Introduction to Corporate Finance

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Chapter 1

• Introduction to Corporate Finance

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Overview

• What is corporate finance?
• What are financial managers hired to do?
• What are the basic forms of business?
• What is the goal of financial management?

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What is Finance?

• Economics
• The study of the allocation of scarce resources
• Finance
• Applied economics that incorporates to
  economics the passage of time and the
  uncertainty of risk

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What is Finance?

• Three interrelated areas of finance
• Money and Capital Markets
• Investments
• Corporate Finance

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Corporate Finance

• Some important questions that are answered using
  finance
• What long-term investments should the firm take
  on?
• Where will we get the long-term financing to pay
  for the investment?
• How will we manage the everyday financial
  activities of the firm?

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Financial Management Decisions

• Capital Budgeting
• The process of planning expenditures on assets
  whose cash flows are expected to extend beyond
  one year.
• Capital Structure
• The mix of debt, preferred stock, and common
  equity with which the firm plans to raise
  capital.
• Working Capital
• A firms short-term assets and liabilities.

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Alternative Forms of Business Organization

• Sole proprietorship
• Partnership
• Corporation

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Sole Proprietorship

• Pros
• Easy to form
• The least regulated
• Control of profits
• Flexibility and control of decision making
• Cons
• Unlimited liability
• Fragile business existence
• Difficulty of raising capital and financing

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Partnership

• General partnership
• Limited partnership
• Pros and cons are similar to those of sole
  proprietorship.
• Limited Liability Partnership (LLP) also called
  Limited Liability Company (LLC)

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Corporation

• Pros
• Unlimited life
• Easy transferability of ownership
• Limited liability
• Ease of raising capital
• Cons
• Double taxation

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The Goal of Financial Management

• What are financial managers hired to do?
• General motors is not in the business of making
  automobiles. General motors is in the business of
  making money.
• Alfred P. Sloan
• What are possible goals of financial management?

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The Goal of Financial Management

• Three equivalent goals of financial management
• Maximize shareholder wealth
• Maximize share price
• Maximize firm value

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Value Maximization and Ethics

• It is not from the benevolence of the butcher,
  the brewer, or the baker, that we expect our
  dinner, but from their regard to their own
  interest. We address ourselves, not to their
  humanity but to their self-love, and never talk
  to them of our own necessities but of their
  advantages.
• Adam Smith, An Inquiry into the Nature and
  Causes of the Wealth of Nations, 1776

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What Stops Financial Managers?

• Law
• Unwritten agreements of fair play
• Reputation

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Do Managers Really Maximize Firm Value?

• Separation of ownership and management
• The Agency Problem
• Between stockholders and management
• Between stockholders and bondholders

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Types of Agency Costs

• Direct agency costs
• Expenditures to monitor managerial actions
• Corporate expenditure that benefits the managers
  but not the shareholders
• Expenditures to structure the organization so
  that the possibility of undesirable management
  action is minimized
• Indirect agency costs
• Cost of a lost opportunity

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Controlling the Managers

• Tying compensation to performance
• Bonus based on performance
• Stock option plans
• Phantom stocks
• The board of directors
• The threat of firing
• The threat of takeover
• Monitoring by specialists

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Cash Flows between the Firm and the Financial
Markets