Chapter 1

2009 Cengage Learning/South-Western

The Scope of Corporate
Finance
2
Corporate Finance in Modern Business
By taking actions that generate benefits in
excess of costs, firms generate wealth for their
investors.
When contemplating all business decisions,
managers should ask:
Does this action create value for the
firms shareholders?
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Career Opportunities in Finance
Corporate
Finance
Budgeting, financial forecasting, cash
management, credit administration,
investment analysis, fund procurement
Commercial
Banking
Consumer banking
Corporate banking
Investment
Banking
High income potential
Very competitive industry
Money
Management
Opportunities in investment advisory firms,
mutual fund companies, pension funds,
investment arms of financial departments
Consulting
Advise on business practices and strategies
of corporate clients
4
Financial Management
External Financing
Capital Budgeting
Corporate Governance
Risk Management
Corporate
Finance
Functions
Corporate Finance Functions
5
The External Financing Function
Raising capital to support companies operations
and investment programs externally, from
either shareholders (equity) or
creditors (debt).
Corporations can raise equity capital privately,
or they may go public by conducting an initial
public offering (IPO) of stock.

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Capital Budgeting selecting the
best projects in which to invest
the resources of the firm, based
on each projects perceived risk
and expected return.
Select investments for which the marginal benefits exceed
the marginal costs.
The Capital Budgeting Function
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The Financial Management Function
Managing firms internal cash flows,
and its mix of debt and equity financing,
to maximize the value of the debt and equity
claims on firms, and
to ensure that companies can pay off their
obligations when they come due.
Involves obtaining seasonal financing, managing
inventories, paying suppliers, collecting from customers,
and investing surplus cash
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The Corporate Governance Function
Developing ownership and corporate governance
structures for companies that ensure that managers
behave ethically and make decisions that benefit
shareholders.
Dimensions of
corporate
governance
Boards of directors
Compensation packages
Auditors
Countrys legal environment - in
U.S., Sarbanes-Oxley Act of 2002
The takeover market disciplines firms that do not
govern themselves.
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The Risk Management Function
Managing firms exposures to all types of risk,
both insurable (such as loss caused by fire or
flood) and uninsurable,
in order to maintain optimum risk-return trade-
offs and thereby maximize shareholder value.
Modern risk management focuses on adverse
interest rate movements, commodity price
changes, and currency value fluctuations.
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Debt & Equity: Two Flavors of Capital
Debt
Capital
Borrowed money.
The borrower is obliged to pay interest,
at a specified annual rate, on the full
amount borrowed, as well as to repay
the principal amount at the debts
maturity.
Equity
Capital
An ownership interest usually in the
form of common or preferred stock.
Common stockholders receive returns
on their investments only after
creditors and preferred stockholders
are paid in full.
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Financial Intermediation
Financial
Intermediary
An institution that raises capital by
issuing liabilities against itself, and
then lends that capital to corporate
and individual borrowers.
Examples: insurance companies,
savings and loan institutions, credit
unions, commercial banks, pension
funds, mutual funds.
Pension funds and mutual funds, have surged to
prominence as corporate finance shifts towards
greater reliance on market-based external
funding.
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Total Value of Primary Corporate Security Issues,
1990 - 2006
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Sole
Proprietorships

No distinction between business and
person
Easy to set up, operate; taxed as
personal income
Personal liability, limited life, difficult to
transfer

Partnerships

Two or more business owners
Partners - liable for every partners
actions

Limited
Partnerships

One or more general partners & many
limited partners
Limited liability of corporation, tax
benefits of partnership
Business Organizational Forms in the U.S.
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Corporations

Legal entity with all the economic rights
and responsibilities of a person
Incorporation occurs at state level; based
on state law
Strengths - limited liability for investors,
unlimited business life
Business Organizational Forms in the U.S.
The Finance
Function in
the
Organization
al Structure
of A Typical
Large
Corporation
15
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Corporations in the U.S.
The Jobs and Growth Tax Relief Reconciliation
Act of 2003 (Tax Relief Act of 2003) dramatically
reduced the double taxation problem.

Double Taxation
Problem

Taxation of corporate income at both
the company and the personal levels.
This is the single greatest disadvantage
of the corporate form.
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Taxation of Business Income for Corporations and
Partnerships
Before the Tax Relief Act of 2003
After the Tax Relief Act of 2003
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S Corporations

Allow shareholders to be taxed as
partners yet retain their limited liability
status.
Must meet certain criteria like having
75 or fewer shareholders.
Can become regular corporations later.

Limited
Liability
Companies
Combine partnerships pass-through
taxation with S corporations limited
liability.
Popular with professional service firms.
Business Organizational Forms in the U.S.
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The Growth of Stock Market Capitalization
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The Corporate Financial Managers Goals
Maximize profit?
Earnings reflect past performance, rather than current
or future performance.
Ignores the timing of the profits.
Ignores cash flows.
Ignores risk.
What should a financial manager try
to maximize?
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The Corporate Financial Managers Goals
Maximize shareholder wealth?
As measured by the market price of the firms stock.
A firms stock price reflects the timing, magnitude,
and risk of the cash flows that investors expect a firm
to generate over time.
Shareholders are the residual claimants of a firm.
What should a financial manager try
to maximize?
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The Corporate Financial Managers Goals
Focus on stakeholders?
Many firms seek to preserve the interests of other
stakeholders, such as employees, customers, tax
authorities, and the communities where the firms
operate.
Doing so provides long-term benefits to shareholders
and is in line with the primary goal of maximizing
shareholder wealth.
What should a financial manager try
to maximize?
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Agency Costs in Corporate Finance
To overcome agency problems:
Rely on market forces to exert managerial discipline;
Incur monitoring and bonding costs to supervise
managers; and
Structure executive compensation packages to align
managers interests with stockholders interests.

Agency Problems
The conflict between the goals of a
firms owners and its managers.
The actual workings of many compensation plans have
been harshly criticized in recent years.
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Ethics in Corporate Finance
Today, society in general and the financial
community in particular are developing and
enforcing higher ethical standards.
The U.S. Congress passed the Sarbanes-Oxley
Act in 2002 to enforce higher ethical standards
and increase penalties for violators.
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The Scope of Corporate Finance
Financial managers should seek to maximize
shareholders wealth.
How?
By performing the five basic duties of corporate finance:
External financing, capital budgeting, financial
management, risk management, corporate governance.
Select investments for which the marginal
benefits exceed the marginal costs.