This document provides an introduction to corporate finance. It discusses the three main questions addressed in corporate finance: what investments a firm should choose, how to raise funds for investments, and how to manage short-term assets. It also covers the goal of financial management to maximize shareholder wealth, the agency problem between owners and managers, and key regulations firms face.
2. 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
Know the goal of financial management
Understand the conflicts of interest that can
arise between owners and managers
Understand the various regulations that firms
face
1-2
3. Chapter Outline
1.1 What is Corporate Finance?
1.2 The Corporate Firm
1.3 The Importance of Cash Flows
1.4 The Goal of Financial Management
1.5 The Agency Problem and Control of the
Corporation
1.6 Regulation
1-3
4. 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?
1-4
5. 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
1-5
6. 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?
1-6
7. 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
1-7
8. 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
1-8
9. The Financial Manager
The Financial Manager’s primary goal is to
increase the value of the firm by:
2. Selecting value creating projects
3. Making smart financing decisions
1-9
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
1-10
11. 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.
1-11
12. Forms of Business Organization
• The Sole Proprietorship
• The Partnership
– General Partnership
– Limited Partnership
• The Corporation
1-12
13. 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
1-13
14. 1.3 The Importance of Cash Flow
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
the firm must exceed
must be a cash Government
the cash flows from
generating activity.
the financial markets.
1-14
15. 1.4 The Goal of Financial Management
• What is the correct goal?
– Maximize profit?
– Minimize costs?
– Maximize market share?
– Maximize shareholder wealth?
1-15
16. Maximize shareholder wealth
• The shareholders have invested in the
corporation, putting their money at risk to
become the owners of the corporation.
• Thus, the financial manager is a caretaker of
the shareholders money, making decisions in
the shareholders interests.
1-16
17. 1.5 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
1-17
18. MINIMIZE POTENTIAL CONFLICT BETWEEN MANAGERS
AND SHAREHOLDERS
• Voting at annual general meetings.
– Shareholders can vote at annual general meetings. At
such meetings they vote in the members of the board of
directors of the firm, who in turn, hire the financial
managers of the business.
– If the shareholders vote in reliable members to the board
of directors, these directors would ensure that the
managers pursue shareholder wealth maximization and
look after the interests of the ordinary shareholders.
These directors will also ensure that the financial
managers
1-18
19. • Stock option plans
– One way to encourage managers to act in the best interest
of the shareholders of the business is to offer them share
option schemes or performance shares.
– Managers exercising these options actually become
owners or shareholders of the company. If they
accumulate sizeable amounts of common shares through
such schemes (where shares are offered to managers at
low prices for good performance), these managers will
look after the interest of the common shareholders and
will be less inclined to pursue their own goals.
1-19
20. • Fear of takeover of the company.
– Managers who want job security will be more inclined to
work in the interest of the owners of the company. Other
firms may view companies which are not run well, but
have the potential to be profitable, as potential targets for
takeover or acquisition purpose.
– This will pressure managers to maximize shareholder
wealth, to ensure that the company will not become a
target for others to take over or acquire. Shareholders
whose interest have been well satisfied and taken care of
by the managers, will also be less inclined to want to sell
their shares in a potential takeover or acquisition of their
company.
1-20
21. • Fear of being fired
– Managers want to keep their jobs, and they will be more
inclined to try to maximize shareholders wealth if this will
ensure that they will be kept on as managers in the
business.
– If they do not perform, they can always be replaced by
others who may be more competent and willing to look
after the shareholders’ wealth.
1-21
22. 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
1-22
23. 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 intended goal
• Corporate control
– The threat of a takeover may result in better
management
• Other stakeholders
1-23
24. 1.6 Regulation
• The Securities Act of 1933 and the Securities
Exchange Act of 1934
– Issuance of Securities (1933)
– Creation of SEC and reporting requirements
(1934)
• Sarbanes-Oxley (“Sarbox”)
– Increased reporting requirements and
responsibility of corporate directors
1-24
Notes de l'éditeur
It is sometimes helpful to relate corporate decisions to individual circumstances. For example, consider discussing how individuals choose to buy cars or homes and how this decision would affect a personal balance sheet.
Note, these actions explicitly relate to the three questions addressed in slide 3.
It may be beneficial to discuss S-Corporations and LLCs in the context of this slide.
It is important to remind students that net income is NOT cash flow.
A common example of an agency relationship is a real estate broker – in particular if you break it down between a buyers agent and a sellers agent. A classic conflict of interest is when the agent is paid on commission, so they may be less willing to let the buyer know that a lower price might be accepted or they may elect to only show the buyer homes that are listed at the high end of the buyer’s price range. Direct agency costs – the purchase of something for management that can’t be justified from a risk-return standpoint, monitoring costs. Indirect agency costs – management’s tendency to forgo risky or expensive projects that could be justified from a risk-return standpoint.
Incentives – discuss how incentives must be carefully structured. For example, tying bonuses to profits might encourage management to pursue short-run profits and forego projects that require a large initial outlay. Stock options may work, but there may be an optimal level of insider ownership. Beyond that level, management may be in too much control and may not act in the best interest of all stockholders. The type of stock can also affect the effectiveness of the incentive. Corporate control – ask the students why the threat of a takeover might make managers work towards the goals of stockholders. Other groups also have a financial stake in the firm. They can provide a valuable monitoring tool, but they can also try to force the firm to do things that are not in the owners’ best interest.