Corporate Finance and Strategy: Introduction and objective

1. What is corporate finance?

- Every decision that a business makes has financial implications and any decision that affects the
finances of a business is a corporate finance decision
- E.g. Marketing, accounting and information systems, OB, corporate strategy, production and
operations management

2. The financial view of the firm (Assets and Liabilities)

- All elements are recorded at market values (cash flows that these assets are expected to generate and
the uncertainty associated with these cash flows)
(a) Assets in place
- Existing investments that generate cash flows today
(b) Growth assets
- Expected value that will be created by future investments
- Growth potential/opportunities
- Very important to growth firms
(c) Debt
- Fixed claim on cash flows, but with little or no role in management
- Fixed maturity and tax deductible
- Growth firms prefer equity to debt due to the risk of going bankrupt and losing growth potential
(growth assets)
(d) Equity
- Residual claim on cash flows with significant role in management
- Perpetual lives (long-term liability)
- Cost of equity is greater than cost of debt since equity holders demand more return for higher risk

3. First principles of Corporate Finance

- Objective: Maximise the value of the business
- Firm value: Determined by how it manages its existing assets and also how well it invests in new
assets.
- Investors base decisions about the firms future based on the quality of the firms projects
(investment decision) and the amount of earnings it reinvests (dividend decision). The financing
decision affects the firm value through creation of a hurdle rate.
- Violating first principles will lead to huge costs. Almost every corporate disaster or bubble has its
origins in a violation of first principles.

(1) The Investment decision

- Invest in assets that earn a return greater than the minimum acceptable hurdle rate
- The hurdle rate reflects the riskiness of the investment and whether the money is raised from debt or
equity, and what returns one could have made by investing elsewhere on similar investments
- The return should reflect the magnitude and the timing of the cash flows, and all side effects
- If the side effects cannot be dollarized, they will have to be ignored (e.g. will options, strategies)
(2) The Financing decision
- Find the right kind of debt for the firm and the right mix of debt and equity to maximise the value of
the investments made
- Firstly, choose a mix of debt and equity. Debt is beneficial due to its tax deductibility.
- Secondly, choose a suitable type of debt. There can be short/long term debt, in different currencies,
with call options etc.
- The firm should try to match the characteristics of the financing as closely as possible to the
characteristics of the assets
(3) The Dividend decision
- If you cannot find investments that make your minimum acceptable rate, you return the cash to
owners of your business
- The decision on how much to reinvest and how much to return to owners (for them to reinvest
elsewhere) is the dividend decision
- How much cash you can return depends upon current and potential investment opportunities
- How you choose to return depends on whether they prefer dividends or buybacks (stock
repurchases)

4. The objective in decision making

- Maximise firm value
- Narrower objective: Maximise stockholder wealth
- If markets are efficient: Maximise stock price
- The objective function should be clear and unambiguous, come with a clear and timely measure
(unambiguous on how to measure the objective), and should not create costs for other entities (e.g.
social costs)
- In a utopian world, maximising stock price will maximise firm value because stock prices will
reflect stockholder wealth and no other group is hurt:
(a) Stockholders hire managers to run their firms for them and because these stockholders have the
power to hire and fire managers (Board of Directors and Annual meetings), managers will set aside
their interests and maximise stock prices
- Alignment of interests may be due to fear of stockholders or because management holds enough
stock in the company

(b) Managers will reveal information honestly and on time, so markets are efficient and stockholders
wealth is maximised
(c) Bondholders are fully protected from stockholder actions, hence they lend money to firms to
maximise firm value (based on optimal financing decision)
- Stockholders may be concerned about the firms reputation if they take actions that hurt lenders and
the damage for future borrowing, or bondholders may have covenants to protect themselves
(d) Because social costs can easily be traced to the firm, the firm does not create any burdens for
society
- However, agency costs may form due to conflict of interests among stockholders, managers,
bondholders and society which may result in the objective function of stock price maximisation going
awry

5. Stockholders vs Managers: Limitations of current measures

(1) The annual meeting
- Supposedly, the stockholders can change the board of directors, and through them, change the
incumbent management at the annual meeting
- However, the power of stockholders to act at annual meetings is diluted due to:
(a) Most small stockholders do not go for meetings because the cost of going to the meeting exceeds
the value of their holdings
(b) Proxy forms are usually not returned as small stockholders may not know enough about how
good/bad the management is, hence incumbent management start off with a clear advantage as proxies
that are not voted become votes for the incumbent management
(c) Large stockholders choose to vote with their feet when they are dissatisfied with management.
This means that they simply sell the stock and move on. (However, there is a trend towards activism)
- Also, institutional investors tend to go along with incumbent managers as they like the managers or
are committing something under the table (e.g. exchange of information for votes), or want to keep
good relations with the managers to avoid decisions made by management that could affect them
negatively
- The bottom line is that the annual meeting is not a good disciplinary mechanism
(2) Board of Directors
- Supposedly, the board of directors fiduciary duty is to ensure that managers serve, and look out for
the interests of the stockholders
- However,
(a) The CEO often hand-picks directors.
- Hence although most directors are outsiders, they are not independent if the CEO has a major say on
who serves on the board
(b) Many directors only hold token stakes in the equity of their corporations
- Hence their interests are not aligned with the stockholders since it will be difficult for them to
empathize with the plight of stockholders when prices go down

