L1 - Introduction to Corporate Finance (1)

Chapter 1
Introduction to Corporate Finance
Corporate Finance
BNKG2002
McGraw-Hill/Irwin
Corporate Finance, 7/e
CHAPTER
1
Introduction to Corporate
Finance
1-3
Chapter Outline
1.1 What is Corporate Finance?

1.2 Corporate Securities as Contingent Claims on Total Firm
Value
1.3 The Corporate Firm
1.4 Goals of the Corporate Firm
1.5 Financial Markets
1.6 Outline of the Text
1-4
What is Corporate Finance?
Corporate Finance addresses the following three

questions:
1. What long-term investments should the firm engage in?

2. How can the firm raise the money for the required
investments?
3. How much short-term cash flow does a company need
to pay its bills?
1-5
The 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
1-6
of the Firm
The Capital Budgeting Decision
Current
Liabilities
Current
Assets
Long-Term
Debt
Fixed Assets What long-

term
1 Tangible investments Shareholders’
2 Intangible should the Equity
firm engage
in? 1-7
of the Firm
The Capital Structure Decision
Current
Liabilities
Current
Assets
Long-Term
How can the firm Debt
raise the money
for the required
Fixed Assets
investments?
1 Tangible Shareholders’
2 Intangible Equity
1-8
of the Firm
The Net Working Capital Investment Decision
Current
Liabilities
Current
Net
Assets Working
Capital
Long-Term
Debt
How much short-

Fixed Assets
term cash flow
1 Tangible does a company
need to pay its Shareholders’
2 Intangible bills? Equity
1-9
Capital Structure
The value of the firm can be thought
of as a pie.
The goal of the manager is to 70%50%30%

25%
increase the size of the pie. DebtDebt
Equity
75%
50%
The Capital Structure decision can
Equity
be viewed as how best to slice up
the pie.
If how you slice the pie affects the size of the pie, then
the capital structure decision matters.
1-10
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

1-11
The Financial Manager
To create value, the financial manager should:

1. Try to make smart investment decisions.
2. Try to make smart financing decisions.
1-12
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 the
Ultimately, the firm
firm must exceed the
must be a cash cash flows from the
generating activity. Government
financial markets.
1-13
1.2 Corporate Securities as
Contingent Claims on Total
Firm Value
 The basic feature of a debt is that it is a promise
by the borrowing firm to repay a fixed dollar
amount of by a certain date.
 The shareholder’s claim on firm value is the
residual amount that remains after the
debtholders are paid.
 If the value of the firm is less than the amount
promised to the debtholders, the shareholders get
nothing.
1-14
Debt and Equity as
Contingent Claims
Payoff to Payoff to
debt holders shareholders
If the value of the firm is If the value of the firm is
more than $F, debt holders less than $F, share holders
get a maximum of $F. get nothing.
$F
$F $F
Value of the firm (X) Value of the firm (X)
Debt holders are promised $F. If the value of the firm is
more than $F, share holders
If the value of the firm is less than $F, they get the
get everything above $F.
whatever the firm if worth.
Algebraically, the bondholder’s claim is: Algebraically, the shareholder’s claim is:
Min[$F,$X] Max[0,$X – $F]
1-15
Combined Payoffs to Debt and Equity
Combined Payoffs to debt holders If the value of the firm is less than
and shareholders $F, the shareholder’s claim is:
Max[0,$X – $F] = $0 and the debt
holder’s claim is Min[$F,$X] = $X.
The sum of these is = $X
Payoff to shareholders
$F
If the value of the firm is more than
Payoff to debt holders $F, the shareholder’s claim is:
Max[0,$X – $F] = $X – $F and the
$F debt holder’s claim is:
Value of the firm (X)
Min[$F,$X] = $F.
Debt holders are promised
$F. The sum of these is = $X
1-16
1.3 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.
1-17
Forms of Business Organization
 The Sole Proprietorship
 The Partnership
 General Partnership
 Limited Partnership
 TheCorporation
 Advantages and Disadvantages
 Liquidity and Marketability of Ownership
 Control
 Liability
 Continuity of Existence
 Tax Considerations
1-18
A Comparison of Partnership
and Corporations
Corporation Partnership
Liquidity Shares can easily be Subject to substantial

exchanged. restrictions.
Voting Rights Usually each share gets General Partner is in

one vote charge; limited partners
may have some voting
rights.
Taxation Double Partners pay taxes on
distributions.
Reinvestment and Broad latitude All net cash flow is
dividend payout distributed to partners.
Liability Limited liability General partners may

