INTRODUCTION TO FINANCE

Lecturer: Tran Thi Minh Tram

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 CHAPTER 5.1: CORPORATE
FINANCE
Source:
• Bodie, Z, & Merton, R. (2000), Finance, Prentice Hall Inc
• CFA – Program Curriculum – Level 1 – Volume 4
• Timothy J.G, Financial Management: Principle and
practices, 6th ed, Freeload Press Publishers.

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Chapter 5.1: Corporate finance

CONCEPT OF CORPORATE FINANCE

FORMS OF BUSINESS OPERATION

CORPORATE FINANCE DECISIONS

CAPITAL BUDGETING

CAPITAL STRUCTURE

WORKING CAPITAL MANAGEMENT

FUNDAMENTALS OF COPORATE FINANCE PRINCIPLES 3

 CONCEPT OF CORPORATE FINANCE
• Corporate finance vs. business finance
• Forms of business operation
• Corporation:
– Ownership and management
– Goals of the corporation
– Agency problem
– What does corporate finance include?

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 What is corporate finance?

• Corporate finance is the financial activities

related to running a corporation.

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 What is corporate finance?
• Corporate finance is the area of finance
dealing with:
– the sources of funding and the capital structure
of corporations
– the actions that managers take to increase the
value of the firm to the shareholders
– the tools and analysis used to allocate financial
resources.

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Corporate finance vs. business finance
• Corporate finance means only the finance of
joint-stock companies. It is a narrow term.
• Corporate finance is different from
business finance. Business finance refers to
the finance of all types of business, i.e. sole
traders, partnership firms, joint-stock
companies, etc. It is a broad term.

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 FORMS OF BUSINESS OPERATION
• Sole proprietorship
• Partnership
• Corporation
• Limited liability company

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 SOLE PROPRIETORSHIP
• A sole proprietorship is a firm owned by an
individual or a family, in which the assets and
liabilities of the firm are the personal assets
and liabilities of the proprietor.

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 Sole proprietorship
• Advantages:
– Easily established
– Minimal organizational costs/ Low
administrative costs
– Keep all generated profits

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 Sole proprietorship
• Disadvantages:
– Unlimited liability: A sole proprietor has unlimited
liability for the debts and other liabilities of the
firm.
• This means that if the firm cannot pay its debts, the
proprietor’s other personal assets can be seized to
satisfy the demands of the firm’s creditors.
– Losses absorbed by owner
– Limited capital
– Limited life

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 PARTNERSHIP
• A partnership is a firm with two or more
owners, called the partners, who share the
equity in the business.
– General partnership: At least one of the partners,
called the general partner, has unlimited liability
for the debts of the firm.
– Special kinds of partnership:
• Limited partnerships (LP): Some partnerships contain
two different classes of partners, general partners and
limited partners.
• Limited liability partnership (LLP ): This is simply a
general partnership that is allowed to operate like a
corporation, with limited liability features.

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 Partnership
• Most partnership are established by a written
contract known as articles of partnership (a
partnership agreement).
– A partnership agreement usually state:
• how much money each partner will contribute
• what the ownership share of each partner will be
• how decisions are to be made, how profits and losses
are to be shared
• who will perform what work for the business
•…

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 General Partnership
• Advantages:
– Minimal organizational requirements
small

– Negligible government regulations

• Disadvantages:
– Unlimited liability
– Must be dissolved or reorganized if a partner
leaves or dies
o Changes in ownership involve dissolving the old
partnership and forming a new one.

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Limited Liability Partnership (LLP)
• Limited Liability Partnership (LLP) is
simply a general partnership that is
allowed to operate like a corporation, with
limited liability features.
• Similar to General partnership:
– Partnership not taxed
– Income passes through to partners and
partners are taxed
• But owners have limited liability like a
corporation.

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 CORPORATION
• A corporation is a firm that is legal entity distinct
from its owners.
– It means: a corporation can own property, borrow,
enter into contracts, be taxed, can sue and be sued…
– Owners are called shareholders;
– Shareholders are entitled to a share of any
distributions from the corporation (e.g., cash
dividends) in proportion to the numbers of shares
they own.
– Shareholders elect Board of directors; Board of
directors elect managers to run the business.
• This is the most popular form of business around
the world.

