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

1-2
 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
1-3
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?

1-4
 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

1-5
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?
1-6
Forms of Business Organization

• Three major forms

– Sole Proprietorship
– Partnership
• General
• Limited
– Corporation
• Limited Liability Company
• Limited Liability Partnerships

1-7
 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

1-8
 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

1-9
 Corporation
• Advantages • Disadvantages
– Limited liability – Separation of
– Unlimited life ownership and
management
– Separation of
– May involve double
ownership and
taxation in some
management
countries (income
– Transfer of taxed at the
ownership is easy corporate rate and
– Easier to raise then dividends taxed
capital at the personal rate)

1-10
 Summary of
3 Business Forms

1-11
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 company’s
stock?

1-12
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

1-14
 Management Goals
• Management goals may be different
from shareholder s’ goals
– Management may be more interested in:
• Consuming expensive perks
• It’s own survival
• It’s 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

1-16
 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

1-17
 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!

1-18
 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

1-19
 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?

1-20
 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)?

1-21
End of Chapter

1-22
 Chapter 2

Financial Statements,
Taxes, and Cash Flow

Copyright © 2012 by McGraw-Hill Education (Asia). All rights reserved.

McGraw-Hill/Irwin
 Key Concepts and Skills
• Know the difference between book
value and market value
• Know the difference between
accounting income and cash flow
• Know the difference between average
and marginal tax rates
• Know how to determine a firm’s cash
flow from its financial statements

2-24
 Chapter Outline
• The Balance Sheet
• The Income Statement
• Taxes
• Cash Flow

2-25
 Balance Sheet
• The balance sheet is a snapshot of the firm’s
assets and liabilities at a given point in time
• Assets are listed in order of decreasing
liquidity
– Ease of conversion to cash
– Without significant loss of value
• Balance Sheet Identity
– Assets = Liabilities + Stockholders’ Equity

2-26
The Balance Sheet –
Figure 2.1

2-27
 Net Working Capital and
Liquidity
• Net Working Capital
– = Current Assets – Current Liabilities
– Positive when the cash that will be received over the next 12
months exceeds the cash that will be paid out
– Usually positive in a healthy firm
• Liquidity
– Ability to convert to cash quickly without a significant loss in value
– Liquid firms are less likely to experience financial distress
– But liquid assets typically earn a lower return
– Trade-off to find balance between liquid and illiquid assets

2-28
Asia-Pacific Corporation Balance
Sheet – Table 2.1

2-29
Market Value vs. Book Value
• The balance sheet provides the book value
of the assets, liabilities, and equity.
• Market value is the price at which the assets,
liabilities ,or equity can actually be bought or
sold.
• Market value and book value are often very
different. Why?
• Which is more important to the decision-
making process?

2-30
 Example 2.2 Klingon
Corporation
KLINGON CORPORATION
Balance Sheets
Market Value versus Book Value
Book Market Book Market
Assets Liabilities and Shareholders’
Equity

NWC $ 400 $ 600 LTD $ 500 $ 500

NFA 700 1,000 SE 600 1,100
1,100 1,600 1,100 1,600

2-31
 Income Statement
• The income statement is more like a video of
the firm’s operations for a specified period of
time.
• You generally report revenues first and then
deduct any expenses for the period
• Matching principle – GAAP says to show
revenue when it accrues and match the
expenses required to generate the revenue

2-32
Asia-Pacific Corporation Income
Statement – Table 2.2

2-33
 Taxes
• The one thing we can rely on with taxes is
that they are always changing
• Marginal vs. average tax rates
– Marginal tax rate – the percentage paid on the
next dollar earned
– Average tax rate – the tax bill / taxable income
• Other taxes

2-34
Corporate Tax Rates Around
the World

2-35
 Example: Marginal Vs.
Average Rates
• Suppose your firm earns $4 million in
taxable income.
– What is the firm’s tax liability?
– What is the average tax rate?
– What is the marginal tax rate?
• If you are considering a project that will
increase the firm’s taxable income by $1
million, what tax rate should you use in
your analysis?

