THE SCOPE OF CORPORATE

FINANCE

Chapter 1
 WHAT COMPANIES DO
Apple’s iPopping results
Prior to the iPad’s launch, financial experts at Apple:
• evaluated the potential market for such a device
• estimated the cost of producing it
• calculated the unit volume that the company would
have to achieve to earn a satisfactory rate of return
• developed a plan to manage the risks that Apple would
confront when making transactions in foreign
currencies.
Sources: Apple Inc. website (http://www.apple.com), 10-Q released on 19 July 2011. http://www.apple.com/pr/library/2011/07/19Apple-
Reports-Third-Quarter-Results.html
 CORPORATE FINANCE IN
MODERN BUSINESS
When contemplating any business decision,
managers should ask:

Does this action create value for the

company’s shareholders?

By taking actions that generate benefits in excess

of costs, companies generate wealth for their
investors.
 CORPORATE FINANCE
FUNCTIONS
Financing

Financial Management

Corporate
finance Capital Budgeting

functions
Risk Management

Corporate Governance
 THE FINANCING FUNCTION

• Raising capital to support the company’s

operations and investment programs, either:
– Externally, from shareholders (equity) or creditors
(debt);
– Internally, by retaining and investing profits.
• Companies can raise external equity capital
privately or they may go public by conducting
an initial public offering (IPO) of shares.
THE FINANCIAL MANAGEMENT
FUNCTION
• Managing a company’s internal cash flows as
efficiently as possible to ensure that a
company can pay off its obligations when they
come due.
− Involves obtaining seasonal financing, managing
inventories, paying suppliers, collecting from
customers and investing surplus cash.
THE CAPITAL BUDGETING FUNCTION
Capital budgeting – selecting the best projects in which
to invest the resources of the company, based on each
project’s perceived risk and expected return.
The capital budgeting process breaks down into three steps:
1) identifying potential investments
2) analysing the set of investment opportunities and selecting those
that create shareholder value
3) implementing and monitoring the selected investments.

Select investments for which the marginal benefits exceed

the marginal costs.
 THE RISK MANAGEMENT
FUNCTION
• Managing the company’s exposure to all types
of risk
• Both insurable (such as loss caused by fire or
flood) and uninsurable
• To maintain optimum risk-return trade-offs and
thereby maximise shareholder value
• Modern risk management focuses on adverse
interest rate movements, commodity price
changes and currency value fluctuations.
 THE CORPORATE GOVERNANCE
FUNCTION
Developing company ownership and corporate governance
structures that ensure that managers behave ethically and
make decisions that benefit shareholders.
• Boards of directors
Dimensions of • Compensation packages
corporate • Auditors
governance • Legislative environment and
compliance requirements
The takeover market disciplines companies that do not
govern themselves.
 DEBT & EQUITY: THE TWO
FLAVOURS OF CAPITAL
• Borrowed money.
Debt • The borrower is obliged to pay interest, at a
capital specified annual rate, on the full amount
borrowed, as well as to repay the principal
amount at the debt’s maturity.

• An ownership interest, usually in the form of

ordinary or preference shares.
Equity • Ordinary shareholders receive returns on
capital their investments only after creditors and
preference shareholders are paid in full.
 FINANCIAL INTERMEDIATION
• An institution that raises capital by
Financial issuing liabilities against itself and
intermediary then lends that capital to corporate
and individual borrowers.
• Examples: insurance companies,
savings and loan institutions, credit
unions, commercial banks, pension
funds, mutual funds.
• Pension funds and mutual funds have surged to
prominence as corporate finance shifts towards a greater
reliance on market-based external funding.
 FINANCE IN PRACTICE
Views on corporate goals and stakeholder groups
 THE CORPORATE FINANCIAL
MANAGER’S GOALS
What should a financial manager try to maximise?

• Maximise profit?
– Earnings reflect past performance rather than current
or future performance
– Ignores the timing of the profits
– Ignores cash flows
– Ignores risk.
 THE CORPORATE FINANCIAL
MANAGER’S GOALS
What should a financial manager try to maximise?

• Maximise shareholder wealth?

– As measured by the market price of the company’s
shares
– A company’s share price reflects the timing, magnitude
and risk of the cash flows that investors expect a
company to generate over time
– Shareholders are the residual claimants of a company.
 THE CORPORATE FINANCIAL
MANAGER’S GOALS
What should a financial manager try to maximise?

• Focus on stakeholders?
– Many companies seek to preserve the interests of
other stakeholders, such as employees, customers,
tax authorities and the communities in which the
companies operate
– Doing so provides long-term benefits to shareholders
and is in line with the primary goal of maximising
shareholder wealth.
AGENCY COSTS IN CORPORATE
FINANCE
Agency problems • The conflict between the goals of a
company's owners and its managers.

• To overcome agency problems:

– Rely on market forces to exert managerial discipline
– Incur monitoring and bonding costs to supervise
managers
– Structure executive compensation packages to align
managers’ interests with shareholders’ interests.

The actual workings of many compensation plans have

been harshly criticised in recent years.
 ETHICS IN CORPORATE
FINANCE
• Today, society in general and the financial
community in particular are developing and
enforcing higher ethical standards

• Ethical behaviour is viewed as necessary and

consistent with a company achieving the goal
of maximising shareholder wealth.
 THE ROLE OF CORPORATE
FINANCE
• Financial managers should seek to maximise
shareholders’ wealth
• How?
− By performing the five basic duties of corporate
finance: external financing, capital budgeting, financial
management, risk management and corporate
governance
• Select investments for which the marginal
benefits exceed the marginal costs.
 LEGAL FORMS OF BUSINESS
ORGANISATION
• No distinction between business and
Sole person
proprietorships • Easy to set up and operate; taxed as
personal income
• Personal liability, limited life, difficult to
transfer

Partnerships • Two or more business owners

• Each partner liable for every partner’s
actions
• One or more general partners and many
Limited limited partners
partnerships • Limited liability of corporation, tax benefits
of partnership
 LEGAL FORMS OF BUSINESS
ORGANISATION

• Separate legal entity with all the economic

Proprietary rights and responsibilities of a person
• Creates roles for employees, directors and
limited
shareholders
company • Regulated under the Corporations Law 2001

• Legal entity with all the economic rights and

responsibilities of a person
Companies • Owned by shareholders
• Strengths – limited liability for investors,
unlimited business life
 CAREER OPPORTUNITIES IN FINANCE
Corporate • Budgeting, financial forecasting, cash
management, credit administration, investment
finance analysis, fund procurement
Commercial • Consumer banking
banking • Corporate banking

Investment • High income potential

• Very competitive industry
banking
• Opportunities in investment advisory
Money companies, mutual fund companies, pension
management funds, investment arms of financial
departments
• Advise on business practices and strategies of
Consulting corporate clients