McGraw-Hill/Irwin

Corporate Finance, 7/e

1-2

CHAPTER
1
Introduction to
Corporate Finance

McGraw-Hill/Irwin
Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved.
1-3

Chapter Outline
1.1 What is Corporate Finance?
1.2 Corporate Securities as Contingent Claims on
Total Firm Value
1.3 The Corporate Firm
1.4 Goals of the Corporate Firm
1.5 Financial Markets
1.6 Outline of the Text
McGraw-Hill/Irwin
Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved.
1-4

What is Corporate Finance?

Corporate Finance addresses the following three
questions:

1. What long-term investments should the firm engage

in?
2. How can the firm raise the money for the required
investments?
3. How much short-term cash flow does a company
need to pay its bills?
McGraw-Hill/Irwin
Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved.
1-5

The Balance-Sheet Model

of the Firm
Total Value of Assets: Total Firm Value to Investors:
Current
Liabilities
Current Assets
Long-Term
Debt

Fixed Assets
1 Tangible Shareholders’
2 Intangible Equity

McGraw-Hill/Irwin
Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved.
1-6

The Balance-Sheet Model

of the Firm
The Capital Budgeting Decision
Current
Liabilities
Current Assets

Long-Term
Debt

Fixed Assets What long-

term
1 Tangible investments Shareholders’
2 Intangible should the Equity
firm engage
in?
McGraw-Hill/Irwin
Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved.
1-7

The Balance-Sheet Model

of the Firm
The Capital Structure Decision
Current
Liabilities
Current Assets

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

McGraw-Hill/Irwin
Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved.
1-8

The Balance-Sheet Model

of the Firm
The Net Working Capital Investment Decision
Current
Liabilities
Current Assets
Net
Working
Capital
Long-Term
Debt

Fixed Assets How much short-

term cash flow
1 Tangible does a company
Shareholders’
need to pay its
2 Intangible Equity
bills?

McGraw-Hill/Irwin
Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved.
1-9

Capital Structure
The value of the firm can be
thought of as a pie.

The goal of the manager is 70%50%30%

25%
to increase the size of the DebtDebt
Equity
pie.
75%
50%
The Capital Structure Equity
decision can be viewed as
how best to slice up a the
pie.
If how you slice the pie affects the size of the pie,
then the capital structure decision matters.
McGraw-Hill/Irwin
Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved.
10

Hypothetical Organization Chart

Board of Directors

Chairman of the Board and

Chief Executive Officer (CEO)

President and Chief

Operating Officer (COO)

Vice President and

Chief Financial Officer (CFO)

Treasurer Controller

Cash Manager Credit Manager Tax Manager Cost Accounting

Capital Expenditures Financial Planning Financial Accounting Data Processing

McGraw-Hill/Irwin
Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved.
11

The Financial Manager

To create value, the financial manager should:
1. Try to make smart investment decisions.
2. Try to make smart financing decisions.

McGraw-Hill/Irwin
Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved.
12

The Firm and the Financial Markets

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

Ultimately, the firm
must be a cash
generating activity.
McGraw-Hill/Irwin
Corporate Finance, 7/e
Taxes (D)
The cash flows from the
firm must exceed the
cash flows from the
Government
financial markets.
© 2005 The McGraw-Hill Companies, Inc. All Rights Reserved.
13

1.2 Corporate Securities as Contingent

Claims on Total Firm Value
The basic feature of a debt is that it is a promise by the
borrowing firm to repay a fixed dollar amount of by a
certain date.
The shareholder’s claim on firm value is the residual
amount that remains after the debtholders are paid.
If the value of the firm is less than the amount
promised to the debtholders, the shareholders get
nothing.

McGraw-Hill/Irwin
Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved.
14

Debt and Equity as Contingent Claims

Payoff to Payoff to
debt holders shareholders
If the value of the firm is If the value of the firm is
more than $F, debt holders less than $F, share holders
get a maximum of $F. get nothing.

