Chapter 1 Introduction to Corporate Finance

McGraw-Hill/Irwin

Copyright 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

Key Concepts and Skills

Know the basic types of financial management decisions and the role of the financial manager Know the financial implications of the different forms of business organization Know the goal of financial management Understand the conflicts of interest that can arise between owners and managers Understand the various types of financial markets
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Chapter Outline
Corporate Finance and the Financial Manager Forms of Business Organization The Goal of Financial Management The Agency Problem and Control of the Corporation Financial Markets and the Corporation
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What Is Corporate Finance?

Corporate finance provides answers to some important questions:
What long-term investments should the firm take on? Where will the firm get the long-term financing to pay for the investments? How will the firm manage its everyday financial activities?

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The Financial Manager

Financial managers try to answer some or all of these questions 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

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Financial Management Decisions

Capital budgeting
What long-term investments or projects should the business take on?

Capital structure
How much should the firm borrow to pay for its assets?
What is the best mixture of debt and equity? The least expensive sources of funds?

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
Sole Proprietorship Partnership
General Limited

Corporation
Limited Liability Company Limited Liability Partnerships

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Sole Proprietorship
Advantages
Easiest to start Least regulated Single owner keeps all the profits Taxed once as personal income

Disadvantages
Limited to life of owner Equity capital limited to owners personal wealth Unlimited liability Difficult to sell ownership interest

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Partnership
Advantages
Two or more owners More capital available Relatively easy to start Income taxed once as personal income

Disadvantages
Unlimited liability
General partnership Limited partnership

Partnership dissolves when one partner dies or wishes to sell Difficult to transfer ownership

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Corporation
Advantages
Limited liability Unlimited life Separation of ownership and management Transfer of ownership is easy Easier to raise capital

Disadvantages
Separation of ownership and management May involve double taxation in some countries (income taxed at the corporate rate and then dividends taxed at the personal rate)
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Summary of 3 Business Forms

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Goal of Financial Management

What should be the goal of a corporation?
Maximize profits? Minimize costs? Maximize market share? Maximize the current value of the companys stock?

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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

The Agency Problem

Agency relationship
The relationship exists when a 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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Management Goals
Management goals may be different from shareholder s goals
Management may be more interested in:
Consuming expensive perks Its own survival Its independence

Management may focus on increased growth and size rather than increasing shareholders wealth

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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Work the Web Example

The Internet provides a wealth of information about individual companies One excellent site is finance.yahoo.com Click on the web surfer to go to the site, choose a company and see what information you can find!

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Financial Markets
Primary market
A market where the firm sells its securities to public for the first time

Secondary markets
A market in which the securities issued by firms are traded
Listed securities trade in an organized exchange, e.g. the stock market (NYSE) Over-the-counter securities are bought from or sold to a dealer
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Quick Quiz
What are the three types of financial management decisions and what questions are they designed to answer? What are the three major forms of business organization? What is the goal of financial management? What are agency problems and why do they exist within a corporation? What is the difference between a primary market and a secondary market?
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Ethics Issues
Is it ethical for tobacco companies to sell a product that is known to be addictive and a danger to the health of the user? Is it relevant that the product is legal? Should boards of directors consider only price when faced with a buyout offer? Is it ethical to concentrate only on shareholder wealth, or should stakeholders as a whole be considered? Should firms be penalized for attempting to improve returns by stifling competition (e.g., Microsoft)?

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End of Chapter

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