Corporate Finance

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Corporate Finance

The relationship between financial decisions is shown in Exhibit 1.1. The company decides on its invest-
ments and approaches investors through ‘financial middlemen’ to provide funds in the form of debt and
equity. Investors do not provide money free. They expect something in return. The investor’s expectation is
the cost of money. For instance, if someone was to lend you Rs 5,000 for a 5-year period, s/he would expect
interest payments at specified intervals and the principal repayment at the end of the loan term. Loan is one
type of liability; there are several others. These liabilities have a cost attached to them—cost of capital. This
also means that the company should earn more than the cost of capital to keep the investors happy. An exam-
ple will clarify the point. Suppose you lend Rs 10,000 to a company at an interest rate of 14 percent. The
company should earn more than 14 percent on its investments to service your debt at all times. If earnings
fall, a default will occur. Do investors not realize the inherent risk of investing in companies? They do. The
investor’s expected rate of return—14 percent in this case—is set after assessing risk. In sum, the investor’s
expected rate of return is a function of risk. We have not defined risk as yet, nor established the relationship
between risk and return. Chapters 3 and 4 are devoted to this.

Exhibit 1.1 Overview of financial decisions

Financing Decision

Intermediaries

FIRM

Investor

expectation

Allocation of resources

capital budgeting

(^)
Retained
earnings
Retail investors
banks and financial
institutions
Project cash-flows
Debt servicing/
dividend decision
Hurdle rate
THE SEARCH FOR THE BEST CORPORATE OBJECTIVE
A firm is a group of claimants such as shareholders, creditors, suppliers, customers, and employees. Share-
holders, the owners of the firm, appoint a board of directors to oversee the functioning and shape the strategic
direction of the company. In theory, the board is supposed to act in the interest of the claimants: but which of
the claimants? Who should the managers serve? Or, to rephrase the question, what should be the objective of