Chapter 1 © 2009 Cengage Learning/South-Western FIN 3303 Business Finance.

Chapter 1

© 2009 Cengage Learning/South-Western

FIN 3303 Business Finance

Business Finance aka Corporate Finance

• Primarily concerned with corporations. But most of what we learn also applies to other legal forms of business, including:

• Sole Proprietorships

• Partnerships

• Limited Partnerships

• S Corporations

• Limited Liability Companies

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Sole Proprietorships

• Owned by one person.

• Owner bears personal liability for all debts of the business

• Unlimited liability

• Taxed only once, as an individual --- all income reported on proprietor’s personal tax return

• Limited lifespan – business ends when proprietor dies

3

General Partnerships

• Two or more owners, each of whom owns a designated percentage of the firm (not necessarily equal)

• Owners may be individuals, corporations, or other partnerships

• Joint and Several liability – each one of the partners can be held liable for all of the debts of the firm

• Taxed only once, each partner reports his share of the profits on his own tax return

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Limited Partnerships

• Must have at least one general partner

• Has one or more limited partners – liability for the firm’s debts is restricted to the amount of his investment

• Limited partners may not participate in management of the company

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Corporations

• One or more owners set up a legal entity that has many of the same rights as an individual

• Owners buy stock in the corporation – make an equity investment known as stockholders or shareholders

• Stockholders may be individuals, partnerships, or other corporations

• Stockholders have limited liability

• Corporate profits are taxed twice. First to the corporation and then stockholder’s dividends are taxed

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S Corporations

• A special type of corporation

• Stockholders have limited liability

• Profits are only taxed once – no corporate income taxes are paid

• Cannot have more than 75 stockholders

• Stockholders must be individuals or certain types of trusts

• The Corporation may not hold a controlling interest in another corporation

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Limited Liability Companies (LLC)

• Similar to S Corporations

• Taxed like a partnership but have limited liability

• May have any number of owners

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9

Financial Management

External Financing

Capital Budgeting

Corporate Governance

Risk Management

Corporate Finance

Functions

Corporate Finance Functions

External Finance

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Investors Company

Invest in the company, by buying its stocks or bonds

Raise capital from investors , by selling its stock or bonds

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The External Financing Function

• Raising capital from investors to support companies’ operations and investment programs externally, from – shareholders (equity) by selling stock to investors– creditors (debt) by selling bonds to investors or

otherwise borrowing from investors

• Corporations can raise equity capital privately,

• or they may go public by conducting an initial public offering (IPO) of stock.

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Capital Budgeting – selecting the best projects in which to invest the resources of the

firm, based on each project’s perceived risk and expected

return.

Select investments for which the marginal benefits exceed the marginal costs.

The Capital Budgeting Function

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The Financial Management Function

• Managing firms’ internal cash flows,

• and its mix of debt and equity financing,

• to maximize the value of the debt and equity claims on firms, and

• to ensure that companies can pay off their obligations when they come due.

Involves obtaining seasonal financing, managing inventories, paying suppliers, collecting from customers, and investing surplus cash

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The Corporate Governance Function

Developing ownership and corporate governance structures for companies that

ensure that managers behave ethically and make decisions that benefit shareholders.

Dimensions of corporate governance

• Boards of directors• Compensation packages• Auditors• Country’s legal environment -

in U.S., Sarbanes-Oxley Act of 2002

The takeover market disciplines firms that do not govern themselves.

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The Risk Management Function

• Managing firms’ exposures to all types of risk,

• both insurable (such as loss caused by fire or flood) and uninsurable,

• in order to maintain optimum risk-return trade-offs and thereby maximize shareholder value.

• Modern risk management focuses on adverse interest rate movements, commodity price changes, and currency value fluctuations.

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Debt & Equity: Two Flavors of Capital

Debt Capital

• Borrowed money.• The borrower is obliged to pay

interest, at a specified annual rate, on the full amount borrowed, as well as to repay the principal amount at the debt’s maturity.

Equity Capital

• An ownership interest usually in the form of common or preferred stock.

• Common stockholders receive returns on their investments only after creditors and preferred stockholders are paid in full.

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Financial Intermediation

Financial Intermedia

ry

• An institution that raises capital by issuing liabilities against itself, and then lends that capital to corporate and individual borrowers.

• Examples: insurance companies, savings and loan institutions, credit unions, commercial banks, pension funds, mutual funds.• Pension funds and mutual funds, have

surged to prominence as corporate finance shifts towards greater reliance on market-based external funding.

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Total Value of Primary Corporate Security Issues, 1990 - 2006

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The Growth of Stock Market Capitalization

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The Corporate Financial Manager’s Goals

• Maximize profit? (accounting profit)– Earnings reflect past performance, rather than

current or future performance.– Ignores the timing of the profits.– Ignores cash flows.– Ignores risk.

What should a financial manager try to maximize?

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The Corporate Financial Manager’s Goals

• Maximize shareholder wealth?– As measured by the market price of the firm’s

stock.– A firm’s stock price reflects the timing,

magnitude, and risk of the cash flows that investors expect a firm to generate over time.

– Shareholders are the residual claimants of a firm.

What should a financial manager try to maximize?

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The Corporate Financial Manager’s Goals

• Focus on stakeholders?– Many firms seek to preserve the interests of

other stakeholders, such as employees, customers, tax authorities, and the communities where the firms operate.

– Doing so provides long-term benefits to shareholders and is in line with the primary goal of maximizing shareholder wealth.

What should a financial manager try to maximize?

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Agency Costs in Corporate Finance

• To overcome agency problems:– Rely on market forces to exert managerial

discipline;– Incur monitoring and bonding costs to

supervise managers; and– Structure executive compensation packages to

align managers’ interests with stockholders’ interests.

Agency Problems

• The conflict between the goals of a firm’s owners and its managers.

The actual workings of many compensation plans have been harshly criticized in recent years.

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Ethics in Corporate Finance

• Today, society in general and the financial community in particular are developing and enforcing higher ethical standards.

• The U.S. Congress passed the Sarbanes-Oxley Act in 2002 to enforce higher ethical standards and increase penalties for violators.

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The Scope of Corporate Finance

• Financial managers should seek to maximize shareholders’ wealth.

• How? By performing the five basic duties of corporate finance: External financing, capital budgeting, financial management, risk management, corporate governance.

• Select investments for which the marginal benefits exceed the marginal costs.