MANAGERIAL FINANCE

Chapter One
Introduction to Corporate Finance

1.1 Definition of Corporate Finance

Basically, corporate finance is the study of how capital investments are evaluated, how funds
are raised to purchase the investments, and how short-term operating cash flows are managed.
The evaluation of capital investment is a capital budgeting decision, how funds are raised to
purchase the investment is a capital structure decision, while the management of short-term
operating cash flows is a working capital management decision. In general, the relevant
questions in corporate finance are as follows:

1. What long-term investments should the firm undertake? (capital budgeting decisions)
2. How should the firm fund these investments? (capital structure decisions)
3. How will the firm manage its everyday financial activities? (working capital
management decisions)

Capital budgeting is the process of planning and managing a firm’s long-term investment.
Here, the financial manager identifies investment opportunities that are worth more than their
costs. We look at the value of cash flows to be generated by these investments and compare it
with the costs to purchase the assets. For example, for a manufacturer of consumer goods such
as Yee Lee Oil Berhad, deciding whether or not to open a new factory would be an important
capital budgeting decision.

Capital structure is the specific mixture of long-term debt and equity the firm uses to finance
its operations. The relevant question to ask here is ‘how much should the firm borrow?’ In
other words, what mixture of debt and equity is the best for the firm? The mixture will affect
the value and the risk of the firm. If a firm had a very low level of debt, it may not be able to
take advantage of tax benefit. Conversely, if the level of debt is too high, the firm has to pay
huge interests and is exposed to risk of default. Another issue of concern here is the source of
funds for the firm. After determining the ‘optimal’ mixture of debt and equity for the firm, the
financial manager needs to figure out the best way to raise those funds. For the debt, is it better
to issue bond or to go for bank borrowing? If issuing bond is selected, what particular type of
bond is the best? The decisions are based on how the firm is affected by risk and ultimately
how value can be created.

Working capital management is the management of firm’s short-term assets, such as

inventory, and its short-term liabilities, such as payables. It is a day-to-day activity that is
conducted to enable the firm to maintain sufficient resources to continue its operations. In so
doing, it involves activities involving receipts and payments of cash.

The three areas described above are the essence of corporate finance and we will explore each
of them in greater details in the remaining chapters.

1.2 The Corporate Firm

A corporation is a legal entity comprised of people or groups of people authorized by law to

conduct businesses and other activities but the corporation and its owners are distinct and
separate from each other. Similar to an individual, a corporation has the right to enter into
contracts, loan and borrow money, sue and be sued, hire employees, own assets and pay taxes.
The owners of the corporation are the shareholders or stockholders. These shareholders
normally comprise of individual shareholders or institutional shareholders. Examples of
institutional shareholders are corporations such as insurance companies and asset management
companies; government-related agencies and also foreign companies.

The shareholders are represented by the board of directors who oversee and control the
management of the company. The chairman leads the board of directors, while the president
or chief executive officer is responsible to lead the management and running of the company
on daily basis. A corporation can be publicly-listed or privately owned. Normally, the basic
structure of a corporation is as follows.
Corporation is one of the three basic forms of business organization, the other two being sole
proprietorship and partnership. Let’s discuss the latter two first.

Sole proprietorship is a type of business entity that is owned and run by one natural person
and in which there is no legal distinction between the owner and the business. Normally sole
proprietorships are small business concerns such as small grocery stores, barber shops and
restaurants. The owners keep all the profits but he or she has unlimited liability for business
debts. In the event that the business falls short of cash and running out of assets, the owners
have to liquidate his or her own personal assets to pay the creditors.

A partnership is a business organization in which two or more individuals own, manage and
operate the business. Normally, all owners are equally and personally liable for the debts from
the business. According to the Malaysian Companies Act 1965 Section 14 (3) (b), a partnership
must consist of not more than 20 members, except to a partnership that is formed based on
professional careers such as lawyers, doctors and accountants. There two types of partnership;
general partnership and limited partnership. In a general partnership, all the partners share in
the gains or losses, and all have unlimited liability for all partnership debts, not just their
particular share of the partnership. In a limited partnership, one or more general partners run
the business and have unlimited liability, but there will be one or more limited partners who
are not active in the business. A limited partner’s liability for business debts is limited to the
amount that partner contributes to the partnership.

A corporation is a legal business entity that is separate and distinct from its owners, and has
the rights, duties and privileges of an actual person in many cases. For example, a corporation
can borrow money and own property, can sue and be sued and can enter into contracts. In
Malaysia, a corporation must firstly be registered with the Companies Commission of Malaysia
(CCM). Forming a corporation also involves preparing a memorandum of association (MOA)
and articles of association (AOA) of the proposed company. In a large corporation, the
stockholders and the management are usually separate groups. The stockholders elect the
board of directors, who then select the managers. Management is responsible with managing
the corporation’s affairs in-line with the stockholders’ interests.

