Chapter 1: Introduction to

corporate finance
Corporate Finance
Ross, Westerfield &
Jaffe

Outline
1.1 What is corporate finance?
1.2 The goal of financial management
1.3 The agency problem and control of the
corporation
1.4 Ethics and corporate governance
1.5 Financial markets

Main tasks of corporate finance

Capital budgeting: the process of planning

and managing a firms long-term investments
fixed assets.
Capital structure: the mixture of debt and
equity maintained by the firm S-T and L-T
debt and equity.
Working capital management: a firms shortterm assets and liabilities current assets
and current liabilities.

The Capital Budgeting Decision

Current
Liabilities

Current
Assets

Fixed Assets
1 Tangible
2 Intangible

Long-Term
Debt

What long-term
investments
should the firm
choose?

Shareholders
Equity

Modern form of firms

Corporation: a business created as a distinct legal

entity composed of one or more individuals or
entities, e.g., IBM.

Separation of control (shareholders) and management

(professionals).
Ownership can be easily transferred.
Limited liability.
Double taxation.
Rather expensive to form.
Agency problems.

Who make the decisions?

Owners

(typically in small businesses).

Professional managers.

Financial managers
Frequently,

financial managers try to address

these tasks.
The top financial manager within a firm is
usually the Chief Financial Officer (CFO).

Treasurer oversees cash management, credit

management, capital expenditures and financial
planning.
Controller oversees taxes, cost accounting,
financial accounting and data processing.

Possible goals of financial

management
Survive
Beat

the competition
Maximize sales
Maximize net income
Maximize market share
Minimize costs
Maximize the value of (stock) shares

The appropriate goal of financial

management

Maximize the (fundamental or economic) value of

(stock) shares is the right goal.
Why? Shareholders own shares. Managers, as
agents, ought to act in a way to benefit
shareholders; i.e., to enhance the value of the
shares.
A limitation of this goal is that value is not directly
observable.

Home Depot CEO gets $210 million

severance for sucking at job
Robert

L. Nardelli, the CEO of Home Depot,

who came under heavy criticism for his pay
package and failure to lift the chain s
stagnant stock price, has abruptly resigned.
He will receive about $210 million in
compensation from the company, including
the current value of retirement and other
benefits. Who would blame him for quitting?
Source:digg.com; submitter: tennova.

Value vs. price

The value of shares are not observable. In contrast, the

price of shares can be observable.
If one believes that share price is an accurate/good
estimate of share value, the appropriate goal would be to
maximize the price of shares.
This belief/assumption is, however, questionable.
But the previous slide (Home Depot ex-CEO),
nevertheless, showed that investors care about stock
price, and that stock price performance is very important
to the tenure of managers.

The agency problem

Agency relationship:

Principals (citizens) hire an agent (the president) to

represent their interest.
Principles (stockholders) hire agents (managers) to run the
company.

Agency problem:

Conflict of interest between principals and agents.

This occurs in a corporate setting whenever the agents do
not hold 100% of the firms shares.
The source of agency problems is the separation of
(owners) control and management.

Agency costs

Direct costs: (1) unnecessary expenses,

such as a corporate jet, and (2) monitoring
costs.
Indirect costs. For example, a manager
may choose not to take on the optimal
investment. She/he may prefer a less risky
project so that she/he has a higher
probability keeping her/his tenure.

Managerial incentives
Managerial

goals are frequently different

from shareholders goals.

Expensive perks.
Survival.
Independence.

Growth

and size (related to compensation)

may not relate to shareholders wealth.

Corporate governance

Compensation:

Corporate control:

Incentives ($$$, options, threat of dismissal, etc.) used to

align management and stockholder interests.
Managers may take the threat of a takeover seriously and
run the business in the interest of shareholders.

Pressure from other stakeholders (e.g., CalPERS, a

powerful corporate police).

Sarbanes-Oxley Act (2002)

Sarbox.
10K

must have an assessment of the firms

internal control structure and financial reporting.
The officers must explicitly declare that 10K
does not contain any false statements or
material omissions.
The officers are responsible for all internal
controls.

Ethics

Managers are expected to behave in an ethical

manner.
The province of ethics is to sort out what is good and
bad.
But, what is the criterion or guideline for doing so?
Philosophers came up with some criteria, but none
of them makes sorting out what is good and bad an
easy task.
Here, we introduce two of these criteria.

Principle 1
Golden

rule: Do unto others as you would

have others do onto you.
But the next example, the so-called
Sopranoism, shows the limitation of this
principle: Whack the next guy with the same
respect youd like to be whacked with, you
know? (Source: Cathcart and Klein, 2007).

Principle II
Confucianism:

Do not do to others what you

do not want done to yourself.
This is a rather robust (but passive) criterion.
But its limitation is that it says nothing about
what you should do.

Dilemma
Ethical

decisions often yield a dilemma.

Suppose that you were the CEO of investment bank XYZ in

2005. The debt/equity ratio of the bank was 20. All of your
competitors raised their debt/equity ratios to 30 to please
the stock market so that their stock prices could be higher
than otherwise would be. You knew that raising the
debt/equity ratio to 30 was rather risky and could destroy
the bank if business went wrong. But you knew the
investors would be disappointed by the otherwise lower
share price if you did not raise the debt/equity ratio.

So, what is the answer?

I

do not have an answer for this kind of ethical

question because it is a dilemma; otherwise, I
would not use the word dilemma.
All I know is that you, as professional
managers, are expected to behave ethically.
One thing I know for sure is that never do
anything that will put you in a prison cell; you
are too cute for a prison cell.

Financial markets
Cash

flows (i.e., financing and

payoffs/dividends/interests) between firms
and financial markets.
Primary markets.
Secondary markets.
- NYSE.
- Nasdaq.

Info about financial markets

Yahoo!

Finance.

End-of-chapter
Concept

questions: 1-10.