Prepared by Ingrid McLeod-Dick Schulich School of Business © 2015 McGraw–Hill Ryerson Limited All Rights Reserved Introduction to Corporate Finance Chapter

Prepared by

Ingrid McLeod-DickSchulich School of Business

© 2015 McGraw–Hill Ryerson LimitedAll Rights Reserved

Introduction to Corporate Finance

Chapter One

1-2

© 2015 McGraw–Hill Ryerson Limited

Chapter Outline

1.1 What is Corporate Finance?

1.2 Corporate Securities as Contingent Claims on Total Firm Value

1.3 The Corporate Firm

1.4 Goals of the Corporate Firm

1.5 Financial Institutions, Financial Markets, and the Corporation

1.6 Trends in Financial Markets and Management

1.7 Outline of the Text

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What is Corporate Finance?

Corporate Finance addresses the following three questions:

1. In what long-lived assets should the firm invest?

2. How can the firm raise cash for required capital expenditures?

3. How should short-term operating cash flows be managed?

LO 1.1

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The Balance-Sheet Model of the Firm (Figure 1.1)

Current Assets

Long-term Assets

1 Tangible

2 Intangible

Total Value of Assets:

Shareholders’ Equity

Current Liabilities

Long-Term Debt

Total Firm Value to Investors:

LO 1.1

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Current Assets

Long-term Assets

1 Tangible

2 Intangible


Current Liabilities

Long-Term Debt

What long-term investments should the firm engage in?

The Capital Budgeting Decision

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How can the firm raise the money for the required investments?

The Capital Structure Decision

Current Assets

Long-term Assets

1 Tangible

2 Intangible


Current Liabilities

Long-Term Debt

LO 1.1

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How much short-term cash flow does a company need to pay its bills?

The Net Working Capital Investment Decision

Net Working Capital


Current Liabilities

Long-Term Debt

Current Assets

Long-term Assets

1 Tangible

2 Intangible

LO 1.1

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Capital Structure (Figure 1.2)

The value of the firm can be thought of as a pie.

The goal of the manager is to increase the size of the pie.

The Capital Structure decision can be viewed as how best to slice up the pie.

If, how you slice the pie affects the size of the pie, then the capital structure decision matters.

50% Debt

50% Equity

25% Debt

75% Equity

70% Debt

30% Equity

LO 1.1

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Hypothetical Organization Chart (Figure 1.3)

Chairman of the Board and Chief Executive Officer (CEO)

Board of Directors

President and Chief Operating Officer (COO)

Treasurer Controller

Cash Manager

Capital Expenditures

Credit Manager

Financial Planning

Tax Manager

Financial Accounting

Cost Accounting

Data Processing

Vice President Finance

LO 1.1

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The Financial Manager

To create value, the financial manager should:

1. Try to make smart investment decisions– Buy assets that generate more cash than they

cost

2. Try to make smart financing decisions– Sell bonds, shares and other financial

instruments that raise more cash than they cost

LO 1.1

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Cash flowfrom firm (C)

The Firm and the Financial Markets (Figure 1.4)

Tax

es (E)

Firm

Government

Firm issues securities (A)

Retained cash flows (D)

Investsin assets(B)

Dividends anddebt payments (F)

Current assetsLong-term assets

Financialmarkets

Short-term debt

Long-term debt

Equity shares

Ultimately, the firm must be a cash generating activity.

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

LO 1.1

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Cash Flows

• Identification of cash flows– Reporting of sales versus collection of cash

– Reporting of expenses versus payment of expenses

• Timing of cash flows– A dollar received today is worth more than a dollar

received next year

• Risk of cash flows– Amount and timing of future cash flows is not certain

– Investors prefer to receive cash flows earlier than later

LO 1.1

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Corporate Securities as Contingent Claims on Total Firm Value

• Debt - a promise by the borrowing firm to repay a fixed dollar amount by a certain date.

• The shareholder’s claim on firm value is the residual amount that remains after the debtholders are paid.

• If the value of the firm is less than the amount promised to the debtholders, the shareholders get nothing.

LO 1.2

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Debt and Equity as Contingent Claims (Figure 1.5)

$F

$F

Payoff to debt holders

Value of the firm (X)

Debt holders are promised $F. If the value of the firm is less than $F, they get whatever the firm is worth.

If the value of the firm is more than $F, debt holders get a maximum of $F.

$F

Payoff to shareholders


If the value of the firm is less than $F, shareholders get nothing.

If the value of the firm is more than $F, share holders get everything above $F.

Algebraically, the bondholder’s claim is: Min[$F,$X]

Algebraically, the shareholder’s claim is: Max[0,$X – $F]

LO 1.2

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Combined Payoffs to Debt and Equity (Figure 1.5)

$F

$F

Combined Payoffs to debt holders and shareholders


Debt holders are promised $F.

Payoff to debt holders

Payoff to shareholders

If the value of the firm is less than $F, the shareholder’s claim is: Max[0,$X – $F] = $0 and the debt holder’s claim is Min[$F,$X] = $X.

The sum of these is = $X

If the value of the firm is more than $F, the shareholder’s claim is: Max[0,$X – $F] = $X – $F and the debt holder’s claim is:

Min[$F,$X] = $F.

The sum of these is = $X

LO 1.2

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1.3 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.

