Chapter 1

OVERVIEW OF CORPORATE FINANCE

ACADEMY OF FINANCE

CORPORATE FINANCE
DEPARMENT

1
 Learning objectives

1 Understand what corporate finance is

2 Understand the position and main responsibilities of Chief

Financial Officer (CFO) in a business

3 Distinguish different forms of business organization and its

effect on business’s financial decision-making process

4 Explain the ultimate goal of corporate financial management

5 Understand the presence of stakeholders and their effects on

corporate objectives

6 Understand the nature and functions of financial markets and

institutions
Contents
 Introduction to finance and financial management

- What is finance?
- What is corporate finance?
- What is financial management?
 Chapter 1: Overview of Corporate Finance

1.1 Corporate finance

Corporate finance: is the study of ways to answer important Qs

what long-term assets should the firm invest in?

How can the firm raise cash for required investment?

How should the generated profits be distributed?

How should short-term assets be managed?

 Chapter 1: Overview of Corporate Finance

1.1 Corporate finance

Financial decisions

Investment Financing Dividend

Working capital
decision decision decision
management
 Chapter 1: Overview of Corporate Finance

1.1 Corporate finance

Investment decision
(Capital budgeting)

Identify investment Account for amount, risk How much to invest

opportunities and timing of returns (Funding demand)
- Huge investment
- Risk associated
Promising Cash flow
projects assessment - Timing
 Chapter 1: Overview of Corporate Finance

Debt
1.1 Corporate finance Investors are lenders

Debt or Equity? Obligation to repay

principal and interests.

Equity
Financing decision Investors become
(Capital structure) owners
Flexibility in structuring
To raise money for
No promise to pay
investment & operation
dividend

E.g: Raising debt

Endless choices - Banks or issuing bonds?
- Which currency?
- Maturity?...

Long-term
consequences
 Chapter 1: Overview of Corporate Finance

1.1 Corporate finance

Pay dividend

Dividend decision
To allocate returns Shareholders’
return
Reinvest
Share
in Business
price
profitable growth
increases
projects

Should the firm pay DIV or not?

If paying DIV, what number is reasonable
 Chapter 1: Overview of Corporate Finance
1.1 Corporate finance

Working capital management

Managing daily activities to ensure sufficient
resources for operation, avoid costly interruptions

Raise cash for Invest spare cash

short-term needs for short periods

- Cash for paying bills

Interest earned on
- Credit sale policy
short-term securities
- Inventory How much cash and inventory should we keep on hand?
Should we sell on credit? If so, what terms we will offers
 Ongoing process and to whom will we extend them?
How will we obtain any needed short term financing?
 Chapter 1: Overview of Corporate Finance
1.1 Corporate finance
The financial manager
 Chapter 1: Overview of Corporate Finance
1.1 Corporate finance Chief financial
The financial manager
officer
- Financial policymaking
- Corporate planning
- Strictly financial issues

Treasurer Controller

- Cash management
- Prepare financial statements
- Raise new capital
- Internal budget and accounts
- Relationship with banks &
- Tax affairs
other investors
 Ensure efficient use of capital
 Obtain & manage capital
 Chapter 1: Overview of Corporate Finance
1.1 Corporate finance
The financial manager

Real assets Financial

assets
 Chapter 1: Overview of Corporate Finance
1.1 Corporate finance
The financial manager

- The financial manager: responsible for financial decisions.

- Small corporations: no single person, responsibility dispersed

throughout the company.

+ Product design: decides kind of real assets the firm invest in

+ Marketing campaign: budget for marketing…..

- Large corporations: usually have an executive manager - Chief Financial

Officer (CFO) to oversee both treasurer’ and the controller’s work.
 Chapter 1: Overview of Corporate Finance

1.2. Forms of business organization

Sole proprietorship Conception ?

Partnership
Advantage ?

Corporation

Disadvantage?
Limited liability
company
 Chapter 1: Overview of Corporate Finance

1.2. Forms of business organization

Sole
Form of business Partnership Corporation
proprietorship

Owner of the business Manager Manager Shareholders

Separation of ownership
No No Yes
and management

The owner’s liability Unlimited Unlimited Limited

Mainly Contribution of partners, Issue securities
Financing choices
owner’s money borrowing and borrowing

Separation of personal
No No Yes
and corporate tax liability
 Chapter 1: Overview of Corporate Finance

1.2. Forms of business organization

Sole proprietorship: a type of business that owned by one

individual.
Normally are small businesses
The owner :
• controls the running of the business or hire another manager.
• can put his own money or borrow the bank for the business
• keeps all profits, that’s why it can minimise agency problems
• has unlimited liability on debts: the bank can ask the owner to sell
personal assets to repay the loan.
 Chapter 1: Overview of Corporate Finance
1.2. Forms of business organization
1 Sole proprietorship:

