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Introduction to Corporate Finance

Chapter 1

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Key Concepts and Skills

Know the basic types of financial managementdecisions and the role of the Financial Manager

Know the financial implications of the various forms of

business organization

Know the goal of financial management

Understand the conflicts of interest that can arisebetween owners and managers

Understand the various types of financial markets

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Chapter Outline

1.1 What is Corporate Finance?

1.2 The Corporate Firm

1.3 The Goal of Financial Management

1.4 The Agency Problem and Control of the

Corporation1.5 Financial Markets

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1.1 What is Corporate Finance?Corporate Finance addresses the following

three questions:

What long-terminvestments should the firm

choose?

How should the firm raise funds for the selected

investments? How should short-term assets be managed and

financed?

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Balance Sheet Model of the Firm

CurrentAssets

Fixed Assets1 Tangible

2 Intangible

Total Value of Assets:

Shareholders

Equity

Current

Liabilities

Long-Term

Debt

Total Firm Value to Investors:

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The Capital Budgeting Decision

Current

Assets

Fixed Assets

1 Tangible

2 Intangible

Shareholders

Equity

Current

Liabilities

Long-TermDebt

What long-terminvestmentsshould the firmchoose?

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The Capital Structure Decision

How should the

firm raise funds

for the selected

investments?

Current

Assets

Fixed Assets

1 Tangible

2 Intangible

Shareholders

Equity

Current

Liabilities

Long-TermDebt

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Short-Term Asset Management

How should

short-term assetsbe managed andfinanced?

Net

WorkingCapital

Shareholders

Equity

Current

Liabilities

Long-TermDebt

Current

Assets

Fixed Assets

1 Tangible

2 Intangible

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Capital StructureThe value of the firm can be

thought of as a pie.

The goal of the manager is

to increase the size of the

pie.

The Capital Structure

decision can be viewed as

how best to slice the pie.

If how you slice the pie affects the size of the

pie, then the capital structure decision matters.

50%

Debt

50%

Equity

25%

Debt

75%

Equity

70%

Debt30%

Equity

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The Financial ManagerThe Financial Managers primary goal is to

increase the value of the firm by:

Selecting value creating investment projects Making smart financing decisions

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Hypothetical Organization Chart

Chairman of the Board andChief Executive Officer (CEO)

Board of Directors

President and ChiefOperating Officer (COO)

Vice President andChief Financial Officer (CFO)

Treasurer Controller

Cash Manager

Capital Expenditures

Credit Manager

Financial Planning

Tax Manager

Financial Accounting

Cost Accounting

Data Processing

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()

(,CFO)

(CEO)

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Cash flowfrom firm (C)

The Firm and the Financial Markets

Tax

es

(D)

Firm

Government

Firm issues securities (A)

Retainedcash flows (F)

Invests

in assets

(B)

Dividends anddebt payments (E)

Current assets

Fixed assets

Financial

markets

Short-term debt

Long-term debt

Equity shares

Ultimately, the firm

must be a cash

generating activity.

The cash flows from

the firm must exceed

the cash flows from

the financial markets.

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1.2 The Corporate Firm The corporate form of business is the

standard method for solving the problems

encountered in raising large amounts of cash. However, businesses can take other forms.

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Forms of Business Organization The Sole Proprietorship The Partnership

General Partnership Limited Partnership

The Corporation

http://www.nolo.com/

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(Unlimited Liability)

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(Limited Liability)

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A Comparison Corporation Partnership

Liquidity Shares can be easily

exchanged

Subject to substantial

restrictions

Voting Rights Usually each share gets one

vote

General Partner is in charge;

limited partners may have

some voting rights

Taxation Double Partners pay taxes on

distributions

Reinvestment and dividend

payout

Broad latitude All net cash flow is

distributed to partners

Liability Limited liability General partners may have

unlimited liability; limited

partners enjoy limited

liability

Continuity Perpetual life Limited life

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1.3 The Goal of Financial Management

What is the correct goal? Maximize profit?

Minimize costs? Maximize market share?

Maximize shareholder wealth?

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QUIZ

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QUIZ

Ans:

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QUIZ

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QUIZ

Ans:

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()

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(1952) / (1958&1963)M&M

/ / (1964)

(1965)

/ / (1973)

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1.4 The Agency Problem (

Agency relationshipPrincipal hires an agent to represent his/her interest

Stockholders (principals) hire managers (agents) torun the company

Agency problem

Conflict of interest between principal and agent

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Managerial Goals

Managerial goals may be different from

shareholder goals

Expensive perquisites

Increased growth and size are not necessarily

equivalent to increased shareholder wealth

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Managing Managers

Managerial compensation Incentives can be used to align management and

stockholder interestsThe incentives need to be structured carefully to

make sure that they achieve their intended goal

Corporate controlThe threat of a takeover may result in better

management

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1.5 Financial Markets

Primary Market Issuance of a security for the first time

Secondary Markets Buying and selling of previously issued securities

Securities may be traded in either a dealer or

auction market NYSE

NASDAQ

http://www.nyse.com/http://www.nasdaq.com/http://www.nasdaq.com/http://www.nyse.com/

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Financial Markets

Firms Investors

Secondary

Market

money

securitiesSueBob

Stocks and

Bonds

Money

Primary Market

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Quick QuizWhat are the three basic questions Financial

Managers must answer?

What is the goal of financial management?

What are agency problems, and why do they existwithin a corporation?

What is the difference between a primary marketand a secondary market?