Corporate Finance and Asset Management Chapter 1

Introduction to Corporate Finance

The balance sheet model of the firm

The shareholder’s claim on first value is the residual amount that remains
after the debtholders are paid.

Forms of business organization

- Sole proprietorship: owned and run by one person, few employees.
It’s easy to create but unlimited personal liability and limited life.
- Partnership:
 general: same than a sole proprietorship but with more
than one owner. All partners are personally liable for all the
firm’s debt. The partnership ends with the death or
withdrawal of any single partner.
 Limited: they have 2 kinds of owners :general partners (run the firm on a day to day basis, have
the same rights and liability as partners in a general partnership), limited partners (limited
liability cannot lose more than their initial inv, no management authority and cannot legally be
involved in the managerial decision making)
- Corporation: legal entity separate from its owners. The corporation is solely responsible for its own
obligations. Setting up a corporation is more costly. The shareholders/stockholders/equity holders own
the company.
- Limited Liability Company LLCs: operate and taxes like a partnership. Retain limited liability for owner
like a coporation.

The importance of cash flows

The agency problem

In corporation, management and ownership are separate  managerial goals may be different form
shareholders goals. The firm can be viewed as a set of contracts : the shareholders can devise contracts that
align the incentives of the managers with the goals of the shareholders.

So the agency problem = will managers work in the shareholders’ best interest?
This is an agency relationship  how do agency costs affect firm value and shareholders wealth ?
- Managerial compensation: contracts can be carefully constructed to be incentive compatible.
- Reputational concerns/ job prospects: managers can be replaced
- Control of the firm: if the managers fail to maximize share price they may be replaced in a hostile
takeover.
Corporate Finance and Asset Management Chapter 1