Advantages
 Owned by an individual, make it
easily and inexpensively
formed and easy to manage
 Has tax advantage because only pay
personal income tax (Taxed once as
personal income tax)
 Few Government and reporting
regulations
 Minimize agency problems related
to separation of ownership rights
and control/management
Disadvantages
 Unlimited personal liability for the
business’s debts. If the business
fails, the sole proprietor is personal
liable for the debt.
 Difficult to obtain large sums of
capital to facilitate growth and
expansion.
 Difficult to transfer to another
 It has limited life. It exist only the
owner does.
 Chapter 1: Overview of Corporate Finance

1.2. Forms of business organization

Partnership: One person pools money and expertises with friends

or business associates.
• Common business structure associated with professional occupations
(such as lawyers or accountants)
• Business is governed by a legal partnership agreement
• Partnership agreement sets out:
- responsibilities in making decisions
- how profits are divided.
• Each partner has unlimited liability on debts

Note: Sole proprietorship and Partnership have tax advantage, i.e they just pay
personal income tax, no corporate income tax liability
 1.2. Forms of business organization
2 Partnership:
Advantages
 Taxed once as personal income tax
 Easy to establish
 Able to raise funds when there is
more than one owner
 Improved management with more
than one owner
 Wider pool of knowledge, skills,
and contacts
Disadvantages
 Still hard to raise capital compared
to corporation
 The partners have unlimited
liabilities to the business
 Not easy to transfer without the
agreement of the remaining partners
 All partners have to bear legal
responsibilities equally if being sued
 Has limited life, when the owners
die, the business does not exist
 Chapter 1: Overview of Corporate Finance

1.2. Forms of business organization

3 Corporation: a business organized as a separate legal entity owned by

shareholders. It is a separate and distinct entity from its owners and
managers
• The owners of corporations are the shareholders who purchase the
company’s ordinary equity capital (Shares).
• Ownership is easily transferable between different owners (much easier than
for unincoporated business), and exists for as long as the company exists
•Limited liability:
- Bases on proportion of shares invested in the company
- No personal responsibility on debts. It means that owners are not subject
to losses beyond the amount originally invested
 Chapter 1: Overview of Corporate Finance

1.2. Forms of business organization

Corporation

Private held Public

- Shares are held by - Shares are traded on

small groups of managers securities market
& investors
- Shares are not sold - Shares are available for
publicly, except negotiation any investor

Tax liability

Corporate tax on profits

Personal tax on dividends
 1.2. Forms of business organization

3 Corporation :

Advantages
 Easy to raise fund
 Easily transferable between
different owners: shares are traded
in the market
 Limited liabilities: Owners are not
subject to losses beyond the amount  Conflict between “big” shareholders
originally invested
 Improved management
 Unlimited life. If the investors die,
the company still lives
Disadvantages
 Double tax (Taxed separately from
individual, income is taxed twice)
 Costly to set up and exist
 Obey a lot of regulations and
reports
and “small” shareholders.
 Agency problem
 Chapter 1: Overview of Corporate Finance

1.2. Forms of business organization

4 Hybrid of limited and unlimited liability in limited partnership:

- General partners: manage business, unlimited liability

- Limited partners: do not manage business, limited liability

• LLC is a hybrid / combination of a partnership and a corporation, as they

provide limited liability to owners (like a corporation) but are taxed like a
partnership

• LLP is similar to a LLC but are used for professional firms, such as
accountants, lawyers, architects and real estate businesses (often called
professional corporation, the business has limited liability, but the
professionals can still be sued personally, for example for malpractice)

• One-partner limited liability companies in Vietnam: mostly state-owned

 1.2. Forms of business organization

4 Hybrid of limited and unlimited liability in limited partnership :

• LLP (Limited Liability Partnership)

• In this type of business, partners are classified as:

General Partners Limited Partners
 Manage day to day activities of  Do not participate in
the business management
 Have unlimited liability for the  Have limited liability (are liable
company’s debt only to their amount of
 Supply expertise investment)
 Supply money

In Vietnam: one limited liability companies, professional corporation

 1.2. Forms of business organization

4 Hybrid of limited and unlimited liability in limited partnership :

Advantages Disadvantages
 Utilize the advantages of limited  Complicated structure
and unlimited forms  General partners have unlimited
 Limited partners have limited liability for the company’s debt
liability
 Have tax advantage (pay personal
income tax)
 Chapter 1: Overview of Corporate Finance

1.3. Goals of financial management

Which year’s profits?

