Chapter 1:

Introduction to
corporate
finance
Corporate Finance
Ross, Westerfield, Jaffe & Jordan
Outline
I. What is corporate finance?
II. The importance of cash flows
III. The goal of financial management
IV. The agency problem and control of the corporation
V. Ethics, sustainability, and corporate governance
VI. Financial markets
Main tasks of corporate
finance
• Capital budgeting: the process of planning and
managing a firm’s long-term investments  fixed
assets.
• Example: deciding whether or not to open a new
restaurant.
• Example: deciding whether or not to introduce a new line
of products.
• Capital structure: the mixture of debt and equity
maintained by the firm  S-T and L-T debt and equity.
• Working capital management: a firm’s short-term
assets and liabilities  current assets and current
liabilities.
The Capital Budgeting
Decision
Current
Current Liabilities
Assets Long-Term
Debt

Fixed Assets What long-term

1 Tangible investments
should the firm Shareholders
2 Intangible choose? ’ Equity
Modern forms of firms
 Corporation: a business created as a distinct
legal entity composed of one or more
individuals or entities, e.g., IBM.
 Separation of control (shareholders) and
management (professionals).
 Ownership can be easily transferred.
 Limited liability.
 Double taxation.
 Rather expensive to form.
 Agency problems.
Who make the
decisions?
 Owners (typically in small businesses).
 Professional managers.
Financial managers
 Frequently, financial managers try to address these
tasks.
 The top financial manager within a firm is usually the
Chief Financial Officer (CFO).
 Treasurer – oversees cash management, credit management,
capital expenditures and financial planning.
 Controller – oversees taxes, cost accounting, financial
accounting and data processing.
How do financial managers
create value w.r.t. cash
flows?
 The firms must create more cash flows than it uses.
Specifically,
 1. Select/acquire assets that generate more (discounted)
cash flows than they cost.
 2. Sell bonds and stocks that raise more cash/capital than
they cost.
The importance of cash flows

Cash for securities issued by the firm (A) Financial

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

Taxes
Ultimately, the firm The cash flows from
must be a cash- the firm should exceed
Government (D)
generating activity. the cash flows from
the financial markets.
Possible goals of financial
management
 Survive
 Beat the competition
 Maximize sales
 Maximize net income
 Maximize market share
 Minimize costs
 Maximize the value of (stock) shares
The “appropriate” goal of
financial management
 Maximize the (fundamental or economic)
value of (stock) shares is the right goal.
 Why? Shareholders own shares. Managers,
as agents, ought to act in a way to benefit
shareholders; i.e., to enhance the value of
the shares.
 A limitation of this goal is that value is not
directly observable.
A sample question
 The primary goal of financial management is to:
 a. maximize current dividends per share of the
existing stock.
 b. maximize the current value per share of the
existing stock.
 c. avoid financial distress.
 d. minimize operational costs and maximize firm
efficiency.
 e. maintain steady growth in both sales and net
earnings.
Home Depot CEO gets $210
million severance for sucking at
job
 Robert L. Nardelli, the CEO of Home Depot, who came
under heavy criticism for his pay package and failure to
lift the chain ’s stagnant stock price, has abruptly
resigned. He will receive about $210 million in
compensation from the company, including the current
value of retirement and other benefits. Who would blame
him for quitting?
 Source:digg.com; submitter: tennova.
Value vs. price
 The value of shares are not observable. In
contrast, the price of shares can be observable.
 If one believes that share price is an
accurate/good estimate of share value, the
appropriate goal would be to maximize the price
of shares.
 This belief/assumption is, however, questionable.
 But the previous slide (Home Depot ex-CEO),
nevertheless, showed that investors care about
stock price, and that stock price performance is
very important to the tenure of managers.
Value maximization and
corporate social responsibility
 Corporate social responsibility (CSR): On a voluntary
basis, firms go beyond their legal and contractual
obligations to operate in ways that enhance rather than
degrade society and the environment; e.g., using fair-
trade ingredients (coffee, tea); providing incentives for
employee engagement in community service; reducing
carbon footprint, etc.
 Do engaging in CSR lead to value maximization? It
depends.
3 visions of CSR (Benabou
and Tirole, 2010,
Economica)
 Vision 1: Win-Win (doing well by doing good).
Being a good corporate citizen can also
maximize firm value. This is particularly so for
the so-called “strategic CSR” that takes a
socially responsible stance to strengthen one’s
market position and raise rivals’ costs and
thereby increase long-term profits and firm
value; e.g., Patagonia’s environmental
activism.
 This vision does not raise any specific
corporate governance issue: this vision of CSR
is consistent with value maximization.
A no-win situation
 The NBA's Golden State Warriors have distanced themselves from
executive board member and minority owner Chamath
Palihapitiya after he repeatedly said he didn't care "about what's
happening to the Uyghurs" on a podcast.
 "As a limited investor who has no day-to-day operating functions
with the Warriors, Mr. Palihapitiya does not speak on behalf of our
franchise, and his views certainly don't reflect those of our
organization," the San Francisco team said Monday.
 Chamath Palihapitiya is the founder of the Social capital, whose
mission is to “advance humanity by solving the world’s hardest
problems.”
 Chamath’s father applied for refugee status in Canada, on the
basis that his father had been criticized for his views on the
violence during the Sri Lankan civil war.
 Source: 01/08/2022, CBS; Wikipedia.
3 Visions of CSR
 Vision 2: Delegated philanthropy. Some stakeholders of the
firm (e.g., employees, customers, investors) are willing to
sacrifice money (e.g., wages, purchasing power, returns) so
as to further social goals. These stakeholders do not have
competitive advantages to pursue their philanthropy due to
information barriers or transaction costs. They have some
demand for corporations to engage in philanthropy on their
behalf; that is, delegated philanthropy.
 Example: employees who are passionate in community
service are often the most motivated employees. Firms have
incentives to provide incentives for employee engagement in
community service.
 Counterexample: “sin stocks” are disliked in the sense that
they are perceived to be of higher risk, thus sold at a lower
price (Hong and Kacperczky, 2009, JFE).
 This vision does not raise any specific corporate governance
issue: this vision of CSR is consistent with value
maximization.
CSR and sustainability
 Bolton and Kacperczyk (2021, JFE) find that stocks of
firms with higher total CO2 emissions (and changes in
emissions) are perceived to be of higher risk.
 Investors demand compensation for their exposure to
carbon emission risk.
 The prices of stocks with higher carbon risk are on
average lower.
Shareholders and other
stakeholders
 Customers
 Suppliers
 Employees (human capital and assets)
 Creditors (bondholders, banks, debtholders)
 Government: tax and regulations
 Community (local / global)
 Owner/shareholder
3 visions of CSR
 Vision 3 (Friedman’s critique, 1970): Insider-initiated
corporate philanthropy. The prosocial behavior (e.g.,
donation to a beloved museum) is not motivated by
stakeholders’ demands or the desire to strengthen the
firm’s long-term market position, but rather reflects
management’s or the board members’ own desires to
engage in philanthropy.
 This is doing charity with others’ money.
 This vision raises serious corporate governance issues.
This vision of CSR is not consistent with value
maximization; it destroys firm value.
The agency problem
 Agency relationship:
 Principals (citizens) hire an agent (the president) to
represent their interest.
 Principles (stockholders) hire agents (managers) to run
the company.
 Agency problem:
 Conflict of interest between principals and agents.
 This occurs in a corporate setting whenever the agents
do not hold 100% of the firm’s shares.
 The source of agency problems is the separation of
(owners’) control and management.
 Example: the 3rd vision of CSR.
Agency costs
 Direct costs: (1) unnecessary expenses, such as a
corporate jet, and (2) monitoring costs.
 Indirect costs. For example, a manager may choose
not to take on the optimal investment. She/he may
prefer a less risky project so that she/he has a higher
probability keeping her/his tenure.
Managerial incentives
 Managerial goals are frequently different from
shareholders’ goals.
 Expensive perks.
 Survival.
 Independence.

