Corporate Finance (MAIB FIN 101) Aug 2022

UNIT 1
• Introduction to financial management:
• four basic areas- corporate finance,
investments, financial institutions and
international finance;
• goals of financial management.
• Goal of the firm and agency problems,

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Corporate Finance (MAIB FIN 101) Aug 2022– Unit 1

2. The
opportunity cost
1. Corporate FIVE THEMES
of capital sets the
finance is all about OF CORPORATE
standard for
maximizing value FINANCE
investment
decisions

.4. Smart
investment
decisions create 3.A safe dollar is
5. Good worth more than a
governance matters more value than
smart financing risky dollar
decisions
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 Corporate Finance (MAIB FIN 101) Aug 2022– Unit 1

STRUCTURE OF CORPORATE FINANCE AND DECISIONS

Investment Decisions
• Often referred to as capital budgeting or capital expenditure (CAPEX) decision
• Purchase of real assets
• Decisions are based on returns on investment

Financing Decisions
• A corporation can raise money from lenders or from shareholders
• Lenders contribute cash, and the corporation pays back the debt plus a fixed rate of interest

• Shareholders put up the cash for equity:

-they do net get a fixed return, and
-therefore, get a fraction of future profits and cash flow

• The choice between debt and equity financing is called the capital structure decision
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What Is a Corporation? -1

A corporation is a legal entity. In the view of the law, it is a legal person that is owned
by its shareholders.

As a legal person, the corporation can

•make contracts,
•carry on a business,
•borrow or lend money, and
•sue or be sued

One corporation can make a takeover bid for another and then merge the two
businesses

Corporations pay taxes—but cannot vote!

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What Is a Corporation? -2

Corporations are formed under law, based on articles of incorporation that

• set out the purpose of the business and
• how it is to be governed and operated
• may specify the composition and role of the board of directors.

A corporation’s directors are elected by the shareholders.

.
A corporation is owned by its shareholders but is legally distinct from them.

shareholders have limited liability, which means that they cannot be held personally
responsible for the corporation’s debts

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When a corporation is first established, its shares may be privately held by a small group of
investors--the company is closely held

When the firm grows, new shares are issued to raise additional capital

Shares are traded in public markets such as the New York Stock Exchange

In some it is common for large corporations to remain in private hands, and

many public companies may be controlled by just a handful of investors.

A large public corporation may have hundreds of thousands of shareholders. who own the
business but cannot possibly manage or control it directly.

This separation of ownership and control gives corporations permanence

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Flow of cash between financial markets and the firm’s operations.

Key: (1) Cash raised by selling financial assets to investors;
(2) cash invested in the firm’s operations and used to purchase real assets;
(3) cash generated by the firm’s operations;
(4a) cash reinvested; (4b) cash returned to investors.

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The Financial Goal of the Corporation

Shareholders Want Managers to Maximize Market Value

Delegating the operation of the firm to professional managers can work only if shareholders
have a common objective.

This is a natural financial objective on which almost all shareholders agree

Profit maximization is not a well- defined financial objective for at least two reasons:

1. Which year’s profits to maximize ? Reducing cost this year may impact next year’s profit

2. A company may be able to increase future profits by cutting this year’s dividend and
investing the freed-up cash in the firm
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 Corporate Finance (MAIB FIN 101) Aug 2022– Unit 1

The Financial Goal of the Corporation and the shareholders

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 Corporate Finance (MAIB FIN 101) Aug 2022– Unit 1

FINANCIAL INSTITUTIONS
Banks
The traditional role of banks has been to take deposits and make loans

The interest charged on the loans is greater than the interest paid on deposits

Most large banks engage in both commercial and investment banking

Both loans and deposits are much larger in wholesale banking than in retail banking

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Commercial Banking

Commercial banking in virtually all countries has been subject to a great deal of regulation

To maintain confidence in banks, government regulators in many countries have introduced

guaranty programs

The nature of deposit insurance varies from country to country

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Investment banking is concerned with

• assisting companies in raising debt and equity,

• providing advice on mergers and acquisitions,

• major corporate restructurings, and other corporate finance decisions

Large banks are also often involved in securities trading (e.g., by providing brokerage
services)

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The main activity of investment banking is raising debt and equity financing for
corporations or governments.

This involves :
• originating the securities, underwriting them, and
• placing them with investors

A prospectus is created outlining the company’s past performance and future prospects.

Sometimes the financing takes the form of a private placement in which the securities are
sold to a small number of large institutional investors, such as life insurance companies or
pension funds

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 Corporate Finance (MAIB FIN 101) Aug 2022– Unit 1

On other occasions it takes the form of a public offering, where securities are offered to
the general public.

Public offering may be on a best efforts or firm commitment basis

An initial public offering (IPO) is typically made on a best -efforts basis or

Firm-commitment basis

IPO : When the company wishing to issue shares is not publicly traded, the share issue is
known as an initial public offering (IPO).

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The correct offering price is difficult to determine and depends on the investment bank’s
assessment of the company’s value.

Dutch Auction Approach :

A few companies have used a Dutch auction approach for their IPOs.

As for a regular IPO, a prospectus is issued and usually there is a road show.

One high-profile IPO that used a Dutch auction was the Google IPO in 2004.

Advisory Services

Investment banks offer advice to companies on mergers and acquisitions, divestments,

major corporate restructurings, and so on

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Insurance Companies and Pension Plans

The role of insurance companies is to provide protection against adverse events

The company or individual seeking protection is referred to as the policyholder. T

The policyholder makes regular payments, known as premiums,
and receives payments from the insurance company if certain specified events
occur.

Insurance is usually classified as life insurance and nonlife insurance, with health
insurance often considered to be a separate category.

Nonlife insurance is also referred to as property-casualty insurance.

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Moral Hazard
Moral hazard is the risk that the existence of insurance will cause the policyholder to
behave differently than he or she would without the insurance.

This different behavior increases the risks and the expected payouts of the insurance
company.

Insurance companies have traditionally dealt with moral hazard in property-casualty and
health insurance in a number of ways.

Typically, there is a deductible. This means that the policyholder is responsible for bearing
the first part of any loss. Sometimes there is a co-insurance provision in a policy.

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Adverse Selection

Adverse selection is the phrase used to describe the problems an insurance company
has when it cannot distinguish between good and bad risks.

It offers the same price to every- one and inadvertently attracts more of the bad risks

To lessen the impact of adverse selection, an insurance company tries to find out as
much as possible about the policyholder before committing itself

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Other Financial Companies / Institutions

Mutual Funds

Non – Banking Finance Corporations

Hedge Funds

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