LECTURE 1

INTRODUCTION
TO CORPORATE FINANCE
Ross, S. A., Westerfield, R. W. & Jordan B.D. (2013): Ch 1
Arnold, G. (2013): Ch 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 different 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 types of financial markets

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 Lecture Outline

 What is Finance?

 Main Tasks of Corporate Finance

 Legal Forms of Business Organization

 Financial Managers

 The Goal of Financial Management

 Governance and Agency

 Financial Institutions and Markets

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 What is Finance?
 Finance can be defined as the science and art of
managing money.
 At the personal level, finance is concerned with
individuals’ decisions about:
• how much of their earnings they spend
• how much they save
• how they invest their savings
 In a business context, finance involves:
• how firms raise money from investors
• how firms invest money in an attempt to earn a
profit
• how firms decide whether to reinvest profits in the
business or distribute them back to investors.

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 Main tasks of corporate finance

 Capital budgeting: the process of planning and

managing a firm’s long-term investments  fixed
assets.
• Example: deciding whether or not to open a new
restaurant.
 Capital structure: the mixture of debt and equity
maintained by the firm  S-T and L-T debt and equity.
 Working capital management: a firm’s short-term
assets and liabilities  current assets and current
liabilities.
 Decisions on dividend policy: payout ratio; cash
dividend or stock dividend?

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 The Capital Budgeting Decision

Current
Liabilities
Current
Assets Long-Term
Debt

Fixed Assets What long-term

1 Tangible
investments
should the firm Shareholders
2 Intangible choose? ’ Equity

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 The Capital Structure Decision

Current
Liabilities
Current
Assets Long-Term
How can the Debt
firm raise the
Fixed Assets money for the
required
1 Tangible investments?
Shareholders
2 Intangible ’ Equity

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The Net Working Capital Investment
Decision

Current
Liabilities
Current
Assets N Long-Term
W Debt
C

Fixed Assets
1 Tangible
How much
short-term cash Shareholders
2 Intangible flow does a ’ Equity
company need
to pay its bills

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 Legal Forms of Business Organization

 A sole proprietorship is a business owned by one

person and operated for his or her own profit.
 A partnership is a business owned by two or more
people and operated for profit.
 A corporation is an entity created by law.
Corporations have the legal powers of an individual in
that it can sue and be sued, make and be party to
contracts, and acquire property in its own name.

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Table 1.1 Strengths and Weaknesses of the Common Legal
Forms of Business Organization

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 Corporation as a 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.

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Figure 1.1 Corporate Organization

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 Who make the decisions?

 Owners (typically in small businesses).

 Professional managers.

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 Financial managers

 Managerial finance is concerned with the duties of the

financial manager working in a business.
 Financial managers administer the financial affairs of
all types of businesses—private and public, large and
small, profit-seeking and not-for-profit. Tasks include:
• developing a financial plan or budget
• extending credit to customers
• evaluating proposed large expenditures
• raising money to fund the firm’s operations
• Paying dividends to shareholders.

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 Financial managers

 Frequently, financial managers try to address the

mentioned 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.

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 Financial managers

 The recent global financial crisis and subsequent

responses by governmental regulators, increased global
competition, and rapid technological change also
increase the importance and complexity of the financial
manager’s duties.
 Increasing globalization has increased demand for
financial experts who can manage cash flows in
different currencies and protect against the risks that
naturally arise from international transactions.

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 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

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 The 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.

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 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.
 Nevertheless, investors care about stock price, and that
stock price performance is very important to the tenure
of managers.

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 The Goal of Financial Management:
Maximize Shareholder Wealth

 Decision rule for managers: only take actions that are

expected to increase the share price.

Figure 1.2 Share Price Maximization Financial decisions and

share price

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 The Goal of Financial Management

Which Investment is Preferred?

 Profit maximization may not lead to the highest possible share price for
at least three reasons:
1. Timing is important—the receipt of funds sooner rather than later is
preferred
2. Profits do not necessarily result in cash flows available to stockholders
3. Profit maximization fails to account for risk

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 The Goal of Financial Management:
What About Stakeholders?
 Stakeholders are groups such as employees,
customers, suppliers, creditors, owners, and others
who have a direct economic link to the firm.
 A firm with a stakeholder focus consciously avoids
actions that would prove detrimental to stakeholders.
The goal is not to maximize stakeholder well-being but
to preserve it.
 Such a view is considered to be "socially responsible."

