Corporate Finance

Thirteenth Edition
Stephen A. Ross / Randolph W. Westerfield / Jeffrey F. Jaffe /
Bradford D. Jordan

Chapter 1:
Introduction to Corporate Finance
 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 the financial manager.
• Understand the conflicts of interest that can arise
between owners and managers.
• Understand the various regulations that firms face.

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 Chapter Outline

1.1 What is Corporate Finance?

1.2 The Corporate Firm
1.3 The Goal of Financial Management
1.4 The Agency Problem and Control of the
Corporation
1.5 Financial Markets

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1.1 What is Corporate Finance?
Corporate Finance addresses the following
three questions (from Balance Sheet):
1. What long-term investments should the firm
choose? (Capital Budgeting)
2. How should the firm raise funds for the selected
investments? (Long-term Financing)
3. How should short-term operating cash flows be
managed and financed? (Management of
Working Capital)

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 Balance Sheet of Firm
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Capital Budgeting Decision
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Capital Structure Decision
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Net Working Capital Management

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 The Financial Manager
The Financial Manager’s primary goal is to
increase the value of the firm by:
p Capital Budgeting
p Capital Structure
p Working Capital management
These three categories can be summarized with
two concrete responsibilities:
1. Selecting value creating projects
2. Making smart financing decisions

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 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

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 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.

• Types of business
• Sole Proprietorship

• Partnership

• Corporation

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 1.2 The Corporate Firm

ß Sole Proprietorship: A business owned by a single

individual
Þ Advantage: ease of start-up, lower regulation, all the
profits, taxed once…
Þ Disadvantage: limited life, unlimited liability, limited
funding,…

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 Forms of Business Organization
ß Partnership: A business much like a sole proprietorship,
but formed by two or more owners.
Þ General Partnership
Ý All partners share in gains/loss, unlimited liability.
Þ Limited Partnership
Ý Limited liability, except for general partner(s).

ß The Corporation
Þ A distinct legal entity composed of one or more owners.
Þ Public ownership and limited liability

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 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 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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 1.3 The Goal of Financial Management

ß What is the correct goal?

Þ Survive!
Þ Avoid financial distress and bankruptcy.
Þ Beat the competition.
Þ Maximize profits.
Þ Minimize costs.
Þ Maximize market share or market sales.
Þ Maintain steady earning growth.

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 1.3 The Goal of Financial Management
(cont.)
ß Maximize shareholder wealth!
Þ From a stockholder (owner) perspective, the goal
of buying he stock is to gain financially.
Þ The goal of financial management is a
corporation is to maximize the current value per
share of the existing stock.
ß èA more general goal

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 1.3 The Goal of Financial Management
(cont.)
Is stock price maximization the same as profit
maximization?

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 1.4 The Agency Problem
ß Agency relationship
Þ Corporations are owned by shareholders but are
run by managers.
Þ Principal (shareholders) hires an agent

(managers) to represent his/her interest.

ß Agency problem
Þ Conflict of interest between principal and agent
Þ e.g. bad M&A, high risky investment

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 1.4 The Agency Problem
Interest of shareholders Interest of managers
• New Investment • Managerial compensation
Opportunities plans
• Dividend versus Retained • Direct intervention by
Earnings shareholders
• The threat of firing
• The threat of takeover

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 Managerial Goals
ß Managerial goals may be different from
shareholder goals
Agency Cost!
Þ Direct agency costs –
1. compensation and perquisites for management;
2. cost of monitoring
Þ Indirect agency costs – sub-optimal decisions
(lost opportunity)
Ý Increased growth and size are not necessarily
equivalent to increased shareholder wealth!
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 Solving Agency Problems
ß Managerial compensation
Þ Incentives can be used to align management and
stockholder interests, e.g. Stock option
Þ The incentives need to be structured carefully to make sure
that they achieve their intended goal
ß Corporate control and monitoring
Þ Proxy fight and the threat of a takeover may result in better
management.
Þ Shareholder monitoring effort
ß Other stakeholders
Þ Employees, customers, suppliers, and even the government.
Þ A stakeholder, other than stockholders or creditors, will also
attempt to exert control over the firm, perhaps to the
detriment of owners.
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 1.5 Financial Markets
ß The financial markets are composed of the money
markets (< 1 year) and the capital markets (> 1 year).
ß The financial markets can be classified further as the
primary market and secondary market.
Þ Primary Market
Ý Issuance of a security for the first time

Þ Secondary Market
Ý Buying and selling of previously issued securities

Ý Securities may be traded in either a dealer or auction market

Ý Over-the-counter (OTC): dealer markets in stocks and longer-

term debt
Ý NYSE (auction market); NASDAQ (dealer market, OTC)

ß Listing
Þ Stocks are traded on an organized exchange
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 Financial Markets

Stocks and
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Bonds
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money

Primary Market
Secondary
Financial markets matter for raising capital and Market
assessing the health of the firm.

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The Firm and the Financial Markets

Firm issues securities (A)

Firm Financial
markets
Invests Retained
in assets cash flows (E) Short-term
(B) debt
Current assets Cash flow Dividends and Long-term
from firm (C) debt payments (F)
Fixed assets debt
Equity shares

Taxes

Government (D)

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 1.6 Regulation
ß The Securities Act of 1933 and the Securities
Exchange Act of 1934.
Þ Issuance of Securities (1933)
Þ Creation of SEC and reporting requirements
(1934)
ß Sarbanes-Oxley (“SOX”)
Þ Increased reporting requirements and
responsibility of corporate directors.

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 Quick Quiz
ß What are the three basic questions Financial
Managers must answer?
ß What are the three major forms of business
organization?
ß What is the goal of financial management?
ß What are agency problems, and why do they exist
within a corporation?
ß What is the difference between a primary market
and a secondary market?

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