Chapter 1

Introduction to Corporate Finance

Slides Updated By:

Tsvetanka Karagyozova,
Department of Economics
York University

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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 Institutions, Financial Markets, and the
Corporation
1.6 Trends in Financial Markets and Management
1.7 Outline of the Text
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What is Corporate Finance?

Corporate Finance addresses the following three

questions:

1. In what long-lived assets should the firm invest?

2. How can the firm raise cash for required capital
expenditures?
3. How should short-term operating cash flows be
managed?

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The Balance-Sheet Model of the Firm

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Two Pie Models of the Firm

50%
Equity

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Hypothetical Organization Chart
(1 of 2)

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Hypothetical Organization Chart
(2 of 2)

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The Financial Manager

To create value, the financial manager should:
1. Try to make smart investment decisions
– Buy assets that generate more cash than they cost

2. Try to make smart financing decisions

– Sell bonds, shares and other financial instruments that
raise more cash than they cost

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Cash Flows Between the Firm and
the Financial Markets

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Cash Flows
• Identification of cash flows
– Reporting of sales versus collection of cash
– Reporting of expenses versus payment of expenses

• Timing of cash flows

– A dollar received today is worth more than a dollar
received next year
– Investors prefer to receive cash flows earlier than later

• Risk of cash flows

– Amount and timing of future cash flows is not certain
– Most investors are risk averse

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Corporate Securities as Contingent
Claims on Total Firm Value
• Debt – a promise by the borrowing firm to repay a
fixed dollar amount 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.
• Debt and equity securities are contingent claims,
contingent on the total firm value.
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Debt and Equity as Contingent Claims

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Combined Payoffs to Debt and Equity
(Figure 1.5)
If the value of the firm is less than $F, the shareholders’s claim
is: Max[0,$X - $F] = $0 and the debtholder’s claim is Min[$F,
$X] = $X.

The sum of these is = $X

If the value of the firm is more than $F, the shareholder’s claim
is: Max[0,$X - $F] =$X - $F and the debtholder’s claim is:
Min[$F,$X] = $F.

The sum of these is = $X

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Business Organization Forms

• 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:
1. The Sole Proprietorship
2. The Partnership
3. The Corporation
4. The Income Trust

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The Sole Proprietorship

A business owned by one person
•Advantages:
– The cheapest type of business to form
– Pays no corporate income taxes; profits are taxed as
individual income

•Disadvantages:
– Unlimited liability for business debts and obligations
– Life limited by the life of the sole proprietor
– Equity money raised limited by the sole proprietor’s
personal wealth
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The Partnership: Definition

Two or more co-owners form a business
•General partnership: all partners provide some
fraction of the work and cash to share the profits and
losses
•Limited partnership: permit the liability of some
(but not all) of the partners to be limited to the amount
of cash each has contributed to the partnership

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The Partnership: Disadvantages

• Advantage:
– Inexpensive and easy to form

• Disadvantages:
– General partners have unlimited liability (liability of
limited partners limited to the contribution each has made
to the partnership)
– Difficult to transfer ownership without dissolving
– Difficult to raise large amounts of cash

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The Corporation
Distinct legal entity owned by its shareholders
•Advantages:
– Limited shareholder liability
– Separates ownership from management
– Ease of ownership transfer
– Perpetual life
•Disadvantages:
– Double taxation of corporate income
• At the corporate level - corporate tax rate
• At the shareholder level – dividends are taxable with dividend
tax credit
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Partnerships vs. Corporation

Corporation Partnership
Liquidity and Shares can easily be Subject to substantial restrictions.
marketability exchanged
Voting Rights Usually each share gets General Partner is in charge;
one vote limited partners may have some
voting rights.
Taxation Double taxation with Taxed as personal income to the
dividend tax credit partners
Reinvestment and Broad latitude All net cash flow is distributed to
Dividend Payout partners.
Liability Limited liability General partners may have
unlimited liability. Limited
partners enjoy limited liability.

