Chapter One Overview of Corporate Finance One Overview of Corporate Finance ... • Capital budgeting analyst/manager ... –cash flows available to common shareholders

© 2005 Pearson Education Canada Inc.

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Chapter One

Overview of Corporate Finance

Principles of Corporate Finance

Canadian Edition

Lawrence J. Gitman and Sean Hennessey


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Learning Goals

LG1 – Define finance and describe its three major areas and career opportunities.

LG2 – Review basic forms of business organization, their strengths and weaknesses.

LG3 – Describe managerial finance function and differentiate from economics and accounting.


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Learning Goals (continued)

LG4 – Identify key activities of financial manager within the firm.

LG5 – Explain why wealth maximization is firm’s goal.

LG6 – Explain how EVA, stakeholder focus, and ethical behaviour relate to firm’s goal.

LG7 – Discuss agency issue as it relates to owner wealth maximization.


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What is Finance?

• At the macro level, finance is the study of financial

institutions and financial markets and how they operate

within the financial system in both the Canadian and

global economies.

• At the micro level, finance is the study of financial

planning, asset management, and fund raising for

businesses and financial institutions.

• Financial management can be described in brief using

the following balance sheet.


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What is Finance?

Assets: Liabilities & Equity:

Current Assets Current Liabilities

Cash & M.S. Accounts payable

Accounts receivable Notes Payable

Inventory Total Current Liabilities

Total Current Assets Long-Term Liabilities

Fixed Assets: Total Liabilities

Gross fixed assets Equity:

Less: Accumulated dep. Common Stock

Goodw ill Paid-in-capital

Other long-term assets Retained Earnings

Total Fixed Assets Total Equity

Total Assets Total Liabilities & Equity

Working

CapitalWorking

Capital

Investment

DecisionsFinancing

Decisions

Macro Finance


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What is Finance?

• A well-developed financial system is a hallmark and

essential characteristic of any modern developed

nation.

• Financial markets, financial intermediaries, and

financial management are the important components.

• Financial markets and financial intermediaries

facilitate the flow of funds from borrowers to savers.

• Financial management involves the efficient use of

financial resources in the production of goods.


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Areas of Specialization in Finance

• Financial Markets

– Markets of users and savers of funds.

• Financial Services

– Design and delivery of financial advice and

products to individuals, businesses, government.

• Managerial Finance

– Financial management of business firms.


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Areas of Employment in Finance

• Financial Analyst

• Capital budgeting analyst/manager

• Project finance manager

• Cash manager

• Credit analyst/manager

• Pension fund manager


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Basic Forms of Business

Organization• Sole Proprietorship

– Owned by one person, operated for personal profit.

• Partnerships

– Owned by two or more people, operated for joint

profit.

• Corporations

– “Legal entity”, owned by individuals, operated for

joint profit.


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Sole Proprietorship

STRENGTHS:

• Low organizational cost

• Income taxed once as

personal income

• Independence

• Secrecy

• Ease of dissolution

WEAKNESSES:

• Unlimited liability

• Limited funding

• Proprietor must be all

• Difficult to develop staff

career opportunities

• Lack of continuity on

death of proprietor


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Partnerships

STRENGTHS:

• Improved funding sources

• Increased managerial talent

• Income split by partnership contract, taxed as personal income

WEAKNESSES:

• Unlimited liability to

all partners

• Partnership dissolved

upon death of partner

• Difficult to liquidate

or transfer ownership


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Corporations

STRENGTHS:

• Owners’ liability limited

• Large capitalization

possible, greater funding

• Ownership readily

transferable

• Indefinite life

• Professional management

WEAKNESSES:

• Higher tax rates

• Expensive organization

• Greater government

regulation

• When publicly traded,

lacks secrecy


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Corporate Organization Chart


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Organization of Finance Functions

• CFO – Chief Financial Officer

• Treasurer responsibilities:

– Financial planning, fund raising, capital

expenditure decisions, cash and credit

management.

• Controller responsibilities:

– Corporate accounting, cost accounting, and tax

management.


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Relationship to Economics

Fundamental Economic Principle:

• Marginal Analysis

– Financial decisions should be made and actions

taken only when the added benefits exceed the

added costs.


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Relationship to Accounting

• Cash Flows

– Accrual Basis: recognizes sales revenue and

expenses incurred to make sale at time of sale.

