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CORPORATE FINANCE4 Principles of corporate finance
• What long-term investments should the firm take on?
o The Investment Principle (Does the investment decision add value to the
firm?
• Where will we get the long-term financing to pay for the investment?
o The Financing Principle (make a decision about using Debt or Equity)
• How will we distribute returns to shareholders?
o The Dividend Principle (how much to re-invest and how much to give to
shareholder)
• How will we manage the everyday financial activities of the firm?
o Management / Ownership principle (agency problem)
All of these decisions are analysed on the basis of how much value they add to the firm
1. The Investment Principle
Firms should invest in assets that earn a return greater than the minimum
acceptable hurdle rate.
➢ Hurdle rate: the investment must be greater than a return that the firm
could get on any other investment
➢ E.g.) if you can get 10% on money market or you buy factory and get 8%
, then you should not buy the factory
➢ Your investment must provide a return greater than you “next best”
investment
The hurdle rate should consider:
➢ The mix of financing sources used to fund the investment (weighted
average of costs)
➢ The risk of the investment – informs us on the cost of financing which
gives us a hurdle rate of the return
As an alternative to the weighted cost of financing, only the cost of equity can be
used as a basis for the hurdle rate, when:
➢ Returns are measured after debt payments
Best measure of investment return is based on time-weighted cash flows (+ / -).
➢ Earlier cash flows weighted moreand later cash flows less. If you value 100
today, its value will decrease the further out you go and the
less valuable the cash flow will be
, ➢ DCF – discount the cash flow based on the risk that is a assumed using the
discount rate
Consider side costs and side benefits (extra ordinary items)
➢ incorporate either into cash flows and returns overtime – can be very
difficult as you must consider idle capacity or patents (or)
➢ value all the components separately, if they are options
• The investment principle applies to all types of investments
➢ projects / infrastructure
➢ investments in foreign markets
➢ cash and marketable securities
➢ investments in short-term assets
➢ acquisitions
2. The Financing Principle
Ultimately two sources of funds – debt & equity
➢ claim on cash flows (Debt holders have the 1st claim on the company and
then equity holders)
➢ tax deductibility (more equity will lose tax deductibility)
➢ Control (if company has too much debt then the debt holders have more
control if they have collateral on assets of the company and limits the use of
these assets by the company)
Choice between debt and equity
➢ a trade-off
➢ optimal mix
➢ value of the firm is maximised
➢ Whether & how firms should move to the optimal?
➢ Value of financial flexibility and control
Optimal type of financing for a firm
➢ has cash flows similar to those generated by the firm’s assets (we want the
cash flow from the asset to finance the debt obligations)
➢ After deciding to invest in the asset, we must now decide how we are going t
finance the asset
, 3. The Dividend Principle
Firms that do not have sufficient investments generating returns higher than the
hurdle rate should return the excess cash to the owners
➢ dividends tend to be sticky and lag earnings (they are lower than earnings as
firm cannot pay out all earnings)
➢ share buybacks as an alternative to dividends (do it on a once off basis)
Once the firm pays the dividend, they create an expectation for future dividends to
be paid.
Once the dividend goes up, a reduction in the dividend will be viewed by the market
negatively (i.e. cash flow issues)
4. The Management Principle
What should be the goal of a corporation? (maximizing shareholder value)
➢ Maximize profit?
➢ Minimize costs?
➢ Maximize market share?
➢ Maximizing firm size?
➢ Maximizing EVA
➢ Maximize value of the company?
➢ Maximize the current value of the company’s shares?
These are intermediate objectives
➢ if they are correlated with the long-term health and value of the company
they work well
➢ if they are not, then there are serious problems
Possible problems that could arise
Agency relationship
➢ Principal hires an agent to represent their interest
➢ Shareholders (principals) hire managers (agents) to run the company nut
manager does not always act in the best interest of the shareholder but
rather for themselves.
➢ Agency problem
, ➢ Conflict of interest between principal and agent
Management goals and agency costs – is the cost/benefit going to be positive or
negative for the shareholder
Could be an agency problems between employees, customers and other
stakeholders
Why do we focus on share prices in practice?
Stock price is easily observable and constantly updated – something to relate to
If markets are efficient with all that that entails, stock prices reflect correct
valuations
What you are prepared to pay today for a share is an indication of what you value
the company at today
Possible Reasons:
1. The managers of the firm put aside their own interests and focus on maximizing
stockholder wealth.
• This might occur either because they are terrified of the power stockholders
have to replace managers
• they own enough stock in the firm that maximizing stockholder wealth
becomes their objective as well.
2. The lenders to the firm are fully protected from expropriation by stockholders.
• that stockholders will not take any action that hurts lenders now if they feel
that doing so might hurt them when they try to borrow money in the future.
• lenders might be able to protect themselves fully by writing covenants
proscribing the firm from taking any action that hurts them.
3. The managers of the firm do not attempt to mislead or lie to financial markets
about the firm’s future prospects
• We hope that info the company gives us is reliable
4. There is sufficient information for markets to make judgments about the effects on
value.
• We believe in market efficiency
5. There are no social costs or social benefits.
• All costs created by t firm in its pursuit of maximizing stockholder wealth can
be traced and charged to the firm. With these assumptions, there are no side
costs to stock price maximization.
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