Financial

Management
BUS 308

Alice M Chung
RHB404
2804 8503
1
 Course Requirements
 Text: Fundamentals of Corporate Finance,
Ross, S.A., Westerfield R.W., Jordan B.D.,
(2019), 12th Edition, McGraw Hill.
 Grading System:
 Class Participation (10%)
 Assignment/Homework (10%)
 Group Written Paper (10%)
 Mid-term Exam (20%)
 Final Exam (50%)

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 Date Class Topic Chapter(s)
Sep 7, 8 Introduction to Corporation Finance 1
Sep 14, 15 Accounting Statements & Cash Flow 2
Sep 21, 22 The Time Value of Money 5, 6
Sep 28, 29 Interest Rates & Bond Valuation 7
Oct 5, 6 Stock Valuation 8
Oct 12, 13 Capital Budgeting 9, 10
Oct 19, 20 Capital Budgeting 10, 11
Mid-term test (Oct 27 - 30) 1, 2, 5 -8
Nov 2, 3 Cost of Capital, Raising Capital 14, 15
Nov 9, 10 Financial Leverage and Capital Structure Policy 16
Nov 16, 17 Risk and Return 12
Nov 23, 24 Portfolio Theory, The CAPM model 13
Nov 30, Dec 1 Group Written Report Due (@ 5:00pm)
Dec 7, 8 Study week
Chapter 1

Introduction to Corporate Finance

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What is Corporate Finance?
 Corporate Finance addresses the following
three questions:
1. What long-term investments should the firm
engage in?
2. How can the firm raise the money for the
required investments?
3. How much short-term cash flow does a
company need to pay its bills?

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The 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

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The Balance-Sheet Model of the
Firm The Capital Budgeting Decision
Current
Liabilities
Current
Assets Long-Term
Debt

Fixed Assets What long-

term
1 Tangible investments Shareholders’
2 Intangible should the Equity
firm engage
in?
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The Balance-Sheet Model of the
Firm The Capital Structure Decision
Current
Liabilities
Current
Assets Long-Term
How can the firm Debt
raise the money
for the required
Fixed Assets
investments?
1 Tangible
Shareholders’
2 Intangible Equity

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The Balance-Sheet Model of the
FirmThe Net Working Capital Investment Decision
Current
Liabilities
Current
Net
Assets Working Long-Term
Capital Debt

How much short-

Fixed Assets
term cash flow
1 Tangible does a company
need to pay its Shareholders’
2 Intangible bills? Equity

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Capital Structure
The value of the firm can be
thought of as a pie.
The goal of the manager is 70%50%30%
25%
to increase the size of the DebtDebt
Equity
pie.
75%
50%
The Capital Structure Equity
decision can be viewed as
how best to slice up a the
pie.
If how you slice the pie affects the size of the
pie, then the capital structure decision matters.
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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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The Financial Manager
To create value, the financial manager
should:
1. Try to make smart investment decisions.
2. Try to make smart financing decisions.

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Example
 The ABC Company refines and trades gold.
At the end of the year, it sold 2,500 ozs. Of
gold for $1 million.
 The company had acquired the gold for
$900,000 at the beginning of the year.
 The company paid cash for the gold when it
was purchased.
 But, it has yet to collect from the customer to
whom the gold was sold.
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Standard Accounting for ABC Co.
 By GAAP (Generally accepted accounting
principle), the sale is recorded even though the
customer has yet to pay.

The ABC Company

Income Statement
Year Ended Dec. 31, 202X
Sales $1,000,000
Costs ($900,000)
Profit $100,000
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Corporate Finance View for ABC
Co.
 From the accounting perspective, ABC Co.
seems to be profitable.
 However, the perspective of Corp. Fin. is
different – It focus on Cash Flow
The ABC Company
Income Statement
Year Ended Dec. 31, 202X
Cash inflow $0
Cash outflow ($900,000)
($900,000)
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The Perspective of Corporation
Finance
 It is interested in whether Cash Flows are
being created by Operations of company.
 Value creation depends on cash flows.
 Therefore, value creation depends on whether
and when it actually receive $1 million in this
case of ABC company.