The main advantage of a corporation, as opposed to sole proprietorship and partnership is that
ownership can be readily transferred, and therefore the life of the corporation is not limited.
The corporation borrows money in its own name, rather than in individuals’ name. Therefore,
the stockholders or the owners have limited liability for corporate debts. The most they can
lose is what they have invested in the corporation. In terms of raising new funds, say for
example new equity, a corporation can sell new shares of stock and pull in new investors.

The main disadvantage of a corporation is that it must pay taxes. Firstly, the profits made by
corporation are taxed with corporate tax. Then, if the company pay out dividends to the
stockholders, the dividends are taxed again as income to the stockholders. This is double
taxation whereby corporate profits are taxed twice: at the corporate level when they are earned
and at the personal level when they are paid out. This is the feature of the classical system of
taxation. However, Malaysia’s tax structure is based on the imputation system of taxation,
which is governed by the Income Tax Act 1967. Under Section 108 (1) of this Act, when a
company makes dividend distributions to stockholders, the system allows the company to
deduct tax imposed on dividend income to stockholders at the ongoing corporate tax rate of the
year of assessment. The amount deducted by the company reflects an amount of dividend tax
credit and the stockholders can claim this amount to offset the tax chargeable on their taxable
income.
 Forms of
Business
Organization

Sole
Partnerships Corporations
Proprietorships

1.3 The Goal of a Firm

Every firm or company has its own goals for doing a certain business. These goals are
formulated to guide the firm to achieve something substantial and significant. The CEO of the
firm takes into consideration various perspectives from the many segments in the firm – for
example, production, marketing, finance, human resources and accounting. Each of this
segment has its own priorities and importance when it comes to helping the firm achieving its
goals. For example, the marketing department may view increasing market share as a more
important goal than say, increasing employees’ satisfaction, set by human resource department.
From the economics standpoint, the main goal of firm should be to maximize profits. Other
goals include increasing market share, maximizing sales, maintaining growth or avoiding
bankruptcy. Of all these various goals, the most common is to maximize profits.

However, based on corporate finance perspective, the most appropriate goal is to maximize
shareholders’ wealth, as measured by the current value per share of the existing stock. Before
we discuss why this is the most appropriate goal, based on corporate finance perspective, let’s
discuss first about what’s wrong with maximizing profits as the ultimate goal. Firstly, profits
are accounting figures which are derived based on accrual and prepaid items. Different
accounting policies adopted may result in different net profit figure. For example, if a company
uses the straight-line method for its depreciation and first-in-first-out (FIFO) method for its
inventory (in an increasing price trend), it may result in higher current profits compared to
using double-digits declining depreciation method and last-in-first-out (LIFO) inventory
method. Therefore, in a way, net profits can be ‘manipulated’ by the managers in such a way
that they are in-line with the targets set by the stockholders. Secondly, being an accounting
figure, net profit does not represent the actual cash flow strength of a firm, and as we shall see
in the next chapter, cash flow tells us more about the value of a firm compared to net profit. A
firm may report a net profit of RM10 million, but this is meaningless, as far as corporate finance
decisions are concerned, if the cash flow is just RM1 million, because the main corporate
finance decisions rely on the availability of cash of the firm. Thirdly, net profit does not
consider the timing and riskiness of cash flows, which may distort the actual value of a firm.
For example, a manager may choose a project that brings in profit in the early stages of the
project so that his or her performance looks good now. However, the risk level of the project
may be high and the cash flows in the later years are negative, and this can jeopardize the firm
in the long-run. With net profits, the timing and riskiness of the cash flows are not being
accounted.

The goal of maximizing shareholder’s wealth, measured by current value per share of
existing stock is considered the most appropriate goal, from finance perspective, for several
reasons. Firstly, the value of stock considers the cash flows of the firm, instead of accounting
figures which are subject to manipulation of accruals and prepaid items. Secondly, valuation
of stock price takes into account all the relevant cash flows far into the foreseeable future.
Thirdly, valuation of stock price takes into account the risk of the cash flows using the cost of
equity, hence is a more accurate assessment of the firm’s value. Fourthly, shareholders are
the owners of the firm and shareholders invest in a firm because they want to add their wealth.
Stock price is considered as the best measure of wealth change because it is a market value
indicator and less susceptible to accounting manipulation. This is of course based on the
assumption that the stock market is efficient, and this will be discussed in greater depth later.

