Chapter 1 Introduction to Corporate Finance Chapter Outline

Chapter 1 Introduction to Corporate Finance

Chapter Outline o o o Corporate Finance and the Financial Manager Forms of Business Organization The Goal of Financial Management The Agency Problem and Control of the Corporation Financial Markets and the Corporation 1 -1

Corporate Finance addresses the following three questions: 1. 2. 3. What long-term investments should the firm choose? How should the firm raise funds for the selected investments? How should short-term assets be managed and financed? 1 -2

Financial Manager o Owners (shareholders) of large corporations are usually not directly involved in making business decisions They employ managers to represent their interests and make decisions on their behalf. o Financial managers are in charge of answering the three questions. o The top financial manager within a firm is usually the Chief Financial Officer (CFO). 1 -3

Financial Management Decisions o Capital budgeting n n o Capital structure n n o What long-term investments or projects should the business take on? Financial manager tries to identify investment opportunities that are worth more to the firm than they cost to acquire CF generated by an asset exceeds its cost. How should we pay for our assets? Should we use debt or equity? Working capital management n How will we manage the everyday financial activities of the firm? 1 -4

Net Working Capital o Net Working Capital = CA – CL o Positive NWC means that the company is able to pay off its short-term liabilities. o Negative NWC means that a company currently is unable to meet its short-term liabilities with its current assets It might lead to Bankruptcy. 1 -5

Forms of Business Organization o The Sole Proprietorship o The Partnership n n o General Partnership Limited Partnership The Corporation 1 -6

Sole Proprietorship o It is a business owned by one person. o No corporate income taxes All profits of the business are taxed as individual income. o Unlimited liability for business debts and obligations No distinction is made between personal and business assets. o The amount of equity that can be raised is limited to the amount of the proprietor’s personal wealth. 1 -7

Sole Proprietorship o Advantages n n Easiest to start Least regulated Single owner keeps all the profits Taxed once as personal income o Disadvantages n n Limited to life of owner Equity capital limited to owner’s personal wealth Unlimited liability Difficult to sell ownership interest 1 -8

Partnership o General Partnership: All partners agree to provide some fraction of the work and cash and to share the profits and losses. • o General partners have unlimited liability for all debts If one general partner is unable to meet his/her commitment, the shortfall must be made up by other general partners. Limited Partnership: It permits the liability of some of the partners to be limited to the amount of cash each has contributed to the partnership. • In general, the limited partner doesn’t participate in managing the business. 1 -9

Partnership o Advantages n n Two or more owners More capital available Relatively easy to start Income taxed once as personal income o Disadvantages n Unlimited liability o n Limited life o n General Partnership dissolves when one partner dies or wishes to sell Difficult to transfer ownership 1 -10

Corporation o The separation of ownership from management gives the corporation several advantages: • Limited Liability Ease of ownership Transfer The corporation has unlimited life • • o These advantages give the corporation an enhanced ability to raise cash (unlike Partnership & Sole Proprietorship) o The main disadvantage is double taxation Corporate Income Tax + Personal Income Tax (that shareholders pay on dividend income they receive) 1 -11

A Comparison Corporation Partnership Liquidity Shares can be easily 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 Partners pay taxes on distributions (Taxes on personal Income only) Reinvestment and dividend payout Corporations have a broad freedom on dividend payout decisions All net cash flow is distributed to partners. Partners are generally prohibited from reinvesting partnership profits. Liability Limited liability General partners may have unlimited liability; limited partners enjoy limited liability Continuity Unlimited life Limited life 1 -12

The Goal of Financial Management o What is the correct goal? n n n o Maximize profit? Maximize Sales? Minimize costs? Avoid Bankruptcy? Maximize shareholder wealth? The goal of financial management in a corporation is to maximize the current value per share of the existing stock. 1 -13

The Agency Problem o Agency relationship n Principal hires an agent to represent his/her interest n Stockholders (principals) hire managers (agents) to run the company o Agency problem n Conflict of interest between principal and agent The managers might not act in the best interest of shareholders. 1 -14

Management Goals o Managerial goals may be different from shareholder goals n n o Expensive perquisites (ex: buying a luxurious corporate jet) Survival Managers might not take an investment (because it is relatively risky) although it is expected to increase the share value. Managers might try to maximize the amount of resources over which they have control and power This leads to an overemphasis on corporate size and growth. n n Increased growth and size are not necessarily equivalent to increased shareholder wealth. Example: Management may overpay to buy up another company just to increase the size of the business or to demonstrate corporate power This does not benefit shareholders. 1 -15

Managing Managers o Managerial compensation n n o Incentives can be used to align management and stockholder interests The incentives need to be structured carefully to make sure that they achieve their intended goal Managerial compensation can be tied to the share value. Corporate control n The threat of a takeover may result in better management Those firms that are poorly managed are more attractive as acquisitions than wellmanaged firms because a greater profit potential exists. 1 -16

Financial Markets and the Corporation Firm issues securities (A) Firm Invests in Assets (B) in assets Retained cash flows (F) (B) Current Assets Current. Assets assets Fixed Debt Equity shares Short-term debt Cash flow from firm (C) Dividends and debt payments (E) Taxes (D) Fixed assets Financial markets Ultimately, the firm must be a cash generating activity. Government Long-term debt Equity shares The cash flows from the firm must exceed the cash flows from the financial markets. 1 -17

Financial Markets o Primary Market n n o Issuance of a security for the first time Corporation is the seller Transaction raises money for the corporation. Secondary Markets n n Buying and selling of previously issued securities (One owner sells to another) Securities may be traded in either a dealer or auction market o o Auction Market: Brokers match buyers and sellers but they do not actually own the commodity that is bought or sold. Dealer Market (Over the Counter): Dealers buy and sell for themselves, at their own risk. 1 -18

Financial Markets Firms Stocks and Bonds Money Investors Bob securities Sue money Primary Market Secondary Market 1 -19