Lecture Note 1.

I
Introduction
d i to C
Corporate Fi
Finance

Financial Management
Main Contents

Why Study Finance?

The Types of Firms

The Financial Manager

The Financial Manager’s Place in the Corporation

The Stock Market

Financial Institutions

Financial Management 2 Lecture Note 1. Introduction

Learning Objectives

Grasp the importance of financial information in both your personal and

business lives

Understand the important features of the types of firms

Why have the advantages of the corporate form led it to dominate economic activity?

Explain the goal of the financial manager and the three main types of
decisions a financial manager makes

Know how a corporation is managed and controlled

Understand some of the ethical issues financial managers face

Understand the importance of financial markets

Recognize
g the role that financial institutions

Financial Management 3 Lecture Note 1. Introduction

1. Why Study Finance?

What is the financial management?

A broad sense: Finance
it is a academic area, which study and analyze all activities managing and controlling the
application of funds (cash inflows and outflows or investing and financing of funds) with
financial markets as the center

A narrow sense: Corporate Finance

it is a kind of Finance in a broad sense
It study and analyze all activities managing and controlling the application of corporate funds
((investingg and financing
g of corporate
p funds))

Financial Management 4 Lecture Note 1. Introduction

1. Why Study Finance? (Cont.)

Why study finance?

Financial information and financial decisions are very important in both your personal
and business lives

Individuals take charge of their personal finances with decisions such as:
When to start saving and how much to save for retirement
Whether
Wh th a car loan
l or lease
l is
i more advantageous
d t
Whether a particular stock is a good investment
How to evaluate the terms for a home mortgage

In your business career, you may face such questions such as:
Should your firm launch a new product?
Which
hi h supplier
li should
h ld your firm
fi choose?
h
Should your firm produce a part or outsource production?
Should your firm issue new stock or borrow money instead?
How can you raise money for your start-up firm?

Financial Management 5 Lecture Note 1. Introduction

2. The Types of Firms

Sole Proprietorship
A business owned and run by one person

The key features of a sole proprietorship

It has the advantage of being straightforward to set up
 Many new businesses use this organizational form
Principal
P i i l limitation(or
li it ti ( weakness)k ) is
i that
th t there
th is i no separation
ti between
b t the
th firm
fi andd the
th owner
 The firm can have only one owner who runs the business
The owner has unlimited personal liability for the firm’s debts
h life
The lif off a sole
l proprietorship
i hi is
i limited
li i d to the
h life
lif off the
h owner
 It is difficult to transfer ownership of a sole proprietorship

For most businesses,

b i the
h disadvantages
di d off a sole
l proprietorship
i hi outweigh
i h the
h
advantages
As soon as the firm reaches a particular phase, the owners typically convert the business into a
f
form th
thatt limits
li it th
the owner’s
’ liability
li bilit

Financial Management 6 Lecture Note 1. Introduction

2. The Types of Firms (Cont.)

(General) Partnership
It is identical to a sole proprietorship except it has more than one owner
Often firms, in which the owners’ personal reputations are the basis for the business, remain as
partnerships
The key features of partnership
Unlimited liability: all partners are liable for the firm’s debt
The
Th partnership
t hi endsd on the
th death
d th or withdrawal
ithd l off any single
i l partner
t
Partners can avoid liquidation if the partnership agreement provides for alternatives such as a
buyout of a deceased or withdrawn partner
A li it d partnership
limited t hi
A partnership with two kinds of owners, general partners and limited partners
General partners
 Have the
h same rights
i h andd privileges
i il as partners in
i any generall partnership
hi
 Are personally liable for the firm’s debt obligations
Limited partners
 Have limited liability and their ownership interest is transferable
 They have no management authority

Financial Management 7 Lecture Note 1. Introduction

2. The Types of Firms (Cont.)

Limited Liability
y Companies
p or Corporations
p
Limits the owners’ liability to their investment
The owners cannot be held personally liable for the firm’s debts
Companies may be private limited companies or public limited companies
 The
Th owners off private
i li i d companies
limited i are not allowed
ll d to trade
d their
h i shares
h on an
organized exchange
 Private limited companies are a relatively new phenomena in the U.S.
Public limited companies are allowed to have their shares traded on an exchange
 Only public limited companies are allowed to be listed
 Most companies choose not to be listed (unlisted companies)

F t
Features off Corporations
C ti
A corporation is a legally defined, artificial being, separate from its owners
A corporation is a legal entity separate and distinct from its owners
 A corporation is solely responsible for its own obligations
 The owners of a corporation are not liable for any obligations the corporation enters into
 The corporation is not liable for any personal obligations of its owners