$F

$F $F
Value of the firm (X) Value of the firm (X)
Debt holders are promised $F. If the value of the firm is
more than $F, share holders
If the value of the firm is less than $F, they get the
get everything above $F.
whatever the firm if worth.
Algebraically, the bondholder’s claim is: Algebraically, the shareholder’s claim is:
Min[$F,$X] Max[0,$X – $F]
McGraw-Hill/Irwin
Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved.
15

Combined Payoffs to Debt and Equity

If the value of the firm is less than

Combined Payoffs to debt holders
and shareholders $F, the shareholder’s claim is:
Max[0,$X – $F] = $0 and the debt
holder’s claim is Min[$F,$X] = $X.
The sum of these is = $X
Payoff to shareholders
$F
If the value of the firm is more than
Payoff to debt holders $F, the shareholder’s claim is:
Max[0,$X – $F] = $X – $F and the
$F debt holder’s claim is:
Value of the firm (X)
Min[$F,$X] = $F.
Debt holders are promised
$F. The sum of these is = $X
McGraw-Hill/Irwin
Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved.
16

1.3 The Corporate Firm

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.

McGraw-Hill/Irwin
Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved.
17

Forms of Business Organization

The Sole Proprietorship
The Partnership
General Partnership
Limited Partnership
The Corporation
Advantages and Disadvantages
Liquidity and Marketability of Ownership
Control
Liability
Continuity of Existence
Tax Considerations
McGraw-Hill/Irwin
Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved.
18

A Comparison of Partnership
and Corporations
Corporation Partnership

Liquidity Shares can easily be Subject to substantial

exchanged. restrictions.

Voting Rights Usually each share gets General Partner is in

one vote charge; limited partners
may have some voting
rights.
Taxation Double Partners pay taxes on
distributions.
Reinvestment and Broad latitude All net cash flow is
dividend payout distributed to partners.

Liability Limited liability General partners may

have unlimited liability.
Limited partners enjoy
limited liability.
Continuity Perpetual life Limited life

McGraw-Hill/Irwin
Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved.
19

1.4 Goals of the Corporate Firm

The traditional answer is that the managers of the
corporation are obliged to make efforts to
maximize shareholder wealth.

McGraw-Hill/Irwin
Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved.
20

The Set-of-Contracts Perspective

The firm can be viewed as a set of contracts.
One of these contracts is between shareholders and
managers.
The managers will usually act in the shareholders’
interests.
The shareholders can devise contracts that align the incentives
of the managers with the goals of the shareholders.
The shareholders can monitor the managers behavior.
This contracting and monitoring is costly.

McGraw-Hill/Irwin
Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved.
21

Managerial Goals
Managerial goals may be different from
shareholder goals
Expensive perquisites
Survival
Independence
Increased growth and size are not necessarily the
same thing as increased shareholder wealth.

McGraw-Hill/Irwin
Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved.
22

Separation of Ownership and Control

Board of Directors

Debtholders

Shareholders
Management

Debt
Assets
Equity

McGraw-Hill/Irwin
Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved.
23
Do Shareholders Control
Managerial Behavior?
Shareholders vote for the board of directors,
who in turn hire the management team.
Contracts can be carefully constructed to be
incentive compatible.
There is a market for managerial talent—this
may provide market discipline to the
managers—they can be replaced.
If the managers fail to maximize share price,
they may be replaced in a hostile takeover.
McGraw-Hill/Irwin
Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved.
24

1.5 Financial Markets

Primary Market
When a corporation issues securities, cash flows from
investors to the firm.
Usually an underwriter is involved
Secondary Markets
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.
McGraw-Hill/Irwin
Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved.
25

Financial Markets

Stocks and
Investors
Bonds
Firms securities
Money Hasan Imam
money

Primary Market
Secondary
Market

McGraw-Hill/Irwin
Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved.
26

Exchange Trading of Listed Stocks

Auction markets are different from dealer
markets in two ways:
Trading in a given auction exchange takes place at a
single site on the floor of the exchange.
Transaction prices of shares are communicated
almost immediately to the public.

McGraw-Hill/Irwin
Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved.
27

1.6 Outline of the Text

I. Overview
II. Value and Capital Budgeting
III. Risk
IV. Capital Structure and Dividend Policy
V. Long-Term Financing
VI. Options, Futures and Corporate Finance
VII. Financial Planning and Short-Term Finance
VIII. Special Topics
McGraw-Hill/Irwin
Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved.