13.3 Corporate finance decisions and firm value

Corporate finance decisions shape a firm's value through strategic resource allocation and risk management. Understanding key principles like time value of money and agency theory helps managers make informed choices that balance shareholder interests with long-term growth.

Capital structure, dividend policy, and investment evaluation methods are crucial tools in maximizing firm value. By optimizing the mix of debt and equity, managing dividend payouts, and using NPV and IRR to assess projects, companies can enhance their financial performance and market position.

Corporate Finance Principles and Firm Value

Maximizing Shareholder Value and Time Value of Money

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• Corporate finance maximizes shareholder value through effective financial decision-making and resource allocation within a firm
• Time value of money principle states a dollar today holds more worth than a dollar in the future due to its potential earning capacity
  • Example: $1,000 invested today at 5$1,050 in one year
• Risk-return tradeoff associates higher potential returns with greater risk
  • Example: Investing in a tech startup (high risk, high potential return) vs. government bonds (low risk, low return)

Agency Theory and Market Efficiency

• Agency theory examines conflicts of interest between shareholders (principals) and managers (agents), impacting corporate financial decisions
  • Example: Managers may prioritize short-term profits to boost their bonuses, potentially harming long-term shareholder value
• Market efficiency hypothesis suggests stock prices reflect all available information, influencing firm financial decisions and market communication
  • Weak form: Past price information
  • Semi-strong form: All publicly available information
  • Strong form: All information, including insider information

Capital Budgeting and Corporate Governance

• Capital budgeting evaluates and selects long-term investment projects maximizing firm value
  • Steps include:
    1. Identify investment opportunities
    2. Estimate cash flows
    3. Assess risk
    4. Calculate project value
    5. Make investment decision
• Corporate governance structures align management decisions with shareholder interests, enhancing firm value
  • Key components:
    • Board of directors
    • Shareholder rights
    • Transparency and disclosure
    • Executive compensation policies

Capital Structure Decisions

Modigliani-Miller Theorem and Trade-off Theory

• Capital structure combines debt and equity to finance company operations and investments
• Modigliani-Miller theorem provides theoretical foundation for capital structure decisions under perfect market conditions
  • Key assumptions:
    • No taxes
    • No transaction costs
    • No bankruptcy costs
    • Perfect information
• Trade-off theory balances tax benefits of debt against costs of financial distress and bankruptcy
  • Example: A company might target a 40% debt-to-equity ratio to optimize tax benefits while managing bankruptcy risk

Pecking Order Theory and Cost of Capital

• Pecking order theory suggests firms prefer internal financing over external, and debt over equity for external financing
  • Financing hierarchy:
    1. Internal funds
    2. Debt
    3. Equity
• Weighted average cost of capital (WACC) represents overall financing cost, incorporating debt and equity costs
  • WACC formula: $WACC = (E/V * Re) + (D/V * Rd * (1-T))$
    • E = Market value of equity
    • D = Market value of debt
    • V = Total market value (E + D)
    • Re = Cost of equity
    • Rd = Cost of debt
    • T = Corporate tax rate

Financial Leverage and Operating Leverage

• Financial leverage measures extent of fixed-income securities use (debt, preferred equity) to finance assets
  • Debt-to-equity ratio: Total Debt / Total Equity
• Degree of operating leverage (DOL) and degree of financial leverage (DFL) affect earnings volatility and risk profile
  • DOL formula: $DOL = \% Change in EBIT / \% Change in Sales$
  • DFL formula: $DFL = \% Change in EPS / \% Change in EBIT$
  • Example: A company with high fixed costs (high DOL) and high debt (high DFL) will experience greater earnings volatility

Dividend Policy and Firm Value

Dividend Theories and Signaling

• Dividend policy determines earnings distribution to shareholders
• Dividend irrelevance theory (Miller and Modigliani) suggests dividend policy doesn't affect firm value under perfect market conditions
• Bird-in-hand theory argues investors prefer certainty of dividend payments over potential future capital gains
• Tax preference theory posits investors may prefer capital gains to dividends due to more favorable tax treatment (capital gains tax vs. income tax)
• Signaling theory suggests dividend policy changes convey information about firm's future prospects
  • Example: A dividend increase might signal management's confidence in future earnings

Share Repurchases and Residual Dividend Policy

• Share repurchases offer alternative to cash dividends, providing tax advantages and flexibility in returning cash to shareholders
  • Methods:
    • Open market repurchases
    • Tender offers
    • Dutch auctions
• Residual dividend policy determines payments based on funds remaining after financing all profitable investment opportunities
  • Steps:
    1. Determine optimal capital budget
    2. Identify target capital structure
    3. Use internal financing as much as possible
    4. Pay dividends from residual funds

Investment Project Evaluation: NPV vs IRR

Net Present Value (NPV) Method

• NPV calculates present value of all future cash flows minus initial investment
  • NPV formula: $NPV = \sum_{t=1}^{n} \frac{CF_t}{(1+r)^t} - CF_0$
    • CFt = Cash flow at time t
    • r = Discount rate
    • CF0 = Initial investment
• NPV decision rule accepts projects with positive NPV, increasing firm value
  • Example: Project A with NPV of $100,000 should be accepted, while Project B with NPV of -$50,000 should be rejected

Internal Rate of Return (IRR) Method

• IRR calculates discount rate making NPV of project equal to zero
  • IRR formula: $0 = \sum_{t=1}^{n} \frac{CF_t}{(1+IRR)^t} - CF_0$
• IRR decision rule suggests accepting projects with IRR greater than required rate of return or cost of capital
  • Example: If cost of capital is 10%, a project with IRR of 15% should be accepted

Comparing NPV and IRR

• NPV and IRR may lead to conflicting decisions for mutually exclusive projects or projects with non-conventional cash flows
  • Example: Project X (NPV: $1,000,000, IRR: 20$1,200,000, IRR: 18%)
• Modified internal rate of return (MIRR) addresses limitations of traditional IRR by assuming reinvestment at cost of capital
  • MIRR formula: $MIRR = \sqrt[n]{\frac{FV(\text{positive cash flows})}{PV(\text{negative cash flows})}} - 1$
• Sensitivity analysis and scenario analysis assess impact of key variable changes on NPV and IRR calculations
  • Example: Analyzing project NPV under optimistic, most likely, and pessimistic scenarios for sales growth