Chapter 1

Goals and
Book Cover
10e
Governance of
the Corporation

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1- 1
 Topics Covered

1.1 Investment and Financing Decisions

1.2 What is a Corporation?
1.3 Who Is the Financial Manager?
1.4 Goals of the Corporation
1.5 Agency Problems, Executive Compensation,
and Corporate Governance
1.6 The Ethics of Maximizing Value
1.7 Careers in Finance
1.8 Preview of Coming Attractions
1.9 Snippets of Financial History
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Investment and Financing Decisions (1 of 6)

▪ Capital Budgeting Decision

– Decision to invest in tangible or intangible
assets
▪ …also called
– Investment Decision
– Capital Expenditure (CAPEX) decision

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Investment and Financing Decisions (2 of 6)

“Capital Budgeting”

TANGIBLE ASSETS INTANGIBLE ASSETS

Southwest Airlines GlaxoSmithKline
Purchase new planes R&D expenditures

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Investment and Financing Decisions (3 of 6)

▪ Financing Decision
– Decision on the sources and amounts of financing
▪ Capital Structure
– The mix of long-term debt and equity financing

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Investment and Financing Decisions (4 of 6)

ASSETS FIRM

Investment Decision
“Capital Budgeting”
Debt Equity

Financing Decision

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Investment and Financing Decisions (5 of 6)

▪ Real Assets
– Assets used to produce goods and services
▪ Financial Assets
– Financial claims to the income generated by the
firm’s real assets

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Investment and Financing Decisions (6 of 6)

▪ Are the following capital budgeting or

financing decisions?
a. Intel decides to spend $7 billion to develop a new
microprocessor
b. BMW borrows 350 million euros (€350 million) from
Deutsche Bank
c. Royal Dutch Shell constructs a pipeline to bring natural
gas onshore from a production platform in Australia
d. Avon spends €200 million to launch a new range of
cosmetics in European markets
e. Pfizer issues new shares to buy a small biotech company

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 What Is a Corporation? (1 of 4)

▪ Corporation
– A business organized as a separate legal entity
owned by stockholders
▪ Types of Corporations
– Public Companies
– Private Corporations
– Limited Liability Corporations (LLC)

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 What Is a Corporation? (2 of 4)

▪ Types of Business Organizations

– Sole Proprietorships
– Partnerships
– Corporations
– Limited Liability Options
• Limited Liability Partnerships
• Limited Liability Corporations
• Professional Corporations
▪ Limited Liability
– The owners of a corporation are not personally
liable for its obligations
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 What Is a Corporation? (3 of 4)

Sole
Partnership Corporation
Proprietorship
Who owns the business? The manager Partners Stockholders
Are managers and owners
No No Usually
separate?
What is the owner’s liability? Unlimited Unlimited Limited
Are the owner and business
No No Yes
taxed separately?

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 What Is a Corporation? (4 of 4)

Sole Proprietorships
Unlimited Liability
Personal tax on profits
Partnerships

Limited Liability
Corporations Corporate tax on profits +
personal tax on dividends

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Who Is the Financial Manager? (1 of 3)

Chief Financial
Officer

Treasurer Controller

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Who Is the Financial Manager? (2 of 3)

▪ Chief Financial Officer (CFO)

– Responsible for financial policy and corporate
planning
▪ Treasurer
– Responsible for cash management, raising of
capital and banking relationships
▪ Controller
– Responsible for preparation of financial
statements, accounting and taxes

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Who Is the Financial Manager? (3 of 3)

(1) Cash raised from investors

(2) Cash invested in firm
(3) Cash generated by operations
(4a) Cash reinvested
(4b) Cash returned to investors
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 Goals of the Corporation (1 of 2)

▪ Shareholders desire wealth maximization

▪ Profit maximization
– Maximize profits? Which year’s profits?
– Earning manipulation
▪ Opportunity cost of capital
– The minimum acceptable rate of return on capital
investment is set by the investment opportunities
available to shareholders in financial markets

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Goals of the Corporation (2 of 2)

The Investment Trade-Off

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 Agency Problem (1 of 5)

▪ Do managers maximize shareholder wealth or

manager wealth?
▪ Mangers have many constituencies called
“stakeholders”
▪ Stakeholder
– Anyone with a financial interest in the
corporation

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 Agency Problem (2 of 5)

▪ Agency problem
– Managers are agents for stockholders and are
tempted to act in their own interests rather than
maximizing value
▪ Agency cost
– Value lost from agency problems or from the
cost of mitigating agency problems

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 Agency Problem (3 of 5)

Ownership vs. Management

Difference in Information Different Objectives

▪ Stock prices vs. returns ▪ Managers vs. stockholders
▪ Dilution of ownership ▪ Top managers vs. lower
▪ Dividend policy managers
▪ Financing decisions ▪ Stockholders vs. banks and
lenders

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 Agency Problem (4 of 5)

▪ Corporate governance
– The laws, regulations, institutions, and
corporate practices that protect shareholders
and other investors

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 Agency Problem (5 of 5)

Elements of good corporate governance

1. Legal requirements
2. Board of directors
3. Activist shareholders
4. Takeovers
5. Information for investors

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 Ethics of Maximizing Value
“It is not from the benevolence of the butcher, the brewer,
or the baker, that we expect our dinner, but from their
regard to their own interest. We address ourselves, not to
their humanity but to their self-love, and never talk to them
of our own necessities but of their advantages.” –Adam
Smith, 1776

Does value maximization justify Is it ethical?

unethical behavior? • Short selling
• Volkswagen • Corporate raiders
• Charles Ponzi • Tax avoidance
• Bernard Madoff

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Preview of Coming Attractions

▪ How do I calculate the value of a stream of

future cash flows?
▪ How do I measure risk?
▪ Where does financing come from?
▪ How do I ensure that the firm’s financial
decisions add up to a sensible whole?
▪ What about some of those other
responsibilities of the financial manager
that you mentioned earlier?
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Snippets of Financial History

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