Chapter 1: Introduction to Corporate Finance

Helen Huang

BUS 290

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 Finance

What is Finance?

Finance ???

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 Finance

What is Finance?

People with ideas but

not enough money
$ People with money
but no ideas/time
(Companies) (Investors)

Retained
earnings Coupon
payments,
dividends
& stock
Projects repurchases

Taxes

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 Finance

What is Finance?

Finance is the study of the cash flows among investors and companies
and other related organizations.
◮ Investment
◮ Corporate finance
◮ Financial markets and institutions

This course serves as an introduction to corporate finance

If you want to major in Finance, there are courses in investment (e.g.
BUS 497, 493, 494), financial markets and institutions (e.g. BUS
498), and more courses in corporate finance (e.g. BUS 395, 491, 495).

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 Finance

Career Opportunities in Finance

Financial services: design and delivery of advice and financial

products to individuals, businesses, and governments

◮ Banking, personal financial planning, investments, real estate,

insurance, etc
Managerial finance: duties of financial manager working in a business
◮ Develop a financial plan or budget, extending credit to customers,
evaluating proposed large expenditures, raising money to fund the
firm’s operations, etc
CFA institute describes investment industry career paths by different
roles:
https://www.cfainstitute.org/en/programs/cfa/charterholder-careers/roles

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 Chapter 1

Chapter 1 Outline

Corporate Finance and the Financial Manager

Corporate Securities
Forms of Business Organization
The Goals of Corporate Firm
Financial Institutions, Financial Markets and the Corporation

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 Corporate Finance

Corporate Finance

Corporate Finance addresses the following three questions:

◮ In what long-lived assets should the firm invest?
◮ How can the firm raise cash for required capital expenditure?
◮ How should short-term operating cash flows be managed?

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 Corporate Finance

Financial Manager

Financial managers try to answer some or all of these questions

The top financial manager within a firm is usually the Chief Financial
Officer (CFO)
◮ Treasurer – oversees cash management, capital expenditures and
financial planning
◮ Controller – oversees taxes, cost accounting, financial accounting and
data processing

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 Corporate Finance

Financial Manager

(B) (A)
Firm’s
operations Financial (D) Investors
Manager
Real assets (C)
(E) (F)
Government
(A) Cash raised from investors
(B) Cash invested in firm
(C) Cash generated by operations
(D) Cash reinvested
(E) Cash paid to government as taxes
(F) Cash returned to investors

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 Corporate Finance

Financial Manager

For example: Ford Canada Inc. is building a plant of $20 million in

Oshawa

(A) issued $20 million of stocks to shareholders

(B) invested these $20 million in the plant
(C) later the plant generated $5 million of cash flows (CFs)
(D) reinvested 50% of $5 million of CFs in the plant
(E) & (F) distributed the remaining 50% of $5 million of CFs as dividends to
shareholders and as tax payments

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 Corporate Finance

Financial Management Decisions

The role of the financial manager is to determine:

◮ What operating assets to invest in?
⋆ Capital Budgeting decision (investment decision)

◮ How to pay for those assets?

⋆ Capital structure decision (financing decision)
◮ How to manage the day-to-day finances of the firm?
⋆ Working capital management

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 Corporate Finance

Financial Management Decisions

Capital Budgeting Decision

The financial manager is concerned with:
◮ The size;
◮ The timing; and
◮ The risks associated with realizing the future benefits produced by the
asset

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 Corporate Finance

Financial Management Decisions

Capital Structure Decision (Financing Decision)

The financial manager can use:
◮ Internal financing – purchase the assets using the firm’s own funds.
◮ External financing – purchase the assets by raising money from
financial institutions or markets.
Working capital management
◮ How do we manage the day-to-day finances of the firm?