Increase future profits by
Cutting basic outlays
to increase short term cutting this year’s dividend?
profits?

Profit
maximization?

Applying different
accounting principles
 The goal of financial management

• The firm’s objective is always to maximize profit. Is this true?

• Corporations commonly measure profits in terms of earnings per

share (EPS), which represent the amount earned during the period
on behalf of each outstanding share of common stock.
• EPS are calculated by dividing the period’s total earnings available
for the firm’s common stockholders by the number of shares of
common stock outstanding.
 Maximize profit?

• No. It fails for a number of reasons: It ignores (1) the timing of

returns, (2) cash flows available to stockholders, and (3) risk.
• Another criticism of profit maximization is the potential for profit
manipulation through the creative use of elective accounting
practices.
• Profit maximization does not achieve the objectives of the firm’s
owners, it should not be the goal of the financial manager.
 Example
• Nick Dukakis, the financial manager of Neptune Manufacturing, a producer of marine
engine components, is choosing between two investments, Rotor and Valve. The following
table shows the EPS that each investment is expected to have over its 3-year life.
Earnings per share (EPS)
• Investment Year 1 Year 2 Year 3 Total for years 1, 2, and 3 Rotor $1.40
$1.00 $0.40 $2.80
Valve $ 0.60 $1.00 $1.40 $3.00
• In terms of the profit maximization goal, Valve would be preferred over Rotor, because it
results in higher total earnings per share over the 3-year period ($3.00 EPS compared with
$2.80 EPS).
• Timing

• Because the firm can earn a return on funds it receives, the receipt
of funds sooner rather than later is preferred.
• In our example, in spite of the fact that the total earnings from Rotor
are smaller than those from Valve, Rotor provides much greater
earnings per share in the first year. The larger returns in year 1
could be reinvested to provide greater future earnings.
• Cash Flows
• Profits do not necessarily result in cash flows available to the
stockholders. Owners’ cash flows are in the form of cash
dividends or the proceeds from selling shares for a higher
price than initially paid. Greater EPS do not necessarily mean
that a firm’s board of directors will vote to increase dividend
payments.
• Furthermore, higher EPS do not necessarily translate into a
higher stock price.
• Risk
• Profit maximization also disregards risk—the chance that actual
outcomes may differ from those expected.
• A basic premise in managerial finance is that a trade-off exists
between return (cash flow) and risk. Return and risk are in fact the
key determinants of share price, which represents the wealth of the
owners in the firm.
• Higher cash flow is generally associated with a higher share price.
Higher risk tends to result in a lower share price because the
stockholder must be compensated for the greater risk.
 Maximize Shareholder Wealth

• The goal of financial management, is to maximize the wealth of

the owners for whom it is being operated.
• The wealth of corporate owners is measured by the share price of
the stock, which in turn is based on the timing of returns (cash
flows), their magnitude, and their risk.
 Financial Financial Decision Return
Alternative or ? Increase Accept
manager Yes
Action Risk? share price?

No

Reject

When considering each financial decision alternative or possible action in terms of its impact on the share price
of the firm’s stock, financial managers should accept only those actions that are expected to increase share price
 Chapter 1: Overview of Corporate Finance

1.3. Goals of financial management

The focus of this subject is primarily on public companies (companies that are
listed on a recognised stock exchange) and are owned by the shareholders
who hold company equity capital.

The goal of financial management:

Maximize the current market value of shares not profit maximization
Corporate finance: studies relationship between financial decisions
and value of share.
We need to learn how to identify those investments, financing, and
dicision that favourably impact on the value of the firm.
 Chapter 1: Overview of Corporate Finance

1.3. Goals of financial management

Is Maximize the current market value of shares

Is not profit maximization

 Chapter 1: Overview of Corporate Finance
1.3. Goals of financial management
Principal Agent
Shareholders Managers

Interest conflict

Do managers
really maximize
value? Agency
problem

Managers do not
behave for
shareholders’ best
interests
 Chapter 1: Overview of Corporate Finance

1.3. Goals of financial management

• The modern corporate form results in a separation of ownership from

corporate control

• Corporate ownership is held in the hands of numerous different

shareholders who cannot efficiently coordinate among themselves for
decision-making purposes

• As a result, the principal (shareholders) engage an agent (the board

of directors and management team) to act on their behalf, and transfer
a large proportion of their decision-making power to the agent

• The agent typically has little or no personal ownership interest in the

company, which gives them an incentive to maximise their own
interests (and personal utility)
 Chapter 1: Overview of Corporate Finance

1.3. Goals of financial management

Examples of agency problems are:

