BUSFIN3120 Chapter 1

Fundamentals of Corporate Finance
Chapter 1
Corporate Finance
and the Financial
Manager
Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved.
What is Finance?
• Finance is the study of how we allocate our assets over time in a risky
world.
• For an individual, it is the study of how we pay our bills today and invest
for the future
• The overall goal is maximizing our net worth, subject to the lifestyle we want to
lead
• For a corporation, it is the study of how they pay their bills and how they
choose to invest in future projects
• The overall goal is maximizing the stock price of the company

Corporate Finance
• Some important questions that are answered using corporate finance
• What long-term investments should the firm take on? (Capital budgeting)
• Where will we get the long-term financing to pay for the investment? (Capital
structure)
• How will we manage the everyday financial activities of the firm? (Working
capital management)
What long-term investments should the firm take on?
Examples.
• For a hotel chain, the decision to build a new property or buy a
property from another chain.
• For an auto manufacturer, the decision to develop a new car or

redesign a current car
• For a record company, the decision of which new band to sign, and
whether to fund a new album by an existing band.
• Evaluating the size, timing and risk of future cash flows is the essence
of capital budgeting.
Where will we get the long-term financing to pay for
the investment? Examples
• Internal Financing: a company finances itself through cash and retained
earnings. Often how subsidiaries get funded.
• External Financing:
• Debt: bank loans, syndicate loans, bonds
• Equity (stock): Initial Public Offering (IPO), Seasoned Equity Offering (SEO)
• The mixture of internal/external and debt/equity will affect both the risk
and value of the firm. Equity (stock) is riskier than debt (bonds), but the
mix matters.
How will we manage the everyday financial activities
of the firm? Examples
• How do we bill our clients? Cash up front, or credit terms?
• What credit terms do we demand from our suppliers?
• Do we set up a revolving line of credit to help manage our day-to-day

cash needs?
• Do we do our accounting and payroll in house or outsource it?
• This is short-term financial management; we will ignore this topic

Goal of Financial Management
• What should be the goal of a corporation?
− Maximize profit?
• Short or long term? NI or CF?
− Minimize costs?
• Some cost-cutting is short-sighted: maintenance, e.g.
− Maximize market share?
• Generally good, but did not work for most dot.coms
− Maximize the current value of the company’s stock?
• This is the measurement we use in finance.
• What if the company does not have publicly-traded stock? Then
maximize the owner’s equity.
• Does this mean we should do anything and everything to maximize
owner wealth? How about unethical behavior?
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
• Risk-taking, perquisite consumption, etc.
• Management goals and agency costs

• Laws requiring outside auditors stem from agency problems
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 goal
• Corporate control
– The threat of a takeover may result in better management
• Other stakeholders
– Employees, customers, suppliers, etc.
Worldwide Stock Markets Ranked by Volume of Trade
(New figure with recent data is Figure 1.3 in the textbook)
Financial Markets: Some Terminology
• Primary market: original sales of securities, such as an IPO or SEO, a
new bond issue, a Treasury auction, etc.
• Secondary markets: Sales between investors of already issued
securities. This is what we generically refer to as the “stock market”
– Dealer market or OTC market: No centralized location, traders linked
electronically. NASDAQ, e.g.
– Auction market: Traders meet at a location and shout it out: NYSE, Chicago
Mercantile Exchange, e.g.
• Other markets: Bond, Foreign Exchange (ForEx), Commodities,
Derivatives
• Transaction Costs
• Ask price - Bid price = “Bid-ask spread”
• Commissions, if using a broker
Figure 1.5 The Financial Cycle
Money
Savers and
Investors Companies
with
projects and
new ideas
W
ag st
es
pro re
,
fits inte
, and
Table 1.2 Financial Institutions and Their Roles in the
Financial Cycle
Institution Source of Money Use of Money
Banks and Credit Unions Deposits (savings) Loans to people and businesses
Examples: Wells Fargo, SunTrust
Insurance Companies Premiums and investment Invests mostly in bonds and some stocks,
Examples: Liberty Mutual, Allstate earnings using the investment income to pay claims
Mutual Funds People’s investments (savings) Buys stocks, bonds, and other financial
Examples: Vanguard, Fidelity instruments on behalf of investors
Pension Funds Retirement savings contributed Similar to mutual funds, except with the
Examples: CalPERS, REST through the workplace purpose of providing retirement income
Hedge Funds Investments by wealthy Invests in any kind of investment in an
Examples: Bridgewater, Citadel individuals and endowments attempt to maximize returns
Venture Capital Funds Investments by wealthy Invests in start-up, entrepreneurial firms
Examples: Kleiner Perkins, individuals and endowments
Sequoia Capital
Private Equity Funds Investments by wealthy Purchases whole companies by using a small
Examples: TPG Capital, KKR individuals and endowments amount of equity and borrowing the rest
Next class: Calculators
• Make sure you have a TI BA-2 calculator for the next class.

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Fundamentals of Corporate Finance

• The overall goal is maximizing the stock price of the company

• For an auto manufacturer, the decision to develop a new car or

• What credit terms do we demand from our suppliers?

• Do we set up a revolving line of credit to help manage our day-to-day

• Do we do our accounting and payroll in house or outsource it?

• This is short-term financial management; we will ignore this topic

• Management goals and agency costs

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