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 Corporation
• Advantages:
– Ownership can be transferred without disrupting
the business, i.e. the corporation is not dissolved
when shares are transferred (unlike sole
proprietorship and partnership).
– Limited liability: Corporation has limited liability,
i.e. in case the corporation fails to pay its debt, the
creditors can only seize the assets of the
corporation, not personal assets of shareholders.
– Better access to capital

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 Corporation
• Disadvantages:
– Time and cost of incorporation
– Corporations pays corporate taxes, resulting in
double taxation of owner.
o First, a corporation pays income tax on the profit it
earns.
o Then the corporation may distribute the profit to the
owners; the owners have to pay tax.

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 Corporation
• Closely-held (private corporation)
– Stock owned privately by small number of owners
and do not extend ownership opportunities to the
general public.
• Publicly traded (public corporation)
– Shares offered to anyone who wants to invest.

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 LIMITED LIABILITY COMPANY
• Some hybrid forms of business, which
combine the tax advantage of partnership
with the limited liability advantage of
corporation:
– Limited liability partnership (LLP)
– Special corporation (S corporation in the US)
– Limited liability company (LLC)
–…

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 Limited liability company
• LLCs are hybrids between partnerships and
corporations.
– LLCs pass their profits and losses through to their
owners, without taxation off the LLC itself (as
partnerships do) .
– LLCs provide limited liability for their owners (like
corporations)
• LLCs are popular because they provide the
“best of both worlds” between partnerships
and corporations.

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 Limited liability company
• Advantages:
– Limited liability
• Disadvantages:
– Government regulations: limited industry of
business

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 Business forms
Proprietorship Partnership Corporation LLC
Ease of Very easy Relatively easy More difficult Relatively
formation easy
Owners’ Unlimited Unlimited for Limited Limited
liability general
partners
Life of firm Dies with owner, Surviving Can live beyond Dies with
unless heirs partners must owner’s owner, heirs
continue deal with the lifetimes may continue
operating or sell deceased operating the
the business partner’s heirs business
Separate No No Yes Yes
legal entity?
Degree of Complete May be limited May be very Depends on
control by for individual limited for the number
owners partner individual of owners
stockholder 23
Corporation

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 Separation of ownership and
management
• In sole proprietorships and many partnership,
the owners and the active managers of the
business are the same people.
• In many other firms, the owners do not
themselves manage the business, but to hire
professional managers, who may not own any
shares in the firm.
• This cause the separation of ownership and
management.

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 Separation of ownership and
management
• For small corporations, shareholders and
managers may be one and the same.
• For large corporations, separation of ownership
and management is a practical necessity:
– Efficiencies of scale
– As large corporations usually have many owners
(shareholders), there is no way that these
shareholders can actively involve in the management.
It needs to be delegated.
– Professional managers have specialized skills
– Diversification of owner’s portfolio
– Savings in the cost of information gathering
– Learning curve/ going concern issues
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The organization of a typical
corporation

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 Organization chart for XYZ Corporation

BOARD OF DIRECTOR

CHIEF EXECUTIVE
OFFICER

VP OPERATIONS VP MARKETING

CHIEF FINANCIAL
OFFICER

VP FINANCIAL
TREASURER CONTROLLER
PLANNING
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 Organization chart for XYZ Corporation

BOARD OF DIRECTOR

senior vice president

responsible for all
CHIEF EXECUTIVE
OFFICER
the financial
VP OPERATIONS functions in the
VPfirm
MARKETING

CHIEF FINANCIAL
OFFICER

VP FINANCIAL
TREASURER CONTROLLER
PLANNING
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 Organization chart for XYZ Corporation

BOARD OF DIRECTOR

CHIEF EXECUTIVE
OFFICER

VP OPERATIONS responsible for analysing

VP MARKETING
major capital
expenditures
CHIEF FINANCIAL
such as proposals to enter new
OFFICER
lines of business or to exit existing
businesses

VP FINANCIAL
TREASURER CONTROLLER
PLANNING
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 Organization chart for XYZ Corporation

BOARD OF DIRECTOR

CHIEF EXECUTIVE
OFFICER

VP OPERATIONS VP MARKETING
oversees the accounting
and auditing activities of
CHIEF FINANCIAL
OFFICER the firm
such as preparation of internal
reports, financial statements

