Business Finance I Chapter 1

Introduction to Corporate Finance

Professor: Michael Epping

Book Used and copyrighted by:

Brealey,Myers, and Allen

Principles of Corporate Finance

11th Global Edition

1-1 Corporate Investment and Financing Decisions

What Is a Corporation?

Legal entity, owned by shareholders

Can make contracts, carry on business, borrow, lend, sue, and be sued

Shareholders have limited liability and cannot be held personally responsible for corporations debts

1-2 The Financial Goal of the Corporation

Stockholders Want Three Things

To maximize current wealth

To transform wealth into most desirable time pattern of consumption

To manage risk characteristics of chosen consumption plan

Profit Maximization

Not a well-defined financial objective

Which years profits?

Shareholders will not welcome higher short-term profits if long-term profits are damaged

Company may increase future profits by cutting years dividend, investing freed-up cash in firm

Not in shareholders best interest if company earns less than opportunity cost of capital

1-2 The Financial Goal of the Corporation

Shareholders desire wealth maximization

Managers have many constituencies, stakeholders

Agency Problems represent the conflict of interest between management and owners

1-1 Corporate Investment and Financing Decisions

Real Assets

Used to produce goods and services

Financial Assets/Securities

Financial claims on income generated by firms real assets

Capital Budgeting/Capital Expenditure (CAPEX)

Decision to invest in tangible or intangible assets

Financing Decision

Sale of financial assets

Capital Structure

Choice between debt and equity financing

Table 1.1 Recent Investment/ Financing Decisions Company Recent Investment Decisions Recent Financing Decisions

Boeing (U.S.) Delivers first Dreamliner after investing a reported $30 billion in development costs.

Reinvests $1.7 billion of profits.

ExxonMobil (U.S.)

Spends $7 billion to develop oil sands at Fort McMurray in Alberta.

Spends $12 billion buying back shares.

GlaxoSmith-Kline (UK)

Spends $4 billion on research and development for new drugs.

Pays $3.2 billion as dividends.

LVMH (France) LVMH acquires the Italian Jeweler, Bulgari, for $5 billion.

Pays for the acquisition with a mixture of cash and shares.

Procter & Gamble (U.S.)

Spends $8 billion on advertising. Raises 100 billion Japanese yen by an issue of 5-year bonds.

Tata Motors (India)

Opens a plant in India to produce the world's cheapest car, the Nano. The facility costs $400 million.

Raises $400 million by the sale of new shares.

Union Pacific (U.S.)

Invests $330 million in 100 new locomotives and 10,000 freight cars and chassis.

Repays $1.4 billion of debt.

Vale (Brazil) Opens a copper mine at Salobo in Brazil. The project cost nearly $2 million.

Maintains credit lines with its banks that allow the company to borrow at any time up to $1.6 billion.

Walmart (U.S.) Invests 12.7 billion, primarily to open 458 new stores around the world.

Issues $5 billion of long-term bonds in order to repay short-term commercial paper borrowings.

Principle 1:

The Risk-Return Trade-off Would you invest your savings in the stock market if it offered the same expected return as your bank?

We wont take on additional risk unless we expect to be compensated with additional return.

The higher the risk of an investment, the higher will be its expected return.

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The Risk-Return Trade-off

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Principle 2:

The Time Value of Money

A dollar received today is worth more than a dollar to be received in the future.

Because we can earn interest on money received today, it is better to receive money earlier rather than later.

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Principle 3:

CashNot ProfitsIs King

In measuring wealth or value, we use cash Flow, not accounting profit, as our measurement tool.

Cash flows are actually received by the firm and can be reinvested. On the other hand, profits are recorded when they are earned rather than when money is actually received.

It is possible for a firm to show profits on the books but have no cash!

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Principle 4:

Incremental Cash Flows

The incremental cash flow is the difference between the projected cash flows if the project is selected, versus what they will be, if the project is not selected.

This difference reflects the true impact of a decision.

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Principle 5:

The Curse of Competitive Markets

It is hard to find exceptionally profitable projects.

If an industry is generating large profits, new entrants are usually attracted. The additional competition and added capacity can result in profits being driven down to the required rate of return.

Product Differentiation (through Service, Quality) and cost advantages (through economies of Scale) can insulate products from competition.

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Principle 6:

Efficient Capital Markets The values of securities at any instant in time fully reflect all publicly available information.

Prices reflect value and are right.

Price changes reflect changes in expected cash flows (and not cosmetic changes such as accounting policy changes). Good decisions drive up the stock prices and vice versa.

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Principle 7:

The Agency Problem

The separation of management and the ownership of the firm creates an agency problem.

Managers may make decisions that are not in line with the goal of maximization of shareholder wealth.

Agency conflict reduced through monitoring (ex. Annual reports), compensation schemes (ex. stock options), and market mechanisms (ex. Takeovers).

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Principle 8:

Taxes Bias Business Decisions

The cash flows we consider for decision making are the after-tax incremental cash flows to the firm as a whole.

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Principle 9:

All Risk is Not Equal

Some risk can be diversified away, and some cannot.

The process of diversification can reduce risk, and as a result, measuring a projects or an assets risk is very difficult. A projects risk changes depending on whether you measure it standing alone or together with other projects the company may take on.

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All Risk is Not Equal

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Principle 10: Ethical Behavior Is Doing the Right Thing, and Ethical

Dilemmas Are Everywhere in Finance

Ethical dilemma Each person has his or her own set of values, which forms the basis for personal judgments about what is the right thing.

Ethics are relevant in business and unethical decisions can destroy shareholder wealth (ex. Enron Scandal).

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