have unlimited liability.
Limited partners enjoy
limited liability.
Continuity Perpetual life Limited life
1-19
1.4 Goals of the Corporate Firm
 The traditional answer is that the managers of the corporation are
obliged to make efforts to maximize shareholder wealth.
1-20
The Set-of-Contracts Perspective
 The firm can be viewed as a set of contracts.
 One of these contracts is between shareholders
and managers.
 The managers will usually act in the shareholders’
interests.
 The shareholders can devise contracts that align the
incentives of the managers with the goals of the
shareholders.
 The shareholders can monitor the managers behavior.
 This contracting and monitoring is costly.
1-21
Managerial Goals
 Managerial goals may be different from shareholder
goals
 Expensive perquisites
 Survival
 Independence
 Increasedgrowth and size are not necessarily the
same thing as increased shareholder wealth .
1-22
Separation of Ownership and Control
Board of Directors
Debtholders
Shareholders
Management
Debt
Assets
Equity
1-23
Do Shareholders Control
Managerial Behavior?
 Shareholders vote for the board of directors, who in turn
hire the management team.
 Contracts can be carefully constructed to be incentive
compatible.
 There is a market for managerial talent—this may
provide market discipline to the managers—they can be
replaced.
 If the managers fail to maximize share price, they may
be replaced in a hostile takeover.
1-24
1.5 Financial Markets
 Primary Market
 When a corporation issues securities, cash flows from
investors to the firm.
 Usually an underwriter is involved
 Secondary Markets
 Involve the sale of “used” securities from one investor to
another.
 Securities may be exchange traded or trade over-the-
counter in a dealer market.
1-25
Financial Markets
Stocks and Investors

Bonds
Firms securities
Money Bob Sue
money
Primary Market
Secondary
Market
1-26
Exchange Trading of Listed Stocks
 Auctionmarkets are different from dealer markets
in two ways:
 Trading in a given auction exchange takes place at a
single site on the floor of the exchange.
 Transaction prices of shares are communicated almost
immediately to the public.
1-27
1.6 Outline of the Text
I. Overview
II. Value and Capital Budgeting
III. Risk
IV. Capital Structure and Dividend Policy
V. Long-Term Financing
VI. Options, Futures and Corporate Finance
VII. Financial Planning and Short-Term Finance
VIII. Special Topics
1-28
CHAPTER
2
Accounting Statements
and Cash Flow
2-29
Chapter Outline
2.1 The Balance Sheet

2.2 The Income Statement
2.3 Net Working Capital
2.4 Financial Cash Flow
2.5 The Statement of Cash Flows
2.6 Summary and Conclusions
2-30
Sources of Information
 Annual reports
 Wall Street Journal
 Internet
 NYSE (www.nyse.com)
 Nasdaq (www.nasdaq.com)
 SEC
 EDGAR
 10K & 10Q reports
2-31
2.1 The Balance Sheet
 An accountant’s snapshot of the firm’s accounting

value as of a particular date.
 The Balance Sheet Identity is:
Assets ≡ Liabilities + Stockholder’s Equity

 When analyzing a balance sheet, the financial
manager should be aware of three concerns:
accounting liquidity, debt versus equity, and value
versus cost.
2-32
The Balance Sheet of the U.S. Composite
Corporation
U.S. COMPOSITE CORPORATION
Balance Sheet
20X2 and 20X1
(in $ millions)
Liabilities (Debt)
Assets 20X2 20X1 The assets are listed in order
and Stockholder's Equity
20X2 20X1
Current assets: Current Liabilities:
Cash and equivalents $140 $107 by the length of time it $213 $197
Accounts payable
Accounts receivable
Inventories
294
269
270
280
normally would take a firm
Notes payable
Accrued expenses
50
223
53
205
Other
Total current assets
58
$761
50
$707
with ongoing operations$486
Total current liabilitiesto $455
Long-term liabilities:
convert them into cash. $117 $104
Deferred taxes
Fixed assets: Long-term debt 471 458
Property, plant, and equipment $1,423 $1,274 Total long-term liabilities $588 $562
Less accumulated depreciation -550 -460
Net property, plant, and equipment 873 814 Stockholder's equity:
Intangible assets and other 245 221 Preferred stock $39 $39
Total fixed assets $1,118 $1,035 Clearly, cash is much more
Common stock ($1 per value) 55 32
liquid than property, plant and
Capital surplus
Accumulated retained earnings
347
390
327
347
equipment.
Less treasury stock
Total equity
-26
$805
-20
$725
Total assets $1,879 $1,742 Total liabilities and stockholder's equity $1,879 $1,742
2-33
Balance Sheet Analysis
 When analyzing a balance sheet, the financial manager
should be aware of three concerns:
1. Accounting liquidity
2. Debt versus equity
3. Value versus cost
2-34
Accounting Liquidity
 Refers to the ease and quickness with which assets can be
converted to cash.
 Current assets are the most liquid.
 Some fixed assets are intangible.
 The more liquid a firm’s assets, the less likely the firm is to
experience problems meeting
short-term obligations.
 Liquid assets frequently have lower rates of return than fixed
assets.
2-35
Debt versus Equity
 Generally, when a firm borrows it gives the bondholders first
claim on the firm’s cash flow.
 Thus shareholder’s equity is the residual difference between
assets and liabilities.
2-36
Value versus Cost
 Audited financial statements of firms carry most
assets at cost.
 Market value is a completely different concept.
2-37
2.2 The Income Statement
 The income statement measures performance over a
specific period of time.
 The accounting definition of income is
Revenue – Expenses ≡ Income
2-38
U.S.C.C. Income Statement
Income Statement
20X2
(in $ millions)
Total operating revenues $2,262