1.4 The Agency Problem

In earlier discussion, we have seen that the main characteristic of a corporation is the separation
of ownership and management. Shareholders elect the board of directors, led by the CEO, who
is responsible to govern the management of the company. In essence, the shareholders are the
principal and the managers are the agent who is supposed to manage the firm based on the
objectives set forth by the shareholders. In reality, however, the objectives and priorities of
these two groups may not be aligned, and agency problem may occur. Agency problem is the
problem that arise due to the conflict of interest between the stockholders and the management
of a firm. For example, the stockholders’ main priority is to choose fairly low-risk projects
that can add value to the firm as a whole, in the long-run. However, the managers may reject
these types of projects and prefer the higher-risk profitable projects so that the current net profit
is much higher than previous year’s net profit and thus they will get higher bonuses and perks.
In another example, the stockholders may want the management to be prudent in spending the
firm’s money, particularly on the operating expenses. The management, on the other hand,
may find it more attractive to spend lavishly on expensive perks such as corporate jets,
entertainment allowances and huge bonuses.

In order to mitigate agency problem, the stockholders have to find mechanisms to control the
management. Agency costs are costs that the firm has to bear in order to mitigate the agency
problems and these costs will reduce firm value. One good example of such mechanism is
monitoring. Examples of monitoring are management report presented to the board of
directors, internal and external audit and reports by financial institutions such as banks and
credit agencies. These control mechanisms can be quite costly especially when they involve
external parties. Another type of mechanism is through compensation plans such as
performance based bonus, salary revision, stock options and benefits. It is believed that if the
management has some stake in the firm, the conflict of interest with the stockholders will be
reduced and alignment of interests can be achieved. Other types of agency costs control
mechanisms are the threat of being fired, the threat of takeovers and also regulations made by
the regulatory bodies.

1.5 Financial Markets and Institutions

The relationship between the firm and the financial markets is shown in the figure below. As
a start, the firm sells shares of stock and borrow money to raise cash. Cash flows to the firm
from the financial market (A). The firm invests the cash in current and fixed assets (B). These
assets generate some cash (C), some of which goes to pay corporate taxes (D). After taxes are
paid, some of this cash flow goes back to the financial markets as cash paid to creditors and
shareholders (E), while the remaining is reinvested in the firm (F).
Like any other market, a financial market is a mechanism of bringing buyers and sellers
together. The products bought and sold in a financial market is predominantly debt and equity,
or variations of both. The main characterization of a financial market is whether it is a primary
market or a secondary market.

A primary market is a market in which new issues of a security are sold to the initial buyers.
In the transaction, the firm is the seller who wishes to raise money as capital and the new
securities issued are transferred to the first-time buyers in exchange for cash. The two types of
primary market transactions are initial public offerings (IPOs) and private placements. An IPO
involves selling securities to the general public while a private placement is a negotiated sale
involving specific buyers. Public offerings of debt and equity must be registered with the
Securities Commission (SC) and the firm is required to disclose relevant information about the
securities. The accounting, legal and transaction costs of public offerings can be large,
depending on the size of the capital raised. Through private placements, securities are sold
privately to large institutions such as life insurance companies or mutual funds, and this does
not involve underwriters and therefore quite straightforward. Although the term ‘market’ is
used, a primary market does not have characteristics of a physical market. It merely refers to
the issuance of securities for the first time by a firm to institutional or individual buyers either
through an IPO or private placement.

A secondary market is a market in which previously issued securities are traded. A secondary
market transaction involves one owner selling to another. In the primary market earlier, the
issuance of a security occurs for the first time and it is owned for the first time by a buyer. The
moment the first time buyer sells it to another buyer, then we enter into the secondary market.
Unlike the primary market, secondary market has characteristics of physical markets whereby
standardized exchange of securities from sellers to buyers take place. A stock exchange is an
example of a secondary market.

In Malaysia, all publicly traded financial securities are traded in Bursa Malaysia, previously
known as the Kuala Lumpur Stock Exchange (KLSE).

1.6 Ethical Aspects of Financial Decisions

Financial decisions are imperative and are done almost daily by the managers of a firm.
Sometimes, the managers are faced with ethical dilemmas where they have to choose between
a more profitable unethical decision versus a less profitable ethical decision. In the long-run,
ethical behavior can be wealth enhancing while unethical behavior is costly as it damages a
firm’s reputation. The shareholder wealth maximization goal can prevent unethical behavior if
the firm’s stock price reflects the extent to which the benefits of such unethical behavior are
less than the expected present value of the future costs of unethical behavior (in the form of
penalties or lost reputation that impact a firm’s risk or return). This implies that unethical
behavior is disclosed publicly in a timely manner and that capital markets are able to accurately
assess its impact on stock value. Therefore, the pursuit of the shareholder wealth maximization
goal has to be constrained by behavior, which certainly must be legal and preferably also
ethical.