting statements.

• Focus on Implications

• As such this tutorial focuses on providing students with practical tools that plays
a major role in understanding
– Firms Investment Decisions
– Financing Option and Optimal Capital Structure
– Dividend and Payout Policies
– Firm Valuation: DDM, DCF, RI, RV
– Merger & Acquisitions

* Corporate Finance – interchangeably used

Study Materials
• Ross, S. A., Westerfield, R. W., & Jordan, B. D. (2012).
Fundamentals of Corporate Finance (9th ed.). New Delhi, Tata
McGraw Hill

• Brealey, R. A., Myers, S. C., Allen, F., & Mahanty, P. (2013).

Principles of Corporate Finance (10th ed.). New Delhi: Tata
McGraw Hill

• Damodaran, A. (2014). Applied Corporate Finance.

Available at:
http://people.stern.nyu.edu/adamodar/pdfiles/acf4E/acf4Ebook.p
df
Summary of assessment

Class test 15%

Case and other assignments 20%

Class participation and conduct 15%

Final term paper 20%

Final exam 30%

• Use of other resources and incase of contradictory points

• Absent in Final Exam
• Class Cancellation
• For other course rules, please check course outline
Term Paper and course norms
• To pick a company to analyze, collect background information and start thinking about the
narrative for the company. (Discussion Feb. end 2020)

• Choose a company that you want to work at, understand, or own, rather than one that you
think will be easy to analyze or widely followed.

• Collect information, both financial and non-financial, about your company and the sector
that it operates in.

• Data for at least 5 years.

• Sector Information (Competitor/Peer Group) : Revenue, Profitability and Leverage Metrics

• Overall Market Trend

• Establish your prior views of this company.

Background Studies
• Covered in previous semester ??

– Capital Market, IPO, Secondary Market

– Agency Relationship, Market Efficiency
– Time Value of Money
– Cash Flow Estimation
– Risk- Return, Cost of Debt, Cost of Equity, WACC
– Capital Budgeting
– Dividend Payout
– Intrinsic Value
– Basic Statistics

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Issue and Intuition
• Types of Firm: Focus on Public Companies

• Manager v/s Investors: Objective

• Theory and models:

– Provide tools to understand, analyze, and solve problems.
– The test of a model or theory then should not be based on its elegance but on its
usefulness in problem solving.

• Common Sense (Not an exact science), History of Business Operations

• My view – Emerging Market and Commodity Trading Experience

*Risk Free Rate and CSR Issues

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Issue and Intuition
• Risk Free Rate:
– Actual v/s Expected Return (No Variance)
– No Default Risk
– No Reinvestment Risk

• Not all government securities are Risk-free:

– Government Bond Rate: US v/s Russia (Risk-Free ?)
– For emerging market: Illiquid Market

• Suggested by literature
Risk-Free Rate= 10 Years US Bond + (Local inflation- US inflation)

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Issue and Intuition
• Addressing CSR Issues
– Firm Objective
– Stakeholders and their Conflicting Demand
– Limited Firm Resources
– Voluntary Participation (why?)
– Recent Development (India and EU)

• Valuation Effect: CAPEX and R&D

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Acknowledge the limitation
• Data Availability: CSR

• Measurement Issues: CSR

• Local Practice in Corporate Financing Decision:

Risk-Free Rate (Treasury Bond), CSR

* Yeti Airlines Claim- Zero Carbon Neutral

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Acknowledging limitation: Our Focus
• Valuation Models and their Inputs:
– Transferable skill
– Concept of risk-return
– Capital Structure

• Dividend Discount Model

• Discounted Cash Flow Model
• Residual Income Model
• Relative Valuation Model
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Introduction: Corporate Financing Decision
• Every decision that a business makes has financial
implications, and any decision which affects the finances of a
business is a corporate finance decision.
• In general, making financial decisions involves answering
following questions:
– What is the expected return ?
– What is the risk exposure ?

Investment Decisions

RETURN
Financing Decisions

?
Dividend Decisions
RISK
Working Capital Decisions
Corporate Financing Decision: Managers

• Corporate finance provides the skills managers

need to:
– Identify and select the corporate strategies and
individual projects that add value to their firm.