(c) Many directors are CEOs/directors of other firms

- They cannot spend much time on their fiduciary duties
- Potential conflict of interest (You challenge me at my meeting, Ill challenge you at yours)
(d) Lack of expertise
- On the companys internal workings, accounting rules etc
- The bottom line is that the board of directors is not a good disciplinary measure
- Example: Disney 1997 had a bad board of directors
(1) Too many insiders (current and ex-employees) who would not want to challenge the CEO
(2) The CEO and chairman were the same person hence there was no challenging regarding issues to
discuss during the meeting
(3) Large boards are not efficient since it is hard to get a consensus during decision making
(4) Some directors had bad reputations
(5) Not independent: Connected based on school of the CEOs kids, personal lawyer etc
- Calpers Tests for Independent Boards
(1) Are a majority of the directors outside directors?
(2) Is the chairman of the board independent of the company? (E.g. He is not the CEO)
(3) Are the compensation and audit committees composed entirely of outsiders?

6. Stockholders vs Managers: Consequences of stockholder powerlessness

- When managers do not fear stockholders, they will often put their interests over stockholder interests
instead of maximising stockholder value
- Managers choose to avoid hostile takeovers even if it means that the stockholders are getting a good
deal, as this would cost them their jobs (see (1) to (4))
- For (1)-(3), only directors approval is required while for (4), stockholders approval is required
- Other ways managers can make stockholders worse off are by investing in bad projects, taking up
too much or too little debt and overpaying on a takeover
(1) Greenmail
- The managers of a target firm of a hostile takeover choose to buy out the potential acquirers
existing stake, at a price much higher than the price paid by the raider, in return for the signing of a
standstill agreement
(2) Golden parachutes
- Provisions in employment contracts that allows for the payment of a lump sum or cash flows over a
period (using shareholders money) if managers lose their jobs in a takeover
(3) Poison pills

- A security where rights or cash flows are triggered by an outside event, generally a hostile takeover.
The objective is to make it difficult and costly to acquire control (e.g. issue new shares to existing
shareholders except for the new bidder to halve his value)
(4) Shark repellents
- Anti-takeover amendments that require stockholder assent
- E.g. Super-majority amendment where an acquirer needs to acquire more than the usual 51% shares
to take over the firm
- Give managers larger bargaining power and may work in the interest of shareholders if managers
bargain for higher prices to be paid for shares
(5) Overpaying on takeovers
- Acquisitions often are driven by management interests rather than stockholders interests
- Quickest and most decisive way to impoverish stockholders
- Usually takeovers are not successful for the bidding firm (but may be successful for the target firm)
and stock prices of bidding firms usually decline on the takeover announcements
- Mergers usually do not work (affect future cash flows) as the profitability of merged firms, relative
to their peer groups, do not increase significantly and a large number of mergers tend to be reversed
which is a clear indication of how unsuccessful mergers tend to be

7. Stockholders vs Managers: Other issues

- If managers are not major stockholders, there would probably be a misalignment of interests
- If government is a major stockholder, the government may force the company to pay more taxes,
force them to lower prices (e.g. for merit goods to gain favour during election) or force the company
not to outsource (leading to inefficiency)
- If institutional investors are major stockholders, it could lead to inefficiency as institutional investors
are usually passive investors that do not involve themselves in management issues
- If outside investors held only non-voting shares (preferred shares), they will have no say in the
election of the board of directors
- If a certain family of companies hold most of the shares, managers may choose to put the familys
interests above other stockholders through decisions that benefit them that may not increase the stock
price (that will benefit all)
- If influential figures (e.g. Steve Jobs) hold large amounts of shares, smaller institutional investors
may feel safer as he will whistle-blow

8. Bondholders vs Stockholders: Examples of the conflict

- Bondholders and stockholders have different objectives due to the different payoff structures
- Bondholders are concerned about safety and ensuring they get paid their claims, and tend to view the
risk in project choice more negatively as they do not get to participate in the upside if the projects
succeed

- Stockholders are more likely to think about upside potentials since they are shielded on downside
due to limited liability
- The heart of the conflict is that what is good for the stockholders (increasing share price/dividends)
may not be whats good for bondholders (reducing default risk/increasing bond price)
- Examples of conflict:
(1) The firm increases dividends significantly
- Stockholders benefit while the lenders are hurt since the firm is riskier without the cash and there
will be less cash to meet debt obligations
- Possibility of bankruptcy increases
(2) The firm takes riskier projects than those agreed to at the outset
- Lenders base their interest rates on their perceptions of how risky a firms investments are
- The higher the risk, the higher the interest rate and hence the bond price falls
(3) The firm borrows more on the same assets (uses the same assets as collateral)
- If lenders do not protect themselves, they can be hurt by firms actions
- Leveraged buyout (LBO) occurs when a bidder uses the target companys cash flows or assets as
collateral to borrow to purchase the shares (e.g. RJR Nabsico case)
- Increases risk of default, hence price of bonds fall

