Chapter 1

Introduction to
Corporate Finance

McGraw-Hill/Irwin Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.
 Goal of Financial
Management
• What should be the goal of a corporation?
– Maximize profit?
– Minimize costs?
– Maximize market share?
– Maximize the current value of the company’s
stock?
• Does this mean we should do anything and
everything to maximize owner wealth?

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 Maximizing
Shareholders’ Wealth
• Maximizing the share price is equivalent to
maximizing shareholders’ wealth
• Why is this a valid goal?
– Decisions are made in shareholders‘
best interest
– Considers cash flows not profits
– Incorporates time dimension
– Does not consider profitability but also
risk
 Corporate Finance

• Some important questions that are

answered using finance:
– What long-term investments should the
firm take on?
– Where will we get the long-term
financing to pay for the investment?
– How will we manage the everyday
financial activities of the firm?

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 Financial Management
Decisions
• Capital budgeting
– What long-term investments or projects
should the business take on?
• Capital structure
– How should we pay for our assets?
– Should we use debt or equity?
• Working capital management
– How do we manage the day-to-day
finances of the firm?
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 Forms of Business
Organization
• Three major forms of Business
Organization
– Sole Proprietorship
– Partnership
• General
• Limited
– Corporation
• Limited Liability Company

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 Sole Proprietorship
• Advantages • Disadvantages
– Easiest to start – Limited to life of
– Least regulated owner
– Single owner keeps – Equity capital
all the profits limited to owner’s
– Taxed once as personal wealth
personal income – Unlimited liability
– Difficult to sell
ownership interest

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 Partnership
• Advantages • Disadvantages
– Two or more – Unlimited liability
owners • General partnership
– More capital • Limited partnership
available – Partnership
– Relatively easy to dissolves when one
start partner dies or
– Income taxed once wishes to sell
as personal income – Difficult to transfer
ownership

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 Corporation
• Advantages • Disadvantages
– Limited liability – Separation of
– Unlimited life ownership and
– Separation of management
ownership and – Double taxation
management (income taxed at
– Transfer of
the corporate rate
ownership is easy and then dividends
taxed at the
– Easier to raise personal rate)
capital

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 Summary of
3 Business Forms

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 The Agency Problem
• Agency relationship
– Principal hires an agent to represent
his/her interests
– Stockholders (principals) hire managers
(agents) to run the company
• Agency problem
– Conflict of interest between principal and
agent
• Agent may not work in the best interest of the
principal

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 Agency Costs
• Costs due to the conflict of interest
between shareholders and management
– Direct
• Corporate expenditure that benefits
management but costs shareholders,
e.g. country club membership
• Costs to monitor management actions,
e.g. auditor costs
– Indirect
• Lost opportunity due to management forgoing
profitable but risky projects for fear of losing job
if project fails
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 Managing Managers
• Managerial compensation
– Incentives can be used to align management
and stockholder interests
– The incentives need to be structured carefully to
make sure that they achieve their goal
• Corporate control
– The threat of a takeover may result in better
management
• Other stakeholders

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 Financial Markets

• Cash flows to the firm

• Primary vs. secondary markets
– Dealer vs. auction markets
– Listed vs. over-the-counter securities

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