VP FINANCIAL
TREASURER CONTROLLER
PLANNING
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 Organization chart for XYZ Corporation

BOARD OF DIRECTOR

CHIEF EXECUTIVE
OFFICER

responsible
VP OPERATIONS for managing VP MARKETING
the financing activities of
the firm and forCHIEF FINANCIAL
working
OFFICER
capital management

VP FINANCIAL
TREASURER CONTROLLER
PLANNING
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 Example of how to organize a finance
responsible for team
- managing the financing activities
- working capital management
- managing relations with the
senior vice president,
external investor community responsible for all the
- managing the firm’s exposure to financial functions in the
currency and interest rate risks firm
- managing the tax department

oversees the accounting

and auditing activities of
the firm
such as preparation of internal
reports, financial statements

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The duties of financial managers
• Analyze past performance
• Forecast a firm’s future performance
• Assess risk
• Evaluate and select investments
• Decide where and when to find money
sources, and how much money to raise
• Determine how much money to return to
investors in the business
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Legal/ ethical challenges for financial
managers

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 Legal challenges
• Environment statues mandating pollution
control equipment
• Workplace safety standards
• Civil rights
• Intellectual property lawsluat so huu tri tue

• ….

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 Ethical challenges
• Fair treatment of:
– Employees
– Customers
– The community
– Society as a whole

➢Ethics codes bo quy tac dao duc

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 Goals of the corporation
• Management rule: Maximize the wealth of current
shareholders - market value of shareholder’s
investment in the firm (maximize the value of the
firm)
– This goal leads managers to make the same investment
decisions that each of the individual owners would have
made had they made the decisions themselves.
– Alternative rules stated in terms of “profit maximization”
are fraught with unresolved issues, and are better
avoided because a corporation could increase profit by
using methods that conflict with shareholders’ interest.

Why need a goal or a rule for management?

How the rule to be set up?
What do we mean by wealth
Profits versus company value 38
 Goals of the corporation
• The shareholder-wealth-maximization rule
depends on the firm’s production technology,
market interest rates, market risk premiums, and
security prices.
• The single-minded pursuit of profits is not
necessarily good for the firm
– Under certain specialized conditions, profit
maximization and maximizing shareholder wealth lead
to the same decisions. But in general there are two
fundamental ambiguities with the profit-maximization
criterion
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Maximize “the value” of the firm
• The value of a firm (or anything else) is
determined by what people are willing to
pay for it.
• The financial manager should make
decisions that cause people to think more
favorably about the firm.
• Value depends on future prospects and
risk.

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 Factors that affect “value”
• The amount of the Future Cash Flows
– Needed to pay the bills
– Not the same as sales or profits
• Timing of Cash Flows
– Cash received sooner is worth more than cash
received later
-> Time Value of Money
• Risk
– Definite cash inflows are generally preferred to
uncertained inflows
-> as uncertainty increase required returns increase
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Factors that affect “value”

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Focus of financial professionals
Cash flows and market value

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 Cash flow
• Cash moving in and out of the firm
– Sales are not necessarily a cash flow
– Expenses are not necessarily a cash flow
• Cash flow is KING, not income
– You can’t pay bills with income

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 Market Value
• What would someone pay today
– Based on expected future cash flows
• The amount
• The timing
• The risk (uncertainty) associated with those cash
flows
• Very different from historical value and
book value

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 Agency problem
• Agency problem: managers, acting as
agents for stockholders, may act in their
own interests rather than maximizing
value.
• Agency problems are mitigated in several
ways:
– Legal and regulatory standards
– Compensation plans
– Monitoring by lenders, stock market analysts
and investors
– The threat that poorly performing managers
will be fired

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WHAT DOES CORPORATE FINANCE
INCLUDE?

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• Planning the finance

2
• Raising the finance

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• Investing the finance

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• Monitoring the finance

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 Planning the finance
• The finance manager plans the finance of
the company. He takes decisions on
questions like:
– How much finance is required by the company?
– What are the sources of finance?
– How to use the finance profitably?

