Chapter 1:

The Scope Of Corporate Finance

Financial Management, 3e
Megginson, Smart, and Graham
PowerPoint Presentation by
Jeff Whitworth, University of Houston-Clear Lake

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 What is Corporate Finance?

 The activities involved in managing

cash flows in a business
environment

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 The 5 Basic Corporate Finance Functions

Financing
(Raising Capital)

Financial Management

Capital Budgeting

Risk Management

Corporate Governance

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 FIGURE 1.1 Which Finance Functions Add
the Most Value?

Source: Servaes and Tufano, “CFO Views on the Importance and Execution of the Finance Function”
(Deutsche Bank, 2006).
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 The Financing Function

 Businesses can raise money in 2 ways:

 Externally from investors or creditors
 Venture capital
 Initial public offering (IPO)
 Money market
 Long-term debt
 Internally by retaining operating cash flows
 Most common method

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 Raising Capital: Key Facts

Most financing from internal rather than

external sources.
Most external financing is debt.
Primary vs. secondary market
transactions or offerings
Financial intermediaries declining as a source
of capital for large firms

Securities markets growing in importance1 - 6

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 The Financial Management Function

Managing daily cash inflows and outflows

Forecasting cash balances

Building a long-term financial plan

Choosing the right mix of debt and equity

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 The Capital Budgeting Function

Capital Budgeting:
Selecting the best projects
in which to invest the
firm’s resources

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 The Capital Budgeting Function

 The capital budgeting process consists

of three steps.
Step 1 - Identifying potential investments
Step 2 - Analyzing those investments to
identify which will create
shareholder value
Step 3 - Implementing and monitoring the
investments selected in Step 2

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 The Risk Management Function
 Identifying, measuring, and managing all
types of risk exposures
 Some risks are insurable, and some risks can
be reduced through diversification.
 Financial instruments like forwards, futures,
options, and swaps may also be used to
hedge market risks such as interest-rate,
price, and currency fluctuations.

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 The Corporate Governance
Function
 Hires and promotes qualified, honest people,
and structures employees’ financial incentives
to motivate them to maximize firm value
 In practice the incentives of stockholders,
managers, and other stakeholders often
conflict.
 Dimensions of corporate governance:
 Board of directors
 Securities and Exchange Commission
 Sarbanes-Oxley Act of 2002

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 The Core Principles of Finance

 The time value of money

 The opportunity to earn a return on invested
funds means that a dollar today is worth
more than a dollar in the future.
 Compensation for risk
 Investors expect compensation for bearing
risk.

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 The Core Principles of Finance

 Don’t put all your eggs in one basket.

 Investors can achieve a more favorable
tradeoff between risk and return by
diversifying their portfolios.
 Markets are smart.
 Competition for information tends to make
markets efficient.
 No arbitrage
 Risk-free money-making opportunities are
extremely scarce.
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 Primary Forms of Business
Organization
• No distinction between business and owner
• Easy to set up and operate
Sole • Business earnings taxed as personal income
Proprietorships • Limited life, Limited access to capital,
Unlimited personal liability

• Similar to sole proprietorship, but has two

or more owners
Partnerships • Joint and several liability
• Share of profits taxed as partnership income

• One or more general partners with unlimited

Limited personal liability
• Most owners are limited partners, who are
Partnerships passive investors with limited liability

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 Primary Forms of Business
Organization
• Separate legal entity with many of the
economic rights and responsibilities of
individuals
• Unlimited life, Limited liability, Separable
contracting, Improved access to capital
Corporations • Owned by shareholders, who elect the
Board of Directors
• Board appoints a President or CEO to
manage day-to-day operations
• In the U.S., incorporation is executed at
state level and governed by state law

Are there any disadvantages for corporations?

YES! Double taxation

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 Table 1.1 Taxation of Business Income
After the Jobs and Growth Tax Relief Reconciliation Act of 2003

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 Hybrid Forms of Business
Organization

• Shareholders are taxed as partners while

still retaining limited liability as corporate
S Corporations shareholders.
• Status is subject to several eligibility
requirements.

• Combines the partnership’s pass-

Limited through taxation with the S
Liability corporation’s limited liability.
• No personal liability for acts of
Companies
malpractice by other partners.

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 What Should a Financial Manager
Try to Maximize?

 Maximize Profit?
 Earnings per share are backward-looking,
dependent on accounting principles
 Does not fully consider cash flow timing
 Ignores risk

 Maximize Shareholder Wealth?

 Maximize stock price, not profits
 Shareholders, as residual claimants, have
better incentives to maximize firm value.
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 Figure 1.2 What Global Companies
Do

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 Figure 1.2 What Global Companies
Do

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 Agency Costs
 Managers act as agents of the owners
who hired them and gave them
decision-making authority to manage
the firm for the owners’ benefit.
 In practice however, self-interest may
cause managers to pursue objectives
other than shareholder wealth
maximization.
 This conflict of goals gives rise to
managerial agency problems.
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 How Agency Costs Can Be
Controlled

 Ways to limit agency problems:

 Activism by institutional investors
 Takeover threat
 Monitoring and bonding
 Compensation contracts
 Tie managerial wealth to stock value

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 Importance of Ethics

 Widespread publicity surrounding

numerous ethical violations began with
the Enron collapse in late 2001.
 Society in general and the financial
community in particular are developing
and enforcing ethical standards.
 Ethical behavior is necessary in order to
maximize shareholder’s wealth.
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