2-36
 The Concept of Cash Flow
• Cash flow is one of the most important
pieces of information that a financial
manager can derive from financial
statements
• The statement of cash flows does not
provide us with the same information that we
are looking at here
• We will look at how cash is generated from
utilizing assets and how it is paid to those
that finance the purchase of the assets

2-37
 Cash Flow From Assets
• Cash Flow From Assets (CFFA) =
Cash Flow to Creditors + Cash Flow
to Stockholders
• Cash Flow From Assets = Operating
Cash Flow – Net Capital Spending –
Changes in NWC

2-38
 Example: Asia-Pacific
Corporation – Part I
• OCF (I/S) = EBIT + depreciation – taxes =
$547

• NCS ( B/S and I/S) = ending net fixed

assets – beginning net fixed assets +
depreciation = $130

• Changes in NWC (B/S) = ending NWC –

beginning NWC = $330

• CFFA = 547 – 130 – 330 = $87

2-39
 Example: Asia-Pacific
Corporation – Part II
• CF to Creditors (B/S and I/S) = interest
paid – net new borrowing = $24
• CF to Stockholders (B/S and I/S) =
dividends paid – net new equity raised
= $63
• CFFA = 24 + 63 = $87

2-40
Cash Flow Summary - Table
2.6

2-41
 Example: Balance Sheet and
Income Statement Information
• Current Accounts
– 2011: CA = 3625; CL = 1787
– 2010: CA = 3596; CL = 2140
• Fixed Assets and Depreciation
– 2011: NFA = 2194; 2008: NFA = 2261
– Depreciation Expense = 500
• Long-term Debt and Equity
– 2011: LTD = 538; Common stock & APIC = 462
– 2010: LTD = 581; Common stock & APIC = 372
• Income Statement
– EBIT = 1014; Taxes = 368
– Interest Expense = 93; Dividends = 285

2-42
 Example: Cash Flows
• OCF = 1,014 + 500 – 368 = 1,146
• NCS = 2,194 – 2,261 + 500 = 433
• Changes in NWC = (3,625 – 1,787) – (3,596 – 2,140)
= 382
• CFFA = 1,146 – 433 – 382 = 331
• CF to Creditors = 93 – (538 – 581) = 136
• CF to Stockholders = 285 – (462 – 372) = 195
• CFFA = 136 + 195 = 331
• The CF identity holds.

2-43
 Quick Quiz
• What is the difference between book value
and market value? Which should we use for
decision-making purposes?
• What is the difference between accounting
income and cash flow? Which do we need to
use when making decisions?
• What is the difference between average and
marginal tax rates? Which should we use
when making financial decisions?
• How do we determine a firm’s cash flows?
What are the equations, and where do we find
the information?

2-44
 Ethics Issues
• Why is manipulation of financial statements
not only unethical and illegal, but also bad
for stockholders?

2-45
 Comprehensive Problem
• Current Accounts
– 2011: CA = 4,400; CL = 1,500
– 2010: CA = 3,500; CL = 1,200
• Fixed Assets and Depreciation
– 2011: NFA = 3,400; 2010: NFA = 3,100
– Depreciation Expense = 400
• Long-term Debt and Equity (R.E. not given)
– 2011: LTD = 4,000; Common stock & APIC = 400
– 2010: LTD = 3,950; Common stock & APIC = 400
• Income Statement
– EBIT = 2,000; Taxes = 300
– Interest Expense = 350; Dividends = 500
• Compute the CFFA

2-46
End of Chapter

2-47
 The Role of the Financial
Manager in a Corporation
HOW THE FINANCE AREA FITS INTO A CORPORATION

Pearson Prentice Hall Foundations of Finance 1 - 48

 Objectives of Income Taxation

• Raise revenues for government expenditures

• Achieve socially desirable goals

• Economic stabilization

Pearson Prentice Hall Foundations of Finance 1 - 49

 Types of Taxpayers
• Individuals
– employees, self-employed persons, members of partnerships
– Report income on personal tax return
• Corporations
– separate legal entity
– Report income on corporate tax return
– Distributed dividends taxed to shareholders
• Fiduciaries
– estates and trusts
– Pay taxes on undistributed income