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 Governance and Agency:
Corporate Governance
 Corporate governance refers to the rules, processes,
and laws by which companies are operated, controlled,
and regulated.
 It defines the rights and responsibilities of the
corporate participants such as the shareholders, board
of directors, officers and managers, and other
stakeholders, as well as the rules and procedures for
making corporate decisions.
 The structure of corporate governance was previously
described in Figure 1.1.

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 Governance and Agency:
Individual versus Institutional Investors

 Individual investors are investors who own relatively

small quantities of shares so as to meet personal
investment goals.
 Institutional investors are investment professionals,
such as banks, insurance companies, mutual funds, and
pension funds, that are paid to manage and hold large
quantities of securities on behalf of others.
 Unlike individual investors, institutional investors
often monitor and directly influence a firm’s corporate
governance by exerting pressure on management to
perform or communicating their concerns to the firm’s
board.
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 Governance and Agency:
Government Regulation
 Government regulation generally shapes the corporate
governance of all firms.
 During the recent decade, corporate governance has
received increased attention due to several high-profile
corporate scandals involving abuse of corporate power
and, in some cases, alleged criminal activity by
corporate officers.

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 Governance and Agency:
Government Regulation
The Sarbanes-Oxley Act of 2002:
 established an oversight board to monitor the accounting industry;
 tightened audit regulations and controls;
 toughened penalties against executives who commit corporate
fraud;
 strengthened accounting disclosure requirements and ethical
guidelines for corporate officers;
 established corporate board structure and membership
guidelines;
 established guidelines with regard to analyzing conflicts of
interest;
 mandated instant disclosure of stock sales by corporate
executives;
 increased securities regulation authority and budgets for auditors
and investigators.
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 Governance and Agency:
The Agency Issue
 A principal-agent relationship is an arrangement in
which an agent acts on the behalf of a principal. For
example, shareholders of a company (principals) elect
management (agents) to act on their behalf.
 Agency problems arise when managers place personal
goals ahead of the goals of shareholders.
 Agency costs arise from agency problems that are
borne by shareholders and represent a loss of
shareholder wealth.

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 The Agency Issue:
Management Compensation Plans
 In addition to the roles played by corporate boards,
institutional investors, and government regulations,
corporate governance can be strengthened by ensuring
that managers’ interests are aligned with those of
shareholders.
 A common approach is to structure management
compensation to correspond with firm performance.

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 The Agency Issue:
Management Compensation Plans
 Incentive plans are management compensation plans
that tie management compensation to share price; one
example involves the granting of stock options.
 Performance plans tie management compensation to
measures such as EPS or growth in EPS. Performance
shares and/or cash bonuses are used as compensation
under these plans.

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The Agency Issue: The Threat of Takeover

 When a firm’s internal corporate governance structure

is unable to keep agency problems in check, it is likely
that rival managers will try to gain control of the firm.
 The threat of takeover by another firm, which believes
it can enhance the troubled firm’s value by
restructuring its management, operations, and
financing, can provide a strong source of external
corporate governance.

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 Financial Institutions & Markets

Firms that require funds from external sources can obtain

them in three ways:
1. through a financial institution
2. through financial markets
3. through private placements

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Financial Institutions & Markets: Financial
Institutions
 Financial institutions are intermediaries that channel
the savings of individuals, businesses, and governments
into loans or investments.
 The key suppliers and demanders of funds are
individuals, businesses, and governments.
 In general, individuals are net suppliers of funds, while
businesses and governments are net demanders of
funds.

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Commercial Banks, Investment Banks, and
the Shadow Banking System
 Commercial banks are institutions that:
– provide savers with a secure place to invest their
funds
– offer loans to individual and business borrowers
 Investment banks are institutions that:
– assist companies in raising capital
– advise firms on major transactions such as mergers
or financial restructurings
– engage in trading and market making activities

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Financial Institutions & Markets: Financial
Markets
 Financial markets are forums in which suppliers of
funds and demanders of funds can transact business
directly.
 Transactions in short term marketable securities take
place in the money market while transactions in long-
term securities take place in the capital market.
 A private placement involves the sale of a new
security directly to an investor or group of investors.
 Most firms, however, raise money through a public
offering of securities, which is the sale of either bonds
or stocks to the general public.