LO 1.3

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Forms of Business Organization• The Sole Proprietorship• The Partnership

– General Partnership– Limited Partnership

• The Corporation• The Income Trust

• Advantages and Disadvantages– Liquidity and Marketability of Ownership– Control– Liability– Continuity of Existence– Tax Considerations

LO 1.3

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A Comparison of Partnership and Corporations Corporation Partnership

Liquidity and marketability Shares can easily be 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 taxation with dividend tax credit

Partnership income is taxable at partner level

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 of existence Perpetual life Limited life

LO 1.3

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Forms of Business Organization• Corporate structure separates ownership from

management – Advantages:

• Ease of ownership changes• Perpetual life and succession• Limited liability

LO 1.3

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Goals of the Corporate Firm

• What are firm decision-makers hired to do?– Managers of the corporation are obliged to make

efforts to maximize shareholder wealth

LO 1.4

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The Set-of-Contracts Perspective

• The firm can be viewed as a set of contracts.• One of these contracts is between shareholders and

managers.• The managers will usually act in the shareholders’

interests.– The shareholders can devise contracts that align the

incentives of the managers with the goals of the shareholders.

– The shareholders can monitor the managers’ behaviour.

• This contracting and monitoring is costly.– These costs are agency costs that arise from conflicts f

interest between managers and shareholders

LO 1.4

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Managerial Goals

• Managerial goals may be different from shareholder goals– Expense preferences– Survival– Independence– Self-sufficiency

• Increased growth and size of firm are not necessarily the same thing as increased shareholder wealth.

LO 1.4

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Separation of Ownership and Control

Board of Directors

Management

AssetsDebt

Equity

Shareholders

Debtholders

LO 1.4

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The Agency Problem O1.

• The agency relationship

• Will managers work in the shareholders’ best interests?– Agency costs

– Direct agency costs– Indirect agency costs

• Control of the firm

• How do agency costs affect firm value (and shareholder wealth)?

LO 1.4

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Do Shareholders Control Managerial Behaviour?

• Shareholders vote for the board of directors, who in turn hire the management team.

• Contracts can be carefully constructed to be incentive compatible.

• There is a market for managerial talent—this may provide market discipline to the managers—they can be replaced.

• If the managers fail to maximize share price, they may be replaced in a hostile takeover.

LO 1.4

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Stakeholders

• In addition to shareholders and management, employees, customers, suppliers, and the public all have a financial interest in the firm and its decisions.

• Different stakeholders may have different goals.

• What’s ethical or socially responsible investing?– Does it create value?

LO 1.4

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Direct finance

LoansFinancial intermediaries

Deposits

Financial Institutions, Financial Markets, and the Corporation (Figure 1.6)

• Financial Institutions

Indirect finance

Funds suppliers

Funds demanders

Financial intermediaries

Funds suppliers

Funds demanders

LO 1.5

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Financial Markets

Money versus Capital Markets

• Money Markets

– For short-term debt instruments

• Capital Markets

– For long-term debt and equity

LO 1.5

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Financial Markets

Primary versus Secondary Markets• Primary Market

– When a corporation issues securities, cash flows from investors to the firm.

– Usually an underwriter is involved

• Secondary Markets– Involve the sale of “used” securities from one investor

to another.– Securities may be exchange traded or trade over-the-

counter in a dealer market.

LO 1.5

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Financial Markets

FirmsInvestors

Secondary Market

money

securitiesSueBob

Stocks and Bonds

Money

Primary Market

LO 1.5

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Listing

• Listing on an organized exchange• Enhances trading liquidity

• cross list on domestic and foreign exchanges

• Facilitates raising equity• To be listed, firms must meet certain minimum criteria.• Listing on Canadian exchange – “comply or explain”

regime• Listing on U.S. exchange– significant disclosure

requirement (SOX) and compliance costs

LO 1.5

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Foreign Exchange Market

• Foreign exchange market is the world’s largest financial market for trading currencies

• Is an over-the-counter market.

• Many different types of participants:• Importers and exporters• Portfolio managers• Foreign exchange brokers• Traders

LO 1.5

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Trends in Financial Markets and Management• Integration and globalization

• Increased risk from volatility

• Financial Engineering reduces costs related to

– Risk

– Taxes

– Financing costs

• Improved computer technology allows economies of scale and scope

LO 1.6

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Trends in Financial Markets and Management (cont.)

• Deregulation is opening the possibility for further changes.

• Recent financial crisis: causes and recovery.

• These trends have made financial management a much more complex and technical activity.

LO 1.6

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Outline of the Text

I. Overview

II. Value and Capital Budgeting

III. Risk

IV. Capital Structure and Dividend Policy

V. Long-Term Financing

VI. Options, Futures, and Corporate Finance

VII. Short-Term Finance

VIII.Special Topics

LO 1.7

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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 is the difference between a primary

market and a secondary market?

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Chapter Summary

Introduces:

•Ways for financial managers to increase the value of the firm by managing:

– investments in assets;– capital structure - debt and equity; and– net working capital.

•Different forms of business organization

•Role and classification of financial markets

•Latest trends in financial management

Documents

Prepared by Ingrid McLeod-Dick Schulich School of Business © 2015 McGraw–Hill Ryerson Limited All Rights Reserved Introduction to Corporate Finance Chapter