Corporate Finance Dr. Himanshu Joshi FORE School of Management, New Delhi

Scope of Financial Management The Chief Financial officer at Boeing and the owner of a small bookstore face the same fundamental choices, though on vastly different scales. Boeing has to decide whether it should invest billions of dollars in a new Super Jumbo jet, capable of carrying 500 or more passengers. The private bookstore owner is faced with the question of whether to add a café to her book store to compete with the Barnes and Noble super store nearby.

Scope of Financial Management Boeing has to decide between raising money by issuing new stock (equity) or bonds (debt), while book store owner has to consider whether to invest her own savings (equity) or take out a bank loan (debt) to expand. Boeing has to determine how of what it makes on its current investments should be returned to its stockholders, and the private bookstore owner has to make judgment about how much she can afford to take out of her business.

Scope of Financial Management Corporate Finance provides the answers to all three of these fundamental questions for both CFO of Boeing and the private bookstore owner.

Corporate Finance and the Firm Corporate finance can be described as the study of the decisions that every firm has to make, but what is a firm? Firm is defined here to mean any business large or small, privately run or publicly traded, and engaged in any kid of operations-manufacturing, retail, or services. Thus as per definition both Boeing and Bookstore are firms.

What is common in Boeing and Bookstore They both own assets. Currently generating earnings. They have to keep investing for future, to grow and prosper. For investing into assets they have to raise money from either of the two sources: Debt or Equity.

Here distinction arises between Boeing and Bookstore, Boeing being and publicly traded firm, can issue stock and bonds in financial markets. The Small bookstore, being a private business, has fewer options. The owner can invest her own savings in business, which would be equity, or borrow from bank, which would be debt.

Functions of Corporate Finance The Investment Function The Financing Function The Dividend Function The Liquidity Management Function

The Investment Function The investment function (principle ) states simply that firm should invest in assets only when they are expected to earn a return greater than a minimum acceptable return. This minimum return, which we term as hurdle rate, should reflect whether the money is raised from debt or equity, and what returns those investing the money could have made elsewhere on similar investments.

Investment Principle Firms have scarce resources that must be allocated among competing uses. Boeing, for instance can use $5 billion to invest into a new generation of aircraft or to expand its defense contracting business. G enerate R evenue or p rofit for the firm Investments (It also include Strategic decisions like M&A) L ower c osts

Financing Function (Principle) The financing principle posits that the mix of debt and equity chosen to finance investments should maximize the value of the investments made. In the context of hurdle rate specified in the investment principle, choosing a mix of debt and equity that minimizes this hurdle rate allows the firm to take more new investments and increase the value of existing investments.

Financing Principle. Financing Various Instruments under each category of debt and equity Deciding the right Debt- Equity Mix

Debt as a source of Finance Benefits 1.Tax Advantage 2.Comparatively Cheaper than Equity Limitations 1. The firm may be unable to make payments, in which case lenders may take control of its assets

Equity as a source of finance Benefits Less risky in comparison to Debt as payment of dividend is not a legal compulsion and it is paid at flexible rate Limitations Costly if firm is earning above normal profits, because firm has to share higher profit with larger no. of shareholders which will reduce EPS

Various Instruments under each category Equity Duration of issue: Perpetual Types: Ordinary shares, preference shares, right issue, share warrants. Debt Duration: Long Term and Short Term Types: single currency vs. multiple currency Bank Financing, Bond Market

Dividend Function (Principle) Firms sometimes can not find investments that earn their minimum required return or hurdle rate. If this short fall persists, firms have to return any cash they generate to the owners.

Dividend Principle How can firms reward their owners? 1.Reinvest the owner’s funds back into new investments and increase the value of their ownership stake in the business. 2.Allow them to withdraw their funds from the business and invest them elsewhere. 3.The decision of how much to reinvest and how much to return to owners is at the core of the dividend principle.

FUNCTIONS of FINANCE FIRM r≥k FINANCING Debt vs. Equity (k) INVESTMENTS To earn minimum hurdle rate (r) Retained Earnings rk SHARE HOLDERS Dividends

Critical Thinking Question for Share Price Maximization as Objective.. Al Dunlap, who, as chief executive officer at Scott Paper, was responsible for turning the company around and making millions for stockholders, has argued that CEOs of firms should focus solely on maximizing stock prices and that the actions they take in the process enrich society as well. Under what conditions would his argument hold? Under what condition it may break down? (Adam Smith – Theory of Invisible hand)

Dividends Financing Investments Share Price