1 Introduction to Corporate Finance
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1Introduction to
Corporate Finance
1.1Corporate Finance and the Financial Manager
FinanceFinance consists of three interrelated
areas:Money and capital marketsInvestmentsCorporate finance
Corporate FinanceThree main areas of concern:
What long-term investments should the firm take?
Where will the firm get the long-term financing to pay for its investments?
How should the firm manage its everyday financial activities?
Financial Management DecisionsCapital budgeting
Strategic long-term investment decisionWhat long-term investments or projects should the firm
take?Capital structure
Strategic long-term financing decisionHow should the firm get the long-term financing to pay
for its investments? What is the mixture of a firm’s debt and equity
financing?Working capital management
Short-term financial planning and managementHow should the firm manage its everyday financial
activities?
The Role of the Financial ManagerForecasting and planningMaking major investments and financing
decisionsCapital budgeting Capital structure Working capital management
Coordination and controlInteraction with money and capital markets
The primary task is to make decisions about sources and uses of funds so as to maximize the value of the firm.
The Financial ManagersThe top financial manager in a firm is usually the
Chief Financial Officer (CFO)Treasurer – cash management, credit management,
capital expenditures, and financial planning, etc.Controller – taxes, cost accounting, financial
accounting and data processing, etc.
Which of the following questions are addressed by financial managers?A. How should a product be marketed?B. Should customers be given 30 or 45 days
to pay for their credit purchases?C. Should the firm borrow more money?D. Should the firm acquire new equipment?
Which one of the following is a capital budgeting decision? A. determining how many shares of stock to
issueB. deciding whether or not to purchase a new
machine for the production lineC. deciding how to refinance a debt issue that
is maturingD. determining how much inventory to keep
on handE. determining how much money should be
kept in the checking account
1.2Forms of Business Organization
Forms of Business OrganizationSole Proprietorship
Partnership Corporation
Owner of the business
Are managers and owners separate?
What is the owner’s liability?
Are the owner and business taxed separately?
Forms of Business OrganizationSole Proprietorship
Partnership Corporation
How is it formed?
How about raising large sums of capital?
What is the life of the business?
How about transferring ownership?
Forms of Business OrganizationSole Proprietorship
Partnership Corporation
Owner of the business
One person Two or more partners
The shareholders
Are managers and owners separate?
No No Yes
What is the owner’s liability?
Unlimited Unlimited Limited
Are the owner and business taxed separately?
No No Yes
Forms of Business OrganizationSole Proprietorship
Partnership Corporation
How is it formed?
Easy Easy Complex and time-consuming
How about raising large sums of capital?
Difficult Difficult Easy
What is the life of the business?
Limited Limited Unlimited
How about transferring ownership?
Difficult Difficult Easy
The Value of the CorporationThe value of a business will probably be
maximized if it is organized as a corporation.Limited liability reduces the firm’s risk. The
lower the firm’s risk, the higher the value.A firm’s value depends on its growth
opportunities. The greater the ability to raise capital, the more its growth opportunities.
The value of the asset depends on its liquidity. The easier the ability to sell the asset and convert it to cash, the higher the value.
1.3The Goal of Financial Management
Possible GoalsMaximize sales?Minimize costs?Maximize profits?Maximize growth?Maximize market share?Maximize stockholder wealth?Maximize stakeholder wealth?
Stakeholders and Their GoalsStakeholder Goal
Owners Dividend or stock appreciation
Managers High salary and perquisites
Creditors Low risk and return of principal and interest
Employees High salary and job security
Customers Low price and high quality
Suppliers High price and long-term relationship
Government Taxes
Society Good citizenship
The Goal of Financial ManagementModern Finance Theory usually assumes that the
objective of the firm is to maximize stockholder wealth.
The goal of financial management in a for-profit business is to make decisions that increase the value of the stock or increase the market value of the equity. Is it good for other stakeholders of the company? Is it good for society?
If the primary goal is appropriately defined, the other goals which are not mutually exclusive can also be accomplished.
1.4Agency Problem
The Agency ProblemAgency relationship
Principal hires an agent to represent his/her interests.
Stockholders (principals) hire managers (agents) to run the company.
Agency problemConflict of interest between principal and
agent.Conflict of interest between stockholders and
managers.
Agency costsThe costs of the conflicts of interest between
stockholders and management.Direct agency costs
Expenditures to monitor managerial actions.Expenditures that benefit the management but
cost the stockholders.Indirect agency costs
Opportunity costs
Managing ManagersProper structuring of managerial incentives
Managerial compensationJob prospects
Control of the firmThe threat of firingThe threat of takeover
1.5Financial Markets
Financial MarketsThe advantages of the corporate form are
enhanced by the existence of financial markets.Easy to transfer ownershipEasy to raise large amounts of capital
Functions Source of fundingInvestor liquidityRisk management Source of information
Primary vs. Secondary MarketsPrimary markets
The original sale of securitiesSecondary markets
The resale of securities after the original sale
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