Introduction to Corporate Finance

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 various
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
 Chapter Outline

1.1 What is Corporate Finance?

1.2 The Corporate Firm
1.3 The Goal of Financial Management
1.4 The Agency Problem and Control of the
Corporation
1.5 Financial Markets
1.1 What is Corporate Finance?
Corporate Finance addresses the following three
questions:
1. What long-term investments should the firm choose?
2. How should the firm raise funds for the selected
investments?
3. How should short-term assets be managed and
financed?
 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
 The Capital Budgeting Decision

Current
Liabilities
Current Assets
Long-Term
Debt

Fixed Assets
What long-term
1 Tangible investments Shareholders’
should the firm
2 Intangible Equity
choose?
 The Capital Structure Decision

Current
Liabilities
Current Assets
Long-Term
How should the Debt
firm raise funds
for the selected
Fixed Assets
investments?
1 Tangible Shareholders’
2 Intangible Equity
 Short-Term Asset Management

Current
Liabilities
Current Assets
Net
Working Long-Term
Capital Debt

How should
Fixed Assets
short-term assets
1 Tangible be managed and
financed? Shareholders’
2 Intangible Equity
 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 the pie.

If how you slice the pie affects the size of the pie,
then the capital structure decision matters.
 The Financial Manager

The Financial Manager’s primary goal is to increase

the value of the firm by:
1. Selecting value creating projects
2. Making smart financing decisions
 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

 The Firm and the Financial Markets

Firm Firm issues securities (A) Financial

markets
Invests
Retained
in assets 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

Taxes (D)

Ultimately, the firm The cash flows from

must be a cash
generating activity.
the firm must exceed
Government
the cash flows from
the financial markets.
 1.2 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.
 Forms of Business Organization
 The Sole Proprietorship
 The Partnership
 General Partnership
 Limited Partnership*

 The Corporation
 Sole Proprietorship

 Sole proprietorship is the cheapest business to form

 Life is Limited
 No formal charter, and few government regulations
must be satisfied for most industries
 Pay no corporate income taxes
 All profits of the business is taxed as individual
income, unlimited liability,
 No distinction between personal and business
assets
 Equity Is limited by the proprietors personal wealth
 A Comparison
Corporation Partnership

Liquidity Shares can be easily Subject to substantial

exchanged restrictions

Voting Rights Usually each share gets one General Partner is in charge;
vote limited partners may have
some voting rights

Taxation Double Partners pay personal taxes

on Partnership profits
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
 Public and Private Limited Companies

 Private Limited  Public Limited

Companies: 2 to 50
Members and it prohibits
invitation to public for
capital issues.
 Restriction on transfer of
shares
Companies:
 Minimum Seven are required to
form a public limited company
with no upper limit.
 Shares are easily transferable.
 The taxation are lower and there
is a wider coverage of companies
act

The main differences relate to certain provisions of the companies act that are not
Applicable to private limited companies. Ex: Voting rights and issues of shares wit
Disproportionate rights, Provisions restricting the power of the board of directors,
Further issues of share capital .
1.3 The Goal of Financial Management

 What is the correct goal?

 Maximize profit?

 Minimize costs?

 Maximize market share?

 Maximize shareholder wealth?

 1.4 The Agency Problem

 Agency relationship
 Principal hires an agent to represent his/her interest

 Stockholders (principals) hire managers (agents) to run the

company
 Agency problem
 Conflict of interest between principal and agent
 Managerial Goals
 Managerial goals may be different from
shareholder goals
 Expensive perquisites
 Survival
 Independence
 Increased growth and size are not necessarily
equivalent to increased shareholder wealth
 Managing Managers

 Managerial compensation
 Incentives can be used to align management and
stockholder interests
 The incentives need to be structured carefully to make
sure that they achieve their intended goal
 Corporate control
 The threat of a takeover may result in better
management
 Other stakeholders
 1.5 Financial Markets
 Primary Market
 Issuance of a security for the first time

 Secondary Markets
 Buying and selling of previously issued securities

 Securities may be traded in either a dealer or auction market

 Financial Markets

Stocks and
Investors
Bonds
Firms securities
Money Bob Sue
money

Primary Market
Secondary
Market
 Quick Quiz

 What are the three basic questions Financial

Managers must answer?
 What are the three major forms of business
organization?
 What is the goal of financial management?
 What are agency problems, and why do they exist
within a corporation?
 What is the difference between a primary market
and a secondary market?