Chapter 1

Introduction to
Corporate Finance

McGraw-Hill/Irwin Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.
 Contents
• Objectives & guiding principles
• Forms of business & conflict of interest
• Specific sources of conflict; agency relationship
• Corporate Governance evaluation
• Environmental, social & governance factors
• Valuation & implication of corporate governance
• Readings in Corporate governance regulations:
Sarbanes-Oxley Act, Dodd-Frank Act, SECP
Corporate Governance Rules 2017
 Corporate Finance
• Some important questions that are
answered using finance:
– What long-term investments should the
firm take on?
– Where will we get the long-term
financing to pay for the investment?
– How will we manage the everyday
financial activities of the firm?

1-3
 Financial Manager
• Financial managers try to answer some or all
of these questions
• The top financial manager within a firm is
usually the Chief Financial Officer (CFO)
– Treasurer – oversees cash management, credit
management, capital expenditures, and financial
planning
– Controller – oversees taxes, cost accounting,
financial accounting and data processing

1-4
 Financial Management
Decisions
• Capital budgeting
– What long-term investments or projects
should the business take on?
• Capital structure
– How should we pay for our assets?
– Should we use debt or equity?
• Working capital management
– How do we manage the day-to-day
finances of the firm?

1-5
 Forms of Business
Organization
• Three major forms in the United States
– Sole Proprietorship
– Partnership
• General
• Limited
– Corporation
• C-Corp
• S-Corp
• Limited Liability Company

1-6
 Sole Proprietorship
• Advantages • Disadvantages
– Easiest to start – Limited to life of
– Least regulated owner
– Single owner keeps – Equity capital
all the profits limited to owner’s
– Taxed once as personal wealth
personal income – Unlimited liability
– Difficult to sell
ownership interest

1-7
 Partnership
• Advantages • Disadvantages
– Two or more – Unlimited liability
owners • General partnership
– More capital • Limited partnership
available – Partnership
– Relatively easy to dissolves when one
start partner dies or
– Income taxed once wishes to sell
as personal income – Difficult to transfer
ownership

1-8
 Corporation
• Advantages • Disadvantages
– Limited liability – Separation of
– Unlimited life ownership and
– Separation of management
ownership and – Double taxation
management (income taxed at
– Transfer of the corporate rate
ownership is easy and then dividends
taxed at the
– Easier to raise
personal rate)
capital

1-9
 Goal of Financial
Management
• What should be the goal of a corporation?
– Maximize profit?
– Minimize costs?
– Maximize market share?
– Maximize the current value of the company’s
stock?
• Does this mean we should do anything and
everything to maximize owner wealth?

1-10
4
Role of The Financial
Manager
(2) (1)

Firm's Financial Financial

(4a)
operations manager markets

(3) (4b)

(1) Cash raised from investors

(2) Cash invested in firm
(3) Cash generated by operations
(4a) Cash reinvested
(4b) Cash returned to investors
6
Ownership vs.
Management
Difference in Information Different Objectives

Stock prices and  Managers vs.

returns stockholders
Issues of shares and  Top mgmt vs.
other securities operating mgmt
Dividends  Stockholders vs. banks
Financing and lenders
 Who make the decisions?

● Owners (typically in small businesses).

● Professional managers.
 The Agency Problem
• Agency relationship
– Principal hires an agent to represent
his/her interests
– Stockholders (principals) hire managers
(agents) to run the company
• Agency problem
– Conflict of interest between principal and
agent
• Management goals and agency costs

1-14
Agency costs

● Direct costs: (1) unnecessary expenses, such as

a corporate jet, and (2) monitoring costs.
Indirect costs. For example, a manager may
● choose not to take on the optimal investment.
She/he may prefer a less risky project
so that she/he has a higher probability keeping
her/his tenure.
 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

1-16
 Financial Markets
• Cash flows to the firm
• Primary vs. secondary markets
– Dealer vs. auction markets
– Listed vs. over-the-counter securities
• NYSE
• NASDAQ

1-17
 Quick Quiz
• What are the three types of financial
management decisions and what questions
are they designed to 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?

1-18
 Corporate governance

● Compensation:
– Incentives ($$$, options, threat of dismissal, etc.) used to align
management and stockholder interests.
●Corporate control:
– Managers may take the threat of a takeover seriously and run the
business in the interest of shareholders.
●Pressure from other stakeholders (e.g., CalPERS, a
powerful corporate police).
Sarbanes-Oxley Act (2002)

● “Sarbox.”
● 10K must have an assessment of the firm’s
internal control structure and financial
reporting.
● The officers must explicitly declare that 10K
does not contain any false statements or
material omissions.
● The officers are responsible for all internal
controls.
Ethics

● Managers are expected to behave in an ethical manner.

● The province of ethics is to sort out what is good and bad.
● But, what is the criterion or guideline for doing so?
● Philosophers came up with some criteria, but none of them
makes sorting out what is good and bad an easy task.
● Here, we introduce two of these criteria.
Principle 1

● Golden rule: Do unto others as you would have

others do onto you.
● But the next example, the so-called Sopranoism,
shows the limitation of this principle: Whack the
next guy with the same respect you’d like to be
whacked with, you know? (Source: Cathcart and
Klein, 2007).
Principle II

● Confucianism: Do not do to others what you do

not want done to yourself.
● This is a rather robust (but passive) criterion.
● But its limitation is that it says nothing about
what you should do.
Dilemma

● Ethical decisions often yield a dilemma.

● Suppose that you were the CEO of investment bank XYZ
in 2005. The debt/equity ratio of the bank was
20. All of your competitors raised their debt/equity ratios to
30 to please the stock market so that their stock prices
could be higher than otherwise would be. You knew that
raising the debt/equity ratio to 30 was rather risky and
could destroy the bank if business went wrong. But
you knew the investors would be disappointed by the
otherwise lower share price if you did not raise the
debt/equity ratio.
 So, what is the answer?

● I do not have an answer for this kind of ethical

question because it is a dilemma; otherwise, I
would not use the word “dilemma.”
● All I know is that you, as professional managers,
are expected to behave ethically.
● One thing I know for sure is that never do
anything that will put you in a prison cell; you
are too cute for a prison cell.
 Financial markets

● Cash flows (i.e., financing and

payoffs/dividends/interests) between
firms and financial markets.
● Primary markets.
● Secondary markets.

- NYSE.
- Nasdaq.