Corporate Finance 1

Corporate FinanceCorporate Finance

KHALID AZIZKHALID AZIZ0322-33857520322-3385752

2Corporate Finance

Corporate Finance addresses the following three questions:

1.What long-term investments should the firm engage in?

2.How can the firm raise money for the required investments?

3.How much short-term cash flow does a company need to pay its bills?

3Corporate Finance

The Balance-Sheet Model of the Firm

Current Assets

Fixed Assets

1 Tangible

2 Intangible

Total Value of Assets:

Shareholders’ Equity

Current Liabilities

Long-Term Debt

Total Firm Value to Investors:

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The Balance-Sheet Model of the Firm

Current Assets

Fixed Assets

1 Tangible

2 IntangibleShareholders’

Equity

Current Liabilities

Long-Term Debt

What long-term investments should the firm engage in?

The Capital Budgeting Decision

(Investment Decision)

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The Balance-Sheet Model of the Firm

How can the firm raise the money for the required investments?

The Capital Structure Decision

(Financing Decision)

Current Assets

Fixed Assets

1 Tangible

2 IntangibleShareholders’

Equity

Current Liabilities

Long-Term Debt

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The Balance-Sheet Model of the Firm

How much short-term cash flow does a company need to pay its bills?

The Net Working Capital Investment Decision

(Financial Decision)

Net Working Capital

Shareholders’ Equity

Current Liabilities

Long-Term Debt

Current Assets

Fixed Assets

1 Tangible

2 Intangible

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Capital Structure

The value of the firm can be thought of as a pie.

The goal of the manager is to increase the size of the pie.

The Capital Structure decision can be viewed as how best to slice up a the pie.If how you slice the pie affects the size of the pie, then the capital structure decision matters.

50% Debt

50% Equity

25% Debt

75% Equity

70% Debt

30% Equity

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Cash flowfrom firm (C)

The Firm and the Financial Markets

Tax

es (D)

Firm

Government

Firm issues securities (A)

Retained cash flows (F)

Investsin assets(B)

Dividends anddebt payments (E)

Current assetsFixed assets

Financialmarkets

Short-term debt

Long-term debt

Equity shares

Ultimately, the firm must be a cash generating activity.

The cash flows from the firm must exceed the cash flows from the financial markets.

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Financial Markets

• Primary Market– When a corporation issues securities, cash flows from

investors to the firm.– Usually an underwriter is involved

• Secondary Markets– Involve the sale of “used” securities from one investor

to another.– Securities may be exchange traded or trade over-the-

counter in a dealer market.

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Financial Markets

FirmsInvestors

Secondary Market

money

securitiesSueBob

Stocks and Bonds

Money

Primary Market

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Financial Markets Financial Institutions Financial Instruments

Financial Institutions

(Banks)

Primary market

Secondary market

Consumers (Savers)

Firms (Spenders)

Financial Markets

CD’s $

$ $

$

exchange ownership

Short term Long term

Stocks & Bonds

Stocks & Bonds

real investment

Loans

$

Investment Environment

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Investment＝Activities that sacrifice present consumption for

future (uncertain) rewards.

Riskless Investment: (1) the asset is default-free.

(2) the maturity of the asset matches the investment horizon of the investor.

represented by dollar returns represented by the rate of return

Riskless Investment deals with the time value of money

$100 $110 10%

Two Elements of Investment: Time and Risk

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Risky Investment and Capital Budgeting

H o l d i n g P e r i o d R a t e o f R e t u r n r t + 1 ＝t

1tt1t

P

DPP

T h e C a p i t a l B u d g e t i n g D e c i s i o n = > H o w t o c h o o s e i n v e s t m e n t p r o j e c t s ?

$ 8 0

$ 9 0

$ 1 0 0

$ 1 3 0

$ 1 4 0

$ 1 0 0

- 2 0 %

- 1 0 %

0 %

3 0 %

4 0 %

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• The basic feature of a debt is that it is a promise by the borrowing firm to repay a fixed dollar amount of by a certain date.

• The shareholder’s claim on firm value is the residual amount that remains after the debtholders are paid.

• If the value of the firm is less than the amount promised to the debtholders, the shareholders get nothing.

Capital Structure :Debt and Equity

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Debt and Equity as Options

$F

$F

Payoff to debt holders

Value of the firm (X)

Debt holders are promised $F. If the value of the firm is less than $F, they get the whatever the firm if worth.

If the value of the firm is more than $F, debt holders get a maximum of $F.

$F

Payoff to shareholders

Value of the firm (X)

If the value of the firm is less than $F, share holders get nothing.

If the value of the firm is more than $F, share holders get everything above $F.

Algebraically, the bondholder’s claim is: Min[$F,$X]

Algebraically, the shareholder’s claim is: Max[0,$X – $F]

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Combined Payoffs to Debt and Equity

$F

$F

Combined Payoffs to debt holders and shareholders

Value of the firm (X)

Debt holders are promised $F.

Payoff to debt holders

Payoff to shareholders

If the value of the firm is less than $F, the shareholder’s claim is: Max[0,$X – $F] = $0 and the debt holder’s claim is Min[$F,$X] = $X.

The sum of these is = $X

If the value of the firm is more than $F, the shareholder’s claim is: Max[0,$X – $F] = $X – $F and the debt holder’s claim is:

Min[$F,$X] = $F.

The sum of these is = $X

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Corporate Governance Separation of Ownership and Control

Board of Directors

Management

AssetsDebt

Equity

Shareholders

Debtholders

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Asymmetric Information and Agency Costs

• There is asymmetric information between shareholders and managers.

• How to induce managers to act in the shareholders’ interests ?– The shareholders can devise contracts that align the incentives

of the managers with the goals of the shareholders.

– The shareholders can monitor the managers behavior.

• (Agency Cost) This contracting and monitoring is costly.

19Corporate Finance

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FINANCIAL ACCOUNTING,COST ACCOUNTING, ECONOMICS & STATISTICS:

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