– Forecast the funding requirements of their

company, and devise strategies for acquiring those
funds.
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Role of a Managers

Firm Firm issues securities (A) Financial

markets
Invests
Invests in assets Retained
in
(B)assets cash flows (F) Short term debt
Long term debt
Current and(B)
Fixed
Equity shares
Assets Short-term debt
Current assets Cash flow Dividends and Long-term debt
Fixed assets from firm (C) debt payments (E)
Equity shares

Taxes (D)

Ultimately, the firm The cash flows from

must be a cash the firm must exceed
Government
generating activity. the cash flows from
the financial markets.
The Firm: Structural set-up

• All corporate finance is built on three principles, which we will

call, rather unimaginatively, the investment principle, the financing
principle, and the dividend principle.

• The investment principle determines where businesses invest

their resources, the financing principle governs the mix of
funding used to fund these investments, and the dividend
principle answers the question of how much earnings should be
reinvested back into the business and how much returned to the
owners of the business.
The Traditional Accounting Balance Sheet

The Balance Sheet

Assets Liabilities
Current Short-term liabilities of the firm
Long Lived Real Assets Fixed Assets Liabilties
Short-lived Assets Current Assets Debt Debt obligations of firm

Investments in securities & Financial Investments Other

assets of other firms Liabilities Other long-term obligations

Assets which are not physical, Intangible Assets

like patents & trademarks Equity Equity investment in firm
The Financial View of the Firm

Assets Liabilities
Existing Investments Fixed Claim on cash flows
Generate cashflows today Assets in Place Debt Little or No role in management
Includes long lived (fixed) and Fixed Maturity
short-lived(working Tax Deductible
capital) assets

Expected Value that will be Growth Assets Equity Residual Claim on cash flows
created by future investments Significant Role in management
Perpetual Lives
Accounting or Financial View
• Finance is forward-looking approach based on cash
flows whereas Accounting is backward-looking that
focuses on profit rather than cash (Cash is King).
• Raising funds and providing return (strategies in
value creation) v/s providing information and
assisting in decision making.
• Finance is focused on market values (captures
expectation) rather than book values (at best
approximation of asset’s replacement costs).
Accounting or Financial
• Problem with Accounting Figures (few e.g.)

– Credit sales are recognized as accounting income,

yet cash has not been received.
– Depreciation expense is a legitimate accounting
expense when calculating income, yet depreciation
expense is not a cash outlay.
– A loan brings cash into a business but is not
income.
Main Principle of Corporate Finance
• 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.
Main Principle of Corporate Finance
• Choose a financing mix that minimizes the hurdle rate
and matches the assets being financed.

• If there are not enough investments that earn the hurdle

rate, return the cash to stockholders.
– The form of returns - dividends and stock buybacks
- will depend upon the stockholders’ characteristics.

Objective: Maximize the Value of the Firm

Main Principle of Corporate Finance
Corporate Finance Decision: Logic
• Value Maximization: Gives corporate finance its
focus. As a result of this singular objective, we
can
– Choose the “right” investment decision rule to use,
given a menu of such rules.
– Determine the “right” mix of debt and equity for a
specific business
– Examine the “right” amount of cash that should be
returned to the owners of a business and the “right”
amount to hold back as a cash balance.
Corporate Finance Decision: Logic
Corporate Finance Decision: Overall Flow
Valuation Model: Some Discussion

• Dividend Discount Model

• Discounted Cash Flow Model
• Residual Income Model
• Relative Valuation Model

• Synergy and Merger

• Existing Capital Structure and Acquisition
Value Maximization : Issues
• 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.
Value Maximization : Arguments
• Maximizing stock price is not incompatible with meeting
employee needs/objectives. In particular:
– Employees are often stockholders in many firms
– Firms that maximize stock price generally are firms that have treated
employees well.

• Maximizing stock price does not mean that customers are not
critical to success. In most businesses, keeping customers happy is
the route to stock price maximization.

• Maximizing stock price does not imply that a company must be a

social outlaw.
Traditional Financial Theory Focuses on
Maximizing Stockholder Wealth: why?
• Stock price is easily observable and constantly updated (unlike
other measures of performance, which may not be as easily
observable, and certainly not updated as frequently).

• 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
The Classical Objective Function
STOCKHOLDERS

Hire & fire Maximize

managers stockholder
- Board wealth
- Annual Meeting

Lend Money No Social Costs

BONDHOLDERS Managers SOCIETY
Protect Costs can be
bondholder traced to firm
Interests
Reveal Markets are
information efficient and
honestly and assess effect on
on time value

FINANCIAL MARKETS
What can go wrong? (Agency Problem)

• Corporate Governance structure and its effectiveness

• Annual Meetings

• Board of Directors (Chairman and CEO)

• Lack of Expertise (Subjective Specific: UNGC, Union)

* Your Project: Presence of Independent member, Subject experts, who OWNS and who RUNS
What can go wrong? (Agency Problem)

