Corporate Finance Theory PDF

# Corporate Finance Theory Corporate finance theory encompasses the principles and concepts that guide financial decision-making within a corporation. It is the field that studies how businesses allocate resources and make investment decisions to maximize shareholder value. ## Capital Structure...

# Corporate Finance Theory Corporate finance theory encompasses the principles and concepts that guide financial decision-making within a corporation. It is the field that studies how businesses allocate resources and make investment decisions to maximize shareholder value. ## Capital Structure It pertains to the mix of debt and equity financing a company utilizes. It involves determining the optimal capital structure that minimizes **the cost of capital** while maximizing shareholder wealth. ## Agency Cost Theory Agency cost theory refers to the various costs and problems that arise due to mismanagement or inefficiency and give rise to conflict of interest among the company stakeholders. An agency cost is a type of internal cost that occurs when the actions of an agent (such as an executive or manager) do not align with the goals of the principal (such as shareholders or owners). These costs can be a major problem for companies of all sizes, as they can lead to decreased profits, reduced competitiveness, and even organizational failure. ### Direct Agency Costs Direct agency costs include: - Monitoring costs - Bonding costs - Residual Losses **Monitoring Costs** - These are the costs that principals incur to monitor the actions of their agents. For example, if a company hires a CEO, it may need to pay a board of directors to ensure that the **CEO** is working in the best interests of the company. **Bonding Costs** - Sometimes, the agent needs to prove their loyalty to the principal. Bonding costs are the expenses incurred when the agent takes actions to signal to the principal that they're acting in the best interests of the firm. This can take the form of financial commitments, *like posting a bond*, or non-financial gestures, such as signing a contract. **Residual Costs/Residual Losses** - Costs incurred by owners when managers make decisions that are not aligned with the firm's best interest. These losses can occur due to *managerial opportunism*, such as excessive risk-taking or pursuing personal gains at the expense of the firm. ### Indirect Agency Costs Indirect agency costs represent lost opportunities. For example, shareholders want to undertake a project that will increase the stock value. However, the management team is afraid that things might turn out badly, which might result in the termination of their jobs. ## How To Reduce Agency Costs? ### **Financial Incentives Scheme** Financial incentives help the agents by motivating them to act for the interest of the company and its benefits. The management receives such incentives when performing well on a project, or achieving the required goals. - **Profit-Sharing Scheme:** The management becomes eligible to receive a certain percentage of the company's profits as a part of the incentive scheme. - **Employee Stock Options:** A predetermined number of shares are available to be bought by the employees at a price that is usually lower than the market. ### **Non-Financial Incentives Scheme** This scheme is less prevalent than the financial incentives scheme. These are less effective in reducing agency costs when compared to the financial incentives scheme. - Non-financial rewards and recognition from peers and colleagues. - Corporate services and added benefits. - Better workspace. - Better, or improved opportunities. ## Trade-Off Model of Capital Structure Introduced by economists Franco Modigliani and Merton Miller, published in the American Economic Review in 1958, titled "The Cost of Capital, Corporation Finance and the Theory of Investment" The theory argues that companies should determine the **optimal mix** of debt and equity financing that balances the benefits and costs of each source. This takes into account factors such as: - The company's *risk profile* - *Expected future cash flows* - *The tax implications* of each source of financing. **Equity Financing** involves raising capital by selling ownership stakes in the company to investors. This can be done through: - Initial public offerings (IPOs) - Private Equity - Venture Capital. **Debt Financing** involves borrowing money from lenders or bond investors, such as banks, or other financial institutions. The borrower agrees to pay back the principal amount borrowed plus interest over a specified period of time. | Key Features | Debt Financing | Equity Financing | | --------------------------- | --------------- | ---------------- | | **Dilution** | No | yes | | **Investor Expertise** | No | yes | | **Risk of Default** | Yes | No | | **Interest Payments** | Yes | No | | **Cost of capital** | Lower | Higher | | **Tax Deductibility** | Yes | No | ## Pecking Order Theory The Pecking Order Theory, also known as the Pecking Order Model, relates to a company's capital structure. Made popular by Stewart Myers and Nicolas Majluf in 1984, the theory states that managers follow a hierarchy when considering sources of financing. According to the pecking order theory, companies follow a hierarchy when making decisions about their capital structure: - **Internal Financing or Retained Earnings:** Firms prefer to use internally generated funds to finance new projects and investments. This allows them to avoid the need for **external financing**, which requires additional transaction costs. - **Debt:** If internal financing is insufficient, firms will issue debt in some form. This can involve getting new loans from banks, or issuing bonds of some variety. Debt, as opposed to raising new equity capital, allows companies to obtain financing while avoiding giving up ownership or control. - **Equity:** Issuing new equity is *seen as a last resort* in the pecking order. This can *dilute ownership* and requires *sharing control* with new shareholders. ## Economic Value Added (EVA) Theory Economic Value Added (EVA), sometimes known as Economic Profit, is *a measure based on the Residual Income technique*. It measures the return generated over and above investors' required rate of return. EVA serves as an indicator of the profitability of projects in which a company invests. Its underlying premise consists of the idea that: 1. Real profitability occurs *when additional wealth is created for investors.* 2. That projects should *generate returns above their cost of capital*. The whole concept of this metric is based on the idea that the company's highest priority must be to *create value for its shareholders*. This "value" must be in the form of profits generated. They must exceed the cost of capital used to generate those profits. If a company's EVA is negative, it means the company is not generating value from the funds *invested into the business*. Conversely, *a positive EVA shows a company is producing value from the funds invested in it*. The EVA formula can be expressed as follows: $EVA = NOPAT - (WACC \times Invested\ Capital)$ where: - **NOPAT** = Net Operating Profit After Tax - **WACC** = Weighted Average Cost of Capital - **Invested Capital** = Shareholders' Equity + Net Debt at the beginning of the period(Alternatively, Invested Capital can be calculated by taking Total Assets minus Cash minus Non-interest Bearing Liabilities) $(WACC \times Invested\ Capital)$ * is also known as the Finance Charge*. **NOPAT** can be calculated using the following formulas: - $NOPAT = EBIT(1 - Tax\ Rate) $ - $NOPAT = OPERATING\ PROFIT \times (1 - Tax\ Rate) $ **Invested Capital** = Total Assets - Non-Interest Bearing Current Liabilities. **Non-Interest Bearing Current Liabilities** are liabilities that do not carry an interest rate, such as accounts payable. $WACC = w_d r_d (1-T) + w_p r_p + w_c r_s$ **Where:** - $w$ = weight; d = debt, p = preferred stock, c = common equity - $r$ = cost; d = debt, p = preferred stock, s = internal equity - $T$ = Tax rate Note that $WACC$ can be calculated by breaking it down into each of the three components. Then, multiplying it by the weight of each, and subsequently summing them together: - **% of Debt * After tax cost of debt** - **% of Preferred Stock * Cost of preferred stock** - **% of Common Equity * Cost of common equity**