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McGraw-Hill/Irwin

Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.

Introduction to Corporate Finance

Chapter 1

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Key Concepts and Skills

Know the basic types of financial management decisions 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 arise between owners and managers

Understand the various regulations that firms face

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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?

Corporate Finance addresses the following three questions:

What long-term investments 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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  • Capital budgeting
  • Capital structure
  • Working capital

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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.

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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 Financial Manager’s primary goal is to increase the value of the firm by:

Selecting value creating projects

Making smart financing decisions

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Note, these actions explicitly relate to the three questions addressed in slide 3.

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Hypothetical Organization Chart

Chairman of the Board and
Chief Executive Officer (CEO)

President and Chief
Operating Officer (COO)

Vice President and
Chief Financial Officer (CFO)

Treasurer

Controller

Cash Manager

Capital Expenditures

Credit Manager

Financial Planning

Tax Manager

Financial Accounting

Cost Accounting

Data Processing

Board of Directors

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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

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It may be beneficial to discuss S-Corporations and LLCs in the context of this slide.

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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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Cash flow
from firm (C)

1.3 The Importance of Cash Flow

Taxes (D)

Retained
cash flows (F)

Invests
in assets
(B)

Dividends and
debt payments (E)

Current assets
Fixed assets

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.

Firm issues securities (A)

Government

Firm

Financial
markets

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It is important to remind students that net income is NOT cash flow.

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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 buyers agent and a sellers 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.

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Managerial Goals

  • Managerial goals may be different from shareholder goals
  • Expensive perquisites
  • Survival
  • Independence
  • 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 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
  • 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.

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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 (“Sarbox”)
  • Increased reporting requirements and responsibility of corporate directors

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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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