Corporate Finance: Goals, Roles & Financial Decisions

TAKEAWAYS:

• Corporate finance’s primary goal is to maximize shareholder wealth by making optimal investment, financing, and dividend decisions.
• Financial managers handle three core functions: capital budgeting (investment), capital structure (financing), and working capital management.
• Agency problems arise when managers’ interests diverge from shareholders’, requiring governance mechanisms like incentives and monitoring.
• Domestic vs. international finance differs in currency risk, political instability, and regulatory complexity (e.g., NEPSE vs. global markets).
• Financial leverage amplifies returns but increases risk; its degree is measured by the degree of financial leverage (DFL) formula.
• Real-world applications include eSewa’s transaction efficiency (working capital), Daraz’s inventory management (capital budgeting), and NTC’s debt financing (capital structure).

1. Introduction to Corporate Finance

Corporate finance is the study of how businesses raise capital, invest funds, and manage financial risks to achieve their goals. Unlike personal finance (individual decisions), corporate finance focuses on large-scale decisions that affect thousands of stakeholders.

1.1 Definition and Purpose

Corporate finance is the application of financial principles to corporate decisions, ensuring long-term sustainability and profitability. Its purpose is to:

• Allocate financial resources efficiently.
• Minimize costs and maximize returns.
• Align financial strategies with business objectives.

2. The Goal of Corporate Finance

The primary objective of corporate finance is to maximize shareholder wealth. This is achieved by:

• Increasing share price (market value of equity).
• Ensuring dividend growth (returns to shareholders).
• Balancing risk and return (no business can ignore risk).

2.1 Shareholder Wealth Maximization

Shareholder wealth is measured by the market value of the firm’s equity. Financial managers must:

• Invest in projects that generate positive NPV (Net Present Value).
• Finance operations at the lowest cost (e.g., debt vs. equity).
• Manage cash flows to avoid liquidity crises.

Example: A Kathmandu-based retail shop (e.g., Sagarmatha Retail) earns Rs. 500,000 in sales but has:

• Variable costs: Rs. 300,000
• Fixed costs: Rs. 100,000
• Debt: Rs. 200,000 at 10% interest

Question: What is the degree of financial leverage (DFL)? Solution: DFL = % Change in EPS / % Change in EBIT = (EBIT - Interest) / EBIT = (500,000 - 300,000 - 100,000 - 20,000) / (500,000 - 300,000 - 100,000) = 1.25

This means a 10% increase in EBIT leads to a 12.5% increase in EPS (due to leverage).

3. Roles of Financial Managers

Financial managers perform three key functions:

Mermaid Diagram:

flowchart TD
    A["Financial Manager"] --> B["Capital Budgeting: Long-term projects"]
    A --> C["Capital Structure: Debt vs. Equity mix"]
    A --> D["Working Capital: Short-term liquidity"]
    B --> E["Example: Daraz's Pokhara warehouse"]
    C --> F["Example: Ncell's bond issuance"]
    D --> G["Example: eSewa's transaction optimization"]

4. Agency Problems and Corporate Governance

Agency problem occurs when managers (agents) act in their own interest rather than shareholders’ (principals). Examples:

• Excessive perks (e.g., CEO luxury cars).
• Risky investments (e.g., Ponzi schemes).
• Underinvestment (e.g., ignoring profitable projects).

classDiagram
    class Shareholder {
      +wealth
      +expects: growth
    }
    class Manager {
      +salary
      +perks
      +risk-taking
    }
    class BoardOfDirectors {
      +monitoring
      +incentives
    }
    Shareholder --> Manager : agency problem
    BoardOfDirectors --> Manager : governance
    BoardOfDirectors --> Shareholder : accountability

Solutions:

5. Domestic vs. International Financial Management

Real-World Tie:

• Nepal Rastra Bank (NRB) manages domestic currency (NPR) and interest rates (e.g., 6-month T-bills at 12%).
• NEPSE lists companies like Ncell and NTC, where international investors face exchange rate risks.

6. Financial Planning and Budgeting

Financial planning involves:

1. Forecasting future revenues, costs, and cash flows.
2. Setting budgets (e.g., annual operating budget).
3. Controlling actual performance vs. plans.

Example: Kathmandu Retail Shop Budget

Mermaid Diagram:

flowchart TD
    A["Financial Plan"] --> B["Forecast Sales"]
    B --> C["Estimate Costs"]
    C --> D["Set Budgets"]
    D --> E["Monitor Performance"]
    E --> F["Adjust as Needed"]

In the Real World

1. eSewa’s Working Capital Management

   • Idea: eSewa optimizes short-term cash flows to process millions of transactions daily without liquidity crises.
   • How? Uses just-in-time funding from banks to cover transaction costs, reducing idle cash.

2. Daraz’s Capital Budgeting

   • Idea: Daraz invests in warehouses and logistics (capital budgeting) to expand delivery networks.
   • Example: A Rs. 50 million investment in a Pokhara warehouse may take 3 years to break even but increases market share.

3. Ncell’s Capital Structure

   • Idea: Ncell balances debt (bonds) and equity (shareholders) to fund network expansion.
   • Risk: High debt increases financial leverage (DFL), but too much debt risks default.

Exam Tip

• For numerical questions (e.g., DFL):

  • Always calculate EBIT first, then subtract interest.
  • Use the formula: DFL = (EBIT - Interest) / EBIT.
  • Show worked steps clearly—partial marks are given for correct intermediate steps.

• For essay questions (e.g., shareholder wealth maximization):

  • Structure your answer in 3 parts:
    1. Definition of shareholder wealth (market value of equity).
    2. How managers achieve it (investment, financing, dividends).
    3. Real-world example (e.g., Ncell’s stock price rise due to network expansion).
  • Avoid vague answers—exams test application, not just theory.

• For comparisons (e.g., domestic vs. international finance):

  • Use a table (as shown above) to highlight key differences.
  • Link to Nepal’s context (e.g., NEPSE vs. global markets).

• For agency problems:

  • List mechanisms (incentives, monitoring, market for control) with Nepali examples (NTC, Ncell).
  • Discuss consequences (e.g., Ncell’s 2020 debt crisis due to poor governance).

Final Note: This unit is highly numerical (DFL, NPV, financial ratios) and conceptual (agency problems, governance). Practice past papers—exams often mix theory with calculations. For example:

• A question on DFL may combine cost data with debt.
• A question on agency problems may ask for solutions in a Nepali context (e.g., NEPSE reforms).