What a firm is deciding
Every subject so far looked at a company from outside. This one sits in the chair: three decisions, repeated forever, and one objective that is less obvious than it sounds.
Chapter 1 · Beginner
Equity, Company analysis and Accounting all look at a company from outside. Corporate finance is the view from the chair.
A firm repeats three decisions, forever.
The three decisions
The investment decision. What should we build, buy or enter? Which projects earn more than they cost? Chapters 2 to 6.
The financing decision. Debt or equity, and in what proportion? Chapters 7 to 11.
The payout decision. What is returned to owners, and how? Chapters 12 and 13.
Everything else — working capital, acquisitions, valuation — is one of these three in a particular setting.
The objective, stated carefully
The textbook answer is "maximise shareholder value". That is right and almost useless until it is made precise, because several more natural-sounding objectives are wrong.
Not maximise profit. Profit is an accounting estimate (the whole of the Accounting subject) and it is measured over one period. A company can raise next year's profit by cutting maintenance, research and marketing — and destroy the business doing it.
Not maximise revenue. Growth bought below cost destroys value faster the more of it you buy.
Not maximise earnings per share. EPS can be raised by buying back shares with borrowed money, which changes the share count and the risk without changing the business.
Maximise the present value of the firm's future free cash flows. That phrasing survives scrutiny because it is explicit about three things the others hide: cash rather than accounting profit, future rather than this period, and present value rather than nominal sum — which means risk and timing are priced in.
Everything in this subject is a tool for evaluating a decision against that criterion.
Working the problem
Raises profit, destroys value: cutting the research budget. The saving lands in this year's profit immediately; the products that would have existed in five years do not. Reported profit rises, the present value of future cash flows falls.
Lowers profit, creates value: building a factory. Depreciation and start-up costs depress profit for years; the cash flows it generates over two decades are worth more than it cost.
What distinguishes them is not profit at all. It is whether the present value of everything that follows went up or down. The accounting result and the value created can point in opposite directions for years at a time, and chapter 3 is the formal statement of that.
The agency problem
The objective assumes someone is pursuing it. Managers are not owners, and their incentives differ in known directions:
- Compensation often tracks reported profit or share price over a few years, while value is created over decades
- Empire-building raises status and may not raise value
- A manager's own career risk is concentrated in one firm, which makes them more cautious about risk than a diversified shareholder would want
In India this has a particular shape. Most listed companies have a dominant promoter group, so the classic manager-versus-shareholder conflict is less central than the majority-versus-minority one: related party transactions, royalty payments, pledged promoter shares. Chapter 6 of the Equity subject reads a shareholding pattern for exactly this reason.
That is why the related party transactions note is on the reading list in chapter 16 of the Accounting subject, and why SEBI's rules concentrate on disclosure and on protecting minority holders.
What constrains the decisions
A firm cannot do whatever maximises value. Three limits run through the subject:
Law. Returning capital is regulated. SEBI's buyback regulations cap a buyback at 25% or less of paid-up capital and free reserves, and require that debt after the buyback is not more than twice paid-up capital and free reserves. Chapter 13 works through why those limits exist.
Capital availability. A positive-value project you cannot finance is not an opportunity.
Information. Outsiders know less than insiders, which makes raising equity expensive at exactly the moments a firm most needs it. Chapter 11 returns to this.
The point
A firm repeats three decisions: what to invest in, how to finance it, and what to return to owners. The objective is the present value of future free cash flows — not profit, revenue or earnings per share, each of which can be raised while value falls. Someone has to be pursuing that objective, which is the agency problem, and in India it usually takes the form of majority against minority rather than managers against owners.
Check yourself
4 questions. Every answer is explained afterwards, including the ones you get right — guessing correctly is not the same as knowing. Score 70% or more and the chapter is marked done.
Question 1 of 4
0 of 4 answered. You can submit with questions unanswered — they simply score zero.
Now do it with your own numbers
Name a decision a company could take that raises reported profit next year and destroys value, and one that lowers reported profit next year and creates it. Say what distinguishes the two.
Cutting something whose benefit arrives later does the first. The distinction is not about profit at all — it is about what happens to the present value of everything that follows.