The operations Cost of goods sold - 1,655
section of the Selling, general, and administrative expenses - 327
Depreciation - 90
income
Operating income $190
statement reports Other income 29
the firm’s Earnings before interest and taxes $219
Interest expense - 49
revenues and Pretax income $170
expenses from Taxes - 84
principal Current: $71
Deferred: $13
operations Net income $86
Retained earnings: $43
Dividends: $43 2-39
Income Statement
20X2
(in $ millions)

The non- Cost of goods sold - 1,655
operating Selling, general, and administrative expenses - 327
Depreciation - 90
section of
the income Other income 29
statement Earnings before interest and taxes $219
includes all Pretax income $170
financing Taxes - 84
costs, such Current: $71
Deferred: $13
as interest Net income $86
expense. Retained earnings: $43
Dividends: $43 2-40
Income Statement
20X2
(in $ millions)

Usually a Cost of goods sold - 1,655
separate Selling, general, and administrative expenses - 327
Depreciation - 90
section Operating income $190
reports as a Other income 29
Earnings before interest and taxes $219
separate Interest expense - 49
item the Pretax income $170
amount of Taxes - 84
Current: $71
taxes Deferred: $13
levied on Net income $86
income. Retained earnings: $43
Dividends: $43 2-41
Income Statement
20x2
(in $ millions)

Cost of goods sold - 1,655
Selling, general, and administrative expenses - 327
Depreciation - 90
Other income 29
Earnings before interest and taxes $219
Net income is the Pretax income $170
“bottom line”. Taxes - 84
Current: $71
Deferred: $13
Net income $86
Retained earnings: $43
Dividends: $43 2-42
Income Statement Analysis
 There are three things to keep in mind when analyzing an
income statement:
1. Accounting Standard (GAAP/IFRS)
2. Non-Cash Items
3. Time and Costs
2-43
Accounting Standards
1. GAAP & IFRS

The matching principal dictates that revenues be
matched with expenses. Thus, income is reported
when it is earned, even though no cash flow may have
occurred
2-44
2. Non Cash Items

 Depreciation is the most apparent. No firm ever writes a
check for “depreciation”.
 Another noncash item is deferred taxes, which does not
represent a cash flow.
2-45
3. Time and Costs

 In the short run, certain equipment, resources, and
commitments of the firm are fixed, but the firm can vary
such inputs as labor and raw materials.
 In the long run, all inputs of production (and hence
costs) are variable.
 Financial accountants do not distinguish between
variable costs and fixed costs. Instead, accounting
costs usually fit into a classification that distinguishes
product costs from period costs.
2-46
2.3 Net Working Capital
Net Working Capital =