 Growth and size (related to compensation) may not relate

to shareholders’ wealth.
Corporate governance
 Corporate governance: the structure of rules, practices,
and processes used to direct and manage a company.
 Compensation:
 Incentives ($$$, options, threat of dismissal, etc.)
used to align management and stockholder interests.
 Corporate control:
 Managers may take the threat of a takeover seriously
and run the business in the interest of shareholders.
 Pressure from other stakeholders (e.g., CalPERS, a
powerful corporate police).
Stakeholders w.r.t. corporate
governance – governments?
 China’s stock regulator plans to propose new rules that
could thwart internet companies’ plans to list in the U.S.
 China plans to propose new rules that would ban
companies with large amounts of sensitive consumer
data from going public in the U.S.
 Source: WSJ, 08/2021
Sarbanes-Oxley Act
(2002)
 “Sarbox.”
 10K must have an assessment of the firm’s internal
control structure and financial reporting.
 The officers must explicitly declare that 10K does not
contain any false statements or material omissions.
 The officers are responsible for all internal controls.
Ethics
 Managers are expected to behave in an ethical
manner.
 The province of ethics is to sort out what is
good and bad.
 But, what is the criterion or guideline for doing
so?
 Philosophers came up with some criteria, but
none of them makes sorting out what is good
and bad an easy task.
 Here, we introduce two of these criteria.
Principle 1
 Golden rule: Do unto others as you would have others do
onto you.
 But the next example, the so-called Sopranoism, shows
the limitation of this principle: Whack the next guy with
the same respect you’d like to be whacked with, you
know? (Source: Cathcart and Klein, 2007).
Principle II
 Confucianism: Do not do to others what you do not want
done to yourself.
 This is a rather robust (but passive) criterion.
 But its limitation is that it says nothing about what you
should do.
Dilemma
 Ethical decisions often yield a dilemma.
 Suppose that you were the CEO of investment
bank XYZ in 2005. The debt/equity ratio of the
bank was 20. All of your competitors raised
their debt/equity ratios to 30 to please the
stock market so that their stock prices could be
higher than otherwise would be. You knew that
raising the debt/equity ratio to 30 was rather
risky and could destroy the bank if business
went wrong. But you knew the investors would
be disappointed by the otherwise lower share
price if you did not raise the debt/equity ratio.
So, what is the answer?
 I do not have an answer for this kind of ethical question
because it is a dilemma; otherwise, I would not use the
word “dilemma.”
 All I know is that you, as professional managers, are
expected to behave ethically.
 One thing I know for sure is that never do anything that
will put you in a prison cell; you are too cute for a prison
cell.
Financial markets
 Cash flows (i.e., financing and
payoffs/dividends/interests) between firms and financial
markets.
 Primary markets.
 Secondary markets.
- NYSE.
- Nasdaq.
Info about financial
markets
 Yahoo! Finance.
End-of-chapter
 Concept questions: 1-10.