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Copyright 2003 Pearson Education, Inc. Slide 1-0

FIN516 CORPORATE

FINANCE

LECTURE 1

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Learning Goals1.Define Corporate finance, the major areas of finance,

and the career opportunities available in this field, and

the legal forms of business organization.

2.Describe the managerial finance function and its

relationship to economics and accounting.

3. Identify the primary activities of the financial manager

within the firm.4.Explain why wealth maximization, rather than profit

maximization, is the firms goal and how the agency

issue is related to it.

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What is Corporate 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 U.S.

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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Assets: Liabilities & Equity:

Current Assets Current Liabil ities

Cash & M.S. Accounts payable

Accounts receivable Notes Payable

Inventory Total Current Liabilities

Total Current Assets Long-Term Liabilities

Fixed Assets: Total Liabilities

Gross f ixed 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

ABC CompanyBalance Sheet

As of December 31, 19xx

WorkingCapital

WorkingCapital

InvestmentDecisions

FinancingDecisions

Macro Finance

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What is Corporate 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 importantcomponents.

Financial markets and financial intermediaries

facilitate the flow of funds from savers (surplus economic units)to borrowers (deficit economic units).

Financial management involves the efficient use of financial

resources in the production of goods.

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Corporate Finance Corporate finance is concerned with the duties of the

financial manager in the business firm.

The financial manageractively manages the financial

affairs of any type of business, whether private or

public, large or small, profit-seeking or not-for-

profit.

Increasing globalization has complicated the

financial management function.

Changing economic and regulatory conditions also

complicate the financial management function.

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Basic Forms ofBusiness Organization

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Corporate Organization

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Other Limited Liability Organizations

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The Corporate Finance Function

The size and importance of the Corporate finance

function depends on the size of the firm.

In small companies, the finance function may be

performed by the company president or accounting

department.

As the business expands, finance typically evolves

into a separate department linked to the president.

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The field of finance is actually an outgrowth of

economics.

In fact, finance is sometimes referred to as financial

economics.

Financial managers must understand the economic

framework within which they operate in order to react

or anticipate to changes in conditions.

Relationship to Economics

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The primary economic principal used by financial

managers is marginal analysis which says that

financial decisions should be implemented only when

benefits exceed costs.

Relationship to Economics

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The firms finance (treasurer) and accounting

(controller) functions are closely-related and

overlapping.

In smaller firms, the financial manager generally

performs both functions.

Relationship to Accounting

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One major difference in perspective and emphasis

between finance and accounting is that accountants

generally use the accrual method while in finance, the

focus is on cash flows.

The significance of this difference can be illustrated

using the following simple example.


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Finance and accounting also differ with respect to

decision-making.

While accounting is primarily concerned with the

presentation of financial data, the financial manager is

primarily concerned with analyzing and interpretingthis

information for decision-making purposes.

The financial manager uses this data as a vital tool for

making decisions about the financial aspects of the

firm.


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Key Activities of the CorporateFinancial Manager

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Goal of the FirmMaximize Profit???

Investment Year 1 Year 2 Year 3 Total

A 2.90$ -$ -$ 2.90$

B -$ -$ 3.00$ 3.00$

EPS ($)

Which Investment is Preferred?

Profit maximization fails to account fordifferences in the level of cash flows (as

opposed to profits), the timing of these cashflows, and the risk of these cash flows.

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Goal of the FirmMaximize ShareholderWealth!!!

Why?

Because maximizing shareholder wealth properly

considers cash flows, the timing of these cash flows,

and the risk of these cash flows.

This can be illustrated using the following simple

valuation equation:

Share Price = Future Dividends

Required Return

level & timingof cash flows

risk of cashflows

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Goal of the FirmMaximize ShareholderWealth!!!

It can also be described using the following flow chart:

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Goal of the FirmEconomic Value Added (EVA)

conomic value added (EVA) is a popular measure

used by many firms to determine whether an

investment - proposed or existing - positively

contributes to the owners wealth.

EVA is calculated by subtracting the cost of funds

used to finance an investment from its after-tax

operating profits. Investments with positive EVAs increase shareholder

wealth and those with negative EVAs reduce

shareholder value.