Current Assets – Current Liabilities
 NWC is usually growing with the firm.
2-47
The Balance Sheet of the U.S.C.C.
Balance Sheet
$252m = $707- $455 20X2 and 20X1
(in $ millions)
Liabilities (Debt)
Assets 20X2 20X1 and Stockholder's Equity 20X2 20X1
Current assets: Current Liabilities:
Cash and equivalents $140 $107 Accounts payable $213 $197
Accounts receivable 294 270 Notes payable 50 53
Inventories 269 280 Accrued expenses 223 205
Other 58 50 Total current liabilities $486 $455
Total current assets $761 $707
Long-term liabilities:
Fixed assets: Here we see NWC grow
Deferred taxes $117to $104
Property, plant, and equipment $1,423 $1,274 Long-term debt 471 458
Less accumulated depreciation -550 -460 $275 million in 20X2 from
Total long-term liabilities$588 $562
Net property, plant, and equipment
Intangible assets and other
873
245
814
221
$252 million in 20X1.
Stockholder's equity:
Total fixed assets $1,118 $1,035
$23 million
Preferred stock
Common stock ($1 par value)
$39
55
$39
32
Capital surplus 347 327
$275m = $761m- $486m This increase of $23 million is
Accumulated retained earnings 390 347
Less treasury stock -26 -20
an investment of the firm.
Total equity $805 $725
Total assets $1,879 $1,742 Total liabilities and stockholder's equity $1,879 $1,742
2-48
2.4 Financial Cash Flow
 In finance, the most important item that can be extracted

from financial statements is the actual cash flow of the firm.
 Since there is no magic in finance, it must be the case that
the cash from received from the firm’s assets must equal the
cash flows to the firm’s creditors and stockholders.
CF(A)≡ CF(B) + CF(S)
2-49
Financial Cash Flow of the U.S.C.C.
Financial Cash Flow
20X2
(in $ millions)
Cash Flow of the Firm

Operating cash flow $238 Operating Cash Flow:
(Earnings before interest and taxes
plus depreciation minus taxes) EBIT $219
Capital spending (173)
(Acquisitions of fixed assets Depreciation $90
minus sales of fixed assets)
Additions to net working capital (23) Current Taxes ($71)
Total $42
OCF $238
Cash Flow of Investors in the Firm
Debt $36
(Interest plus retirement of debt
minus long-term debt financing)
Equity 6
(Dividends plus repurchase of
equity minus new equity financing)
Total $42 2-50
Financial Cash Flow of the U.S.C.C.
Financial Cash Flow
20X2
(in $ millions)
Operating cash flow $238
plus depreciation minus taxes)
Capital Spending
Capital spending (173) Purchase of fixed assets
(Acquisitions of fixed assets
$198
Additions to net working capital (23) Sales of fixed assets (25)
Total $42
Cash Flow of Investors in the Firm Capital Spending $173
Debt $36
Equity 6
Total $42
2-51
Financial Cash Flow of the
U.S.C.C. U.S. COMPOSITE CORPORATION
Financial Cash Flow
20X2
(in $ millions)

Operating cash flow $238 NWC grew
plus depreciation minus taxes) from $275
Capital spending (173) million in
minus sales of fixed assets) 20X2 from
Additions to net working capital (23)
Total $42
$252 million
in 20X1.
Debt $36
(Interest plus retirement of debt This increase
Equity 6
of $23 million
(Dividends plus repurchase of is the addition
Total $42
to NWC.
2-52
U.S.C.C.
Financial Cash Flow
20X2
(in $ millions)
Operating cash flow $238
Total $42
Debt $36
Equity 6
Total $42 2-53
U.S.C.C.
Financial Cash Flow
20X2
(in $ millions)
Operating cash flow $238 Cash Flow to
(Earnings before interest and taxes Creditors
Interest $49
(Acquisitions of fixed assets Retirement
minus sales of fixed assets) of debt 73
Total $42 Debt service 122
Cash Flow of Investors in the Firm Proceeds from new

Debt $36 debt sales (86)
(Interest plus retirement of debt Total 36
Equity 6
Total $42 2-54
U.S.C.C.
Financial Cash Flow
20X2
(in $ millions)
Operating cash flow $238 Cash Flow to
(Earnings before interest and taxes Stockholders
plus depreciation minus taxes) Dividends $43
(Acquisitions of fixed assets Repurchase of
minus sales of fixed assets) stock 6
Cash to Stockholders 49
Total $42
Cash Flow of Investors in the Firm Proceeds from new
Debt $36 stock issue (43)
(Interest plus retirement of debt Total $6
Equity 6
Total $42 2-55
U.S.C.C.
Financial Cash Flow
20X2
(in $ millions)
Operating cash flow $238 The cash from
(Earnings before interest and taxes received from the
plus depreciation minus taxes) firm’s assets must
(Acquisitions of fixed assets equal the cash flows
minus sales of fixed assets) to the firm’s
Additions to net working capital (23) creditors and
Total $42
stockholders:
Debt $36 CF ( A) 
minus long-term debt financing) CF ( B )  CF ( S )
Equity 6
Total $42 2-56
2.5 The Statement of Cash Flows
 There is an official accounting statement called the

