CHAPTER 1

The Scope of Corporate

Finance
 What is Finance?
 Concerned with maintenance and creation of
economic value or wealth.
 Focuses on decision making with an eye toward
creating wealth.
 The activities involved in managing cash flows in a
business environment.
 Companies must make best use of capital, while
balancing needs of corporate shareholders,
managers, and other stakeholders.

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 The Financial Manager
 Would be in charge of answering the three
questions:
 What long-term investments should you take
on?
 Where will you get the long term financing to
pay for your investment?
 How will you manage your everyday financial
activities such as collecting from customers
and paying suppliers?

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 The Financial
Management Function
Financing
(Capital-Raising)

Capital Budgeting

Financial Management

Corporate Governance

Risk Management

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 The Legal Forms of Business
Organization
1. Sole Proprietorship: a business owned by a single
individual and has a minimum amount of legal structure.
Advantages:
a. Easily established with few complications
b. Minimal organizational costs

c. Does not have to share profits or control with others.

Disadvantages:
a. Unlimited liability for the owner
b. the amount of equity is limited to the amount of the
owner’s personal wealth
c. Business terminates immediately upon death of owner
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 The Legal Forms of Business
Organization
2. Partnership: a business formed by two or more
individuals or entities.
 Two types of partnership:

 General Partnership: all the partners share in

gains or losses (agreements) and all have
unlimited liability for all partnership debts.
 Limited Partnership: one or more general
partners will run the business and have
unlimited liability, but there will be one or more
limited partners who will not actively participate
in the business.
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 The Legal Forms of Business
Organization
1. Corporation: a business created as a distinct legal entity
composed of one or more individuals or entities.
Advantages:
a. Ownership (represented by shares of stock) can be readily
transferred
b. The life of corporation is not limited
c. Limited liability of owners
d. Ability to raise large amounts of capital is increased
Disadvantages:
a. Due to corporation is a “legal” person, it must pay taxes
b. Most difficult and expensive form of business to establish

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 The Goal of Financial
Management
 The goal of financial management –
“to maximize the current value per share of existing
stock”
 Maximize Profit?
 Earnings per share are backward-looking, dependant on
accounting principles
 Do not fully consider cash flow timing

 Ignores risk

 Maximize Shareholder Wealth?

 Maximize stock price, not profits

 Shareholders as residual claimants, have better

incentives to maximize firm value.
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 The Agency Problems
 The possibility of conflict of interest between the
stockholders and management of a firm.
 Managers act as agents of the owners who hired them
and gave them decision-making authority to manage
the firm for the owners’ benefit.
 In practice however, self-interests may cause
managers to pursue objectives other than shareholder-
wealth maximization.
 This conflict of goals gives rise to managerial agency
problems.

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 How Agency Costs Can Be
Controlled
 Ways to overcome agency problems:
 Takeovers

 Monitoring and bonding

 Compensation contracts

Executive compensation packages

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 Financial Markets and The
Corporation
A. Firm issues securities

Financial
B. Firm invests
E. Reinvested cash flows Markets
in assets

Short-term debt
Current Assets
C. Cash flow from F. Dividends and Long-term debt
Fixed Assets firm’s assets debt payments Equity shares

D. Government
Other stakeholders
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 Financial Markets and The
Corporation
A. Firm issues securities E. Reinvested cash flows
to raise cash are plowed back into
B. Firm invests in assets firm.
C. Firm’s operations F. Cash is paid out to
generate cash flow investors in the form of
D. Cash is paid to interest and dividends.
government as taxes.
Other stakeholders
may receive cash.

* Refer previous page

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 Financial Markets and The
Corporation
 Primary versus Secondary Markets
 Primary Market: the original sale of securities by
governments and corporations.
 Two types:
a. Initial Public Offering (IPO) – the first time
issued in market to the public
b. Private Placements – a negotiated sale involving
a specific buyer
 Secondary Markets: these securities are bought
and sold after the original sale.

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The 5 Core Principles of Finance
1. The Time Value of Money
 The opportunity to earn a return on invested
funds means that a dollar today is worth
more than a dollar in the future.
 Business decisions involved a trade-off
between spending money today and
receiving money in the future.

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 The 5 Core Principles of Finance
2. Compensation of Risk
 Investors expect compensation for bearing
risk.

3. Don’t Put Your Eggs in One Basket

 Investors can achieve a more favorable
trade-off between risk and return by
diversifying their portfolios (Harry
Markowitz, 1990).
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 The 5 Core Principles of Finance
4. Markets are Smart
 Competition for information tends to make
markets efficient.
 Prices of financial assets quickly, and
accurately, reflect all information that
investors have access to.
 Investors should just simply buy and hold a
diversified portfolio than try to pick winners
and losers in the stock market.

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The 5 Core Principles of Finance
5. No Arbitrage
 Arbitrage refers to a trading strategy in
which an investor simultaneously buys
and sells the same asset in different
markets at different prices to earn an
instant, risk-free profit.

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THE END