Financial Management 8 Lecture Note 1. Introduction

2. The Types of Firms (Cont.)

Formation of a Corporation
Must be legally formed
A legal document (or corporate charter) is created on formation of the company
C t charter
Corporate h t specifies
ifi th
the iinitial
iti l rules
l that
th t govern how
h the
th corporation
ti isi run
More costly than setting up a sole proprietorship

Ownership of a Corporation
No limit on the number of owners
The entire ownership stake of a corporation is divided into shares
The collection of all the outstanding shares of a corporation is known as the equity of the
corporation
An owner of a share in the corporation is known as a shareholder, stockholder, or
equity holder
Shareholders are entitled to dividend payments
 Usually receive a share of the dividend payments that is proportional to the amount of stock
they
h own
No limitation on who can own its shares
Financial Management 9 Lecture Note 1. Introduction
1.2 The Types of Firms

Tax Implications for Corporate Entities

A corporation’s profits are subject to taxation separate from its owners’ tax obligations
Shareholders of a corporation pay taxes twice: double taxation
Th corporation
The i pays tax on its
i profits
fi
When the remaining profits are distributed to the shareholders, the shareholders pay their own
personal income tax on this income

Tax problem: Example 1.1

You are a shareholder in a corporation. The corporation earns $5 per share before taxes. After it
has paid taxes
taxes, it will distribute the rest of its earnings to you as a dividend
When the corporate tax rate is 40% and your tax rate on dividend income is 15%, How much of
the earnings remains after all taxes are paid?
 Corporation earning after tax = $5 $5*(1-0
(1-0.4)
4) = $3
 Individual income after tax = $3*(1-0.15) = $2.55
 Total effective tax rate = 2.45/5 = 49%

Financial Management 10 Lecture Note 1. Introduction

1.2 The Types of Firms

S Corporations and C Corporations in the US

S Corporations
The firm’s profits/losses are not subject to corporate taxes
 Profits/losses
P fit /l ll t d directly
are allocated di tl tot shareholders
h h ld based b d on their
th i ownership
hi
Shareholders must include these profits as income on their individual tax returns, even if no
money is distributed to them
C Corporations
Must pay corporate taxes on its profits
 Since individuals must pay personal income taxes on these dividends, shareholders in such
corporations effectively must pay taxes twice
Most corporations in the US are C corporations
Problem: Example 1.2
Reworkk Example l 1.1
1 1 assuming
i the
h corporation
i ini that
h example
l has
h elected
l d subchapter
b h S
treatment and your tax rate on non-dividend income is 30%
 Corporate tax rate = 0%
 Individual
I di id l income
i after
ft tax
t = $5*(1-0.3)
$5*(1 0 3) = $3
$3.5
5
 Shareholder pays substantially lower effective tax rate

Financial Management 11 Lecture Note 1. Introduction

1.2 The Types of Firms

Characteristics of the different types of firms

Financial Management 12 Lecture Note 1. Introduction

3. The Financial Manager

The financial manager has three main tasks

Making investment decisions
The financial manager must weigh the costs and benefits of each investment or project
Th mustt decide
They d id which
hi h iinvestments
t t or projects
j t qualify
lif as goodd uses off the
th shareholders’
h h ld ’
money
Make financing decisions
The
Th financial
fi i l manager mustt decide
d id whether
h th to
t raise
i more money from
f new andd existing
i ti owners
by selling more shares (equity) or to borrow the money (bonds and other debt)
Manage cash flow from operating activities (working capital)
Th financial
The fi i l manager mustt ensure that
th t the
th firm
fi has
h enoughh cashh on hand
h d to
t meett its
it
obligations at each point in time

Th G
The Goall off the
th Firm
Fi
The overriding goal of financial management is to maximize the wealth of the
shareholders

Financial Management 13 Lecture Note 1. Introduction

4. The Financial Manager’s Place

Shareholders own the corporation but rely on financial managers to

actively manage the corporation
The board of directors and the management team headed by the CEO possess direct
control of the corporation

Financial Management 14 Lecture Note 1. Introduction

4. The Financial Manager’s Place (Cont.)

Ethics and Incentives in Corporations

Agency Problems
When managers(agent) put their own self-interest ahead of the interests of those
shareholders(principal)
 Further potential for conflict of interest and ethical considerations arise when some
stakeholders in the corporation benefit and other lose from a decision
The main cause of agency problems is the information asymmetry about the firm value and
business activities
There are two types of agency problems
 Agency
g y pproblems between shareholders and managers g
 Agency problems between shareholders and creditors (or debt holders)

Financial Management 15 Lecture Note 1. Introduction

4. The Financial Manager’s Place (Cont.)

Ethics and Incentives in Corporations (cont.)

