Chapter 1

Introduction to Corporate Finance

McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

Key Concepts and Skills

• Know the basic types of financial management decisions and the role of the financial manager

• Know the financial implications of the different forms of business organization

• Know the goal of financial management• Understand the conflicts of interest that can

arise between owners and managers• Understand the various types of financial

markets

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Chapter Outline

• 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

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What Is Corporate Finance?

• Corporate finance provides answers to some important questions:– What long-term investments should the

firm take on?– Where will the firm get the long-term

financing to pay for the investments?– How will the firm manage its everyday

financial activities?

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The Financial Manager

• Financial managers try to answer some or all of these questions

• The top financial manager within a firm is usually the Chief Financial Officer (CFO)– Treasurer – oversees cash management, credit

management, capital expenditures, and financial planning

– Controller – oversees taxes, cost accounting, financial accounting and data processing

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Financial Management Decisions

• Capital budgeting– What long-term investments or projects

should the business take on?

• Capital structure– How much should the firm borrow to pay for

its assets?• What is the best mixture of debt and equity?• The least expensive sources of funds?

• Working capital management– How do we manage the day-to-day finances

of the firm?1-6

Forms of Business Organization

• Three major forms – Sole Proprietorship– Partnership

• General• Limited

– Corporation• Limited Liability Company• Limited Liability Partnerships

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Sole Proprietorship

• Advantages– Easiest to start– Least regulated– Single owner keeps

all the profits– Taxed once as

personal income

• Disadvantages– Limited to life of

owner– Equity capital

limited to owner’s personal wealth

– Unlimited liability– Difficult to sell

ownership interest

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Partnership

• Advantages– Two or more

owners– More capital

available– Relatively easy to

start– Income taxed once

as personal income

• Disadvantages– Unlimited liability

• General partnership

• Limited partnership

– Partnership dissolves when one partner dies or wishes to sell

– Difficult to transfer ownership

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Corporation

• Advantages– Limited liability– Unlimited life– Separation of

ownership and management

– Transfer of ownership is easy

– Easier to raise capital

• Disadvantages– Separation of

ownership and management

– May involve double taxation in some countries (income taxed at the corporate rate and then dividends taxed at the personal rate)

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Summary of 3 Business Forms

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Goal of Financial Management

• What should be the goal of a corporation?– Maximize profits?– Minimize costs?– Maximize market share?– Maximize the current value of the company’s

stock?

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Maximizing Shareholders’ Wealth

• Maximizing the share price is equivalent to maximizing shareholders’ wealth

• Why is this a valid goal?– Decisions are made in shareholders‘

best interest– Considers cash flows not profits– Incorporates time dimension– Does not consider profitability but also

risk

The Agency Problem

• Agency relationship– The relationship exists when a principal

hires an agent to represent his/her interests

– Stockholders (principals) hire managers (agents) to run the company

• Agency problem– Conflict of interest between principal and

agent• Agent may not work in the best interest of the

principal

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Management Goals

• Management goals may be different from shareholder s’ goals– Management may be more interested in:

• Consuming expensive perks• It’s own survival • It’s independence

• Management may focus on increased growth and size rather than increasing shareholders’ wealth

Agency Costs

• Costs due to the conflict of interest between shareholders and management– Direct

• Corporate expenditure that benefits management but costs shareholders, e.g. country club membership

• Costs to monitor management actions, e.g. auditor costs

– Indirect• Lost opportunity due to management forgoing

profitable but risky projects for fear of losing job if project fails

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Managing Managers

• Managerial compensation– Incentives can be used to align management

and stockholder interests– The incentives need to be structured carefully to

make sure that they achieve their goal

• Corporate control– The threat of a takeover may result in better

management

• Other stakeholders

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Work the Web Example

• The Internet provides a wealth of information about individual companies

• One excellent site is finance.yahoo.com• Click on the web surfer to go to the site,

choose a company and see what information you can find!

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Financial Markets

• Primary market– A market where the firm sells its

securities to public for the first time

• Secondary markets– A market in which the securities issued

by firms are traded• Listed securities trade in an organized

exchange, e.g. the stock market (NYSE)• Over-the-counter securities are bought from or

sold to a dealer

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Quick Quiz

• What are the three types of financial management decisions and what questions are they designed to answer?

• What are the three major forms of business organization?

• What is the goal of financial management?• What are agency problems and why do they

exist within a corporation?• What is the difference between a primary

market and a secondary market?

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Ethics Issues

• Is it ethical for tobacco companies to sell a product that is known to be addictive and a danger to the health of the user? Is it relevant that the product is legal?

• Should boards of directors consider only price when faced with a buyout offer?

• Is it ethical to concentrate only on shareholder wealth, or should stakeholders as a whole be considered?

• Should firms be penalized for attempting to improve returns by stifling competition (e.g., Microsoft)?

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End of Chapter

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