Chapter 1 Introduction to Corporate Finance Mc GrawHillIrwin

Chapter 1 Introduction to Corporate Finance Mc. Graw-Hill/Irwin Copyright © 2007 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Key Concepts and Skills q Know the basic types of financial management decisions and the role of the Financial Manager q Know the financial implications of the various forms of business organization q Know the goal of financial management q Understand the conflicts of interest that can arise between owners and managers q Understand the various types of financial markets Mc. Graw-Hill/Irwin Copyright © 2007 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Chapter Outline 1. 1 What is Corporate Finance? 1. 2 The Corporate Firm 1. 3 The Goal of Financial Management 1. 4 The Agency Problem and Control of the Corporation 1. 5 Financial Markets Mc. Graw-Hill/Irwin Copyright © 2007 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

1. 1 What is Corporate Finance? 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? Mc. Graw-Hill/Irwin Copyright © 2007 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Balance Sheet Model of the Firm Total Value of Assets: Current Assets Total Firm Value to Investors: Current Liabilities Long-Term Debt Fixed Assets 1 Tangible 2 Intangible Mc. Graw-Hill/Irwin Shareholders’ Equity Copyright © 2007 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

The Capital Budgeting Decision Current Liabilities Current Assets Long-Term Debt Fixed Assets 1 Tangible 2 Intangible Mc. Graw-Hill/Irwin What long-term investments should the firm choose? Shareholders’ Equity Copyright © 2007 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

The Capital Structure Decision Current Liabilities Current Assets How should the firm raise funds for the selected Fixed Assets investments? 1 Tangible 2 Intangible Mc. Graw-Hill/Irwin Long-Term Debt Shareholders’ Equity Copyright © 2007 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Short-Term Asset Management Current Assets Fixed Assets 1 Tangible 2 Intangible Mc. Graw-Hill/Irwin Current Liabilities Net Working Capital How should short -term assets be managed and financed? Long-Term Debt Shareholders’ Equity Copyright © 2007 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Capital Structure 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 the pie. 70% 50% 25% 30% Debt Equity 75% 50% Equity If how you slice the pie affects the size of the pie, then the capital structure decision matters. Mc. Graw-Hill/Irwin Copyright © 2007 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

The Financial Manager’s primary goal is to increase the value of the firm by: 1. Selecting value creating projects 2. Making smart financing decisions Mc. Graw-Hill/Irwin Copyright © 2007 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Hypothetical Organization Chart Board of Directors Chairman of the Board and Chief Executive Officer (CEO) President and Chief Operating Officer (COO) Vice President and Chief Financial Officer (CFO) Treasurer Controller Cash Manager Credit Manager Tax Manager Cost Accounting Capital Expenditures Financial Planning Financial Accounting Data Processing Mc. Graw-Hill/Irwin Copyright © 2007 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

The Firm and the Financial Markets Firm issues securities (A) Invests in assets (B) Retained cash flows (F) Short-term debt Cash flow from firm (C) Dividends and debt payments (E) Taxes (D) Current assets Fixed assets Ultimately, the firm must be a cash generating activity. Mc. Graw-Hill/Irwin Financial markets Government Long-term debt Equity shares The cash flows from the firm must exceed the cash flows from the financial markets. Copyright © 2007 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

1. 2 The Corporate Firm o o 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. Mc. Graw-Hill/Irwin Copyright © 2007 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Forms of Business Organization o o The Sole Proprietorship The Partnership n n o General Partnership Limited Partnership The Corporation Mc. Graw-Hill/Irwin Copyright © 2007 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

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 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 Perpetual life Limited life Mc. Graw-Hill/Irwin Copyright © 2007 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

1. 3 The Goal of Financial Management o What is the correct goal? n n Mc. Graw-Hill/Irwin Maximize profit? Minimize costs? Maximize market share? Maximize shareholder wealth? Copyright © 2007 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

1. 4 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 Mc. Graw-Hill/Irwin Copyright © 2007 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Managerial Goals o Managerial goals may be different from shareholder goals n n n o Expensive perquisites Survival Independence Increased growth and size are not necessarily equivalent to increased shareholder wealth Mc. Graw-Hill/Irwin Copyright © 2007 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Managing Managers o Managerial compensation n Incentives can be used to align management and stockholder interests n The incentives need to be structured carefully to make sure that they achieve their intended goal o Corporate control n The threat of a takeover may result in better management o Other stakeholders Mc. Graw-Hill/Irwin Copyright © 2007 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

1. 5 Financial Markets o Primary Market n o Issuance of a security for the first time Secondary Markets n n Buying and selling of previously issued securities Securities may be traded in either a dealer or auction market o o Mc. Graw-Hill/Irwin NYSE NASDAQ Copyright © 2007 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Financial Markets Firms Stocks and Bonds Investors Money Bob securities Sue money Primary Market Secondary Market Mc. Graw-Hill/Irwin Copyright © 2007 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Quick Quiz o What are three basic questions Financial Managers must answer? o What are three major forms of business organization? o What is the goal of financial management? o What are agency problems, and why do they exist within a corporation? o What is the difference between a primary market and a secondary market? Mc. Graw-Hill/Irwin Copyright © 2007 by The Mc. Graw-Hill Companies, Inc. All rights reserved.