CORPORATE FINANCE 2011/12

Seminar 1:

1. What are the major disadvantages of the sole proprietorship and

partnership forms of business organisation? What benefits are there
to these types of business organisation as opposed to the corporate
form? Why are some sole proprietors unwilling to change the form of
business organisation to the corporate form?

Outline answer:

The major disadvantages of the sole proprietorship and partnership forms

of business organisation are:

Unlimited liability for business debts on the part of the owner

Limited life of the business
Difficulty of transferring ownership

The major advantage is that they are much simpler and less costly to set
up than a corporation. Also the owners have day-to-day control of the
organisation.

The reasons why sole proprietors are often unwilling to change to a

corporation is that it typically involves a loss of control (separation of
ownership from management) and this brings with it agency type
problems.

2. What is the primary disadvantage of the corporate form of

organisation? Name at least two of the advantages of corporate
organisation.

Outline answer:

Primary disadvantage:
Principal agent relationship.

With the separation of ownership and control the management of the

company passes into the hands of professional managers (agents) who
may not always work in the best interests of the owners.

Advantages:
Limited liability
Ease of raising funds
Ease of transferring ownership

3. What are the reasons why debt capital in a firm typically has a lower
cost of capital than does equity capital in the same firm? Will debt
 capital in a firm always have a lower cost of capital than equity
capital in a different firm? Why or why not?

Outline answer:

It is this right to payments irrespective of the performance of the company

which is the reason why debt holders are said to have a prior claim on
the assets of the company and this prior claim means that from the point
of view of the providers of funds, debt capital is less risky than equity
capital and therefore requires a lower rate of return. Thus the cost of debt
capital is lower than the cost of equity capital.

In addition to the fact that debt capital is cheaper than equity capital
because debt holders face less risk, debt capital has a further advantage
over equity capital from the point of view of the firm. This advantage
relates to the differential tax treatment of interest payments on debt and
dividend payments on equity. In many countries, including the UK, the
interest payments on debt are said to be tax deductible, which means that
interest payments are deducted from total income to arrive at the taxable
income of the company. In contrast, dividend payments are not tax
deductible. Thus, two companies with identical operating incomes, but
which differ in terms of their level of debt will have different taxable
incomes and, therefore, after tax incomes. This tax deductibility of debt
payments means that debt capital provides a tax shield which is not
provided by equity capital and thus further lowers the (after tax) cost of
debt from the point of view of the firm.

Debt capital in a firm will NOT always have a lower cost of capital than
equity capital in a different firm. What matters is the risk. Since one firm
may be much riskier than another it is possible that the debt capital of the
riskier firm will have a higher cost than the equity capital of the less risky
firm.

4. For the purpose of the exposition of financial management

techniques, the assumed single objective of commercial entities is
often taken to be the maximisation of firm and equity valuation.
Comment on the extent to which this assumed single objective is
realistic and explain why corporate management need to be
concerned with firm valuation.

Outline answers:

In theory, since the firm is owned by the shareholders it should be run

with their interests in mind. Thus the sole objective of managers should be
to maximise the value of the firm for those shareholders. This can be
represented by either the current value of equity or the discounted future
dividend stream which will be received by shareholders.
In practice things are not so simple. Firstly (and least importantly)
shareholders may invest for reasons other than pure financial gain. For
example, members of pressure groups may buy shares to try to change
company policy, people may buy shares out of loyalty to a local company
etc. In addition, the firm may be thought of as having a number of
objectives (some of which will be conflicting), resulting from the fact that
it has responsibility to others, e.g.:
(a) employees and management to ensure continued, useful and
profitable employment;
(b) the environment and society at large (e.g. not to add to pollution, not
to produce harmful products)
(c) government and country not to break the law

However, of most importance is the fact that there is often a separation of

ownership from control. The managers of the firm are delegated
responsibility for acting on behalf of the shareholders of the firm.
Managers may wish to pursue their own goals which may conflict with
those of the shareholders.

Nevertheless, management cannot ignore the firm's valuation and the

wishes of shareholders for the following main reasons:
(i) if firm value falls below what it could be, the risk of take-over is
increased (with the likely change of management)
(ii) firms may face problems raising additional finance if managers pursue
their own goals
(iii) the managerial labour market is likely to value managers who pursue
the interests of owners, more highly.
(iv) threat of bankruptcy - managers have more to lose if the firm is
bankrupt, since they have much of their wealth (their human capital) tied
up in the company.

