CHAPTER 1

I N T R O D U C T I O N T O C O R P O R AT E F I N A N C E

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 KEY CONCEPTS AND SKILLS

• Know the three main concerns of corporate

financial management
• Grasp the goal of financial management
• Enumerate the financial benefits and drawbacks
of differing forms of business organization
• Understand the conflicts of interest that can arise
between owners and managers
• Comprehend that corporate organizations are
enhanced by financial markets

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 CHAPTER OUTLINE

1.1 What is Corporate Finance?

1.2 The Corporate Firm
1.3 The Importance of Cash Flows
1.4 The Goal of Financial Management
1.5 The Agency Problem and Control of the
Corporation
1.6 Regulation

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 1.1 WHAT IS CORPORATE FINANCE?

• Economic resources are required to establish and

maintain a firm:
• Funds enable materials and processes for delivering
salable goods and services
• Funds are essential for assembling a workforce
• Funds are required to purchase long-lived assets such as
equipment and buildings
• The Balance Sheet offers insight into the array of
decisions, activities and objectives of the
Financial Manager

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 BALANCE SHEET MODEL
OF THE FIRM

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 THE BALANCE SHEET REVEALS…

…the top three concerns of corporate finance:

1. What long-term investments should the firm

choose?
2. How should the firm raise funds for the
selected investments?
3. How should current assets be managed and
financed?

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 THE CAPITAL BUDGETING
DECISION

What long-term
investments should
the firm choose?

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 THE CAPITAL STRUCTURE
DECISION

How should the

firm raise funds
for the selected
investments?

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 SHORT-TERM ASSET MANAGEMENT

How should
short-term
assets be
managed and
financed?

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 THE FINANCIAL MANAGER

• The firm’s three main financial concerns are

usually handled by a top officer and aides:
• V.P. or Chief Financial Officer
• Strategist, coordinator, authority
•Treasurer
• Cash flow, capital expenditures, capital structure
• Controller
• Accounting, information systems, taxes

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 HYPOTHETICAL ORGANIZATION
CHART

Chairman of

Vice President and

Chief Officer (CFO)

Financial Planning

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 1.2 THE CORPORATE FIRM

• First company problem: raise funds

• 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

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 FORMS OF BUSINESS
ORGANIZATION
• The Sole Proprietorship
• The Partnership
• General Partnership
• Limited Partnership
• The Corporation

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 A COMPARISON

Corporation Partnership

Liquidity and Shares can be easily Subject to substantial

marketability exchanged restrictions

Voting Rights Usually each share gets General Partner is in charge;

one vote limited partners may have
some voting rights

Taxation Double Partners pay taxes on

distributions
Reinvestment and Broad latitude All net cash flow is
dividend payout distributed to partners

Liability Limited liability General partners may have

unlimited liability; limited
partners enjoy limited
liability

Continuity Perpetual life Limited life

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 A GLOBAL PHENOMENON

• The corporate form of organization is not unique

to the United States:

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 1.3 THE IMPORTANCE OF
CASH FLOWS
• If the firm is to prosper, it must:
• Buy assets that generate more cash than they cost
• Sell financial instruments that raise more cash than they
cost
• The successful firm generates more cash than it
uses

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 THE CONCEPTUAL FLOW OF CASH

Ultimately, the firm

must be a cash The cash flows from
generating activity. the firm must exceed
the cash flows from
the financial markets.
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 CASH FLOW ≠
ACCOUNTING INCOME
• Do not confuse cash flow and accounting income
• Non-Cash expense example: Depreciation
• Non-Cash revenue example: Sales on Account

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 1.4 THE GOAL OF FINANCIAL
MANAGEMENT
• What is the correct goal?
• Maximize profit?
• Minimize costs?
• Maximize market share?
• Maximize the value of shareholder equity?

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 1.5 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

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 AGENCY COST

• Cost of Conflict of Interest

• Example:
• Large investment positions firm for long term positive
cash flow but has risk in short run
• Owners want this investment – Increases firm value
• Managers object – Risk may have personal cost
• If managers prevail, foregone long term cash flow is the
Agency Cost

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 MANAGEMENT GOALS

• Management goals may be different from

shareholder goals
• Expensive perquisites
• Survival
• Independence
• Increased growth and size
• Often lead to management reward
• Not necessarily in best interest of shareholders

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 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 intended goal
• Corporate control
• The threat of a takeover may result in better
management
• Influence of other stakeholders

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 1.6 REGULATION

• Sarbanes-Oxley Act of 2002 (“Sarbox”)

• Increased reporting requirements and responsibility
of corporate directors
• Personal consequences for non-compliance
• The Securities Act of 1933 and the Securities
Exchange Act of 1934
• Issuance of Securities (1933)
• Creation of SEC and reporting requirements (1934)

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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 major regulations impact public firms?

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