Session 1: An Overview of Corporate Finance

Trimester 3/2023

September 12, 2023

1 / 30
Outline

1. What is Corporate Finance

2. The Corporate Firm

3. The Importance of Cash Flows

4. The Goal of Financial Management

5. The Agency Problem and Control of the Corporation

2 / 30
What is next?

1. What is Corporate Finance

2. The Corporate Firm

3. The Importance of Cash Flows

4. The Goal of Financial Management

5. The Agency Problem and Control of the Corporation

3 / 30
The balance sheet model of the firm

Figure: The balance sheet model of the firm

4 / 30
The balance sheet model of the firm
Left hand side
Current assets: short lives (inventory).
Fixed assets: last a long time.
+ Tangible fixed assets (land, building, machinery and equipment).
+ Intangible fixed assets (patents and trademarks).
Right hand side
Current liabilities (short term debt): Loans and other obligations that must be repaid
within one year.
Long term debt (non-current liabilities): Debt that does not have to be repaid within one
year.
Shareholder‘s Equity: the difference between the value of the assets and the debt of the
firm.

5 / 30
Three important questions in Corporate Finance

• In what long-lived assets should the firm invest?

Capital budgeting: The process of making and managing expenditures on long-lived
assets.
• How can the firm raise funds for required capital expenditures/investments?
Capital structure: the proportions of the firm‘s financing from current and long-term
debt and equity
• How should short-term operating cash flows be managed?
Short-term management of cash flow is associated with a firm‘s net working capital (i.e.,
current assets minus current liabilities).

6 / 30
What is next?

1. What is Corporate Finance

2. The Corporate Firm

3. The Importance of Cash Flows

4. The Goal of Financial Management

5. The Agency Problem and Control of the Corporation

7 / 30
Three basic legal forms:
(i) The Sole Proprietorship.
(ii) The Partnership.
(iii) The corporation.

8 / 30
The Sole Proprietorship

A sole proprietorship is a business owned by one person.

Important features:
• Cheapest business to form; No formal charter is required; Few government regulations
must be satisfied.
• Pays no corporate income taxes; All profits of the business are taxed as individual income.
• Has unlimited liability for business debts and obligations. No distinction is made between
personal and business assets.
• The life of the sole proprietorship is limited by the life of the sole proprietor.
• The equity money that can be raised is limited to the proprietor‘s personal wealth.

9 / 30
The Partnership

Any two or more people can get together and form a partnership.

Two categories: (i) General partnerships; (ii) Limited partnerships.

- General partnerships:
• All partners agree to provide some fraction of the work and cash and to share the profits
and losses.
• Each partner is liable for all of the debts of the partnership.
A general partner with a $ 1,000 contribution could lose the $1,000 plus any other
indebtedness of the partnership.
• The partnership agreement may be an oral agreement or a formal document.

10 / 30
The Partnership (Cont.)

Any two or more people can get together and form a partnership.

Two categories: (i) General partnerships; (ii) Limited partnerships.

- Limited partnerships:
• Permit the liability of some of the partners to be limited to the amount of cash each has
contributed to the partnership.
• At least one partner is a general partner.
• The limited partners do not participate in managing the business.

11 / 30
The Partnership (Cont.)

Important features:
• Inexpensive and easy to form; Written documents, business licenses and filing fees are
required.
• General partners have unlimited liability for all debts.
The liability of limited partners is usually limited to the contribution each has made
to the partnership.
If one general partner is unable to meet his or her commitment, the shortfall must be
made up by the other general partners.

12 / 30
The Partnership (Cont.)

Important features:
• The general partnership is terminated when a general partner dies or withdraws (but this is
not so for a limited partner).
• It is difficult for a partnership to transfer ownership without dissolving; Limited partners
may sell their interest in a business.
• It is difficult for a partnership to raise large amounts of cash (i.e., limited to a partner‘s
ability and desire to contribute to the partnership).
• Income from a partnership is taxed as personal income to the partners.

13 / 30
The Partnership (Cont.)

Sole Proprietorship and Partnerships: Pros and Cons

- Pros:
• Cost of getting started.
• Regulatory requirements.
- Cons:
• Unlimited liability.
• Limited life of the enterprise.
• Difficulty of transferring ownership.
• Difficulty in raising cash

14 / 30
The Corporation

- The most important form of business enterprises.