Continuity of Perpetual life Limited life

Existence
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Goals of the Corporate Firm

• What is the primary goal of the corporation?
– Impossible to give a definitive answer
– Traditional answer: Add value for the
shareholders
• Problem: Vague
– Set-of-contracts viewpoint: Offers an
alternative answer

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The Set-of-Contracts Perspective

• The firm can be viewed as a set of contracts.

• One of these contracts is between shareholders and
managers.
• Managers are agents hired to act on behalf of
shareholders, who are the principals.
• Both managers and shareholders pursue their own
self-interests.

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The Agency Problem

• Managers will usually act in the shareholders’ interests.
– Shareholders can devise contracts that align the incentives
of managers with the goals of the shareholders.
– Shareholders can monitor managers’ behaviour.
• But: this contracting and monitoring is costly.
– These costs are agency costs that arise from conflicts of
interest between managers and shareholders.
• Agency problems do not mean that interests of managers
and shareholders cannot be aligned. Only that it is costly
to do so.
• Agency problems can never be perfectly solved.

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Managerial Goals
• Managerial goals may be different from shareholder
goals
– Expense preferences (Williamson, 1963)
– Survival
– Independence
– Self-sufficiency

• Increased growth and size of firm are not

necessarily the same thing as increased shareholder
wealth.

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Separation of Ownership and
Control

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Do Shareholders Control Managerial
Behaviour?
• Argument: shareholders do not control
management because ownership is too diffuse and
fragmented.
– Over 70 percent of U.S. corporations are widely held
compared to around 15 percent in Canada

• The extent to which shareholders can control

managers depends on
– The costs of monitoring management
– The costs of control devices
– The benefits of control

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Control Devices Available to
Shareholders
1. Shareholders vote for the board of directors, who
in turn hire the management team.
2. Contracts can be carefully constructed to be
incentive compatible.
3. If the managers fail to maximize share price, they
may be replaced in a hostile takeover.
4. There is a market for managerial talent—this may
provide market discipline to the managers—they
can be replaced.
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Stakeholders

• In addition to shareholders and management,

employees, customers, suppliers, and the public all
have a financial interest in the firm and its
decisions.
• Different stakeholders may have different goals.
• Ethical or socially responsible investing: screening
and selecting securities based on social or
environmental criteria
– Does it create value?

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Financial Institutions, Financial
Markets, and the Corporation

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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 Markets:
Primary vs. Secondary 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.

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Listing
• Listing on an organized exchange
• Enhances trading liquidity
• cross list on domestic and foreign exchanges
• Facilitates raising equity
• To be listed, firms must meet certain minimum criteria.
• Listing on Canadian exchange – “comply or explain” regime
• Listing on U.S. exchange– significant disclosure
requirement (SOX) and compliance costs

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Foreign Exchange Market

• Foreign exchange market is the world’s largest
financial market for trading currencies
• Is an over-the-counter market.
• Many different types of participants:
• Importers and exporters
• Portfolio managers
• Foreign exchange brokers
• Traders

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Trends in Financial Markets
and Management (1 of 2)
• Integration and globalization
• Increased risk from volatility
• Financial Engineering reduces costs related to
– Risk
– Taxes
– Financing costs

• Improved computer technology allows economies

of scale and scope

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Trends in Financial Markets
and Management (2 of 2)
• Deregulation is opening the possibility for further
changes.
• Recent financial crisis: causes and recovery.
• These trends have made financial management a
much more complex and technical activity.

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Outline of the Text

1. Overview
2. Value and Capital Budgeting
3. Risk
4. Capital Structure and Dividend Policy
5. Long-Term Financing
6. Options, Futures, and Corporate Finance
7. Financial Planning and Short-Term Finance
8. Special Topics

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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?

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Chapter Summary
Introduces:
– Basic ideas of corporate finance
– The ways in which financial managers can create value for
the firm.
– The description of debt and equity securities as contingent
claims.
– The different types of firms
– The role of financial markets in corporate finance.
– The types of financial markets.
– The latest trends in the financial markets.

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