Corporate Finance: Principles and Practices

Posted on Feb 24, 2025 in Business Administration and Management (BAM)

Corporate Finance: Principles and Practices

Corporate Finance encompasses every decision a business makes, as each decision has financial implications. Marketing, Sales, Branding, and Accounting are integral parts of a larger picture: corporate finance.

Characteristics

  • Assets: Items or rights owned by the company.
    • Assets in Place: Existing investments (e.g., buildings, factories).
    • Growth Assets: Future growth opportunities (e.g., acquiring another company). Calculated as (Debt + Equity) – Assets.
  • Liabilities: Obligations, categorized as debt or equity.
    • Debt: Borrowed money, prioritized in payments and bankruptcy claims, but with limited company control (e.g., bank loans). Calculated from total liabilities.
    • Equity: Owner’s investment, with more management power but residual claims (e.g., capital). Calculated by multiplying share price by the number of shares.

Three Principles of Corporate Finance

The primary goal of a firm is to maximize the value/price of its stock and the wealth of its stockholders.

  • The Investment Decision/Principle: Invest in assets only if the return exceeds a minimum acceptable hurdle rate.
    • Hurdle Rate: Reflects the investment’s risk and the mix of debt and equity used.
    • Return: Considers the magnitude, timing of cash flows, and all side effects. Ensure more money comes in than goes out, and receive payments before making them.
  • The Financing Decision/Principle: Determine the optimal mix of debt and equity to maximize the firm’s value.
    • Understand the magnitude and value of assets.
    • Consider time characteristics: whether assets are long-term or short-term to manage debt repayment.
  • The Dividend Decision/Principle: Serve stockholders by maximizing firm value. Return money to investors if suitable investment opportunities are lacking.

Key Characteristics of Corporate Finance

  1. Common Sense: Apply logical reasoning (e.g., finance at 6% instead of 9%).
  2. Focus: Maximize the firm’s value as the primary objective.
  3. Know Your State in the Life Cycle: Understand the company’s stage.
  • Mature Company: Value based on existing investments (dividends, debt-equity mix, significant assets).
  • Growth Company: Value based on future investments (no dividends, high equity, fewer assets).
Universal: Applicable to all types of businesses. Follow the Principles: Adherence to core principles is crucial for success.

Main Goal

Maximize stock price. While not the only goal, it is the primary one, reflecting the overall aim of maximizing firm value.

Relationships

Stockholders – Managers

Stockholders exert control over managers through:

  • Annual Meeting: Proxy votes protect managers if not all shareholders attend, potentially leaving managers with a majority of shares. The board of directors is also selected.
  • Board of Directors: Ideally controls the CEO, but often the CEO influences board selection. The board should ideally consist of no more than 10 members.

When power shifts from stockholders to managers, managers may prioritize their interests. They might engage in:

  • Greenmail: Offering a higher price than a hostile takeover to retain their positions.
  • Golden Parachutes: Adjusting contracts to protect managers during hostile takeovers.
  • Poison Pills: Acquiring cash flow rights to defend against hostile takeovers.
  • Shark Repellents: Anti-takeover amendments requiring approval at the annual meeting, often controlled by the CEO.
  • Overpaying in Takeovers: Acquisitions driven by the CEO’s ego rather than sound financial reasoning.
  • Hostile Takeover (OPA): A competitor attempts to acquire a company against the managers’ wishes, who may then obstruct the acquisition.

Managers – Bondholders

If banks lend without protection, companies might increase debt to boost stock value, raising the hurdle rate, which is detrimental to the initial lender. In bankruptcy, lenders may not recover their funds.

Managers – Society

Social costs, like pollution, are significant factors.

Managers – Financial Markets

Markets react strongly to bad news, often irrationally, due to misleading or delayed information from companies. Small companies rely heavily on trust for financing.

Note: Prior to analyzing financial figures, assess who controls the company, as the CEO’s actions significantly impact shareholders.

Reality: Solutions to Problems

  1. Different Governance: Assign oversight of managers to other entities.
  2. Different Objective: Choose an objective other than maximizing firm value, such as maximizing growth or sales. These should be temporary goals.
  3. Reduce Potential Problems: The most effective approach. Markets self-correct over time.
  • Stockholders – Managers: Imperial managers may eventually face proxy challenges or hostile acquisitions.
  • Managers – Bondholders: Lenders now impose special conditions and clauses to prevent excessive debt acquisition.
  • Managers – Financial Markets: Stock prices collapse when companies are dishonest, damaging credibility even when performance improves. Growth companies should maintain transparency.
  • Managers – Society: Companies exceeding social cost limits often face societal backlash (e.g., tobacco companies).