INTRODUCTION TO CORPORATE FINANCE

MODULE 1
1
01 02 03 04
Know the basic Describe the legal Know the goal of How various
types of financial forms of business financial corporate
management organization. management governance
decisions and the mechanisms
role of the Financial attempt to manage
Manager agency problems?

KEY CONCEPTS AND SKILLS

2
Key Concepts and Skills

▪ Know the basic types of financial management

decisions and the role of the Financial Manager
▪ Know the financial implications of the various forms
of business organization
▪ Know the goal of financial management
▪ Understand the conflicts of interest that can arise
between owners and managers
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
1.1 What Is Corporate Finance?

Corporate Finance addresses the following

three questions:
1. What long-term investments should the firm choose?
2. How should the firm raise funds for the selected
investments?
3. How should short-term assets be managed and
financed?
Balance Sheet Model of the Firm
Total Value of Assets: Total Firm Value to Investors:
Current
Liabilities
Current
Assets Long-Term
Debt

Fixed Assets
1 Tangible
Shareholders
2 Intangible ’ Equity
The Capital Budgeting Decision
Current
Liabilities
Current
Assets Long-Term
Debt

Fixed Assets
What long-
1 Tangible term Shareholders
investments
2 Intangible ’ Equity
should the
firm choose?
The Capital Structure Decision
Current
Liabilities
Current
Assets Long-Term
How should the Debt
firm raise funds
for the selected
Fixed Assets investments?
1 Tangible Shareholders
2 Intangible ’ Equity
Short-Term Asset Management

Current
Liabilities
Current
Net
Assets Working Long-Term
Capital Debt

How should
Fixed Assets
short-term
1 Tangible assets be
managed and Shareholders
2 Intangible financed? ’ Equity
The Financial Manager

The Financial Manager’s primary goal is to

increase the value of the firm by:

1. Selecting value creating projects

2. Making smart financing decisions
Hypothetical Organization Chart
Board of Directors

Chairman of the Board and

Chief Executive Officer (CEO)

President and Chief

Operating Officer (COO)

Vice President and

Chief Financial Officer (CFO)

Treasurer Controller

Cash Manager Credit Manager Tax Manager Cost Accounting

Capital Expenditures Financial Planning Financial Accounting Data Processing

1.2 The Corporate Firm

▪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.
Forms of Business
Organization

• The Sole Proprietorship

• The Partnership
• General Partnership
• Limited Partnership
• The Corporation
A Comparison
Corporation Partnership
Liquidity Shares can be easily Subject to substantial
exchanged restrictions
Voting Rights Usually each share gets one General Partner is in charge;
vote limited partners may have
some voting rights
Taxation Double Partners pay taxes on
distributions
Reinvestment and dividend Broad latitude All net cash flow is
payout distributed to partners
Liability Limited liability General partners may have
unlimited liability; limited
partners enjoy limited liability

Continuity Perpetual life Limited life

International Corporations
1.3 The Importance of Cash Flow
Firm Firm issues securities (A) Financial
markets
Invests
Retained
in assets cash flows (F)
(B)
Short-term debt
Current assets Cash flow Dividends and Long-term debt
Fixed assets from firm (C) debt payments (E)
Equity shares

Taxes (D)
Ultimately, the firm The cash flows from the firm
must be a cash Government must exceed the cash flows
generating activity. from the financial markets.
1.4 The Goal of Financial Management

▪What should be the primary goal for the firm?

▪ Maximize profit?

▪ Minimize cost?

▪ Maximize market share?

▪ Maximize shareholder wealth?

Which Investment is Preferred?
1.4 Goal of Finance: Maximizing profit?

▪Maximizing profit is not a suitable goal because:

1. Timing is important—the receipt of funds sooner rather than later is
preferred
2. Profits do not necessarily result in cash flows available to
stockholders
3. Profit maximization fails to account for risk
1.4 Goal of Finance: Minimizing cost?

▪Minimizing cost is not a suitable goal because:

▪ Minimizing costs may increase current profits but the
future well-being of the company may be affected, for
example,
▪ Reducing maintenance costs may result in machines breaking
down earlier in the future
▪ Reducing R&D expenditures may cause the products to be less
competitive
▪ Reducing headcount may reduce the quality of service
1.4 Goal of Finance: Maximizing market share?

▪Maximizing market share is not a suitable goal

because:
▪ In order to increase market the firm may large amounts in
advertising and promotion
▪ Having a large market share may not translate into higher
profits if the firm cannot increase revenue much more by
increasing prices
1.4 Goal of Finance: Maximizing shareholder wealth?

▪This is the right goal of finance because:

▪ It avoids the problems of the other goals by taking risk,
level of cash flow, and timing into consideration.
▪ Maximize stock price, not profits
▪ Shareholders, as residual claimants, have better incentives
to maximize firm value.
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
Managerial Goals

▪Managerial goals may be different from

shareholder goals
▪ Expensive perquisites
▪ Survival
▪ Independence
▪Increased growth and size are not necessarily
equivalent to increased shareholder wealth
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
▪ Other stakeholders
Corporate Governance

▪Corporate governance relates to the rights and

responsibilities of various stakeholders in the
firm
▪A firm with good corporate governance would
▪ Respect the rights of the shareholders and other
stakeholders
▪ Ensure that the board of directors represent the best
interests of shareholders
▪ Operate in a transparent manner