Corporate Finance, 2eby Smart, Megginson, Gitman

Chapter 1The Scope Of Corporate FinanceProfessor XXXXXCourse Name / Number

What is Corporate Finance?The activities involved in managing cash flows in a business environment

The Core Principles of FinanceThe time value of moneyThe opportunity to earn a return on invested funds means that a dollar today is worth more than a dollar in the future.Compensation for riskInvestors expect compensation for bearing risk.

The Core Principles of FinanceDont put your eggs in one basketInvestors can achieve a more favorable trade-off between risk and return by diversifying their portfolios.Markets are smartCompetition for information tends to make markets efficient.No arbitrageArbitrage opportunities are extremely scarce.

The 5 Basic Corporate Finance Functions

The Financing FunctionBusinesses can raise money in 2 ways:externally from investors or creditorsIPOsPrimary market transactionsSecondary market transactionsinternally by retaining operating cash flowsMost common method

Raising Capital: Key FactsPrimary vs. secondary market transactions or offeringsMost financing from internal rather than external sourcesMost external financing is debtFinancial intermediaries declining as a source of capital for large firmsSecurities markets growing in importance

The Total Value of Primary (Capital-Raising) Corporate Security Issues, 1990 2004

Growth in Global Security Issues

The Capital Budgeting Function

The Capital Budgeting FunctionThe capital budgeting process consists of three steps.Step 1 - identifying potential investmentsStep 2 - analyzing those investments to identify which will create shareholder valueStep 3 - implementing and monitoring the investments selected in step 2

The Financial Management FunctionManaging daily cash inflows and outflowsForecasting cash balancesBuilding a long-term financial planChoosing the right mix of debt and equity

The Corporate Governance FunctionHires and promotes qualified, honest people, and structures employees financial incentives to motivate them to maximize firm valueIn practice the incentives of stockholders, managers, and other stakeholders often conflict.Dimensions of corporate governance:Board of directorsSecurities and Exchange CommissionSarbanes-Oxley Act of 2002

Value of Global Mergers & Acquisitions

The Risk Management FunctionIdentifying, measuring, and managing all types of risk exposuresSome risks are insurable, and some risks can be reduced through diversification.Financial instruments like forwards, futures, options, and swaps may also be used to hedge market risks such as interest-rate, price, and currency fluctuations.

Business Organizational Formsin the United StatesSole ProprietorshipsNo Distinction Between Business & OwnerEasy To Set Up, Operate; Business Earnings Taxed As Personal IncomeLimited Life, Limited Access to Capital, Unlimited Personal LiabilityPartnershipsTwo Or More OwnersJoint and Several LiabilityLimited Life, Limited Access to Capital, Unlimited Personal LiabilityLimited PartnershipsOne Or More General Partners with Unlimited Personal LiabilityMost Partners are Totally Passive with Limited Liability - Limited Partners; Share of Profits Taxed as Partnership Income

Business Organizational Formsin the United StatesAre there any disadvantages for corporations? YES! Double taxation CorporationsSeparate Legal Entity With Many of the Economic Rights & Responsibilities of IndividualsUnlimited Life, Limited Liability, Separable Contracting, Unlimited Access to CapitalOwned by Shareholders, Who Elect the Board of DirectorsIn the U.S., Incorporation is Executed At State Level and Governed by State Law

Taxation of Business IncomeAFTER the Jobs and Growth Tax Relief Reconciliation Act of 2003

Business Organizational Formsin the United StatesS CorporationsShareholders are taxed as partners while still retaining Limited Liability as Corporate ShareholdersStatus is Subject to Several Eligibility RequirementsLimited- Liability CompaniesCombines the Partnerships Pass-Through Taxation with the S Corporations Limited Liability

Forms of Business OrganizationsUsed by Non-U.S. CompaniesBritain: public limited companies (PLC)Germany: Aktiengesellschaft (AG)France: Socit GnraleSpain, Mexico, and elsewhere in Latin America: Sociedad AnnimaHistorically, the telephone, television, utility, airline and railroad companies in many European countriesPrivatization programs have reduced the role of the states around the worldHow much has been raised through Privatization Programs?State-Owned EnterprisesLimited-Liability Companies

Worldwide Privatization Revenues

What Should a Financial Manager Try to Maximize?Maximize Profit?Earnings per share are backward-looking, dependent on accounting principles,Do not fully consider cash flow timing Ignores riskMaximize Shareholder Wealth?Maximize stock price, not profitsShareholders, as residual claimants, have better incentives to maximize firm value.

World Stock Market Capitalization

Agency CostsManagers act as agents of the owners who hired them and gave them decision-making authority to manage the firm for the owners benefit.In practice however, self-interests may cause managers to pursue objectives other than shareholder-wealth maximization.This conflict of goals gives rise to managerial agency problems.

How Agency Costs Can Be ControlledWays to overcome agency problems:TakeoversMonitoring and bondingCompensation contractsExecutive compensation packages

Importance of EthicsWidespread publicity surrounding numerous ethical violations began with the Enron collapse in late 2001. Society in general and the financial community in particular are developing and enforcing ethical standards.Ethical behavior is necessary in order to maximize shareholders wealth.