Law on Corporate Finance

Module I
Umang Ghildyal
What are the components of a Balance Sheet?
Financial Balance Sheet of a Business
Objectives of Corporate Finance
• THE CLASSICAL OBJECTIVE
• MODERN OBJECTIVE
The Three Major Decisions in Corporate
Finance
 The Allocation decision
• Where do you invest the scarce resources of your business?
• What makes for a good investment?
 The Financing decision
• Where do you raise the funds for these investments?
• Generically, what mix of owner’s money (equity) or borrowed
money(debt) do you use?
 The Dividend Decision
• How much of a firm’s funds should be reinvested in the business
and how much should be returned to the owners?
First Principles 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.
 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
Stakeholders of a company
Managerial Interest overwhelming
Stockholder Interest
• Greenmail
• Golden Parachutes
• Poison Pills
• Shark Repellants
• Overpaying on takeovers
Alternate Corporate Governance System
• Germany – Crossholdings by Banks
• Japan – Keiretsus – Crossholdings by 50 companies
Different objective function
• Maximising earnings
• Maximising revenues
• Maximising firm size
• Maximising market share
Risk and Return
• Corelation of risk and return
• Hurdle rate
• Risk has to be measured from the perspective of not just any investor
in the stock, but of the marginal investor, defined to be the investor
most likely to be trading on the stock at any given point in time.
Behavioural finance scholars present three aspects of risk assessment
that are at variance with the mean–variance school’s view of risk:

• Loss aversion
• Familiarity bias
• Emotional factors
The Components of Risk
• project-specific
• Competitive risk
• industry-specific risk
• international risk
• market risk

• How do firms reduce risk?

Risk free rate
• Duration match with govt
security
Estimating the Cost of Equity

• In the CAPM, this expected return can be written as:

• Expected return = Risk-free rate + Beta ∗ Expected risk premium

• In the APM and multifactor model, the expected return would be written as follows:
• Expected return = Risk-free rate +n Σj=1 𝛽j ∗ Risk premiumf
Equity risk premium
Calculation Risk Premium
Measuring Returns Right: The Basic
Principles
• Use cash flows rather than earnings. You cannot spend earnings. ¨
• Use incremental cash flows relating to the investment decision, i.e.,
cashflows that occur as a consequence of the decision, rather than
total cash flows. ¨
• Use time weighted returns, i.e., value cash flows that occur earlier
more than cash flows that occur later.
• The Return Mantra: Time-weighted, Incremental Cash Flow Return
Setting the table: What is an investment /
project?
• An investment/project can range the spectrum from big to small, money making
to cost saving:
• Major strategic decisions to enter new areas of business or new markets.
• Acquisitions of other firms are projects as well, notwithstanding attempts to
create separate sets of rules for them.
• Decisions on new ventures within existing businesses or markets.
• Decisions that may change the way existing ventures and projects are run.
• Decisions on how best to deliver a service that is necessary for the business to
run smoothly. ¨
• Put in broader terms, every choice made by a firm can be framed as an
investment.
Example
• ADAG Group building Theme Park in Maharashra
• New Coal mine for Adani Enterprises Ltd
• Tata Neu
• Acquisition of Harman by Tata Motors Ltd
What should the return on project be
compared to?
• a. The riskfree rate of 6.75% (T. Bond rate)
• b. The cost of equity for ADAG as a company (11.52%)
• c. The cost of equity for ADAG theme parks (10.09%)
• d. The cost of capital for ADAG as a company (10.81%)
• e. The cost of capital for ADAG theme parks (09.61%)
• f. None of the above
Discounted cash flow measures of return
• Net Present Value (NPV): The net present value is the sum of the present
values of all cash flows from the project (including initial investment).
• NPV = Sum of the present values of all cash flows on the project, including the
initial investment, with the cash flows being discounted at the appropriate
hurdle rate (cost of capital, if cash flow is cash flow to the firm, and cost of
equity, if cash flow is to equity investors)
• Decision Rule: Accept if NPV > 0
• Internal Rate of Return (IRR): The internal rate of return is the discount rate
that sets the net present value equal to zero. It is the percentage rate of
return, based upon incremental time-weighted cash flows.
• Decision Rule: Accept if IRR > hurdle rate
Closure on Cash Flows
• In a project with a finite and short life, you would need to compute a salvage
value, which is the expected proceeds from selling all of the investment in the
project at the end of the project life. It is usually set equal to book value of fixed
assets and working capital
• In a project with an infinite or very long life, we compute cash flows for a
reasonable period, and then compute a terminal value for this project, which is
the present value of all cash flows that occur after the estimation period ends..
• Assuming the project lasts forever, and that cash flows after year 10 grow 2% (the
inflation rate) forever, the present value at the end of year 10 of cash flows after
that can be written as:
• Terminal Value in year 10= CF in year 11/(Cost of Capital - Growth Rate)
• =715 (1.02) /(.0846-.02) = $ 11,275 million
Some new securities at first sight are difficult to categorize as either debt or equity. To check where on the
spectrum between straight debt and straight equity these securities fall, answer the following questions:

• 1. Are the payments on the securities contractual or residual?

• If contractually set, it is closer to debt.
• If residual, it is closer to equity.
• 2. Are the payments tax-deductible?
• If yes, it is closer to debt.
• If no, if is closer to equity.
• 3. Do the cashflows on the security have a high priority or a low priority if the firm is in financial trouble?
• If it has high priority, it is closer to debt.
• If it has low priority, it is closer to equity.
• 4. Does the security have a fixed life?
• If yes, it is closer to debt.
• If no, it is closer to equity.
• 5. Does theownerofthesecuritygetashareofthecontrolofmanagementofthefirm?
• If no, it is closer to debt.
• If yes, it is closer to equity.
Types of equity

• 1. Owner’s Equity

• 2. Venture Capital and Private Equity

• 3. Common Stock
Types of Debt

• 1. Bank Debt

• 2. Bonds

• 3. Leases
Private Firm Expansion: Raising Funds from Private Equity

• Provoke equity investor’s interest:

• Valuation and return assessment:

• Structuring the deal:

• Postdeal management:

• Exit:
The Underpricing of IPOs: A Behavioral Perspective

• Stable buyers

• The impresario hypothesis

The Costs of Debt

• Debt Increases Expected Bankruptcy Costs

• Debt Creates Agency Costs
• The potential for disagreement between stockholders and bondholders can show up in as real costs in two
ways:
• 1. If lenders believe there is a significant chance that stockholder actions might make them worse off, they
can build this expectation into higher interest rates on debt.
• 2. If bondholders can protect themselves against such actions by writing in restrictive covenants, two costs
follow:
• a. the direct cost of monitoring the covenants, which increases as the covenants become more detailed and
restrictive.
• b. the indirect cost of lost investments, because the firm is not able to take certain projects, use certain types
of financing, or change its payout; this cost will also increase as the covenants becomes more restrictive.
HOW FIRMS CHOOSE THEIR CAPITAL STRUCTURES

• Financing Mix and a Firm’s Life Cycle

• Financing Mix Based on Comparable Firms

• Following a Financing Hierarchy

Dividend Decision