• Management focusing on maximising company size

(empire-building) as a measure of prestige or success, or
to maximise their pay

• Excessive consumption of perquisites (such as luxurious

offices, expense accounts, underlying staff and company
travel)

• Cutting out R&D expenditure as it will lower current profits,

even though it may lead to profitable future capital projects
and higher stock prices
 Chapter 1: Overview of Corporate Finance

1.3. Goals of financial management

Compensation plans: incentive schemes

Board of directors: recovery plan,

new board election

Threat of being taken over

Specialists' monitoring: stock advisors,

banks,…

Legal and regulatory requirements:

accounting standards, transparency,
insider trading
 Chapter 1: Overview of Corporate Finance

1.4. Financial institutions and markets

 Chapter 1: Overview of Corporate Finance

1.4. Financial institutions and markets

Financial markets

* The stock market: a market on which securities are issued & traded.

- A security: a traded financial asset

- A corporation can “go public” by Initial public offering (IPO) on the primary
stock market.
- IPO provides finance for real assets investment.
 New issue increases Value of capital
Number of shares

- Secondary market shares freely traded

ownership transfer
no effect on the company
increase market liquidity…
 Chapter 1: Overview of Corporate Finance

1.4. Financial institutions and markets

Financial markets
* Other financial markets:

Shares: reflect ownership Bonds: reflect borrowing

no definite maturity vary in maturity

- Bonds and debt securities:

+ Maturity:

+ Interest: floating or fixed?

+ Level of protection offered by issuer

- Bonds can be “called” or converted into shares.

 Debt structure should be considered

- Money market: short-term securities (< 1year maturity)

- Capital market: long-term debt and equity

 Chapter 1: Overview of Corporate Finance

1.4. Financial institutions and markets

• Financial intermediaries: an organization that raises money from
investors and provides financing to individuals and companies.

Financial
intermediaries

Shares (1)
Investors Mutual funds Pension funds %Paycheck Employees
$$$ (2)

Portfolios

Investment return
 Chapter 1: Overview of Corporate Finance

1.4. Financial institutions and markets

* Financial institutions:
ROLE ?
Conception ?
Banks

Financial institutions

Insurance
companies
 Chapter 1: Overview of Corporate Finance

1.4. Financial institutions and markets

* Functions of financial markets:

Company

Obligations
Funds

Banks
Insurance Cos. Intermediary
Brokerage firms
Obligations Funds

Depositors
Policymakers Investor
Investors
 Chapter 1: Overview of Corporate Finance
1.4. Financial institutions and markets
* Functions of financial markets:

Transporting cash Risk transfer and

across time diversification

Functions
Information provision Liquidity

Payment mechanism
 Chapter 1: Overview of Corporate Finance

Summary
a. Financial management can be broken down into the investment or capital
budgeting decision, financing decision and dividend decision. The firm has to
decide how much to invest and which real assets to invest in and how to raise
the necessary cash and how to distribute the profit.
b. Almost all managers are involved to some degree in investment decisions,
but some managers specialize in finance, for example, the treasurer, controller,
and CFO).
c. Value maximization is the natural financial goal of the firm. Maximizing
value maximizes the wealth of the firm’s owners; its shareholders. Shareholders
can invest or consume that wealth as they wish.
d. Conflicts of interest between managers and stockholders can lead to agency
problems. These problems are kept in check by compensation plans that link the
well-being of employees to that of the firm; by monitoring of management by
the board of directors, security analysts, and creditors; and by the threat of
takeover.
 Chapter 1: Overview of Corporate Finance

Summary

e. The ultimate source of financing is individuals’ savings. The savings may flow
through financial markets and intermediaries. The intermediaries include mutual
funds, pension funds, and financial institutions, such as banks and insurance
companies.
f. Mutual and pension funds allow investors to diversify in professionally managed
portfolios. Pension funds offer an additional tax advantage, because the returns on
pension investments are not taxed until withdrawn from the plan.
g. Financial markets help channel savings to corporate investment, and they help
match up borrowers and lenders. They provide liquidity and diversification
opportunities for investors. Trading in financial markets provides a wealth of useful
information for the financial manager.
 Chapter 1: Overview of Corporate Finance

Summary

h. Financial institutions carry out a number of similar functions but in different way.
They channel savings to corporate investment, and they serve as intermediaries
between borrowers and lenders. They provide liquidity for depositors and, of course,
play a special role in the economy's payment systems. Insurance company allow
policyholders to pool risks.
i. In conclusion, Corporate finance is a field of economics relating to financing,
investing and dividend decisions within a company. These decisions are conducted in
an effective way and oriented to the value maximazation objective by financial
managers of the firms.