Nonetheless, there will be some room for discretion and thus movement
away from the assumed single objective.

5. Why is it necessary to assume a goal for the firm when considering

how managers in firms should make financial decisions?

Outline answer:

In the absence of a goal management would not have a criterion for

choosing among alternatives. A systematic approach to financial decisions
requires the formulation of a goal (or set of goals) which can serve as a
guide for managerial decisions. Given the goal(s), management can
devise a consistent set of optimal rules for reaching the goal(s). If the
assumed goal is a good proxy for managerial aspirations, these decision
rules will also provide a good explanation and prediction of the firm's
decisions in practice.
 6. To what extent is it in the interest of the shareholders of publicly
quoted companies to link the rewards of managers to the financial
performance of the company?

Outline answers:

This question ties up very much with earlier questions. The shareholders
of publicly quoted companies will wish managers to undertake activities
which lead to the maximisation of shareholder wealth. Managers may only
have a small stake in the company. Therefore there is a potential conflict
of interest between the managers and shareholders, e.g. managers may
think it is in their interests to increase the overall size and market share of
the company. To encourage commonality of objectives between managers
and shareholders it might seem sensible to tie managers remuneration in
some way to the financial performance of the company. BUT the
shareholders must be careful to choose a link which is in their interest.
Choice of the wrong link may lead managers to pursue goals which do not
maximise benefits to shareholders. A number of bonus schemes are found
in practice:

(a) percentage of total profits - this encourages managers to maximise the

profits of the company. BUT profit needs to be carefully defined. Also,
maximisation of profits is not necessarily in the interest of shareholders as
it takes no account of the capital used to generate the profit, or of the
opportunities foregone. This latter point is linked to the time period under
consideration. Projects which have long lead times before generating
returns might maximise shareholder wealth, but short-term profits may be
reduced.

(b) percentage of profits made above a certain amount - same problems

as (a).

(c) link rewards to increased earnings per share - EPS is a leading

shareholder indicator. BUT this again could lead to activities not
compatible with wealth maximisation, e.g. possibility of adopting an
acquisitions policy in which companies with low P/E ratios are acquired by
issuing new shares. Although this would lead to an immediate increase in
EPS, long-term growth may be jeopardised.

(d) options - this directly links managers interests to shareholder interests.

Any increase in share value will lead to an increase in the value of the
option. BUT these schemes are sometimes politically 'unacceptable' and
can dilute the control of current shareholders.

7. Can managers create value? If so, how? Discuss why value creation
is difficult.
Outline answers:

Creating value to shareholders is probably the most important and

challenging task of managers of modern corporations. Managers can
create value by (a) investing in positive net present value projects, and (b)
issuing financial instrument that cost less than they raise. Essentially,
value can be created if managerial decisions raise more cash inflows than
cash out-flows. However, value creation is difficult because:
(a) identification of cash flows is difficult because most financial
statements represent transactions rather than cash-flows causing
difficulties in assessing cash-flows,
(b) timing of cash flows is important because of the time value of money,
and
(c) risks associated with cash flows (uncertain timing and default risk).

8. The pay-offs to equity-holders and debt-holders are contingent

upon the value of the firm. Discuss.

Outline answers:

An outline answer to this question can be found on a lecture slide. The

pay-offs to the claims of both equity holders (E) and debt holders (D) of a
limited company depend on the value of the firm (V). Therefore, they are
known as contingent claims. Debt holders have priority over the claims of
equity holders.
Debt holders claim and pay-off:
If V D debt holders receive D.
If V < D debt holders receive V.
Therefore, the value of D is contingent on V.
Shareholders claim:
If V> D equity holders receive (V-D).
If V< D equity holders receive nothing.
In summary, if anything is left after paying for the claims of debt holders
(i.e. if V > D) shareholders receive the residual. Shareholders have claim
over the residual value of the firm (i.e. V - D). If V < D, shareholders do
not receive any payment; they are not required to pay for the short-fall
either (limited liability).