How to reduce the agency problems
Reducing information asymmetry:
 Strengthen
St th monitoring
it i off managers’’ activities
ti iti
Trying managers’ compensation too closely to performance
Using the market discipline
 When
Wh th the share
h pricei deteriorates
d t i t due d tot lower
l performance,
f the
th board
b d off directors
di t mighti ht
react by replacing the CEO
 A corporate raider may initiate a hostile takeover

Financial Management 16 Lecture Note 1. Introduction

5. The Stock Market

The financial markets

The markets in which various financial assets or securities are traded
The financial trading ways
Direct financing: the consumers and supplies are directly trading the financial assets in the
market
Indirect financing: the consumers and supplies are indirectly trading the financial assets
through financial intermediaries (or financial institutions)
Types of financial markets according to maturities of financial assets
Money market
 The markets in which financial assets with less than 1-year maturity are traded
 Major financial assets: Treasury bill, Eurodollar, certificate of deposit(CD), commercial
paper(CP), Repurchase paper(RP or repo), MSB in Korea, etc
Capital market
 The markets in which financial assets with more than 1-year
y maturityy are traded
 Major financial assets: stock and bond

Financial Management 17 Lecture Note 1. Introduction

5. The Stock Market

Corporations can be private or public

A private company has a limited number of owners and there is no organized market
for its shares
The value of shares issued by a private company can be difficult to determine
A public company has many owners and its shares trade on an organized market,
called a stock market (stock exchange or bourse)
Stock
S k marketsk provide liquidity
id li idi for
f a company’s’ shares
h andd determine
d i the
h market
k price
i
for those shares

Financial Management 18 Lecture Note 1. Introduction

5. The Stock Market (Cont.)

Primary and Secondary Markets

Primary market refers to a corporation issuing new securities(stock or bond) and
selling them to investors
S d
Secondary k t iis a market
market k t where
h already
l d issued
i d securities
iti are traded
t d d between
b t
investors in
Auction market and dealer market
Auction market is a market where share prices are set through direct interaction of
buyers and sellers  ex) NYSE, KRX
Dealer market is a market where dealers buyy and sell for their own accounts  ex))
NASDAQ
Market makers (Specialists in NYSE)
Individuals on a stock exchange who match buyers with sellers
They provide stock markets with price information and liquidity
Bid-Ask Spread: transaction costs of stock trading
The difference between bid price (buying price of market maker) and ask(offer) price (selling
price of market maker)
Financial Management 19 Lecture Note 1. Introduction
Stock trading procedure in Korea

금감위(원)

투자자(매입) 증권회사 유가증권시장 증권회사 투자자(매 )

(한국거래소)

현금흐름
증권예탁원

유가증권흐름

감 ∙통제
통제

Financial Management 20 Lecture Note 1. Introduction

6. Financial Institutions

Financial
c institutions
s u o s
Entities that provide financial services, such as taking deposits, managing investments,
brokering financial transactions, or making loans

The Financial cycle

The circulation process of fund in financial markets
Step 1: People invest and save their money
Step 2: Through loans and stock, that money flows to companies who use it to fund growth
through new products, generating profits and wages
Step 3: The money then flows back to the savers and investors

All financial institutions play a role at some point in the financial cycle

Financial Management 21 Lecture Note 1. Introduction

6. Financial Institutions (Cont.)

Types
ypes oof Financial
c Institutions
s u o s
Market intermediaries
Financial institutions that provide financial services in direct financial markets
Investment banks, security companies, various types of funds, asset management companies,
etc

Financial
Fi i l intermediaries
i t di i
Financial institutions that provide financial services in indirect financial markets
Commercial banks, credit unions, insurance companies, etc

Financial conglomerates/financial services firms combine more than one type of

institution

Financial Management 22 Lecture Note 1. Introduction

1.6 Financial Institutions

Role
o e of
o Financial
c Institutions
s u o s
Financial institutions i) move funds from savers to borrowers, ii) move funds through
time, iii) help spread out risk-bearing

Reducing transaction costs

FIs can reduce transaction costs of financial trading using the effects of economy of scale

Changing the characteristics of financial assets

FIs can make various financial assets with different shape
shape, contract condition
condition, maturity
maturity, risk
structure, etc

Creating the means of payment and settlement

Currency, check, credit card, electronic money, etc

Financial Management 23 Lecture Note 1. Introduction