Chapter 1 Goals and Governance of the Corporation

1.1 Investment and Financing Decisions

The Investment (Capital Budgeting) Decision

An investment decision, also called, capital budgeting or capital expenditure (CAPEX) decision, is
the decision to invest in tangible or intangible assets. Its what investments to make, where to put
the money.
The world of business can be intensely competitive, and corporations prosper only if the can keep
launching new products or services. In some cases the costs and risks of doing so are large.
Investment decisions can vary in the money they represent, from a couple hundred dollars, to
even billions of dollars.
Not all investments succeed.

The Financing Decision

The financial managers second main responsibility is to raise the money that the firm requires for
its investments and operations. This is the financing decision: the decision on the sources and
amounts of financing. Its how the company will pay for the investments.
One way to finance is by issuing shares to investors known as equity investors. Another way is to
issue debt to debt investors. The choice between debt and equity is often called the capital
structure decision. Capital refers to the firms sources of LT financing.
When the firm invests, it acquires real assets: assets used to produce goods and services. The firm
finances its investments in real assets by issuing financial assets to investors: financial claims to
the income generated by the firms real assets.
Financial assets that can be purchased and traded by investors in public markets are called
securities.
In some ways, investment decisions are more important than financing decisions, cause value
comes mainly from the investment side of the balance sheet.
Financing decisions may not add much value compared to good investment decisions, but they can
destroy value if they are stupid.

1.2 What Is a Corporation?

A corporation is a business organized as a separate legal entity owned by stock holders.

A corporations owners are called shareholders or stockholders. They dont directly own the
business real assets, but they have indirect ownership via financial assets (shares).
The shareholders have limited liability: they are not personally liable for the corporations
obligations. The corporation is legally distinct from the shareholders.
1.3 Who Is the Financial Manager?

The chief financial officer (CFO) is the one who supervises all financial functions and sets overall
financial strategy. He is deeply involved in financial policy and corporate financial planning, and is
in constant contact to the CEP.
Below the CFO there is usually a treasurer (responsible for financing, cash management, and
relationships with banks and other financial institutions) and a controller (responsible for
budgeting, accounting, and taxes). Thus the treasurers main function is to obtain and manage the
firms capital, whereas the controller ensures that the money is used efficiently.
We will use the term financial manager to refer to anyone responsible for an investment or
financing decision.
The financial manager gets cash from investors, invests it in the firms operations, and when cash
is generated by these operations, that cash is reinvested and also returned to investors. So the
financial manager stands between the firm and outside investors.

1.4 Goals of the Corporation

Shareholders Want Managers to Maximize Market Value

Since in large corporations the management and ownership is separated, delegation can only work
if the shareholders have a common goal, which is maximize the current market value of
shareholders investment in the firm.
The natural financial goal of the corporation is to maximize market value.

The Investment Trade-Off

Why do some investments increase market value and others reduce it?
There is a trade-off for corporate investment decisions. When the company has cash, it can invest
in real assets, or pay out cash to shareholders who can buy financial assets. If cash is reinvested,
the opportunity cost is the expected rate of return that shareholders could have obtained by
investing in financial assets. The shareholders will want to proceed with the option that has the
higher rate of return.
So the minimum rate of return is called the hurdle rate or 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.
The opp cost of capital depends on the risk of the proposed investment project, not only because
shareholders are risk-averse, but also because they have to trade-off risk against return when they
invest on their own.

1.5 Agency Problems, Executive Compensation, and Corporate Governance

Managers are not the shareholders, but agents of the shareholders. So the agency problem is that
managers are agents for stockholders and are tempted to act in their own interests rather than
maximizing value.
Losses in value from agency problems are called agency costs: value lost from agency problems or
from the cost of mitigating agency problems.
A stakeholder is anyone with a financial interest in the corporation. Whenever stakeholders
interests do not coincide, agency problems arise.
Agency problems are controlled in three ways:
1- Corporations set up internal controls and decision-making procedures to prevent wasteful
spending and discourage careless investment.
2- Corporations try to design compensation schemes that align managers and shareholders
interests.
3- Corporations are constrained by corporate governance: the laws, regulations, and corporate
practices that protect shareholders and other investors.

1.6 The Ethics of Maximizing Value

Most of the times, there is little conflict between doing well (maximizing value) and doing good
(being ethical). Profitable firms are those with satisfied customers and loyal employees, not
dissatisfied customers and an unhappy workforce.
Of course, ethical issues do arise in business sometimes. But reputation can help managers play
fair. If you do something that undermines your firms reputation, the costs can be enormous.
It is not always easy to know what is ethical behavior, and there can be many gray areas.

1.7 Careers in Finance

There are several careers in finance:

-Financial analyst in the finance department of a corporation.
-Work in a financial institution, like a bank.
-Investment banking.
-Insurance industry.
-Managing money, like mutual funds.
-Stockbroker.

1.8 Preview of Coming Attractions

Algunos puntos importantes:

1- Corporate finance is about adding value.
2- The opportunity cost of capital sets the standard for investments.
3- A safe dollar is worth more than a risky one.
4- Smart investment decisions create more value than smart financing decisions.
5- Good governance matters.
1.9 Snippets of Financial History

Gilada.