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 Raising the finance
• The finance manager raise (collects)
finance for the company. Finance can be
collected from many sources:
– Borrowing
– Retaining and reinvesting cash flow
– Selling additional shares of stock to the
corporation’s shareholders

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 Investing the finance
• The finance manager uses the finance to
achieve the objectives of the company.
There are two types of corporate finance:
fixed capital and working capital.
– Fixed capital is used to purchase fixed assets
like land, buildings, machinery, etc.
– While working capital is used to purchase raw
materials. It is also used to pay the day-to-day
expenses like salaries, rent, taxes, electricity
bills, etc.

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 Monitoring the finance
• The finance manager monitors (i.e. controls
and manages) the finance of the company, ex:
– He has to minimize the cost of finance.
– He has to minimize the wastage and misuse of
finance.
– He has to minimize the risk of investment of
finance.
– He also has to get maximum return on the finance.
• Monitoring the finance is an art and science. It
is a very complex job. There are new tools &
techniques for monitoring funds.

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CORPORATE FINANCE DECISIONS
• Corporate finance boils down to financial
decisions made by corporations:

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• Capital budgeting

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• Capital structure

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• Working capital management

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 Capital budgeting
• Capital budgeting is the process of evaluating
proposed investment projects for a firm.
– Process of making decisions about which long-term
projects the corporation should accept for investment and
which it should reject.
• Managers must:
– Determine which projects are acceptable
– Rank mutually exclusive projects by order of
desirability to the firm

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 Capital budgeting
easily influenced or harmed by something

• Projects susceptible to capital budgeting

process can be categorized as:
– Replacement projects
– Expansion projects
– New products and services
– Regulatory, safety, and environment projects
– Other

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 Capital budgeting
• The accept/reject decision method
– Net Present Value (NPV)
– Internal Rate of Return (IRR)
– Modified Internal Rate of Return (MIRR)
– Payback period
– Discounted payback period
– Average Accounting Rate of return (AAR)
– Profitability index (PI)
– NPV profile

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 Capital structure
• Capital structure is the mixture of funding
sources (debt, preferred stock or common
stock) that a firm uses to finance its assets.
– What blend of sources is best for the company?
o Each sources has a different cost

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 Capital structure
• Capital structure decision finds the answer for
question: “What is the best weighting for the
elements in the capital structure of the
company?”
– Debt?
– Preferred stock?
– Common stock?

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 Capital structure in real world
• Firms attempts to balance the costs and
benefits of debt to reach the optimal mix that
maximizes the value of the firm.
• Capital structure choices affect the cost of
capital:
– Since debt is cheaper than equity, use of debt will
initially lower the cost of capital.
– At high levels of debt, the cost of capital will
increase as investors perceive the risk of the firm
to be increasing substantially.
Why debt is cheaper than equity?

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 Working capital management
• Working capital: the amount of the firm’s current assets
– Cash
– Accounts receivable
– Marketable securities
– Inventory
– Prepaid expenses
• The firm’s current liabilities:
– Accounts payable
– Notes payable
– Current and accrued expenses

Net Working Capital = Current Assets – Current Liabilities

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 Working capital management
Current assets: Current liabilities:
• Cash & Marketable • Payables
securities • Short-term debt
• Receivables •…
• Inventories
•… Net working
capital Long-term liabilities
Fixed assets:
• Tangible assets
• Intangible assets

Owner’s equity

Net Working Capital = Current Assets – Current Liabilities

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 Working capital management
• The goal of effective working capital
management is to ensure that a company has
adequate ready access to the funds necessary
for day-to-day operating expenses, while at
the same time making sure that the
company’s assets are invested in the most
productive way.

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 Working capital management
• Managing the level and financing of working
capital is necessary:
– To keep costs under control
(e.g. storage of inventory)
– To keep risk levels at an appropriate level
(e.g. liquidity)

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 Working capital management
• Determining the “correct” level of Working
Capital
– Balance Risk & Return
– Benefits of Working Capital
o Higher liquidity (lower risk)
– Costs of Working Capital
o Lower returns

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FUNDAMENTALS OF CORPORATE
FINANCE PRINCIPLES

• Cost of capital
• Measures of leverage
• Corporate governance
• …

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 Summary
• In this chapter you have learned about:
– Concept of business finance/corporate finance
– Forms of business operation
– Corporate and related issues:
✓Separation of ownership and management
✓Goals of corporate finance
✓Corporate finance decisions
– Corporate financial decisions:
✓ Capital budgeting
✓ Capital structure
✓ Working capital management
– Fundamentals of corporate finance principles

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