9. Firms vs Financial markets

- There are two problems with using stock prices as an estimate for shareholder wealth
(1) The information problem
- Managers control the release of information to the general public
- Information that is negative is sometimes suppressed or delayed by managers seeking a better time
to release it (manipulate information flow)
- Rationale: Panic trading can cause prices to change more than they should. Furthermore, firms hope
that by delaying bad news, it will either go away or be paired with future good news to release to
investors
- In some cases, firms intentionally release misleading information about their current conditions and
future prospects to financial markets in order to keep investors happy and raise market prices
- It is easier for small firms to manipulate information because of the large number of analysts
following larger firms
(2) Market inefficiency: Problem with using financial markets to evaluate performance
- Investors are irrational and prices often move for no reason at all, thus prices are much more volatile
than justified by the underlying fundamentals.
- Short-term price movements have little to do with information hence it is inaccurate to use
daily/monthly stock prices as a measure of managerial performance

- Investors (especially short-term investors) are short-sighted and do not consider the long-term
implications of actions taken by the firm (e.g. LT investment in R&D)
- Financial markets are manipulated by insiders and hence prices may not be reflective of true value

10. Firms vs Society

- A social cost or benefit is a cost/benefit that accrues to society as a whole and not to the firm making
the decision
- E.g. Environmental cost, QOL cost, creation of jobs, supporting development, creating access to
goods
- Social costs may be considerable but cannot be traced back to the firm. Also, they may not be known
at the time of the decision
- They are difficult to quantify and also person-specific, meaning that different decision-makers weigh
them differently

11. Solution 1: Choose a different objective function

- Instead of using stock price maximisation as an intermediate objective function to maximising
shareholder wealth, one may choose other objectives
- However, these other objective functions, if correlated to the long-term health and benefit of the
company, will work well. If they do not, the firm will end up with a disaster.
(1) Maximise market share
- More observable and measurable
- Assumption: Higher market share means more pricing power and higher profits
(2) Maximise profit
- Higher profits translate into higher value in the long-term
(3) Maximise revenue/size
- CEOs desire to increase the sizes of their corporate empires
(4) Maximise social welfare
(5) Maximise consumer satisfaction
- Quality products at lower price

12. Solution 2: Maximise stock price, subject to constraints

- Stock price maximisation can be rescued as an objective if we are able to figure out a way to reduce
agency costs
- The strength of stock price maximisation objective function is its internal self-correction mechanism
(groups learn from their mistakes and try to correct them in subsequent periods)
(1) Stockholders vs Managers: A more active market for corporate control

- Stockholders/institutional investors are taking part more actively during annual meetings to voice
their displeasure, monitoring companies they invest in and demanding changes
- The Icahn effect: Some individuals Billionaire Robin Hood/ Shareholders Friend specialize in
taking large positions in companies where they feel need to change their management ways and push
for changes (punish managers and help small shareholders)
- The hostile acquisition threat: The best defence against a hostile takeover is to run your firm well
and earn good returns for your stockholders
- More effective board of directors: Smaller boards with fewer insiders, directors are increasingly
compensated with stocks and options instead of cash and more directors are identified and selected by
a nominating committee rather than being chosen by the CEO
(2) Bondholders vs Stockholders: Bondholders protection/defence
- More restrictive bond covenants: restrict the firms investment policy (riskier projects transfer
wealth), dividend policy and additional leverage
- New types of bonds: Puttable bonds where the bondholder can put the bond back to the firm and get
face value if the firm takes actions that hurt them, and Ratings Sensitive Notes where the interest rate
on the notes adjusts to that appropriate for the rating of the firm
- Hybrid bonds: With an equity component so bondholders can become equity investors if they feel it
is in their best interests to do so
(3) Firms vs Financial Markets: Sceptical and punitive markets
- Analysts to provide an active market for information: Although they are more likely to issue buy
rather than sell recommendations, the payoff to uncovering negative news about a firm for their
clients that analysts is large enough since such news is eagerly sought
- Option trading becomes more common so its easier to trade on bad news and in the process, it is
revealed to the rest of the market
- Investor access to information is improved so it is getting more difficult for firms to control when
and how information gets out to markets
- When firms mislead markets, the punishment is swift and savage (market value falls by a huge
extent due to investors lack of trust in firm and negative view on future cash flows)
(4) Firms vs Society: Regulations and investors/customers backlash
- Government response: Laws and regulations
- For firms catering to a more socially conscious clientele, failure to meet societal norms can lead to
loss of business and value (e.g. flouting labour rules)
- Investors may choose not to invest in stocks of firms they view as socially irresponsible