© 2007 Thomson South-Western
Corporate Finance, 2eby Smart, Megginson, Gitman
© 2007 Thomson South-Western
Chapter 1The Scope Of Corporate Finance
Professor XXXXX
Course Name / Number
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What is Corporate Finance?
The activities involved in managing cash flows in a business environment
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The Core Principles of Finance
The time value of moneyThe opportunity to earn a return on
invested funds means that a dollar today is worth more than a dollar in the future.
Compensation for riskInvestors expect compensation for
bearing risk.
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The Core Principles of Finance
Don’t put your eggs in one basketInvestors can achieve a more
favorable trade-off between risk and return by diversifying their portfolios.
Markets are smartCompetition for information tends to
make markets efficient.
No arbitrageArbitrage opportunities are extremely
scarce.
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The 5 Basic Corporate Finance Functions
Financing(Capital-Raising)
Capital Budgeting
Financial Management
Corporate Governance
Risk Management
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The Financing Function
Businesses can raise money in 2 ways:externally from investors or creditors
IPOsPrimary market transactionsSecondary market transactions
internally by retaining operating cash flowsMost common method
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Raising Capital: Key Facts
Primary vs. secondary market transactions or offerings
Most financing from internal rather than external sources
Most external financing is debt
Financial intermediaries declining as a source of capital for large firms
Securities markets growing in importance
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The Total Value of Primary (Capital-Raising) Corporate Security Issues, 1990 –2004
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Growth in Global Security Issues
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Capital Budgeting – selecting the best
projects in which to invest the firm’s
resources
The Capital Budgeting Function
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The Capital Budgeting Function
The capital budgeting process consists of three steps.Step 1 - identifying potential
investmentsStep 2 - analyzing those investments to
identify which will create shareholder value
Step 3 - implementing and monitoring the investments selected in step 2
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The Financial Management Function
Managing daily cash inflows and outflows
Forecasting cash balances
Building a long-term financial plan
Choosing the right mix of debt and equity
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The Corporate Governance Function
Hires and promotes qualified, honest people, and structures employees’ financial incentives to motivate them to maximize firm value
In practice the incentives of stockholders, managers, and other stakeholders often conflict.
Dimensions of corporate governance: Board of directors Securities and Exchange Commission Sarbanes-Oxley Act of 2002
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Value of Global Mergers & Acquisitions
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The Risk Management Function
Identifying, measuring, and managing all types of risk exposures
Some risks are insurable, and some risks can be reduced through diversification.
Financial instruments like forwards, futures, options, and swaps may also be used to hedge market risks such as interest-rate, price, and currency fluctuations.
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Sole Proprietorshi
ps
• No Distinction Between Business & Owner
• Easy To Set Up, Operate; Business Earnings Taxed As Personal Income
• Limited Life, Limited Access to Capital, Unlimited Personal Liability
Partnerships• Two Or More Owners• Joint and Several Liability• Limited Life, Limited Access to Capital,
Unlimited Personal Liability
Limited Partnerships
• One Or More General Partners with Unlimited Personal Liability
• Most Partners are Totally Passive with Limited Liability - Limited Partners; Share of Profits Taxed as Partnership Income
Business Organizational Formsin the United States
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Are there any disadvantages for corporations? YES! Double taxation
Corporations
• Separate Legal Entity With Many of the Economic Rights & Responsibilities of Individuals
• Unlimited Life, Limited Liability, Separable Contracting, Unlimited Access to Capital
• Owned by Shareholders, Who Elect the Board of Directors
• In the U.S., Incorporation is Executed At State Level and Governed by State Law
Business Organizational Formsin the United States
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Taxation of Business IncomeAFTER the Jobs and Growth Tax Relief Reconciliation Act of 2003
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S Corporations
• Shareholders are taxed as partners while still retaining Limited Liability as Corporate Shareholders
• Status is Subject to Several Eligibility Requirements
Limited- Liability
Companies
• Combines the Partnership’s Pass-Through Taxation with the S Corporation’s Limited Liability
Business Organizational Formsin the United States
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• Britain: public limited companies (PLC)
• Germany: Aktiengesellschaft (AG)• France: Société Générale• Spain, Mexico, and elsewhere in
Latin America: Sociedad Anónima• Historically, the telephone,
television, utility, airline and railroad companies in many European countries
• Privatization programs have reduced the role of the states around the world
How much has been raised through Privatization Programs?
State-Owned Enterprises
Limited-Liability
Companies
Forms of Business OrganizationsUsed by Non-U.S. Companies
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Worldwide Privatization Revenues
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What Should a Financial Manager Try to Maximize?
Maximize Profit?Earnings per share are backward-looking,
dependent on accounting principles,Do not fully consider cash flow timing Ignores risk
Maximize Shareholder Wealth?Maximize stock price, not profitsShareholders, as residual claimants, have
better incentives to maximize firm value.
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0
5000
10000
15000
20000
25000
30000
35000
40000
1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005
US
$ in
Bill
ions
.
United States United Kingdom Japan Other Developed Emerging Markets
World Stock Market Capitalization
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Agency Costs
Managers act as agents of the owners who hired them and gave them decision-making authority to manage the firm for the owners’ benefit.
In practice however, self-interests may cause managers to pursue objectives other than shareholder-wealth maximization.
This conflict of goals gives rise to managerial agency problems.
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How Agency Costs Can Be Controlled
Ways to overcome agency problems:TakeoversMonitoring and bondingCompensation contracts
Executive compensation packages
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Importance of Ethics
Widespread publicity surrounding numerous ethical violations began with the Enron collapse in late 2001.
Society in general and the financial community in particular are developing and enforcing ethical standards.
Ethical behavior is necessary in order to maximize shareholder’s wealth.