what is corporate finance?

Corporate FinanceLecture 01: Introduction

Course Info

• Guangyu Nie

• Office: SIBA 402

• Email: [email protected]

• Office Hours: Wednesday, 3:00 – 4:00 p.m.

mailto:[email protected]

Course Info

• Prerequisites: basic level math and statistics• Calculator: any calculator with will do.• Textbook: Ross, Westerfield, Jaffee: Corporate

Finance, 10th. ed., ISBN 0077511387 / 978-0077511388.

• Scores: • Class Participation (20%).

• Final Exam (80%)

What is Corporate Finance?

Corporate Finance addresses the following two questions:

1. What investments should the firm engage in?

2. How can the firm raise the money for the required investments?

3. How much short-term cash flow does a company need to pay its bills?

The Balance-Sheet Model of the Firm

Current Assets

Fixed Assets

1 Tangible

2 Intangible

Total Value of Assets:Total Value of Assets:

Shareholders’ Equity

Total Firm Value to Investors:Total Firm Value to Investors:


Current Assets


Current Liabilities

Long-Term Debt

What long-What long-term term investments investments should the should the firm engage firm engage in?in?

The Capital Budgeting DecisionThe Capital Budgeting Decision


How can the firm How can the firm raise the money raise the money for the required for the required investments?investments?

The Capital Structure DecisionThe Capital Structure Decision

Current Assets

Fixed Assets

1 Tangible

2 IntangibleShareholders’

Equity

Current Liabilities

Long-Term Debt


How much short-How much short-term cash flow term cash flow does a company does a company need to pay its need to pay its bills?bills?

The Net Working Capital Investment DecisionThe Net Working Capital Investment Decision

Net Working Capital


Current Liabilities

Long-Term Debt

Current Assets

Fixed Assets

1 Tangible

2 Intangible

Capital StructureThe 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 up the pie.

If how you slice the pie affects the size of the pie, then the capital structure decision matters.

50% Debt

50% Equity

25% Debt

75% Equity

70% Debt

30% Equity

The Financial Manager

To create value, the financial manager should:

1.Try to make smart investment decisions.

2.Try to make smart financing decisions.

Cash flowfrom firm (C)

The Firm and the Financial Markets

Taxe

s (E)

Firm

Government

Firm issues securities (A)

Retained cash flows (D)

Investsin assets(B)

Dividends anddebt payments (F)

Current assetsFixed assets

Financialmarkets

Short-term debt

Long-term debt

Equity shares

Ultimately, the firm must be a cash generating activity.

The cash flows from the firm must exceed the cash flows from the financial markets.

Accounting Profits v.s. Cash Flow

• Example 1: The Midland Company refines and trades gold. At the end of the year, it sold 2,500 ounces of gold for $1 million. The company had acquired the gold for $900,000 at the beginning of the year. The company paid cash for the gold when it was purchased. Unfortunately it has yet to collect from the customer to whom the gold was sold.

Accounting Profits v.s. Cash Flow

Cash Flow Timing

• Example 2: Evaluate two projects, A and B, with the same initial cost, $10,000.

Risk of Cash Flows• Example 3: Evaluate two projects in Europe and in Japan

with the same initial investment:

Corporate Securities as Contingent Claims on Total Firm Value

• The basic feature of a debt is that it is a promise by the borrowing firm to repay a fixed dollar amount by a certain date.

• The shareholder’s claim on firm value is the residual amount that remains after the debtholders are paid.

• If the value of the firm is less than the amount promised to the debtholders, the shareholders get nothing.

Debt and Equity as Contingent Claims

$F

$F

Payoff to debt holders

Value of the firm (X)

Debt holders are promised $F. If the value of the firm is less than $F, they get whatever the firm is worth.

If the value of the firm is more than $F, debt holders get a maximum of $F.

$F

Payoff to shareholders


If the value of the firm is less than $F, share holders get nothing.

If the value of the firm is more than $F, share holders get everything above $F.

Algebraically, the bondholder’s claim is: Min[$F,$X]

Algebraically, the shareholder’s claim is: Max[0,$X – $F]

Combined Payoffs to Debt and Equity

$F

$F

Combined Payoffs to debt holders and shareholders


Debt holders are promised $F.

Payoff to debt holders

Payoff to shareholders

If the value of the firm is less than $F, the shareholder’s claim is: Max[0,$X – $F] = $0 and the debt holder’s claim is Min[$F,$X] = $X.

The sum of these is = $X

If the value of the firm is more than $F, the shareholder’s claim is: Max[0,$X – $F] = $X – $F and the debt holder’s claim is:

Min[$F,$X] = $F.

The sum of these is = $X

Forms of Business Organization

• 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.

Forms of Business Organization• The Sole Proprietorship

• The Partnership

• General Partnership

• Limited Partnership

• The Corporation

• The Limited Liability company (LLC).

• Advantages and Disadvantages

• Liquidity and Marketability of Ownership

• Control

• Liability

• Continuity of Existence

• Tax Considerations

A Comparison of Partnership and Corporations

Corporation Partnership

Liquidity Shares can easily be 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 with dividend tax credit

Partnership income is taxable.

Reinvestment 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

Goals of the Corporate Firm

• What are firm decision-makers hired to do?

• The traditional answer is that the managers of the corporation are obliged to make efforts to maximize shareholder wealth.


• Survive.

• Avoid financial distress and bankruptcy.

• Beat the competition.

• Maximize sales or market share.

• Minimize costs.

• Maximize profits.

• Maintain steady earnings growth.

POSSIBLE GOALS


• For listed companies, the goal of financial management is to maximize the current value per share of the existing stock.

Managerial Goals

• Managerial goals may be different from shareholder goals• Expensive perquisites, a jet, etc.

• Secure the job.

• Independence

• Increased growth and size are not necessarily the same thing as increased shareholder wealth.

Separation of Ownership and Control

Board of Directors

Management

AssetsDebt

Equity

Shareholders

Debtholders

The Agency Problem

• The agency relationship• Will managers work in the shareholders’ best

interests?– Agency costs

– Direct agency costs– Indirect agency costs

• Control of the firm• How do agency costs affect firm value (and

shareholder wealth)?

Do Shareholders Control Managerial Behaviour?

• Shareholders vote for the board of directors, who in turn hire the management team.

• Contracts can be carefully constructed to be incentive compatible.

• There is a market for managerial talent—this may provide market discipline to the managers—they can be replaced.

• If the managers fail to maximize share price, they may be replaced in a hostile takeover / proxy fight.

Direct finance

LoansFinancial intermediaries

Deposits

Financial Institutions, Financial Markets, and the Corporation

• Financial Institutions

Indirect finance

Funds suppliers

Funds demanders

Financial intermediaries

Funds suppliers

Funds demanders

Financial Markets

Money versus Capital Markets• Money Markets

– For short-term debt instruments• Capital Markets

– For long-term debt and equity

Financial Markets

Primary versus Secondary Markets• Primary Market

– When a corporation issues securities, cash flows from investors to the firm.

– Usually an underwriter is involved• Secondary Markets

– Involve the sale of “used” securities from one investor to another.

– Securities may be exchange traded or trade over-the-counter in a dealer market.

Financial Markets

FirmsInvestors

Secondary Market

money

securitiesSueBob

Stocks and Bonds

Money

Primary Market

what is corporate finance?

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