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Goal of the FirmWhat About Other Stakeholders?

Stakeholders include all groups of individuals who have adirect economic link to the firm including:

Employees

Government

Customers

Suppliers

Creditors

Owners

The "Stakeholder View" prescribes that the firm make aconscious effort to avoid actions that could bedetrimental to the wealth position of its stakeholders.

Such a view is considered to be "socially responsible."

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Ethics is the standards of conduct or moral judgment -

have become an overriding issue in both our society

and the financial community

Ethical violations attract widespread publicity

Negative publicity often leads to negative impacts on a

firm

The Role of EthicsEthics Defined

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The Role of EthicsConsidering Ethics

To assess the ethical viability of a proposed action,

ask:

Does the action unfairly single out an individual or

group? Does the action affect the morals, or legal rights of

any individual or group?

Does the action conform to accepted moralstandards?

Are there alternative courses of action that are less

likely to cause actual or potential harm?

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Ethics programs seek to:

reduce litigation and judgment costs

maintain a positive corporate image

build shareholder confidence

gain the loyalty and respect of all stakeholders

The expected result of such programs is to positively

affect the firm's share price.

The Role of EthicsEthics & Share Price

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The Agency Issue

Whenever a manager owns less than 100% of the

firms equity, a potential agency problem exists.

In theory, managers would agree with shareholder

wealth maximization.

However, managers are also concerned with their

personal wealth, job security, fringe benefits, and

lifestyle.

This would cause managers to act in ways that do not

always benefit the firm shareholders.

The Agency Problem

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The Agency Issue

MarketForces such as major shareholders and the

threat of a hostile takeover act to keep managers in

check.

AgencyCosts may be incurred to ensure management

acts in shareholders interests. (incentive)

Resolving the Problem

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Financial Institutions & Markets

Firms that require funds from external sources can

obtain them in three ways:

through a bank or other financial institution

through financial markets

through private placements

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The Relationship between FinancialInstitutions and Financial Markets

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Both individuals and businesses must pay taxes on

income.

The income of sole proprietorships and partnerships is

taxed as the income of the individual owners, whereas

corporate income is subject to corporate taxes.

Both individuals and businesses can earn two types of

income -- ordinaryand capital gains.

Under current law, tax treatment of ordinary income

and capital gains change frequently due frequently

changing tax laws.

Business Taxes

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Ordinary income is earned through the sale of a firms

goods or services and is taxed at the rates depicted in

Table 1.4 on the following slide.

Business TaxesOrdinary Income

Example

Calculate federal income taxes due if taxable income is$80,000.

Tax = .15 ($50,000) + .25 ($25,000) + .34 ($80,000 - $75,000)

Tax = $15,450

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Business TaxationOrdinary Income

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Business TaxationAverage & Marginal Tax Rates

Example

What is the marginal and average tax rate for the previousexample?

Marginal Tax Rate = 34%

Average Tax Rate = $15,450/$80,000 = 19.31%

A firms marginal tax rate represents the rate at which

additional income is taxed.

The average tax rate is the firms taxes divided by

taxable income.

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Business TaxationDebt versus Equity Financing

Example

Two companies, Debt Co. and No Debt Co., both expect

in the coming year to have EBIT of $200,000. During the

year, Debt Co. will have to pay $30,000 in interest

expenses. No Debt Co. has no debt and will pay not

interest expenses.

In calculating taxes, corporations may deduct operating

expenses and interest expense but not dividends paid.

This creates a built-in tax advantage for using debt

financing as the following example will demonstrate.

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As the example shows, the use of debt financing can

increase cash flow and EPS, and decrease taxes paid.

The tax deductibility of interest and other certain

expenses reduces their actual (after-tax) cost to the

profitable firm.

It is the non-deductibility of dividends paid that resultsin double taxation under the corporate form of

organization.

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Business TaxationCapital Gains

A capital gain results when a firm sells an asset such

as a stock held as an investment for more than its

initial purchase price.

The difference between the sales price and the

purchase price is called a capital gain.

For corporations, capital gains are added to ordinaryincome and taxed like ordinary income at the firms

marginal tax rate.

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ppt Int. 16 (Kasi)