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 Corporate Finance

Corporate Securities

Debt: a promise by the borrowing firm to repay a fixed dollar amount

by a certain date Payoff to
debtholders

Value of the firm (X )

F
Equity: the amount that remains after the debt holders are paid
Payoff to
equity shareholders

Value of the firm (X )

F

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 Corporate Finance

Corporate Securities

The debt and equity securities issued by a firm derive their value form
the total value of the firm. Debt and equity securities are contingent
claims on the total firm value

Payoff to debtholders
and equity shareholders

Value of the firm (X )

F

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 Corporate Finance

Corporate Securities: Example

A firm has $10,000 debt outstanding, due in one year

Payoff to
debtholders

$10K
$7K

Value of the firm

$7K $15K
$10K
Payoff to
equity shareholders

$5K
Value of the firm
$7K $15K
$10K

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 The Corporate Firm

Organizing a Business

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.
◮ Sole proprietorship
◮ Partnership
◮ Corporation
⋆ In other countries, corporations are also called joint stock companies,
public limited companies and limited liability companies

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 The Corporate Firm

Organizing a Business

Corporation
Who owns the Shareholders
business?
Are managers and Usually
owners separate?
What is the Limited
owner’s liability?
Are the owner & Yes
business taxed sep-
arately?

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 The Corporate Firm

Organizing a Business

Corporations
◮ A business which is legally distinct from its owners, who are called
shareholders
◮ Advantages:
⋆ Unlimited life
⋆ Limited liability – the shareholders can lose only the amount they have
invested in the company’s shares (stocks)
⋆ Transfer of ownership is easy
⋆ Easier to raise capital
◮ Disadvantages:
⋆ The cost (time and money) involved for corporations
⋆ Double taxation – the government taxes corporate earnings (i.e.
corporate taxes) and the dividends paid out of those earnings to the
shareholders (i.e. personal income taxes)

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 The Corporate Firm

Organizing a Business

Corporations
◮ Private corporations. Example, Hudson’s Bay company, MaCain Foods
Ltd
◮ Public corporations. Examples, Suncor Energy Inc., TD, etc
◮ Public companies have a lot of flexibility when raising funds, but are
subject to more regulations such as disclosure requirements.

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 The Corporate Firm

Organizing a Business

One distinctive feature of a corporation is the separation of

ownership and management. In a corporation, the shareholders
may own the firm, but they do not usually manage it
Five Largest Corporations by Revenue, 2023 Ranking
Company Revenue Ownership
(in $ millions)
Brookfield Asset Mgmt Inc. 75,730 Widely held
Alimentation Couche-Tard Inc. 70,540 Widely held
Cenovus Energy 55,270 Widely held
Suncor Energy 44,570 Widely held
Imperial Oil 44,220 Widely held
Source: Top 10 Biggest companies by revenue in Canada (2023 data)
https://www.economicactivity.org/top-10-biggest-companies-by-revenue-in-canada-2023-data/
Last accessed Jan 8, 2024

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 The Corporate Firm

Organizing a Business

Separation of ownership and management can be both an advantage

and a disadvantage
◮ Advantages
⋆ You can benefit from ownership in several different businesses
(diversification)
⋆ You can take advantage of the expertise of others (comparative
advantage)
⋆ Easier to transfer ownership
◮ Disadvantage
⋆ Managers may not act in the best interest of owners

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 The Corporate Firm

Organizing a Business

The shareholders elect a Board of Directors which appoints

management
◮ The Board is supposed to:
⋆ Represent the shareholders’ interests
⋆ Ensure that management is running the firm in the shareholders’ best
interests

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 The Corporate Firm

Organizing a Business

Corporations

Elect
SHAREHOLDERS BOARD

! !

ts Pr
p oin ofi
t
Ap s
Manages
MANAGEMENT CORPORATION

! !

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 The Corporate Firm

Organizing a Business

Corporations
If you can put the pieces
together, you should see
why most large firms are
organized as corporations!

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 Objectives of Corporations

Goals of the Corporate Firm

What should be the goal of a corporation?

◮ Maximize profit?
◮ Minimize costs?
◮ Maximize market share?
◮ Maximize the current value of the company’s stock?
Does this mean we should do anything and everything to maximize
owner wealth?
◮ NO!!!

