Chapter 01 - Introduction to Corporate Finance

Chapter 1
INTRODUCTION TO CORPORATE FINANCE

CHAPTER ORGANIZATION
1.1 Corporate Finance and the Financial Manager
What Is Corporate Finance?
The Financial Manager
Financial Management Decisions
1.2 Forms of usiness !rgani"ation
#ole $roprietorship
$artnership
Corporation
% Corporation &' %nother (ame)
1.* The +oal of Financial Management
$ossi&le +oals
The +oal of Financial Management
% More +eneral +oal
#ar&anes-!,le'
1-1
Chapter 01 - Introduction to Corporate Finance
1.- The %genc' $ro&lem and Control of the Corporation
%genc' .elationships
Management +oals
Do Managers %ct in the #toc/holders0 Interests?
#ta/eholders
1.1 Financial Mar/ets and the Corporation
Cash Flo2s to and from the Firm
$rimar' 3ersus #econdar' Mar/ets
1.4 #ummar' and Conclusions
ANNOTATED CHAPTER OUTLINE
1.1. Corporate Finance and The Financial Manager
%. What Is Corporate Finance?
Corporate finance addresses se3eral important 5uestions6
1. What long-term in3estments should the firm ta/e on?
7Capital &udgeting8
2. Where 2ill 2e get the long-term financing to pa' for the
in3estment? 7Capital structure8
*. 9o2 2ill 2e manage the e3er'da' financial acti3ities of
the firm? 7Wor/ing capital8
. The Financial Manager
The Chief Financial !fficer 7CF!8 or :ice-$resident of Finance coordinates
the acti3ities of the treasurer and the controller.
The controller handles cost and financial accounting; ta,es; and
information s'stems.
The treasurer handles cash management; financial planning; and
capital e,penditures.
1-2
Chapter 01 - Introduction to Corporate Finance
C. Financial Management Decisions
The financial manager is concerned 2ith three primar' categories of financial
decisions.
1. Capital budgeting < process of planning and managing a
firm0s in3estments in fi,ed assets. The /e' concerns are
the si"e; timing and ris/iness of future cash flo2s.
2. Capital structure < mi, of de&t 7&orro2ing8 and e5uit'
7o2nership interest8 used &' a firm. What are the least
e,pensi3e sources of funds? Is there an optimal mi, of de&t
and e5uit'? When and 2here should the firm raise funds?
*. !r"ing capital #anage#ent < managing short-term
assets and lia&ilities. 9o2 much in3entor' should the firm
carr'? What credit polic' is &est? Where 2ill 2e get our
short-term loans?
1.2. Forms of usiness !rgani"ation
%. #ole $roprietorship < % &usiness o2ned &' one person.
%d3antages include ease of start-up; lo2er regulation; single o2ner
/eeps all the profits; and ta,ed once as personal income.
Disad3antages include limited life; limited e5uit' capital;
unlimited lia&ilit' and lo2 li5uidit'.
. $artnership < % &usiness 2ith multiple o2ners; &ut not
incorporated.
+eneral partnership < all partners share in gains or losses= all ha3e
unlimited lia&ilit' for all partnership de&ts.
>imited partnership < one or more general partners run the
&usiness and ha3e unlimited lia&ilit'. % limited partner0s lia&ilit' is
limited to his or her contri&ution to the partnership and the' cannot
help in running the &usiness.
%d3antages include more e5uit' capital than is a3aila&le to a sole
proprietorship; relati3el' eas' to start 7although 2ritten agreements
are essential8; and income ta,ed once at personal ta, rate.
Disad3antages include unlimited lia&ilit' for general partners;
1-*
Chapter 01 - Introduction to Corporate Finance
dissolution of partnership 2hen one partner dies or 2ishes to sell;
lo2 li5uidit'.
C. Corporation < % distinct legal entit' composed of one or more
o2ners.
Corporations account for the largest 3olume of &usiness 7in dollar
terms8 in the ?.#. %d3antages include limited lia&ilit'; unlimited
life; separation of o2nership and management 7a&ilit' to o2n
shares in se3eral companies 2ithout ha3ing to 2or/ for all of
them8; li5uidit'; and ease of raising capital.
Disad3antages include separation of o2nership and management
7agenc' costs8 and dou&le ta,ation. The ne2 ta, la2s reduce the
le3el of dou&le ta,ation; &ut it has not &een eliminated.