statement of cash flows.
 This helps explain the change in accounting cash,
which for U.S. Composite is $33 million in 20X2.
 The three components of the statement of cash
flows are
 Cash flow from operating activities
 Cash flow from investing activities
 Cash flow from financing activities
2-57
U.S.C.C. Cash Flow
from Operating Activities
Cash Flow from Operating Activities
20X2
(in $ millions)
To calculate
Operations
cash flow from
Net Income $86
operations, start Depreciation 90
with net income, Deferred Taxes 13
add back Changes in Assets and Liabilities
noncash items Accounts Receivable (24)
like depreciation Inventories 11
and adjust for Accounts Payable 16
Accrued Expenses 18
changes in
Notes Payable (3)
current assets Other (8)
and liabilities
(other than Total Cash Flow from Operations $199
cash). 2-58
U.S.C.C. Cash Flow
from Investing Activities
Cash Flow from Investing Activities
20X2
(in $ millions)
Cash flow from

Acquisition of fixed assets $(198)
investing activities Sales of fixed assets 25
involves changes Total Cash Flow from Investing Activities $(173)
in capital assets:
acquisition of fixed
assets and sales of
fixed assets
(i.e. net capital
expenditures).
2-59
U.S.C.C. Cash Flow
from Financing Activities
Cash Flow from Financing Activities
20X2
(in $ millions)
Cash flows to Retirement of debt (includes notes) $(73)

and from Proceeds from long-term debt sales 86
Dividends (43)
creditors and
Repurchase of stock (6)
owners include Proceeds from new stock issue 43
changes in Total Cash Flow from Financing $7
equity and debt.
2-60
U.S.C.C. Statement of Cash
Flows Operations
Net Income $86
The statement of Depreciation 90
Deferred Taxes 13
cash flows is the Changes in Assets and Liabilities
addition of cash Accounts Receivable (24)
Inventories 11
flows from Accounts Payable 16
Accrued Expenses 18
operations, Notes Payable (3)
cash flows Other (8)
Total Cash Flow from Operations $199
from investing Investing Activities
Acquisition of fixed assets $(198)
activities, and Sales of fixed assets 25
cash flows from Total Cash Flow from Investing Activities $(173)
Financing Activities
financing Retirement of debt (includes notes) $(73)
activities. Proceeds from long-term debt sales
Dividends
86
(43)
Repurchase of stock (6)
Proceeds from new stock issue 43
Total Cash Flow from Financing $7 2-61
Change in Cash (on the balance sheet) $33

Statement of Cash Flows versus
Cash Flow from the Firm
 Since interest paid is deducted as an expense when net
income is calculated (and not deducted under financing
activities) there is a difference between cash flow from
operations and total cash flow to the firm—the difference is
interest expense.
2-62
2.5 Summary and Conclusions
 Financial statements provide important information regarding the
value of the firm.
 You should keep in mind:
 Measures of profitability do not take risk or timing of cash flows into
account.
 Financial ratios are linked to one another.
2-63

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Chapter 1

Introduction to Corporate Finance

1.1 What is Corporate Finance?

Corporate Finance addresses the following three

1. What long-term investments should the firm engage in?

Fixed Assets What long-

How much short-

The goal of the manager is to 70%50%30%

Chairman of the Board and

President and Chief

Vice President and

Cash Manager Credit Manager Tax Manager Cost Accounting

Capital Expenditures Financial Planning Financial Accounting Data Processing

To create value, the financial manager should:

2. Try to make smart financing decisions.

Liquidity Shares can easily be Subject to substantial

Voting Rights Usually each share gets General Partner is in

Liability Limited liability General partners may

Stocks and Investors

2.1 The Balance Sheet

 An accountant’s snapshot of the firm’s accounting

Assets ≡ Liabilities + Stockholder’s Equity

Revenue – Expenses ≡ Income

Total operating revenues $2,262

Total operating revenues $2,262

Total operating revenues $2,262

Total operating revenues $2,262

1. GAAP & IFRS

2. Non Cash Items

3. Time and Costs

Net Working Capital =

 NWC is usually growing with the firm.

 In finance, the most important item that can be extracted

Cash Flow of the Firm

Cash Flow of the Firm

Cash Flow of Investors in the Firm Proceeds from new

 There is an official accounting statement called the

Cash flow from

Cash flows to Retirement of debt (includes notes) $(73)

Change in Cash (on the balance sheet) $33

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