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Financial Institutions & Markets: Financial
Markets (cont.)
 The primary market is the financial market in which
securities are initially issued; the only market in which
the issuer is directly involved in the transaction.
 Secondary markets are financial markets in which
preowned securities (those that are not new issues) are
traded.

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 Figure 1.4
Flow of Funds

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 The Firm and the Financial Markets

Firm Financial
Firm issues securities (A) markets
Invests in
assets (B) Short-term
Retained cash debt
flows (F) Long-term
Current assets
Fixed assets Dividends and debt
Cash flow debt payments Equity shares
from firm (E)

Taxes (D)
(C)

Ultimately, the firm The cash flows from

must be a cash Government the firm must exceed
generating activity the cash flows from
the financial markets
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 The Money Market

 The money market is created by a financial

relationship between suppliers and demanders of
short-term funds.
 Most money market transactions are made in
marketable securities which are short-term debt
instruments, such as:
• U.S. Treasury bills issues by the federal government
• commercial paper issued by businesses
• negotiable certificates of deposit issued by financial
institutions
 Investors generally consider marketable securities to
be among the least risky investments available.
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 The Money Market (cont.)

 The international equivalent of the domestic (U.S.)

money market is the Eurocurrency market.
 The Eurocurrency market is a market for short-term
bank deposits denominated in U.S. dollars or other
marketable currencies.
 The Eurocurrency market has grown rapidly mainly
because it is unregulated and because it meets the
needs of international borrowers and lenders.
 Nearly all Eurodollar deposits are time deposits.

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 The Capital Market

 The capital market is a market that enables suppliers

and demanders of long-term funds to make
transactions.
 The key capital market securities are bonds (long-term
debt) and both common and preferred stock (equity, or
ownership).
– Bonds are long-term debt instruments used by
businesses and government to raise large sums of
money, generally from a diverse group of lenders.
– Common stock are units of ownership interest or
equity in a corporation.
– Preferred stock is a special form of ownership that
has features of both a bond and common stock.
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 The Capital Market

Lakeview Industries, a major microprocessor

manufacturer, has issued a 9 percent coupon interest rate,
20-year bond with a $1,000 par value that pays interest
semiannually.
– Investors who buy this bond receive the contractual
right to $90 annual interest (9% coupon interest
rate  $1,000 par value) distributed as $45 at the
end of each 6 months (1/2  $90) for 20 years.
– Investors are also entitled to the $1,000 par value at
the end of year 20.

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 Broker Markets and
Dealer Markets
Broker markets are securities exchanges on which the
two sides of a transaction, the buyer and seller, are
brought together to trade securities.
– Trading takes place on centralized trading floors of
national exchanges, such as NYSE Euronext, as well
as regional exchanges.

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 Broker Markets and
Dealer Markets (cont.)
 Dealer markets, such as Nasdaq, are markets in which
the buyer and seller are not brought together directly
but instead have their orders executed by securities
dealers that “make markets” in the given security.
– The dealer market has no centralized trading floors.
Instead, it is made up of a large number of market
makers who are linked together via a mass-
telecommunications network.
 As compensation for executing orders, market makers
make money on the spread (bid price – ask price).

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 International Capital Markets

 In the Eurobond market, corporations and

governments typically issue bonds denominated in
dollars and sell them to investors located outside the
United States.
 The foreign bond market is a market for bonds issued
by a foreign corporation or government that is
denominated in the investor’s home currency and sold
in the investor’s home market.
 The international equity market allows corporations
to sell blocks of shares to investors in a number of
different countries simultaneously.

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 The Role of Capital Markets

 From a firm’s perspective, the role of capital markets is

to be a liquid market where firms can interact with
investors in order to obtain valuable external financing
resources.
 From investors’ perspectives, the role of capital
markets is to be an efficient market that allocates funds
to their most productive uses.
 An efficient market allocates funds to their most
productive uses as a result of competition among
wealth-maximizing investors and determines and
publicizes prices that are believed to be close to their
true value.

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