INTRODUCTION TO CORPORATE FINANCE

Chapter 1

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KEY CONCEPTS AND SKILLS• Know the three main concerns of corporate

financial management• Grasp the goal of financial management• Enumerate the financial benefits and drawbacks

of differing forms of business organization• Understand the conflicts of interest that can arise

between owners and managers• Comprehend that corporate organizations are

enhanced by financial markets

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CHAPTER OUTLINE

1.1 What is Corporate Finance?1.2 The Corporate Firm1.3 The Importance of Cash Flows1.4 The Goal of Financial Management1.5 The Agency Problem and Control of the

Corporation1.6 Regulation

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1.1 WHAT IS CORPORATE FINANCE?

• Economic resources are required to establish and maintain a firm:• Funds enable materials and processes for

delivering salable goods and services• Funds are essential for assembling a

workforce• Funds are required to purchase long-lived

assets such as equipment and buildings• The Balance Sheet offers insight into the array of decisions, activities and objectives of the Financial Manager

BALANCE SHEET MODEL OF THE FIRM

Current Assets

Fixed Assets

1 Tangible

2 Intangible

Total Value of Assets:

Shareholders’ Equity

Current Liabilities

Long-Term Debt

Total Firm Value to Investors:

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THE BALANCE SHEET REVEALS…

…the top three concerns of corporate finance:1. What long-term investments should the firm

choose?2. How should the firm raise funds for the

selected investments?3. How should current assets be managed and

financed?

THE CAPITAL BUDGETING DECISION

Current Assets

Fixed Assets

1 Tangible

2 IntangibleShareholders’

Equity

Current Liabilities

Long-Term Debt

What long-term investments should the firm choose?

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THE CAPITAL STRUCTURE DECISION

How should the firm raise funds for the selected investments?

Current Assets

Fixed Assets

1 Tangible

2 IntangibleShareholders’

Equity

Current Liabilities

Long-Term Debt

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SHORT-TERM ASSET MANAGEMENT

How should short-term assets be managed and financed?

Net Working Capital

Shareholders’ Equity

Current Liabilities

Long-Term Debt

Current Assets

Fixed Assets

1 Tangible

2 Intangible

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THE FINANCIAL MANAGER

• The firm’s three main financial concerns are usually handled by a top officer and aides:

• V.P. or Chief Financial Officer• Strategist, coordinator, authority

•Treasurer• Cash flow, capital expenditures, capital structure

• Controller• Accounting, information systems, taxes

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HYPOTHETICAL ORGANIZATION CHART

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

Capital Expenditures

Credit Manager

Financial Planning

Tax Manager

Financial Accounting

Cost Accounting

Data Processing

Board of Directors

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1.2 THE CORPORATE FIRM

• First company problem: raise funds• 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.

FORMS OF BUSINESS ORGANIZATION

• The Sole Proprietorship• The Partnership• General Partnership• Limited Partnership• The Corporation

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A COMPARISON  Corporation Partnership

Liquidity and marketability

Shares can be easily exchanged

Subject to substantial restrictions

Voting Rights Usually each share gets one vote

General Partner is in charge; limited partners may have some voting rights

Taxation Double Partners pay taxes on distributions

Reinvestment and dividend payout

Broad latitude All net cash flow is 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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A GLOBAL PHENOMENON

• The corporate form of organization is not unique to the United States:

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1.3 THE IMPORTANCE OF CASH FLOWS

• If the firm is to prosper, it must:• Buy assets that generate more cash than they

cost• Sell financial instruments that raise more cash

than they cost

• The successful firm generates more cash than it uses

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THE CONCEPTUAL FLOW OF CASH

Ultimately, the firm must be a cash generating activity.

The cash flows from the firm must exceed the cash flows from the financial markets.

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CASH FLOW ≠ ACCOUNTING INCOME

• Do not confuse cash flow and accounting income• Non-Cash expense example: Depreciation• Non-Cash revenue example: Sales on Account

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1.4 THE GOAL OF FINANCIAL MANAGEMENT

•What is the correct goal?• Maximize profit?• Minimize costs?• Maximize market share?• Maximize shareholder wealth?

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1.5 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

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AGENCY COST

• Cost of Conflict of Interest• Example:• Large investment positions firm for long term

positive cash flow but has risk in short run• Owners want this investment – Increases firm value• Managers object – Risk may have personal cost

• If managers prevail, foregone long term cash flow is the Agency Cost

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MANAGEMENT GOALS

• Management goals may be different from shareholder goals• Expensive perquisites• Survival• Independence

• Increased growth and size • Often lead to management reward• Not necessarily in best interest of shareholders

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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• Influence of other stakeholders

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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 Act of 2002 (“Sarbox”)• Increased reporting requirements and responsibility of

corporate directors• Personal consequences for non-compliance

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QUICK QUIZ

• What are the three basic questions Financial Managers must 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 major regulations impact public firms?