© 2005 Pearson Education Canada Inc. BZUPAGES.COM 1-1 Chapter One Overview of Corporate Finance Principles of Corporate Finance Canadian Edition Lawrence.

© 2005 Pearson Education Canada Inc.

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Chapter OneOverview of Corporate Finance

Principles of Corporate Finance

Canadian Edition

Lawrence J. Gitman and Sean Hennessey


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Learning Goals

LG1 – Define finance and describe its three major areas and career opportunities.

LG2 – Review basic forms of business organization, their strengths and weaknesses.

LG3 – Describe managerial finance function and differentiate from economics and accounting.


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Learning Goals (continued)

LG4 – Identify key activities of financial manager within the firm.

LG5 – Explain why wealth maximization is firm’s goal.

LG6 – Explain how EVA, stakeholder focus, and ethical behaviour relate to firm’s goal.

LG7 – Discuss agency issue as it relates to owner wealth maximization.


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What is Finance?

• At the macro level, finance is the study of financial institutions and financial markets and how they operate within the financial system in both the Canadian and global economies.

• At the micro level, finance is the study of financial planning, asset management, and fund raising for businesses and financial institutions.

• Financial management can be described in brief using the following balance sheet.


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What is Finance?

Assets: Liabilities & Equity:

Current Assets Current Liabilities

Cash & M.S. Accounts payable

Accounts receivable Notes Payable

Inventory Total Current Liabilities

Total Current Assets Long-Term Liabilities

Fixed Assets: Total Liabilities

Gross f ixed assets Equity:

Less: Accumulated dep. Common Stock

Goodw ill Paid-in-capital

Other long-term assets Retained Earnings

Total Fixed Assets Total Equity

Total Assets Total Liabilities & Equity

WorkingCapital

WorkingCapital

InvestmentDecisions

FinancingDecisions

Macro Finance


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What is Finance?• A well-developed financial system is a hallmark and

essential characteristic of any modern developed nation.

• Financial markets, financial intermediaries, and financial management are the important components.

• Financial markets and financial intermediaries facilitate the flow of funds from borrowers to savers.

• Financial management involves the efficient use of financial resources in the production of goods.


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Areas of Specialization in Finance

• Financial Markets– Markets of users and savers of funds.

• Financial Services– Design and delivery of financial advice and

products to individuals, businesses, government.

• Managerial Finance– Financial management of business firms.


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Areas of Employment in Finance

• Financial Analyst

• Capital budgeting analyst/manager

• Project finance manager

• Cash manager

• Credit analyst/manager

• Pension fund manager


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Basic Forms of Business Organization

• Sole Proprietorship– Owned by one person, operated for personal profit.

• Partnerships– Owned by two or more people, operated for joint

profit.

• Corporations– “Legal entity”, owned by individuals, operated for

joint profit.


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Sole Proprietorship

STRENGTHS:• Low organizational cost• Income taxed once as

personal income• Independence• Secrecy• Ease of dissolution

WEAKNESSES:• Unlimited liability• Limited funding• Proprietor must be all• Difficult to develop staff

career opportunities• Lack of continuity on

death of proprietor


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Partnerships

STRENGTHS:• Improved funding

sources• Increased managerial

talent• Income split by

partnership contract, taxed as personal income

WEAKNESSES:• Unlimited liability to

all partners• Partnership dissolved

upon death of partner• Difficult to liquidate

or transfer ownership


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Corporations

STRENGTHS:• Owners’ liability limited• Large capitalization

possible, greater funding• Ownership readily

transferable• Indefinite life• Professional management

WEAKNESSES:• Higher tax rates• Expensive organization• Greater government

regulation• When publicly traded,

lacks secrecy


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Corporate Organization Chart


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Organization of Finance Functions

• CFO – Chief Financial Officer

• Treasurer responsibilities:– Financial planning, fund raising, capital

expenditure decisions, cash and credit management.

• Controller responsibilities:– Corporate accounting, cost accounting, and tax

management.


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Relationship to Economics

Fundamental Economic Principle:

• Marginal Analysis– Financial decisions should be made and actions

taken only when the added benefits exceed the added costs.


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Relationship to Accounting

• Cash Flows– Accrual Basis: recognizes sales revenue and

expenses incurred to make sale at time of sale.– Cash Basis: recognizes revenues and expenses

as they occur.


