UNIVERSITY OF ECONOMICS HO CHI MINH CITY

Chapter 1
Introduction to Corporate Finance
Chapter Outline
1.1 What is Corporate Finance?
1.2 The Corporate Firm
1.3 The Goal of Financial Management
1.4The Agency Problem and Control of the Corporation
Balance Sheet Model of the Firm
Total Value of Assets: Total Firm Value to Investors:
Current
Liabilities
Current Assets
Long-Term
Debt

Fixed Assets
1 Tangible
Shareholders’
2 Intangible Equity
The Capital Budgeting Decision
Current
Liabilities
Current Assets
Long-Term
Debt

Fixed Assets
What long-term
1 Tangible investments Shareholders’
should the firm
2 Intangible Equity
choose?
( capital budgeting,
investment decision)
The Capital Structure Decision
Current
Liabilities
Current Assets
Long-Term
How should the Debt
firm raise funds
for the selected
Fixed Assets
investments?
1 Tangible ( capital structure, or
Shareholders’
2 Intangible financing decision) Equity
Short-Term Asset Management
Current
Liabilities
Current Assets
Net
Working Long-Term
Capital Debt

How should
Fixed Assets
short-term assets
1 Tangible be managed and
financed? Shareholders’
2 Intangible Equity
1.1 What Is Corporate Finance?
Corporate Finance addresses the following three questions:
1. What long-term investments should the firm choose?
( capital budgeting decision, or investment decision)

2. How should the firm raise funds for the selected investments?
( capital structure decision or financing decision)

3. How should short-term assets be managed and financed?

( working capital management)
The Financial Manager (CFO)
The Financial Manager’s primary goal is to increase the value of the firm by:

1. Selecting value creating projects

2. Making smart financing decisions

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 ( Accountant Chief)

Cash Manager Credit Manager Tax Manager Cost Accounting

Capital Expenditures Financial Planning Financial Accounting Data Processing

1.2 Forms of Business Organization
 The Sole Proprietorship : The sole proprietorship is a business owned by one person. It
has unlimited liability for business debt.

 The Partnership
• General Partnership: Each partner is liable for all of the debts of the partnership
• Limited Partnership : require that (1) at least one partner be a general partner and (2) the
limited partners do not participate in managing the business

The Corporation ( joint stock company, public limited company, or limited liability company)
: is a legal entity that is separate and distinct from its owners
A Comparison
Corporation Partnership

Liquidity Shares can be easily Subject to substantial

exchanged restrictions

Voting Rights Usually each share gets one General Partner is in charge;
vote limited partners may have
some voting rights

Taxation Double Partners pay taxes on

distributions
Reinvestment and dividend Broad latitude All net cash flow is
payout distributed to partners

Liability Limited liability General partners may have

unlimited liability; limited
partners enjoy limited
liability
Continuity Perpetual life Limited life
1.3 The Goal of Financial Management

 What is the correct goal?

• Maximize profit?

• Minimize cost?

• Maximize market share and sales?

• Avoid financial distress and bankruptcy?

• Survive?

• Maximize shareholder wealth, the value of existing owner’s equity?

1.3 Goal of Finance – Maximizing profit?

 Maximizing profit is not a suitable goal because:

• Profits can be increased by reducing cost.
o This is discussed in the next slide.

• Profits are not cash flows. We are actually more interested in cash
flow.

• Risk is not taken into account

1.4 Goal of Finance - Minimizing cost?

 Minimizing cost is not a suitable goal because:

• Minimizing costs may increase current profits but the future well-being
of the company may be affected, for example,
• Reducing maintenance costs may result in machines breaking down earlier in the
future

• Reducing R&D expenditures may cause the products to be less competitive

• Reducing headcount may reduce the quality of service

1.3 Goal of Finance - Maximizing market share?

 Maximizing market share is not a suitable goal because:

• In order to increase market the firm may large amounts in
advertising and promotion

• Having a large market share may not translate into higher profits if
the firm cannot increase revenue much more by increasing prices
1.4 Goal of Finance - Maximizing shareholder wealth?

 This is the right goal of finance because:

• It avoids the problems of the other goals by taking risk into consideration,
as well as the impact on future cash flows of the firm’s actions
o An investment may promise high returns, but if the risks involved are too high, then the
investment may not be viable.
o As the share price depends not only on current cash flows but future cash flows as well,
any action taken by the firm would consider not just the short term effects but the long
term effects to the firm
1.4 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
Agency cost
• Agency cost : refers to the costs of the conflict of interest between
stockholders and management. These costs can be indirect or direct.
• Direct agency costs :
- Firm expenditure that benefits management but costs the stockholders
- Monitoring cost

• Indirect agency costs : is a lost opportunity when managers give up to invest a

good project because they afraid of lost their jobs if the project fails.
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
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?
 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 (maximize the value of existing

owners’ equity)

 Understand the conflicts of interest that can arise between owners and
managers ( agency problem)