Assignment 1
SiriP
Chapter1.IntroductiontoCorporateFinance1.pptxFinancial Statements Analysis and Financial Models
Chapter 1
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Key Concepts and Skills
Know the three main concerns of corporate financial management
Grasp the goal of financial management
Enumerate the financial benefits and drawbacks of differing forms of business organization
Understand the conflicts of interest that can arise between owners and managers
Comprehend that corporate organizations are enhanced by financial markets
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Chapter Outline
1.1 What is Corporate Finance?
1.2 The Corporate Firm
1.3 The Importance of Cash Flows
1.4 The Goal of Financial Management
1.5 The Agency Problem and Control of the Corporation
1.6 Regulation
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1.1 What Is Corporate Finance?
Economic resources are required to establish and maintain a firm:
Funds enable materials and processes for delivering salable goods and services
Funds are essential for assembling a workforce
Funds are required to purchase long-lived assets such as equipment and buildings
The Balance Sheet offers insight into the array of decisions, activities and objectives of the Financial Manager
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Balance Sheet Model of the Firm
Current Assets
Fixed Assets
1 Tangible
2 Intangible
Total Value of Assets:
Shareholders’ Equity
Current Liabilities
Long-Term Debt
Total Firm Value to Investors:
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It is sometimes helpful to relate corporate decisions to individual circumstances. For example, consider discussing how individuals choose to buy cars or homes and how this decision would affect a personal balance sheet.
The Balance Sheet Reveals…
…the top three concerns of corporate finance:
What long-term investments should the firm choose?
How should the firm raise funds for the selected investments?
How should current assets be managed and financed?
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The Capital Budgeting Decision
Current Assets
Fixed Assets
1 Tangible
2 Intangible
Shareholders’ Equity
Current Liabilities
Long-Term Debt
What long-term investments should the firm choose?
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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-Term Debt
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Short-Term Asset Management
How should short-term assets be managed and financed?
Net Working Capital
Shareholders’ Equity
Current Liabilities
Long-Term Debt
Current Assets
Fixed Assets
1 Tangible
2 Intangible
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The Financial Manager
The firm’s three main financial concerns are usually handled by a top officer and aides:
V.P. or Chief Financial Officer
Strategist, coordinator, authority
Treasurer
Cash flow, capital expenditures, capital structure
Controller
Accounting, information systems, taxes
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Note, these actions explicitly relate to the three questions addressed in slide 5.
Hypothetical Organization Chart
Chairman of
Vice President and Chief Officer (CFO)
Financial Planning
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1.2 The Corporate Firm
First company problem: raise funds
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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Note: May be appropriate to expand on why the corporate form of business allows for the acquisition of more investment capital than other organizational forms.
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Forms of Business Organization
The Sole Proprietorship
The Partnership
General Partnership
Limited Partnership
The Corporation
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Proprietorships: May be useful to explain that a large quantity of businesses are proprietorships and that their prospects are limited because of the limited capital available to them and the risks they are exposed to.
Partnerships: May be useful to discuss partnerships as a common form of organizing professional services. May also be beneficial to discuss S-Corporations and LLCs in the context of this slide.
A Comparison
Corporation
Partnership
Liquidity and marketability
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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A Global Phenomenon
The corporate form of organization is not unique to the United States:
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1.3 The Importance of Cash Flows
If the firm is to prosper, it must:
Buy assets that generate more cash than they cost
Sell financial instruments that raise more cash than they cost
The successful firm generates more cash than it uses
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The Conceptual Flow of Cash
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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Cash Flow ≠ Accounting Income
Do not confuse cash flow and accounting income
Non-Cash expense example: Depreciation
Non-Cash revenue example: Sales on Account
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1.4 The Goal of Financial Management
What is the correct goal?
Maximize profit?
Minimize costs?
Maximize market share?
Maximize shareholder wealth?
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1.5 The Agency Problem
Agency relationship
Principal hires an agent to represent his/her interest
Stockholders (principals) hire managers (agents) to run the company
Agency problem
Conflict of interest between principal and agent
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A common example of an agency relationship is a real estate broker – in particular if you break it down between a buyer’s agent and a seller;s agent. A classic conflict of interest is when the agent is paid on commission, so they may be less willing to let the buyer know that a lower price might be accepted or they may elect to only show the buyer homes that are listed at the high end of the buyer’s price range.
Direct agency costs – the purchase of something for management that can’t be justified from a risk-return standpoint; monitoring costs.
Indirect agency costs – management’s tendency to forgo risky or expensive projects that could be justified from a risk-return standpoint.
Agency Cost
Cost of Conflict of Interest
Example:
Large investment positions firm for long term positive cash flow but has risk in short run
Owners want this investment – Increases firm value
Managers object – Risk may have personal cost
If managers prevail, foregone long term cash flow is the Agency Cost
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Note, this slide may be a useful entrée into the discussion of management’s goals relative to those of owners.
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Management Goals
Management goals may be different from shareholder goals
Expensive perquisites
Survival
Independence
Increased growth and size
Often lead to management reward
Not necessarily in best interest of shareholders
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Managing Managers
Managerial compensation
Incentives can be used to align management and stockholder interests
The incentives need to be structured carefully to make sure that they achieve their intended goal
Corporate control
The threat of a takeover may result in better management
Influence of other stakeholders
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Incentives – discuss how incentives must be carefully structured. For example, tying bonuses to profits might encourage management to pursue short-run profits and forego projects that require a large initial outlay. Stock options may work, but there may be an optimal level of insider ownership. Beyond that level, management may be in too much control and may not act in the best interest of all stockholders. The type of stock can also affect the effectiveness of the incentive.
Corporate control – ask the students why the threat of a takeover might make managers work towards the goals of stockholders.
Other groups also have a financial stake in the firm. They can provide a valuable monitoring tool, but they can also try to force the firm to do things that are not in the owners’ best interest.
1.6 Regulation
The Securities Act of 1933 and the Securities Exchange Act of 1934
Issuance of Securities (1933)
Creation of SEC and reporting requirements (1934)
Sarbanes-Oxley Act of 2002 (“Sarbox”)
Increased reporting requirements and responsibility of corporate directors
Personal consequences for non-compliance
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Quick Quiz
What are the three basic questions Financial Managers must answer?
What are the three major forms of business organization?
What is the goal of financial management?
What are agency problems, and why do they exist within a corporation?
What major regulations impact public firms?
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