Key Concepts and Skills

q Know

the basic types of financial management

decisions and the role of the Financial Manager
q Know the financial implications of the various
forms of business organization
q Know the goal of financial management
q Understand the conflicts of interest that can
arise between owners and managers
q Understand the various types of financial
markets
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Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

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
Corporation
1.5 Financial Markets

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1.1 What is Corporate Finance?

Corporate Finance addresses the following
three questions:
1.
2.
3.

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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Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

Balance Sheet Model of the Firm

Total Value of Assets:

Current Assets

Total Firm Value to Investors:

Current
Liabilities
Long-Term
Debt

Fixed Assets
1 Tangible
2 Intangible
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Shareholders
Equity
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

The Capital Budgeting Decision

Current
Liabilities

Current Assets

Long-Term
Debt
Fixed Assets
1 Tangible
2 Intangible
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What long-term
investments
should the firm
choose?

Shareholders
Equity

Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

The Capital Structure Decision

Current
Liabilities

Current Assets

How should the

firm raise funds
for the selected
Fixed Assets
investments?
1 Tangible
2 Intangible
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Long-Term
Debt

Shareholders
Equity

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Short-Term Asset Management

Current Assets

Fixed Assets
1 Tangible
2 Intangible
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Current
Liabilities
Net
Working
Capital

How should
short-term assets
be managed and
financed?

Long-Term
Debt

Shareholders
Equity

Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

Capital Structure
The 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.

70%50%30%
25%
DebtDebt
Equity
75%
50%
Equity

If how you slice the pie affects the size of the pie,
then the capital structure decision matters.
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Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

The Financial Manager

The Financial Managers primary goal is to
increase the value of the firm by:
1. Selecting value creating projects
2. Making smart financing decisions

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Hypothetical Organization Chart

Board of Directors
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

Credit Manager

Tax Manager

Cost Accounting

Capital Expenditures

Financial Planning

Financial Accounting

Data Processing

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The Firm and the Financial Markets

Firm

Firm issues securities (A)

Invests
in assets
(B)

Retained
cash flows (F)
Short-term debt
Cash flow
from firm (C)

Dividends and
debt payments (E)
Taxes (D)

Current assets
Fixed assets

Ultimately, the firm

must be a cash
generating activity.
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Financial
markets

Government

Long-term debt
Equity shares

The cash flows from

the firm must exceed
the cash flows from
the financial markets.

Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

1.2 The Corporate Firm

o

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

o
o

The Sole Proprietorship

The Partnership
n
n

General Partnership
Limited Partnership

The Corporation

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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

o

What is the correct goal?

n
n
n
n

Maximize profit?
Minimize costs?
Maximize market share?
Maximize shareholder wealth?

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1.4 The Agency Problem

o Agency

relationship

n Principal

hires an agent to represent his/her interest

n Stockholders (principals) hire managers (agents) to
run the company
o Agency

problem

n Conflict

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of interest between principal and agent

Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

Managerial Goals
o

Managerial goals may be different from

shareholder goals
n
n
n

Expensive perquisites
Survival
Independence

Increased growth and size are not necessarily

equivalent to increased shareholder wealth

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Managing Managers
o Managerial

compensation

n Incentives

can be used to align management and

stockholder interests
n The incentives need to be structured carefully to
make sure that they achieve their intended goal
o Corporate

control

n The

threat of a takeover may result in better

management

o Other
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stakeholders
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

1.5 Financial Markets

o

Primary Market
n

Issuance of a security for the first time

Secondary Markets
n
n

Buying and selling of previously issued securities

Securities may be traded in either a dealer or
auction market
o
o

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NYSE
NASDAQ

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Financial Markets

Firms

Stocks and
Bonds
Money

Investors
Bob

securities

Sue

money
Primary Market
Secondary
Market
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Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

Quick Quiz
o What

are the three basic questions Financial

Managers must answer?
o What are the three major forms of business
organization?
o What is the goal of financial management?
o What are agency problems, and why do they exist
within a corporation?
o What is the difference between a primary market
and a secondary market?
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Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.