D. % Corporation &' %nother (ame)
Corporations e,ist around the 2orld under a 3ariet' of names. Ta&le 1.1 lists
se3eral 2ell-/no2n companies; along 2ith the t'pe of compan' in
the original language.
1.*. The +oal of Financial Management
%. $ossi&le +oals
Pr!$it %a&i#i'ati!n < this is an imprecise goal. Do 2e 2ant to
ma,imi"e long-run or short-run profits? Do 2e 2ant to ma,imi"e
accounting profits or some measure of cash flo2? ecause of the
different possi&le interpretations; this should not &e the main goal
of the firm.
. !ther possi&le goals that students might suggest include
minimi"ing costs or ma,imi"ing mar/et share. oth ha3e potential
pro&lems. We can minimi"e costs &' not purchasing ne2
e5uipment toda'; &ut that ma' damage the long-run 3ia&ilit' of the
firm. Man' @dot .comA companies got into trou&le in the late BC0s
&ecause their goal 2as to ma,imi"e mar/et share. The' raised
su&stantial amounts of capital in I$!s and then used the mone' on
ad3ertising to increase the num&er of @hitsA on their site.
9o2e3er; man' firms failed to translate those @hitsA into enough
re3enue to meet e,penses and the' 5uic/l' ran out of capital. The
stoc/holders of these firms 2ere not happ'= stoc/ prices fell
dramaticall' and it &ecame difficult for these firms to raise
additional funds. Man' of these companies ha3e gone out of
1--
Chapter 01 - Introduction to Corporate Finance
&usiness.
C. The +oal of Financial Management
-Ma,imi"e the current 3alue per share of the e,isting stoc/-
From a stoc/holder 7o2ner8 perspecti3e; the goal of &u'ing the
stoc/ is to gain financiall'. Thus; the goal of financial
management in a corporation is to
D. % More +eneral +oal - To ma,imi"e the mar/et 3alue of o2ners0
e5uit'.

Man' students thin/ that this means that firms should do @an'thingA to
ma,imi"e stoc/holder 2ealth. It is important to point out that
unethical &eha3ior does not ultimatel' &enefit o2ners.
D. #ar&anes-!,le'
@#ar&o,A or @#!E;A as it is commonl' referred to; 2as designed to
reduce the li/elihood of corporate scandals &' increasing in3estor
protection &' limiting certain actions &' e,ecuti3es and increasing
o3erall reporting re5uirements. The latter in particular has
increased the cost of incorporation and has led some firms to a3oid
going pu&lic or e3en to @go dar/.A
1.-. The %genc' $ro&lem and Control of the Corporation
%. Agenc( Relati!ns)ips < The relationship &et2een stoc/holders
and management is called the agenc' relationship. This occurs
2hen one part' 7principal8 hires another 7agent8 to act on their
&ehalf. The possi&ilit' of conflicts of interest &et2een the parties
is termed the agenc' pro&lem.

. Management +oals
%genc' costs
direct costs < compensation and per5uisites for management
indirect costs < cost of monitoring and su&-optimal decisions
1-1
Chapter 01 - Introduction to Corporate Finance
C. Do Managers %ct in the #toc/holders0 Interests?
Managerial compensation can &e used to encourage managers to act in the
&est interest of stoc/holders. !ne commonl' cited tool is stoc/
options. The idea is that if management has an o2nership interest
in the firm; the' 2ill &e more li/el' to tr' to ma,imi"e o2ner
2ealth.
#toc/holders technicall' ha3e control of the firm; and dissatisfied
shareholders can oust management 3ia pro,' fights; ta/eo3ers; etc.
9o2e3er; this is easier said than done. #taggered elections for
&oard mem&ers often ma/e it difficult to remo3e the &oard that
appoints management. $oison pills and other anti-ta/eo3er
mechanisms ma/e hostile ta/eo3ers difficult to accomplish.
#ta/eholders are other groups; &esides stoc/holders; that ha3e a 3ested interest
in the firm and potentiall' ha3e claims on the firm0s cash flo2s.
#ta/eholders can include creditors; emplo'ees; and customers.
1.1. Financial Mar/ets and the Corporation
%. Cash Flo2s to and from the Firm
% firm issues securities 7stoc/s and &onds8 to raise cash for in3estments
7usuall' in real assets8. The operating cash flo2s generated from
the in3estment in assets allo2s for the pa'ment of ta,es;
rein3estment in ne2 assets; pa'ment of interest and principal on
de&t; and pa'ment of di3idends to stoc/holders.