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 Objectives of Corporations

Goals of the Corporate Firm

Three equivalent goals of financial management:

◮ Maximize shareholder wealth
◮ Maximize share price
◮ Maximize firm value

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 Objectives of Corporations

Goals of the Corporate Firm

But, there could be agency problems

◮ Agency relationship
⋆ Principal hires an agent to represent their interests
⋆ Stockholders (principals) hire managers (agents) to run the company
◮ Agency problem
⋆ Conflicts of interest can exist between the principal and the agent
⋆ Managers may have their own interests and “hidden agenda”
◮ Agency costs
⋆ Direct agency costs – the purchase of something for management that
can’t be justified from a risk-return standpoint, monitoring costs
⋆ Indirect agency costs – management’s tendency to forgo risky or
expensive projects that could be justified from a risk-return standpoint

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 Objectives of Corporations

Goals of the Corporate Firm

Agency problems can be reduced in several ways:

◮ Compensation plans
⋆ Options: e.g. managers have an option to purchase 10,000 shares of
stock at $10 each. So the total payoff to managers is
10, 000 × (Pricenew − $10)
⋆ Of course now the managers have incentives to work hard to boost the
share price!

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 Objectives of Corporations

Goals of the Corporate Firm

Reduce agency problems:

◮ Board of Directors: e.g. Leo Apotheker, CEO, HP (or Hewlett
Packard) was fired after ‘dismal’ quarters
◮ Threat of takeovers: e.g. Canadian Airlines and Chapters were taken
over and their (senior) managers were replaced
◮ Specialist monitoring: security analysts, banks etc. monitor the
performance of managers constantly

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 Objectives of Corporations

Social Responsibility and Ethical Investing

Investors are increasingly demanding that corporations behave

responsibly
Issues include how a corporation treats the community in which it
operates, their customers, corporate governance, their employees, the
environment and human rights
Controversial business activities include alcohol, gaming, genetic
engineering, nuclear power, pornography, tobacco and weapons

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Financial Institutions, Financial Markets, and the Corporation

Financial Institutions

Financial institutions act as intermediaries between suppliers and

users of funds
Institutions earn income on services provided:
◮ Indirect finance – Earn interest on the spread between loans and
deposits

Funds Deposits Financial Loans Funds

suppliers intermediaries demanders

◮ Direct finance – Service fees (e.g. banker’s acceptance and stamping

fees)

Funds Financial Funds

suppliers intermediaries demanders

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Financial Institutions, Financial Markets, and the Corporation

Financial Markets

Money vs. capital markets

◮ Money Markets: for short-term debt instruments
◮ Capital Markets: for long-term debt and equity

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Financial Institutions, Financial Markets, and the Corporation

Financial Markets

Primary vs. secondary markets

◮ Primary markets: original sale of securities by governments and
corporations.
⋆ When a corporation issues securities, cash flows from investors to the
firm.
⋆ Usually an underwriter is involved
◮ Secondary markets: markets where securities are bought and sold after
the original sale.
⋆ Involve the sale of “used” securities from one investor to another.
⋆ Securities may be exchange traded or trade over-the-counter in a dealer
market.

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Financial Institutions, Financial Markets, and the Corporation

Financial Markets

Stocks and Bonds Investors

Firms Money securities
Sue Bob
money

Primary Market

Secondary Market

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Financial Institutions, Financial Markets, and the Corporation

Listing

Listing on an organized exchange

◮ Enhance trading liquidity
◮ Facilitating raising equity

To be listed, firms must meet certain minimum criteria.

Canadian companies listed in the U.S. – significant disclosure
requirement (SOX)

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Financial Institutions, Financial Markets, and the Corporation

Foreign Exchange Market

Foreign exchange market is the world’s largest financial market.

Foreign exchange market is an over-the-counter market.
Many different types of participants:
◮ Importers and exporters
◮ Portfolio managers
◮ Foreign exchange brokers
◮ Traders

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 Summary

Summary of Chapter 1

Three questions addressed in corporate finance: capital budgeting,

capital structure, and day-to-day finance.
A corporation is legally distinct from its owners (shareholders).
◮ Its shareholders have limited liability.
◮ Ownership and management are usually separate.

The primary goal of the firm

What is an agency relationship and what is agency cost
What is ethical investing
The role of financial markets

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