CHAPTER 1

INTRODUCTION TO
CORPORATE FINANCE
MAF603-CORPORATE FINANCE
CHAPTER OUTLINE
• Function and Objectives of Corporate Finance
• What is Corporate Finance?
• Objectives of Corporate Finance
• Creating Value or Maximizing Shareholders’ Wealth

• Stakeholder Objectives and Possible Conflicts

• Range of Stakeholders and their Objectives
• Possible Conflicts between Stakeholders’ Objectives

• Agency Problem and Control of the Corporation

• Agency Relationship and Agency Problem
• Control Mechanism and Agency Cost
 Function and Objectives of Corporate Finance
• What is Corporate Finance?
How?
to raise fund for
What? CORPORATE capital
Assets should FINANCE expenditures
be invested

How?
To manage short term
operating Cash flows
Corporate Finance Overview
The purpose of corporate managers is to maximize the value of the business through proper planning and
implementing management resources while balancing risk and profitability.

Corporate investment Capital Financing Dividends and returns of capital

Which projects or
business to invest in
Decide which projects
earn the highest returns
with risk adjustment
Determine how to fund
capital investment To decide when the dividends
To optimize capital should be paid to the investors
structure
Function and Objectives of Corporate Finance
Objectives of Corporate Finance
• The financial manager’s primary goal is to increase the value of the firm to
maximise shareholders' wealth by:
1. Selecting value-creating projects
Value is created if the cash paid to shareholders and bondholders is greater than the
cash raised in the firm. In other words, the net present value of the decisions must be
positive.

2. Making smart investment and financing decisions

Try to make smart investment decisions buy assets that generate more cash than
they cost.
Try to make smart financing decisions sell bonds and stocks and other financial
instruments that raise more cash than they cost.
Maximising shareholder wealth

Maximising shareholder wealth usually means maximising the total of:

• The share price, plus

• Dividends (a transfer of cash from the company to shareholders)

A company can therefore maximise shareholder wealth by a mix of share

price increase and paying dividends.
Long term, these depend on the company earning profits that generate a
strong net cash inflow.
 Function and Objectives of Corporate Finance
Creating Value or Maximizing Shareholders’ Wealth
Survival –smart

4 5
Maximize investment &
Market Share financing decision
management need to consider the investment if
Product are well accepted by the
that investment favorably impact the share value
customers and able to beat the
even though relatively risky venture that could
competitors’ product on price and
affect the management position
quality

Beat
Competition 3 How to Maximize
Shareholders’ 6 Earnings Growth
EPS, DPS
Avoid Financial

2 7
Value??
Maximize Distress & Bankruptcy
Profit &
unnecessary borrowings
Market Share could lead to high
leverage and bankruptcy

Maximize
Sales &
Minimize 1 effort to improve the
financial performance
8 Corporate
Governance
good set of system, process and principles affecting the way a firm is
managed for the survival of the business and benefit the
Cost and cash flow of the firm stakeholders in the long run.

Management must acts in accordance to the shareholders’ best interests by making decisions
that increase the value of the stock.
Overview 1
'Value for money' if a not-
for-profit organisation
Maximisation of
shareholder
wealth
Linking to – Encouraged by –
Corporate objectives Corporate governance
Needs of other stakeholders Agency theory

Investment
Financing decision Dividend decision
decision
Risk

Raising capital to
New projects Pay out or
finance investment
Acquisitions reinvest?
Minimise cost of
Working capital
capital
Stakeholder Objectives and Possible Conflicts

• Range of Stakeholders and their Objectives

• Possible Conflicts between Stakeholders’ Objectives
 Range of Stakeholders and Their Objectives
SHAREHOLDERS EMPLOYEES
to obtain a suitable return they receive salary or wages
from their investment and from the company and
to ‘maximize their wealth’. concern about job security or
career prospects.

CUSTOMERS
satisfaction of customer FUND PROVIDERS
needs to be achieved to protect their
through the provision of investment and concern
value for money about the ability of the
products and services company to meet its
interest and principal
repayment obligations.
SUPPLIERS
major suppliers to a GOVERNMENT
company might have As regulator to
some influence over company and source
its actions. of taxation income

DIRECTORS &
MANAGERS SOCIETY
concerns of society on issues
individuals whose careers, such as business ethics, human
income and personal rights, the protection of the
wealth might depend on environment and avoiding
the company they work for pollution
STAKEHOLDERS’
OBJECTIVES
Possible Conflicts between Stakeholders’ Objectives

Usually, different sets of stakeholders have different objectives and often

these are in conflict. For example:

Management has to balance stakeholders' objectives and their power to try

to keep most happy most of the time.
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Agency Problem and Control of the Corporation

• Agency Relationship and Agency Problem

• Control Mechanism and Agency Cost

16
 Agency Relationship and Agency Problem

• Agency Theory and Its Relationship

 Agency relationships occur when one party, the principal, employs another party, the
agent, to perform a task on their behalf. In particular, directors or managers or
management (agents) act on behalf of shareholders (principals or owners).
 As a part of this arrangement, the owners must delegate decision-making authority
to the management. Ideally, the ‘contract’ between the owners and the managers
should ensure that the managers always act in the best interests of the shareholders.
 However, it is impossible to arrange the ‘perfect contract’, because decisions by the
managers (agents) affect their own personal interests as well as the interests of the
owners. Managers will give priority to their personal interests over those of the
shareholders.