- Three sets of distinct interests: the shareholders (the owners), the directors, and the
corporate officers (the top management).
- Shareholders control the corporation‘s direction, policies, and activities.
- Shareholders elect a board of directors, who in turn select top management.
+ There may be a large overlap among the shareholders, the directors, and the top
management.
Top management usually own shares and often serve on the board of directors.

15 / 30
The Corporation (cont.)

Important features
• Ownership can be readily transferred to new owners.
• The corporation has unlimited life (i.e., the death or withdrawal of an owner does not
affect the corporation‘s legal existence.)
• The shareholders‘ liability is limited to the amount invested in the ownership shares.
If a shareholder purchased $1,000 in shares of a corporation, the potential loss would be
$1,000.

16 / 30
The Corporation (cont.)

The Corporation: Pros and cons

- Pros:
• Limited liability.
• Ease of ownership transfer.
• Perpetual life.
Greater ability to raise cash.
- Cons:
• Double taxation.
The federal government taxes corporate income.
Shareholders have to pay personal income tax on the dividend income.

17 / 30
 Table: Legal status of firms around the world

Legal status Percentage

Shareholding company with shares traded publicly 5.33
Shareholding company with non-traded shares 43.55
Sole proprietorship 31.73
Partnership 8.41
Limited partnership 9.25
Other 1.75

Source: World Bank Enterprise Survey.

18 / 30
What is next?

1. What is Corporate Finance

2. The Corporate Firm

3. The Importance of Cash Flows

4. The Goal of Financial Management

5. The Agency Problem and Control of the Corporation

19 / 30
Good financial manager will create value from the firm‘s (i) capital budgeting, (ii) financing,
and (iii) net working capital activities.
How?
• Try to buy assets that generate more cash than they cost.
• Sell bonds, stocks, and other financial instruments that raise more cash than they cost.
The firm must create more cash flow than it uses!

20 / 30
Figure: Cash Flows between the Firm and the Financial Markets

21 / 30
Identification of Cash Flows

- It is not easy to directly observe cash flows generated by the firm.

- Financial analysts‘ job: to extract cash flow information from accounting statements.
- Accounting Profit versus Cash Flows.
Example 1.1 (Textbook, p. 9)

Table: Income Statement - Accounting View

Item Value
Sales $1,000,000
Costs $900,000
Profit $100,000

22 / 30
Identification of Cash Flows (cont.)

Example 1.1 (Textbook, p. 9)

Table: Income Statement - Financial View

Item Value
Cash inflows $0
Cash outflows $900,000
-$900,000

23 / 30
Timing of Cash Flows

- The value of an investment made by a firm depends on the timing of cash flows.

Table: Cash flows timing

Year Project 1 Project 2

1 $0 $4,000
2 $0 $4,000
3 $0 $4,000
4 $20,000 $4,000
Total $20,000 $16,000

24 / 30
What is next?

1. What is Corporate Finance

2. The Corporate Firm

3. The Importance of Cash Flows

4. The Goal of Financial Management

5. The Agency Problem and Control of the Corporation

25 / 30
The Goal of Financial Management

What is the correct goal of Financial Management?

• Survive?
• Avoid financial distress and bankruptcy?
• Beat the competition?
• Maximize sales or market share?
• Maximize profit?
• Minimize costs?
• Maximize shareholder wealth?
Profitability related goal & Risk-related goal.

26 / 30
The Goal of Financial Management

From the stockholders‘ point of view, what is a good financial management decision?
- To maximize the current value per share of the existing stock.
- To maximize the value of the existing owners‘ equity.

27 / 30
What is next?

1. What is Corporate Finance

2. The Corporate Firm

3. The Importance of Cash Flows

4. The Goal of Financial Management

5. The Agency Problem and Control of the Corporation

28 / 30
- Agency relationship: The relationship between stockholders and management. It
appears when someone (the principal) hires another (the agent) to represent his or her
interests.
E.g., Stockholders (principals) hire managers (agents) to run the company.
- Agency problem: When there is a conflict of interest between the principals and the
agents.
* Managers may engage in empire building ( Jensen, 1974; Williamson, 1964).
* Managers also may entrench themselves in their positions, making it difficult to oust
them when they perform poorly (Shleifer and Vishny, 1989).

29 / 30
Other types of agency problem:
- The conflict between owners who possess the majority or controlling interest in the firm
(agents) and the minority or noncontrolling owners (principals).
- The conflict between the firm itself (agent) - including, particularly, its owners - and the
other parties with whom the firm contracts, such as creditors, employees, and customers
(principals).

30 / 30