Foundations Of Finance Corporation In A Nutshell PDF

FOUNDATIONS OF FINANCE CORPORATION IN A NUTSHELL Alejandro Rodríguez Gallego Email: [email protected] Office: CD-435 ICADE | Foundations of Finance | 2024  TABLE OF CONTENTS 1 CORPORATION IN A NUTSHELL TODAY’S SESSION...

FOUNDATIONS OF FINANCE CORPORATION IN A NUTSHELL Alejandro Rodríguez Gallego Email: [email protected] Office: CD-435 ICADE | Foundations of Finance | 2024  TABLE OF CONTENTS 1 CORPORATION IN A NUTSHELL TODAY’S SESSION 2 THE FINANCIAL STANDPOINT 3 AGENCY PROBLEM GOAL OF FINANCIAL MANAGEMENT 4 Q&A 4  TODAY’S SESSION Today we are going to talk about: Features of a corporation as a form of business organization. Conflicts of interest that can arise between owners and managers. The three main concerns of corporate financial management. The goal of financial management. 5  INTRO CORPORATION IN A NUTSHELL INCLUDING A BIT OF ROLE PLAY! 6  OUR FIRM Imagine you are an entrepreneur that has a business idea: Manufacture & sell wood tables! 7  COMPANIES Corporation Partnership Liquidability and Shares can be easily Subject to substantial restrictions Marketability exchanged Usually each share gets General Partner is in charge, limited partners Voting Rights one vote may have some voting rights Taxation Double Partners pay taxes on distributions Reinvestment and Broad latitude All net cash flow is distributed to partners dividend payout General partners may have unlimited Liability Limited liability liability, limited partners enjoy limited liability Continuity Perpetual life Limited life 8  A FINANCIAL POINT OF VIEW (I) Chief Financial Officer Investments Financing 9  A FINANCIAL POINT OF VIEW (II) Investments Financing Chief Financial Officer Short-term Short-term Current liabilities Current assets Long-term debt Loans Bonds Fixed assets Tangible Long-term Long-term Intangible Shareholders’ equity Assets Equity & Liabilities Inventory Suppliers Machinery Loans Manufacturing Plant Bonds Brand Shares 10  THE TOP 3 CONCERNS OF FINANCIAL MANAGEMENT Investments NET WORKING CAPITAL Financing Is the firm able to meet short-term Short-term Short-term obligations? Current How long does it take to get paid / pay ? liabilities Current assets … Non-current liabilities Non-current Long-term Long-term assets Equity CAPITAL BUDGETING CAPITAL STRUCTURING What assets should I buy? How to finance the firm? At what cost? At what cost? Expect to produce? Expect to pay financiers? … … 11  INTRO THE AGENCY PROBLEM 12  THE AGENCY RELATIONSHIP Agency relationship: Principal hires an agent to represent his/her interest. For example Stockholders (principals) hire managers (agents) to run the company. Class discussion A real estate broker, who is paid on commission, and a buyer. And now real estate broker vs. seller. Agency problem: Conflict of interest between principal and agent. 13  AGENCY COST Agency cost: the cost of conflict of interest. Direct agency cost Indirect agency cost Example Large investment positions firm for long-term positive cash flow but has risk in short run. Owners want this investment: Increases firm value. Managers object: Risk may have personal cost. If managers prevail, the foregone long-term cash flow is the Agency Cost. 14 GORDON GECKO’S SPEECH Wall Street (1987) Go to scene at 1:15:20 – 1:17:20 15  AGENCY PROBLEMS Economic agents act according to their own interest This is not a judgement. But you cannot expect that, out of duty or love, people consistently act against their interest. Single biggest issue in real world and academic finance (at least corporate finance) – a.k.a. Corporate Governance. We will see: Different goals of actors in the finance world. Kinds of agency problems. Potential solutions. 16  THE AGENCY PROBLEM 1. Managers won’t work for the owners unless it’s in their best interest Separation of ownership and management within the corporation. Conflicts of interest between shareholders (principal) and managers (agents) may arise. 2. Agency costs: the cost of the conflict of interest between management and stockholders. Hard to calculate but should be minimized. 3. Managers need to be monitored and their interest aligned with those of the shareholders Incentive plans, management compensations (shares, stock options). Use of debt, dividends. M&A: ultimate mechanism of the market of corporate control. 17  MANAGEMENT GOALS Management goals may be different from shareholder goals Expensive perquisites: e.g., private plane. Survival: keep the job! Independence. Increased growth and size: Often lead to management reward. Not necessarily in best interest of shareholders. 18  DIFFERENT PARTIES Earn through dividends/buybacks & increases in firm value (stock price). DO NOT have priority in liquidation. Shareholders DO have voting rights (decision power). Their payoff is a positive function of Firm value. DO like risk! Financiers Earn through interest payments & return of the principal. DO have priority in liquidation. Manager Debtholders DO NOT have voting rights (decision power). Their payoff is capped at a maximum. Earn through salary, bonus. DO NOT like risk! Reputation depends on firm size and other non-financial issues. May or may not like risk! 19  SHAREHOLDERS VS. DEBTHOLDERS PAYOFF Picture a firm that has only one investment project that generates the whole money (cash-flows, CFs) for the firm. If this investment is riskier the probability of success decreases (prob. of bankruptcy increases), but the money in return is higher! (risk-return trade-off!) The firm is financed both through debt (B) and equity (E) With the CFs generated by the project the firm will (1) pay back debtholders and (2) if there is money left, distribute the rest in dividends to shareholders. 20  THE AGENCY PROBLEM In principle, it seems that choosing investment projects that have more risk (and, hence, more expected return) is (more) beneficial to shareholders. However, is this good / optimal for other stakeholders or even the firm ? NO! Debtholders: Projects with more risk also have higher probability of failure / bankruptcy (i.e. CF