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Accounting vs. Financial ViewsAccounting View(Accrual Basis)

Income StatementPeakes Quay, Inc.

For year ended 12/31

Financial View(Cash Basis)

Cash Flow StatementPeakes Quay, Inc.

For year ended 12/31

Sales revenue $100,000Less: Costs 80,000Net Profit $ 20,000

Cash inflow $ 0Less: Cash outflow 80,000Net cash flow ($80,000)


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Financial Manager–Key Activities

Balance Sheet

CurrentAssets

_______________FixedAssets

CurrentLiabilities

_______________Long-Term Funds(Debt & Equity)

Financial Analysis & Planning

MakingInvestmentDecisions

MakingFinancingDecisions


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Should Firms Maximize Profit?

• Corporations commonly define profit as “Earnings per Share” (EPS).– A measure of total earnings divided by total

number of ownership shares.

• EPS ignores critical factors of– the timing of the returns.– cash flows available to common shareholders.– risk factors facing the firm.


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Or Should Firms Maximize Shareholder Wealth?

• Evaluating Shareholder Wealth addresses factors of timing, cash flows and risk ignored by the EPS.

• Therefore, Maximizing Shareholder Wealth is a more comprehensive goal for the firm, its managers and employees.

• This can be explored through “economic valued added” and a focus on stakeholders.


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Economic Value Added – EVA®

• EVA measures whether an investment contributes to shareholder wealth.

• EVA is calculated by subtracting cost of funds used from after-tax operating profits.

• While popular, EVA is essentially derived from the concept of “net present value.”


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What about Stakeholders?

• Stakeholders include groups that have direct economic links to the firm.

• Stakeholders include not only owners, but also employees, customers, suppliers, and creditors.

• Maintaining positive stakeholder relationships helps maximize long-term benefits to shareholders.


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Importance of EthicsThe standards of conduct or moral judgment:• Honesty, trustworthiness, fair dealing are

foundations of sustainable business relations:– With customers,– With suppliers,– With creditors,– With employees,– With owners.

• Ethical behaviour is necessary to achieve the goal of maximizing shareholder wealth.


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Internal Ethical Review

• Are rights of stakeholders being violated?• Does firm have extra duties to stakeholders?• Will a decision unfairly discriminate benefits

among stakeholders?• If stakeholders are harmed, should this be

remedied? How?• What is the relationship between shareholders

and stakeholders?


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Financial Goals of a Company

• Maximize sales.• Maximize cash flow.• Maximize market

share.• Maximize profit.• Minimize costs.

• Maximize return on sales, investment, equity.

• Ensure earnings stability.

• Achieve target goals for sales, profits, market share or return.


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Agency Issues: The Principal-Agent Problem

• Whenever ownership is independent of management there exists potential problem of conflicts.

• The owner’s goals for the firm are best described as maximizing shareholder wealth.

• Managers are also concerned with personal wealth, job security, lifestyle, and benefits. These concerns may conflict with shareholder interests.


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Resolving the Agency Problem

• Good corporate governance by the Board of Directors is the heart of any resolution.

• Agency Costs – the costs of this governance:– Monitoring costs,– Bonding costs,– Structuring compensation costs.

• Market forces, such as the potential for hostile takeover provide some deterrence.

• Legal forces, fraud, and fiduciary misconduct laws aim to act as deterrents as well.


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Current View on Incentive Plans

• Executive compensation packages generally include incentive plans that grant stock options, performance-based shares, or cash bonuses upon meeting or exceeding corporate goals.

• Such packages may also include long-term benefits that can protect the manager against poor corporate performance.


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Overview of Text

Part 1: Introduction to Corporate Finance

Part 2: Financial Analysis and Planning

Part 3: Important Financial Concepts

Part 4: Long-Term Financial Decisions

Part 5: Long-Term Investment Decisions

Part 6: Working Capital Management

Part 7: Special Topics in Corporate Finance

© 2005 Pearson Education Canada Inc. BZUPAGES.COM 1-1 Chapter One Overview of Corporate Finance Principles of Corporate Finance Canadian Edition Lawrence.

Documents

pearson education canada

financial intermediaries

secrecy slide

study of financial planning

delivery of financial

financial services design

death of proprietor

transfer ownership slide