Pearson Prentice Hall Foundations of Finance 1 - 50

 Computing Taxable Income ($000’s)

Sales $50,000
Cost of Goods Sold 23,000
Gross Profit $27,000
Operating Expenses
Administrative Expenses $4,000
Depreciation Expense 1,500
Marketing Expenses 4,500
Total Operating Expenses $10,000
Operating Income $17,000
Other Income 0
Interest Expense 1,000
Taxable Income $16,000

Pearson Prentice Hall Foundations of Finance 1 - 51

 Corporate Tax Rates

Income Rate
$ 0 - $50,000 15%
$50,001 - $75,000 25%
$75,001 - $10,000,000 34%
Over $10,000,000 35%

Additional surtax:
• 5% on income between
$100,000 and $335,000
• 3% on income between
$15,000,000 and $18,333,333
Pearson Prentice Hall Foundations of Finance 1 - 52
Ten Principles That Form The
Foundations of Financial
Management

“…although it is not necessary to

understand finance in order to understand
these principles, it is necessary to
understand these principles in order to
understand finance.”
 Principle 1: The Risk-Return
Trade-off
• We won’t take on additional risk unless we
expect to be compensated with additional
return.
• Investment alternatives have different
amounts of risk and expected returns.
• The more risk an investment has, the higher
its expected return will be.

Pearson Prentice Hall Foundations of Finance 1 - 54

 Principle 2: The Time Value
of Money
• A dollar received today is worth more than a
dollar received in the future.

• Because we can earn interest on money

received today, it is better to receive money
earlier rather than later.

Pearson Prentice Hall Foundations of Finance 1 - 55

 Principle 3: Cash—Not Profits
—Is King
• Cash Flow, not accounting profit, is
used as our measurement tool.

• Cash flows, not profits, are actually

received by the firm and can be
reinvested.

Pearson Prentice Hall Foundations of Finance 1 - 56

 Principle 4: Incremental Cash
Flows

• It is only what changes that counts

• The incremental cash flow is the difference

between the projected cash flows if the project
is selected, versus what they will be, if the
project is not selected.

Pearson Prentice Hall Foundations of Finance 1 - 57

 Principle 5: The Curse of
Competitive Markets
• It is hard to find exceptionally profitable projects
• If an industry is generating large profits, new entrants
are usually attracted. The additional competition and
added capacity can result in profits being driven down
to the required rate of return.
– Product Differentiation, Service and Quality can
insulate products from competition

Pearson Prentice Hall Foundations of Finance 1 - 58

 Principle 6: Efficient Capital
Markets
• The markets are quick and the prices
are right.

• The values of all assets and securities

at any instant in time fully reflect all
available information.

Pearson Prentice Hall Foundations of Finance 1 - 59

 Principle 7: The Agency
Problem
• Managers won’t work for the owners unless it
is in their best interest

• The separation of management and the

ownership of the firm creates an agency
problem.
– Managers may make decisions that are not in line
with the goal of maximization of shareholder wealth.

Pearson Prentice Hall Foundations of Finance 1 - 60

 Principle 8: Taxes Bias
Business Decisions

• The cash flows we consider are the

after-tax incremental cash flows to
the firm as a whole.

Pearson Prentice Hall Foundations of Finance 1 - 61

 Principle 9: All Risk is Not
Equal

• Some risk can be diversified away, and

some cannot
• The process of diversification can
reduce risk, and as a result, measuring
a project’s or an asset’s risk is very
difficult.

Pearson Prentice Hall Foundations of Finance 1 - 62

 Principle 10: Ethical Behavior Is Doing the Right
Thing, and Ethical Dilemmas Are Everywhere in
Finance

• Each person has his or her own set of

values, which forms the basis for
personal judgments about what is the
right thing

Pearson Prentice Hall Foundations of Finance 1 - 63