– Cash Basis: recognizes revenues and expenses

as they occur.


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Accounting vs. Financial Views

Accounting View

(Accrual Basis)

Income Statement

Peakes Quay, Inc.

For year ended 12/31

Financial View

(Cash Basis)

Cash Flow Statement

Peakes Quay, Inc.

For year ended 12/31

Sales revenue $100,000

Less: Costs 80,000

Net Profit $ 20,000

Cash inflow $ 0

Less: Cash outflow 80,000

Net cash flow ($80,000)


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Financial Manager–Key Activities

Balance Sheet

Current

Assets

_______________

Fixed

Assets

Current

Liabilities

_______________

Long-Term Funds

(Debt & Equity)

Financial Analysis & Planning

Making

Investment

Decisions

Making

Financing

Decisions


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Should Firms Maximize Profit?

• Corporations commonly define profit as “Earnings per Share” (EPS).

– A measure of total earnings divided by total number of ownership shares.

• EPS ignores critical factors of

– the timing of the returns.

– cash flows available to common shareholders.

– risk factors facing the firm.


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Or Should Firms Maximize

Shareholder Wealth?• Evaluating Shareholder Wealth addresses

factors of timing, cash flows and risk ignored by the EPS.

• Therefore, Maximizing Shareholder Wealth is a more comprehensive goal for the firm, its managers and employees.

• This can be explored through “economic valued added” and a focus on stakeholders.


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Economic Value Added – EVA®

• EVA measures whether an investment

contributes to shareholder wealth.

• EVA is calculated by subtracting cost of

funds used from after-tax operating profits.

• While popular, EVA is essentially derived

from the concept of “net present value.”


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What about Stakeholders?

• Stakeholders include groups that have direct economic links to the firm.

• Stakeholders include not only owners, but also employees, customers, suppliers, and creditors.

• Maintaining positive stakeholder relationships helps maximize long-term benefits to shareholders.


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Importance of Ethics

The standards of conduct or moral judgment:

• Honesty, trustworthiness, fair dealing are foundations of sustainable business relations:– With customers,

– With suppliers,

– With creditors,

– With employees,

– With owners.

• Ethical behaviour is necessary to achieve the goal of maximizing shareholder wealth.


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Internal Ethical Review

• Are rights of stakeholders being violated?

• Does firm have extra duties to stakeholders?

• Will a decision unfairly discriminate benefits among stakeholders?

• If stakeholders are harmed, should this be remedied? How?

• What is the relationship between shareholders and stakeholders?


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Financial Goals of a Company

• Maximize sales.

• Maximize cash flow.

• Maximize market

share.

• Maximize profit.

• Minimize costs.

• Maximize return on

sales, investment,

equity.

• Ensure earnings

stability.

• Achieve target goals

for sales, profits,

market share or return.


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Agency Issues:

The Principal-Agent Problem

• Whenever ownership is independent of

management there exists potential problem of

conflicts.

• The owner’s goals for the firm are best described

as maximizing shareholder wealth.

• Managers are also concerned with personal

wealth, job security, lifestyle, and benefits. These

concerns may conflict with shareholder interests.


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Resolving the Agency Problem

• Good corporate governance by the Board of Directors is the heart of any resolution.

• Agency Costs – the costs of this governance:– Monitoring costs,

– Bonding costs,

– Structuring compensation costs.

• Market forces, such as the potential for hostile takeover provide some deterrence.

• Legal forces, fraud, and fiduciary misconduct laws aim to act as deterrents as well.


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Current View on Incentive Plans

• Executive compensation packages generally

include incentive plans that grant stock

options, performance-based shares, or cash

bonuses upon meeting or exceeding

corporate goals.

• Such packages may also include long-term

benefits that can protect the manager

against poor corporate performance.


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Overview of Text

Part 1: Introduction to Corporate Finance

Part 2: Financial Analysis and Planning

Part 3: Important Financial Concepts

Part 4: Long-Term Financial Decisions

Part 5: Long-Term Investment Decisions

Part 6:Working Capital Management

Part 7: Special Topics in Corporate Finance

Documents

Chapter One Overview of Corporate Finance One Overview of Corporate Finance ... • Capital budgeting analyst/manager ... –cash flows available to common shareholders