What is Corporate Finance

1
What is Corporate Finance?

• Corporate Finance is the study of decisions that
  firms make
• What is a firm?
• Any business in any area of economic activity,
  large or small, private or publicly traded
• Firms own assets that generate earnings and seek
  to invest and grow

2
Principles of Corporate Finance

• Investment Principle Invest in projects that
  yield a return greater than the minimum
  acceptable hurdle rate (Ch. 10)
• Returns on projects should be measured in terms
  of cash flows generated and the timing of these
  cash flows (Ch. 9, 12)
• The hurdle rate should be higher for riskier
  projects and reflect the financing mix used (debt
  or equity) (Ch. 7,8)

3

• The Financing Principle Choose a financing mix
  that minimizes the hurdle rate and matches the
  assets being financed (Ch. 16-18)
• Is there an optimal financing mix and, if so,
  what is it?
• Debt is beneficial as long as the marginal
  benefits exceed the marginal costs

4

• The Dividend Principle If there are not enough
  investments that earn the hurdle rate, return the
  cash to stockholders (Ch. 21)
• How much of the cash flows generated by the
  firms assets should be reinvested?
• How much of the cash flows should be returned to
  stockholders?

5
The Objective of the Firm

• The objective in corporate finance is to maximize
  the value of the firm
• How do we measure the value of the firm?
• Historical or book value of firms assets not a
  good choice
• Market value of firms assets is preferred. This
  is determined by the cash flows that the firms
  assets are expected to generate and the
  uncertainty of these cash flows

6
From maximizing firm value to maximizing
stockholder wealth

• A narrower objective in corporate finance is to
  maximize stockholder wealth
• In the case of a publicly traded firm, and when
  markets are viewed to be efficient, this is
  further narrowed to maximizing the stock price

7
Why do we focus on stock price as opposed to firm
value?

• Stock price is easily observable and constantly
  updated
• If investors are rational (?) stock prices
  reflect both the short- and the long-term effects
  of a firms decisions
• Stock price is a real measure of stockholder
  wealth since stockholders can sell their stock
  and receive the price now

8
Are things that simple in reality?

• Various groups associated with a firm
  (stockholders, lenders/bondholders, managers,
  society) have conflicting interests
• These conflicts create costs for the firm called
  agency costs
• In the presence of agency costs, stock price
  maximization may no be achieved

9
Stock price maximization breaks down because

• The interests of managers conflict with the
  interests of stockholders
• Lenders are not protected against expropriation
  by stockholders
• Financial markets do not operate efficiently and
  stock prices do not reflect the true value of the
  firm
• Significant social costs can be created as a
  by-product of stock price maximization

10
What can be done then?

• Choose a different mechanism for corporate
  governance
• Choose a different objective maximize stock
  price, but
• Reduce the potential for conflict by making
  managers into stockholders
• Provide honest and prompt information to markets

11
Additional topics

• Basic tools to examine all of the above issues
• Time value of money (Ch. 3)
• Understanding financial statements (Ch. 4)
• Asset/Firm valuation (Ch. 5)
• Risk and return (Ch. 6)
• Other topics of interest
• Mergers and acquisitions (Ch. 26)