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 Hypothetical Organization Chart

Board of Directors

Chairman of the Board and

Chief Executive Officer (CEO)

Vice President and

Chief Financial Officer (CFO)

Treasurer Controller

Cash Manager Credit Manager Tax Manager Cost Accounting

Manager

Financial Accounting Information Systems

Capital Expenditures Financial Planning Manager Manager

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No reproduction or distribution without the prior written consent of McGraw-Hill Education.
 Agency Relationship and Agency Problem

• Agency Problem or Conflict

– In such relationships there is a possibility of a conflict of interest between the principal
and the agent. Such a conflict is called an agency problem.
– ***Factors that may contribute to agency problem may be due the following
causes:
o Moral hazard - manager’s incentive to obtain benefits in kind is higher when he has no shares in co.
o Effort level - manager may work less hard than they would if they were the owners of the company.
o Earnings retention – managers prefer to grow the company, and increase its sales turnover and assets, rather than to
increase the returns to the company’s shareholders.
o Risk aversion – managers reluctant to invest in higher-risk projects to protect their job.
o Time horizon - shareholders are concerned about the long-term financial prospects of their company whereas managers
might only be interested in the short-term. Eg annual bonuses on short term performances.

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 Control Mechanism and Agency Cost
Agency Cost
• Agency costs are the costs that the shareholders incur when professional managers
run their company.
• The cost of resolving the conflict of interest between managers and shareholders are
called agency costs.
• Agency costs do not exist when the owners and the managers are exactly the same individuals.
• Agency costs start to arise as soon as some of the shareholders are not also directors of the
company.
• Agency costs are potentially very high in large companies, where there are many different
shareholders and a large professional management

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 Control Mechanism – Reducing the Agency Problem
•It can be divided into direct and indirect agency cost.
• Direct agency costs are:
o Cost of monitoring the action and performance of managers.
 Preparing accounts and having them audited involve cost
 Managerial reward scheme such as remuneration packages for managers incur high cost

o Cost of implementing control devices

 Established a set of contracts
 Hiring of non executive directors as member of the Board

• Indirect agency cost is a lost opportunity borne by shareholders.

• Example: When the management does not want to take risky investment in view of fear of losing
jobs in case the investment turn out badly even though the new investment expected to increase the
share value. Promoting the selfish investment strategy by the management cause the stockholders
may lose a valuable opportunity. This becomes an indirect agency cost because it arises out of the
shareholder and management conflict but does not have a directly quantifiable value.

21
 ***Control Mechanism – Reducing the Agency Problem
1 4
Established
Set of Contract
•Established a set of contracts
between a principal and an agent
which clearly explain the principal-
agent relationship that would
suggests managers of corporate
firm to act for the best interest of
2
shareholders.
Managerial Reward
Scheme
3
•Devise appropriate incentives such as
stock options plan and performance
shares or bonuses that tied up to
earnings so that management have the
incentive to pursue the goal of the
shareholders. It should be given on the
basis of performance (KPI) as measured
by earnings per share or other similar
criteria like share price
Board of Directors
•Shareholders determine the
members of board of directors
(BOD) through voting who in turn
hire the management team. If
shareholders believe the firm
underperforming and the BOD is
not sufficiently aggressive in
holding the managers to carry out
task, they can replace the BOD in
the next election. Effective BOD
consists largely independent non
executive directors
Annual Reports
& Audited Accounts
•Requirement for the directors to
present an annual report and audited
accounts to the shareholders, setting
out the financial performance and
financial position of the company
 ***Control Mechanism – Reducing the Agency Problem

1
Gearing Ratio

4
Stable Dividend
•Impose the management to take up
Policy
a reasonable level of debt.
Consequently, debt decrease the
•Providing a stable dividend policy to agency costs connected with free
reduce free cash flow. According to agency cash flow by reducing the cash flow
problem perspectives, when the that have to be available for spending
management increases dividend, it reduces based upon the decision of the
the possibility of the management misusing manager. This influence of debt
the firm’s free cash flow. reflecting it as the determining
element of company financial mix 

2
Corporate Control

3
Threat of Firing
•The threat of a takeover may •Threat of firing to management
result in better management who are not acting for the best
interest of stockholders

Embed a good set of system, process and principles affecting the way a firm is managed under good
corporate governance can assist the management to act for the best interests of shareholders.
 Control Mechanism – Reducing the Agency Problem

Shareholders may experience residual losses (loss wealth due to

divergent/bad behavior of the managers) since agency problems can never
be perfectly solved.

Why???

End of Chapter 1
24
Sources was adapted from:
• Ross, Westerfield, Jaffe, Rodziah, Shelia, (2016) Corporate Finance (2 nd.
Ed), McGraw Hill.
• ACCA F9 Financial Management Study Text 2016

25
Your turn!

• Question 1
Explain how the financial managers increase the value of the firm
to maximise shareholders' wealth.

Question 2 Describe the concept of Agency Relationship.

Question 3
Identify the control mechanisms used to reduce agency
problems.