Chapter 1

Introduction to Corporate Finance

McGraw-Hill/Irwin Copyright © 2009 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 various forms
of business organization
 Understand 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
1.1 What is Corporate Finance?
1.2 The Corporate Firm
1.3 The Goal of Financial Management
1.4 The Agency Problem and Control of the
Corporation
1.5 Financial Markets

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1.1 What is Corporate Finance?
Corporate Finance addresses the following
three questions:
1. What long-term investments should the firm
choose?
2. How should the firm raise funds for the selected
investments?
3. How should short-term assets be managed and
financed?

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Balance Sheet Model of the Firm
Total Value of Assets: Total Firm Value to Investors:
Current
Liabilities
Current
Assets Long-Term
Debt

Fixed Assets
1 Tangible
Shareholders’
2 Intangible Equity
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The Capital Budgeting Decision
Current
Liabilities
Current
Assets Long-Term
Debt

Fixed Assets
What long-term
1 Tangible investments
Shareholders’
should the firm
2 Intangible Equity
choose?

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The Capital Structure Decision
Current
Liabilities
Current
Assets Long-Term
How should the Debt
firm raise funds
for the selected
Fixed Assets
investments?
1 Tangible Shareholders’
2 Intangible Equity

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Short-Term Asset Management
Current
Liabilities
Current
Net
Assets Working Long-Term
Capital Debt

How should
Fixed Assets
short-term assets
1 Tangible be managed and
financed? Shareholders’
2 Intangible Equity

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Capital Structure
The value of the firm can be
thought of as a pie.
The goal of the manager is 70%50%30%
25%
to increase the size of the DebtDebt
Equity
pie.
75%
50%
The Capital Structure Equity
decision can be viewed as
how best to slice the pie.

If how you slice the pie affects the size of the

pie, then the capital structure decision matters.
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The Financial Manager
The Financial Manager’s primary goal is to
increase the value of the firm by:

1. Selecting value creating projects

2. Making smart financing decisions

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Hypothetical Organization Chart
Board of Directors

Chairman of the Board and

Chief Executive Officer (CEO)

President and Chief

Operating Officer (COO)

Vice President and

Chief Financial Officer (CFO)

Treasurer Controller

Cash Manager Credit Manager Tax Manager Cost Accounting

Capital Expenditures Financial Planning Financial Accounting Data Processing

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The Firm and the Financial Markets
Firm Firm issues securities (A) Financial
markets
Invests
Retained
in assets cash flows (F)
(B)
Short-term debt
Current assets Cash flow Dividends and Long-term debt
Fixed assets from firm (C) debt payments (E)
Equity shares

Taxes (D)

The cash flows from

Ultimately, the firm
must be a cash
generating activity.
the firm must exceed
Government
the cash flows from
the financial markets. 1-12
1.2 The Corporate Firm
 The corporate form of business is the standard
method for solving the problems encountered
in raising large amounts of cash.
 However, businesses can take other forms.

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Forms of Business Organization
 The Sole Proprietorship
 The Partnership
 General Partnership
 Limited Partnership
 The Corporation

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A Comparison
Corporation Partnership

Liquidity Shares can be easily Subject to substantial

exchanged restrictions

Voting Rights Usually each share gets one General Partner is in charge;
vote limited partners may have
some voting rights

Taxation Double Partners pay taxes on

distributions
Reinvestment and dividend Broad latitude All net cash flow is
payout distributed to partners

Liability Limited liability General partners may have

unlimited liability; limited
partners enjoy limited
liability
Continuity Perpetual life Limited life
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1.3 The Goal of Financial Management
 What is the correct goal?
 Maximize profit?
 Minimize costs?
 Maximize market share?
 Maximize shareholder wealth?

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1.4 The Agency Problem
 Agency relationship
 Principal hires an agent to represent his/her interest
 Stockholders (principals) hire managers (agents) to
run the company
 Agency problem
 Conflict of interest between principal and agent

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Managerial Goals
 Managerial goals may be different from
shareholder goals
 Expensive perquisites
 Survival
 Independence
 Increased growth and size are not necessarily
equivalent to increased shareholder wealth

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Managing Managers
 Managerial compensation
 Incentivescan be used to align management and
stockholder interests
 The incentives need to be structured carefully to
make sure that they achieve their intended goal
 Corporate control
 The
threat of a takeover may result in better
management
 Other stakeholders
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1.5 Financial Markets
 Primary Market
 Issuance of a security for the first time
 Secondary Markets
 Buying and selling of previously issued securities
 Securities may be traded in either a dealer or
auction market
 NYSE
 NASDAQ

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Financial Markets

Stocks and
Investors
Bonds
Firms securities
Money Bob Sue
money

Primary Market
Secondary
Market
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