Chapter 1 © 2009 Cengage Learning/South-Western The Scope of Corporate Finance.

Chapter 1

© 2009 Cengage Learning/South-Western

The Scope of Corporate Finance

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Corporate Finance in Modern Business

• By taking actions that generate benefits in excess of costs, firms generate wealth for their investors.

When contemplating all business decisions, managers should ask:

Does this action create value for the firm’s shareholders?

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Career Opportunities in Finance

Corporate Finance

• Budgeting, financial forecasting, cash management, credit administration, investment analysis, fund procurement

Commercial Banking

• Consumer banking• Corporate banking

Investment Banking

• High income potential• Very competitive industry

Money Manageme

nt

• Opportunities in investment advisory firms, mutual fund companies, pension funds, investment arms of financial departments

Consulting • Advise on business practices and strategies of corporate clients

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Financial Management

External Financing

Capital Budgeting

Corporate Governance

Risk Management

Corporate Finance

Functions

Corporate Finance Functions

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The External Financing Function

• Raising capital to support companies’ operations and investment programs externally, from – either shareholders (equity) or – creditors (debt).

• 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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Sole Proprietorshi

ps

• No distinction between business and person

• Easy to set up, operate; taxed as personal income

• Personal liability, limited life, difficult to transfer

Partnerships• Two or more business owners• Partners - liable for every partner’s

actions

Limited Partnerships

• One or more general partners & many limited partners

• Limited liability of corporation, tax benefits of partnership

Business Organizational Forms in the U.S.

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Corporations

• Legal entity with all the economic rights and responsibilities of a person

• Incorporation occurs at state level; based on state law

• Strengths - limited liability for investors, unlimited business life

Business Organizational Forms in the U.S.

The Finance Function in the Organizational Structure of A Typical Large Corporation

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Corporations in the U.S.

• The Jobs and Growth Tax Relief Reconciliation Act of 2003 (Tax Relief Act of 2003) dramatically reduced the double taxation problem.

Double Taxation Problem

• Taxation of corporate income at both the company and the personal levels.

• This is the single greatest disadvantage of the corporate form.

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Taxation of Business Income for Corporations and Partnerships

Before the Tax Relief Act of 2003

After the Tax Relief Act of 2003

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S Corporations

• Allow shareholders to be taxed as partners yet retain their limited liability status.

• Must meet certain criteria like having 75 or fewer shareholders.

• Can become regular corporations later.

Limited Liability

Companies

• Combine partnerships’ pass-through taxation with S corporations’ limited liability.

• Popular with professional service firms.

Business Organizational Forms in the U.S.

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The Growth of Stock Market Capitalization

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The Corporate Financial Manager’s Goals

• Maximize 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.