Introduction to Corporate Finance Financial Policy and Planning

Outline Meaning of Financial Management Meaning of Corporate Finance Significance Goal of a Firm Motivating Management

Meaning of Corporate Finance Corporate finance can be defined as a body of knowledge that deals with the following three issues: What long-term strategic investments a firm should undertake? What long-term strategic financing alternatives that a firm should use to raise capital to finance its long-term strategic investments? How much short-term cash flow does a company need to ensure smooth day-to-day operations of the firm?

Long-term strategic investments decisions are also known as the capital budgeting decisions of the firm. Long-terms strategic financing decisions involve a decision on mix of debt and equity financing for the company and are known as capital structure decisions Dividend policy decisions also fall into this category. Management of short-term cash flows relates to working capital management.

The above-mentioned three issues are discussed and analyzed within the basic framework of time value of money and principles of risk and return. Moreover, financial statements analysis helps the management in moving towards the right path in the interests of the shareholders. Thus, we can define corporate finance as a study of the principles, policies, and institutions that shape corporate financial decisions

Why Financial Management is an Important? There are financial implications of virtually all business decisions and non-financial executives must know enough finance to work these implications into their own specialized analyses Lack of understanding of basic principles of finance may have disastrous implications for a firm Eastern Airline filed for bankruptcy partially due to lack of understanding of financial implications of its decisions.

Goal of Firm in a Corporate Form of Organization Separation of ownership from management in a company form of organization Owners (shareholders) elect the management (board of directors) Management is in an agency relationship to shareholders Given that management is managing the firm on behalf of the shareholders, what should be the goal of a firm? Should it be maximization of sales revenue? Should it be minimization of costs? Should it be maximization of employee welfare? Should it be maximization of society welfare? Should it be maximization of customer satisfaction?

Goal of a Firm? The overall goal should be maximization of owners’ welfare It also means maximization of shareholder wealth Shareholder wealth is maximized through market price per share maximization It is also consistent with maximization of profits at a given level of risk

How to Ensure the Management Acts in Shareholders’ Interest? Managerial Incentives Performance-based Incentive Plans Executive Stock Option Plans Performance Shares Direct Intervention by Shareholders The Threat of Firing The Threat of Hostile Takeover

Performance-based incentive Plans Firms are increasingly linking managerial compensation to the firm’s performance by instituting performance-based incentive plans Stock options allow management to purchase pre-designated number of shares at some time in the future at a predetermined price. The stock options will have value only if the market price of the stock rises above the exercise price of the option. This serves as an incentive to the management to take actions that would ensure growth of stock price through comparison with competitors.

Performance shares are shares of stock given to executives on the basis of performance as defined by objective measures such as earnings per share, return on assets, return on equity, and so forth. Managerial performance may also be judged in a relative sense Other methods of motivating top management: Kodak requires its top executives to invest one to four times the base salary in Kodak shares GM requires top executives to hold GM common stock equivalent in market value to the manager’s annual salary Xeros, Union Carbide, and Hershey Foods also require top executives to invest in the common stock of the firm

Direct Intervention by Shareholders Direct intervention more easy now with institutional ownership of shares Shareholders being the ultimate owners can force management to act in their best interests or risk losing the job Lockheed’s CEO Daniel Tellep had to adopt shareholders’ proposals that made the company an attractive target for takeover. This resulted in Lockheed Martin in Institutional investors who owned 46% stake played a key role.

Threat of Firing Of course, shareholders can remove the existing management by voting them and with institutional investors this threat has become a reality. American Express, Goodyear, GM, IBM, Apple have lost their CEOs at some point due to shareholders’ unhappiness

Threat of Hostile Takeover Hostile takeover is a takeover of a firm against the wishes of existing management. Hostile takeovers are most likely to occur when a firm’s stock is undervalued relative to its potential due to poor management. RJR Nabisco was the target of hostile takeover by KKR group IBM initial bid for Lotus Development Corporate was hostile Oracle bid for Peoplesoft Can management prevent hostile takeovers?