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The Firm and the Financial Markets
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

must be a cash the firm must exceed
Government
generating activity. the cash flows from
the financial markets. 17
Risk of Cash Flow
 The amount and timing of cash flows are not
usually known with certainty.
 For example:
 DEF company is attempting to choose between 2
proposals for new products.
 Both proposals will provide additional cash flows
over a 4-year period and will initially cost
$10,000
 Which one is better for DEF company?
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Example
Year New Product A New Product B
1 $0 $4,000
2 $0 $4,000
3 $0 $4,000
4 $20,000 $4,000
Total $20,000 $16,000
 Product A is better?!
 However the cash flows from B come earlier than
those of A.
 It all depends on whether the value of getting cash
from B up front out weight the extra total cash from
A. 19
 Corporate Securities as Contingent
Claims on Total Firm Value
 What is the essential difference between debt and equity?
 The answer can be found by thinking about what happens
to the payoffs to debt and equity when the value of the
firm changes.
 The basic feature of a debt is that it is a promise by the
borrowing firm to repay a fixed dollar amount of by a
certain date.
 The shareholder’s claim on firm value is the residual
amount that remains after the debtholders are paid.
 If the value of the firm is less than the amount promised
to the debtholders, the shareholders get nothing.
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Debt and Equity as Contingent Claims
Payoff to Payoff to
debt holders shareholders
If the value of the firm is If the value of the firm
more than $F, debt is less than $F, share
holders get a maximum holders get nothing.
of $F.
$F

$F $F
Value of the firm (X) Value of the firm (X)

Debt holders are promised $F. If the value of the firm is more
than $F, share holders get
If the value of the firm is less than
everything above $F.
$F, they get the whatever the firm
is worth. Algebraically, the
Algebraically, the bondholder’s shareholder’s claim is:
Max[0,$X – $F] 21
claim is: Min[$F,$X]
Combined Payoffs to Debt and Equity

Combined Payoffs to debt holders If the value of the firm is less than
and shareholders $F, the shareholder’s claim is:
Max[0,$X – $F] = $0 and the debt
holder’s claim is Min[$F,$X] = $X.
The sum of these is = $X
Payoff to shareholders
$F
If the value of the firm is more than
Payoff to debt holders $F, the shareholder’s claim is:
Max[0,$X – $F] = $X – $F and the
$F debt holder’s claim is:
Value of the firm (X)
Min[$F,$X] = $F.
Debt holders are promised
$F. The sum of these is = $X
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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.

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Forms of Business Organization
 The Sole Proprietorship
 The Partnership
 General Partnership
 Limited Partnership
 The Corporation
 Advantages and Disadvantages
 Liquidity and Marketability of Ownership
 Control
 Liability
 Continuity of Existence
 Tax Considerations 24
 A Comparison of Partnership and
Corporations
  Corporation Partnership

Liquidity Shares can easily be 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 Broad latitude All net cash flow is

distributed to partners.

Liability Limited liability General partners may have

unlimited liability. Limited
partners enjoy limited
liability.

Continuity Perpetual life Limited life 25

 Goals of the Corporate Firm
 The traditional answer is that the managers of
the corporation are obliged to make efforts to
maximize shareholder wealth.
 That means the corporation will attempt to
maximize the shareholders’ wealth by taking
actions that increase the current value per share
of existing stock of the firm.

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The Set-of-Contracts Perspective
 The firm can be viewed as a set of contracts.
 One of these contracts is between shareholders
and managers.
 The managers will usually act in the
shareholders’ interests.
 The shareholders can devise contracts that align the
incentives of the managers with the goals of the
shareholders.
 The shareholders can monitor the managers
behavior.
 This contracting and monitoring is costly. 27
Managerial Goals
 Managerial goals may be different from
shareholder goals
 Expensive perquisites
 Survival

 Independence

 Increased growth and size are not necessarily

the same thing as increased shareholder
wealth.
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Separation of Ownership and
Control
Board of Directors

Debtholders

Shareholders
Management

Debt
Assets
Equity
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Do Shareholders Control Managerial
Behavior?
 Shareholders vote for the board of directors,
who in turn hire the management team.
 Contracts can be carefully constructed to be
incentive compatible.
 There is a market for managerial talent—this
may provide market discipline to the
managers—they can be replaced.
 If the managers fail to maximize share price,
they may be replaced in a hostile takeover. 30
Financial Markets
 Primary Market
 When a corporation issues securities, cash flows
from investors to the firm.
 Usually an underwriter is involved

 Secondary Markets
 Involve the sale of “used” securities from one
investor to another.
 Securities may be exchange traded or trade over-
the-counter in a dealer market.

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Financial Markets
Stocks and Investors
Firms Bonds securities
Bob Sue
Money
money

Primary Market
Secondary Market

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