EC384 Corporate Finance

1. EC384 Corporate Finance Lecturer: Sule Alan (salan@essex.ac.uk) Office Hours: Tuesdays 11:00 – 12.00 Room: 5B.120 Textbooks: Brealey, Myers and Allen, “Corporate Finance”

2. What is Corporate Finance? • The Theory of Corporate Finance studies the financial decisions of corporations. • Corporations are companies with public traded shares or public companies. • Two broad type of financial decisions: • What investments should a firm undertake? • How should it pay for those investments?

3. The Role of the Financial Manager • The Financial Manager or Chief Financial Officer (CFO) is responsible for taking • Investment decisions: which projects to finance, in which countries, etc. • Financing decision: combinations between equity and debt. • He / she stands between the firm’s operations and the financial market.

4. (2) (1) Financial Firm's Financial (4a) manager operations markets (4b) (3) (1) Cash raised from investors (2) Cash invested in firm (3) Cash generated by operations (4a) Cash reinvested (4b) Cash returned to investors

5. The Importance of CFO • The importance of the CFO increased during the 90's. • This is due to many financial developments in that period. • For example the 90's saw the emergence of “complicated” financial instruments such as: CMO's (Collateralized mortgage obligations), IO (interest only bonds), PO (principal only bonds), PAC, TAC, IOetters, etc.

6. The Separation of Ownership and Control • The shareholders are ultimately responsible for the company. • However, they are not involved in the management of the company. • The Board of Directors monitors management on behalf of the shareholders. • It is meant to define and approve major business decisions and corporate strategies, executive compensation, risk management and audits.

7. Maximizing the Firm’s Profits • The shareholders objective is to maximize the value of the firm; i.e. maximize profits. • To do this, the financial manager needs to search for suitable investment opportunities. • That is, how does a CFO decide whether it is worthwhile investing in a project? • To answer this question, we need to define the concept of net present value.

8. Introduction to Present Value • Basic principal: one pound today is worth more than a pound tomorrow. • What is the value today of £120 to be received one year from now? • To calculate the present value we need to discount the expected payoff by the rate of return offered by an equivalent investment alternative in the capital market.

9. Introduction to Present Value • This rate of return is called the opportunity cost of capital. • The opportunity cost of capital can include risk. • The opportunity cost of capital for an investment project is the expected rate of return demanded by investors in common stocks or other securities subject to the same risk of the project.

10. Introduction to Present Value • Suppose that the opportunity cost of capital is given by 5% per year. • The present value of £120 is then given by PV = discount factor x 120 PV = [1/(1+0.05)]x120 PV = 114.3 • Let the expected payoff of a project be £120 a year from now.

11. Introduction to Present Value • The present value of this project is also its market price. • Investors will be willing to buy the investment from you in a years time at £120 and hence are willing to buy it today for £114.3. • If this project has an initial cost of £100, the net present value is NPV = PV - C = 14.3

12. Introduction to Present Value • Note that the NPV is positive and the return of the project is higher than the opportunity cost of capital. Return = profit/investment Return = (120-100)/100 Return = 20% > 5% • Decision rule to undertake a project: • NPV >0 • Rate of return > opportunity cost of capital

13. Introduction to Present Value • In the case of a multi-period investment, the present value is given by PV = ΣCt / (1+rt)t , where Ct and rt are the project’s cash flow and opportunity cost of capital at each point t in time. • The sequences of rt is called the term structure of interest rates. • The Net Present Value in this case is given by NPV = -C0 + PV, where C0 is the initial cash flow.

14. Maximizing Profits = Max NPV • Investing in a project with positive net present value increases the shareholders wealth. • Assuming the existence of a well-functioning, competitive capital market, the shareholder can borrow against his future profit and is able to increase consumption today or in the future.

15. Maximizing Profits = Max NPV • A project with positive NPV increases inter-temporal consumption and utility Ctom Inter-temporal Budget constraint with new project A B U1 U0 Cnow

16. Maximizing Profits = Max NPV • A competitive capital market is crucial! • A competitive capital market is one in which there is no opportunity for arbitrage. • There are no further gains from trade in competitive capital markets. • Evidence suggest that capital markets function fairly well.

17. Maximizing Profits = Max NPV • Shareholders want three things: • Maximize current wealth • Smooth consumption patterns • Choose the risk plan of that consumption plan • The last two targets can be achieved through a competitive capital market. • The Shareholders need the CFO / CEO to help them achieve wealth maximization. • This is done by maximizing the NPV of the firm’s investment projects.

18. Principal-Agent Problems • What if managers’ and owners’ objective differ? • We can view the relation between the shareholders and the managers as a principal-agent relation. • Shareholders are the principal • Managers are the agent • Shareholders want managers to maximize the value of the firm (profit maximization). • Managers may have a different objective. • Agency costs: monitoring and influencing actions.

19. Moral Hazard • A moral hazard situation arises when the principal cannot observe the actions of the agent. • Examples: • Insufficient effort: inefficient allocation of work time to various tasks. • Extravagant investments: pet projects and/or building empires to the detriment of shareholders • Entrenchment strategies: actions taken to secure positions. • Self-dealing: consumption of perks, pick successors, select costly suppliers or finance political parties.

20. Managerial Incentives • Managerial incentives and the firm’s interest are align through explicit and implicit incentives. • Explicit or Monetary incentives: • The compensation package: salary (fixed) and bonus, stocks and stock options (incentive components). • Performance measures can be quite imperfect.

21. Managerial Incentives • Bonus based compensation packages create a strong incentive for the short term instead of the long term. • This trade-off arises when making decisions of subcontracting, marketing, maintenance and investment. • Stock based incentives create a stronger preference for the long term. • Bonuses and stocks options are complements. An increase in short term incentives must be accompanied with an increase in long term incentives.

22. Managerial Incentives • Implicit incentives: • Poor performance may induce the BoD to fire the CFO. • Poor performance may end up in a takeover, bankruptcy or reorganization. • Explicit and implicit incentives are substitutes. • Stronger implicit incentives imply less explicit incentives to curb moral hazard.

23. Debt as an Incentive Mechanism • Debt puts pressure on managers by taking cash out of the firm and prevents them to “consume” it. • Debt incentivizes as managers must take into account their future obligations to repay on time. • Under financial distress, creditors can take over the control rights of the firm by forcing it into bankruptcy.

24. Course Objectives • Analyze these and related issues in more detail, providing a strong economic intuition. • In particular, I would like to address the following: • Should the firm finance its operations through debt or equity? • How does the debt structure of a firm affect incentives? • How should investors be repaid?