First class on Corporate Finance

Anyone who has ever toyed with the idea of becoming a writer knows that writing involves great discipline. It is not as much fun as reading and the adage well begun is half done does not apply to writing. Also, it is said that writing about a topic is the best way to learn the topic. This effort of mine is therefore expected to achieve dual benefits. First, it should be able to lend some discipline to my otherwise aimless life and it should also be able to help me learn the intricacies of the world of finance.

Let me caution the reader now itself that I am a beginner as far as finance is concerned (coming to think of it, I am practically a greenhorn.) Reading on will add value to you only if you have absolutely no idea about finance but want to accompany another beginner in his journey of discovery!

Let me begin by narrating the financial habits of my father in contrast to my own financial habits. My father likes to save. That’s putting it mildly. Supreme happiness for him means depositing his entire salary in some secure instrument such as the Provident Fund for the employees of the Government of India. I am quite the opposite. Money bites me and I am always keen to get rid of it. I know a few restaurant owners who thank their stars everyday for this habit of mine.

Therefore, it follows that if given Rs. 100, my father would promptly deposit it in some saving scheme and I would spend it, slightly more promptly.

One fine day, along comes this fine young Financial Manager. For convenience, we will ascribe to him the highly imaginative acronym FM. He says that if anyone gives him Rs. 100, he will invest it in a project that will guarantee Rs. 125 at the end of the first year. The financial manager is the modern incarnation of Yudhishthir and therefore he cannot lie and we can rest assured that Rs. 100 invested in this project will become Rs. 125 in one year (problems start when we take this guarantee away. But like a physicist who is allowed to consider a horse to be a sphere for simplicity, I am also allowed to assume the existence of perfectly honest financial managers.) The FM also mentions in the passing that the current borrowing rate in the neighbourhood bank is 10%.

My father, as expected, promptly pays up and moves one step closer to supreme happiness. On the other hand, I am confused. The urge to retain the money and spend it on a nice juicy steak is almost irresistible. I know I will gain Rs. 25 if I deposit the money but postponing a steak for one whole year is not my way of doing things. So I decide to be noble and resist the urge of the extra Rs. 25 and spend the money right then. By doing so, I prove that I am a complete financial idiot.

Instead, had I been a financial wizard, I would have promptly paid up and taken a written promise from the FM that he will return Rs. 125 to me in one year. I would have then walked into a local bank and given them the written promise, thereby convincing them that one year from now, I will surely be able to pay them Rs. 125. Since the borrowing rate is 10%, the bank would have gladly lent me (125/1.10)*1 = Rs. 113.64 right at that moment. So, not only would I have had money to spend, I would have actually had Rs. 13.64 extra to spend right now.

And this brings us to a very elegant conclusion regarding the world of finance. As the FM here had so deftly done, the guiding aim of the financial manager is to find projects that will increase the value of the shareholder’s wealth. To put it less politically correctly, it is his job to find or design investments that will have returns higher than the returns the investors normally expect. If he can do so, every investor, regardless of his spending (or saving habits) will have reasons to invest in the firm. A true financial wizard is one to whom every person in this world wants to give her money to!

Therefore, the trick is to be able to correctly identify investments that have such characteristics. Learning corporate finance is about mastering this trick.