• Bond Holder: Increase Dividend and Risky Projects

• Financial Market: Delay or Omission of Bad news (Even

Fraudulent information)

• Social: Difficult to quantify, Voluntary nature and Obfuscation

attempt, Cannot be traced to firms
This is what can go wrong
STOCKHOLDERS

Managers put
Have little control their interests
over managers above stockholders

Lend Money Significant Social Costs

BONDHOLDERS Managers SOCIETY
Bondholders can Some costs cannot be
get ripped off traced to firm
Delay bad Markets make
news or mistakes and
provide can overreact
misleading
information
FINANCIAL MARKETS
The Counter Reaction
STOCKHOLDERS

1. More activist Managers of poorly

investors run firms are put
2. Hostile takeovers on notice.

Protect themselves Corporate Good Citizen Constraints

BONDHOLDERS Managers SOCIETY
1. Covenants 1. More laws
2. New Types 2. Investor/Customer Backlash
Firms are
punished Investors and
for misleading analysts become
markets more skeptical

FINANCIAL MARKETS
Solutions: Corporate Governance and beyond

• Choose a different objective for the firm.

• Choose a different mechanism for corporate

governance
Choose a Different Objective Function
• Firms can always focus on a different objective function.
Examples would include
– maximizing earnings
– maximizing revenues
– maximizing firm size
– maximizing market share

• The key thing to remember is that these are intermediate

objective functions.
– To the degree that they are correlated with the long-term health
and value of the company, they work well.
– To the degree that they do not, the firm can end up with a disaster
Corporate Governance Mechanism
• Hires and promotes qualified, honest people, and
structures employees’ financial incentives to
motivate them to maximize firm value

• Corporate governance Mechanism:

– Structure: e.g. Germany v/s Anglo-Saxon
– Intuitional Investors and Stakeholders’ Role
– Specific Corporate Governance Mechanism

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 The Stockholder Backlash
• Institutional investors such as CALPERS and the Lens
Funds have become much more active in monitoring
companies that they invest in and demanding changes in the
way in which business is done

• At annual meetings, stockholders have taken to expressing

their displeasure with incumbent management by voting
against their compensation contracts or their board of
directors (also long-term view)
In response, boards are becoming more
independent…
• Boards have become smaller over time. The median size of a board of directors
has decreased from 16 to 20 in the 1970s to between 9 and 11 in 1998. The
smaller boards are less unwieldy and more effective than the larger boards.

• There are fewer insiders on the board. In contrast to the 6 or more insiders that
many boards had in the 1970s, only two directors in most boards in 1998 were
insiders.

• Directors are increasingly compensated with stock and options in the company,
instead of cash. In 1973, only 4% of directors received compensation in the
form of stock or options, whereas 78% did so in 2012.

• More directors are identified and selected by a nominating committee rather

than being chosen by the CEO of the firm. In 2012, 75% of boards had
nominating committees; the comparable statistic in 1973 was 2%.
 Recent Investment/ Financing Decisions
Company Investment Decisions Financing and Dividend Decisions
Delivers first Dreamliner after investing a
Boeing (U.S.) Reinvests $1.7 billion of profits.
reported $30 billion in development costs.
ExxonMobil Spends $7 billion to develop oil sands at
Spends $12 billion buying back shares.
(U.S.) Fort McMurray in Alberta.
GlaxoSmith- Spends $4 billion on research and
Pays $3.2 billion as dividends.
Kline (UK) development for new drugs.
LVMH LVMH acquires the Italian Jeweler, Pays for the acquisition with a mixture of cash
(France) Bulgari, for $5 billion. and shares.
Procter & Raises 100 billion Japanese yen by an issue of 5-
Spends $8 billion on advertising.
Gamble (U.S.) year bonds.
Opens a plant in India to produce the
Tata Motors
world's cheapest car, the Nano. The facility Raises $400 million by the sale of new shares.
(India)
costs $400 million.
Invests $330 million in 100 new
Union Pacific
locomotives and 10,000 freight cars and Repays $1.4 billion of debt.
(U.S.)
chassis.
Maintains credit lines with its banks that allow
Opens a copper mine at Salobo in Brazil.
Vale (Brazil) the company to borrow at any time up to $1.6
The project cost nearly $2 million.
billion.
Invests 12.7 billion, primarily to open 458 Issues $5 billion of long-term bonds in order to
Walmart (U.S.)
new stores around the world. repay short-term commercial paper borrowings.
Practical
• Beta Calculation and its implications