Theory of Corporate Finance RWJChapter 1 What is

+ Theory of Corporate Finance RWJ-Chapter 1

+ What is Corporate Finance? n What long-term investments should the firm engage in? n n How can the firm raise money for the required investments? n n n Capital Budgeting: The process of planning and managing a firm’s longterm investments Investment opportunities: value vs. cost of these opportunities What do we need to learn? Capital Structure: The mixture of debt and equity to support long-term investments What do we know? And Why is important? How much short-term cash flow does a company need to pay its bills? n n Working Capital Management: Capital required for the firm’s day to day activities (current assets and liabilities) What do we know? And why is it important?

+ What is our Strategy? n We learn: n The basic tools to answer these questions n Financial Statements n Cost of Equity n Cost of Debt n Project Evaluation n Firm and Bond Valuations n To link these tools in our 3 fundamental questions n Moreover, corporate finance is a very important tool for investments? Why?

+ Let’s examine these questions in a Balance-Sheet Model The Capital Budgeting Decision Current Liabilities Current Assets Fixed Assets 1. Tangible 2. Intangible What long-term investments should the firm engage? Long-Term Debt Shareholders’ Equity

+ The Capital Structure Decision Current Liabilities Current Assets Fixed Assets 1. Tangible 2. Intangible How can the firm raise the money for the required investments? Long-Term Debt Shareholders’ Equity

+ The Net Working Capital Investment Decision Current Liabilities Current Assets Net Working Capital Fixed Assets 1. Tangible 2. Intangible How much short-term cash flow does a company need to pay its bills? Long-Term Debt Shareholders’ Equity

+ Goals of Financial Management n Maximize the current value of the firm. n n How can a financial manager do it? n Identify the best investments n Find the best financial arrangements (i. e. , best capital structure) Who are the owners of the firm? n Shareholders: “Residual Owners”

+ Agency Problem and Agency Cost n Agency problem exists whenever the principal hires another agent to represent his/her interest n Two types of agency problems: n n Between shareholders and managers (equity-related agency problems) n Between shareholders and bondholders (debt-related agency problems) Agency costs: the costs of devising appropriate incentives for managers and then monitoring their behavior

+ Agency Problem between Shareholders and Managers n n Managerial goals may be different from shareholder goals n Expensive perquisites n Risk aversion (managers might be more risk averse) n Free cash related problems (Hubris) How can shareholders control managerial behavior? n Directors (Board of Directors) n BOD can devise compensation plan to align the management incentives n BOD can also fire badly performing managers