. $rimar' 3ersus #econdar' Mar/ets
Pri#ar( #ar"et < the mar/et in 2hich securities are sold &' the compan'.
$u&lic and pri3ate placements of securities; #DC registration; and
under2riters are all part of the primar' mar/et.
*ec!ndar( #ar"et < the mar/et 2here securities that ha3e alread' &een
issued are traded &et2een in3estors. The stoc/ e,changes; such as
the (e2 For/ #toc/ D,change; and the o3er-the-counter mar/et;
such as the (%#D%G; are part of the secondar' mar/et.
Dealer +ersus Aucti!n %ar"ets < % dealer mar/et is one 2here 'ou ha3e
se3eral traders that carr' an in3entor' and pro3ide prices at 2hich
1-4
Chapter 01 - Introduction to Corporate Finance
the' stand read' to &u' 7&id8 and sell 7as/8 the securities. The
(asda5 mar/et is an e,ample of a dealer mar/et. %n auction
mar/et has a ph'sical location 2here &u'ers and sellers are
matched; 2ith little dealer acti3it'.
1-H
Chapter 01 - Introduction to Corporate Finance
1.4. #ummar' and Conclusions
)( *)are,O-ner .alue/
At The Coca-Cola Company, our publicly stated mission is to create value over
time for the owners of our business. In fact, in our society, that is the mission of any
business: to create value for its owners.
hy! The answer can be summed up in three reasons.
"irst, increasing share-owner value over time is the #ob our economic system
demands of us. e live in a democratic capitalist society, and here, people create
specific institutions to help meet specific needs. $overnments are created to help meet
civic needs. %hilanthropies are created to help meet social needs. And companies are
created to help meet economic needs. &usiness distributes the lifeblood that flows
through our economic system not only in the form of goods and services, but also in the
form of ta'es, salaries and philanthropy.
Creating value is a core principle on which our economic system is based( it is
the #ob we owe to those who have entrusted us with their assets. e wor) for our share
owners. That is * literally * what they have put us in business to do.
+aying that we wor) for our share owners may sound simplistic - but we
fre,uently see companies that have forgotten the reason they e'ist. They may even try in
vain to be all things to all people and serve many masters in many different ways. In any
event, they miss their primary calling, which is to stic) to the business of creating value
for their owners.
"urthermore, we must always be mindful of the fact that while a healthy company
can have a positive and seemingly infinite impact on others, a sic) company is a drag on
the social order of things. It cannot sustain #obs, much less widen the opportunities
available to its employees. It cannot serve customers. It cannot give to philanthropic
causes.
And it cannot contribute anything to society, which is the second reason we wor)
to create value for our share owners: If we do our #obs, we can contribute to society in
very meaningful ways. -ur Company has invested millions of dollars in .astern .urope
since the fall of the &erlin all, and people there will not soon forget that we came early
to meet their desires and needs for #obs and management s)ills. In the process, they are
becoming loyal consumers of our products, while we are building value for our share
owners * which was our #ob all along.
1-I
Chapter 01 - Introduction to Corporate Finance
Certainly, we * as a Company * ta)e it upon ourselves to do good deeds that
directly raise the ,uality of life in the communities in which we do business. &ut the real
and lasting benefits we create don/t come because we do good deeds, but because we do
good wor) * wor) focused on our mission of creating value over time for the people who
own the Company. Among those owners, for e'ample, are university endowments,
philanthropic foundations and other similar nonprofit organi0ations. If The Coca-Cola
Company is worth more, those endowments are similarly enriched to further strengthen
the educational institutions/ operations( if The Coca-Cola Company is worth more, those
foundations have more to give, and so on. There is a beneficial ripple effect throughout
society.
%lease note that I said creating value 1over time,2 not overnight. Those two
words are at the heart of the third reason behind our mission: "ocusing on creating value
over the long term )eeps us from acting shortsighted.
I believe share owners want to put their money in companies they can count on,
day in and day out. If our mission were merely to create value overnight, we could
suddenly ma)e hundreds of decisions that would deliver a staggering short-term windfall.
&ut that type of behavior has nothing to do with sustaining value creation over time. To
be of uni,ue value to our owners over the long haul, we must also be of uni,ue value to
our consumers, our customers, out bottling partners, our fellow employees and all other
sta)eholders * over the long haul.
Accordingly, that is how the long-term interests of the sta)eholders are served *
as the long-term interests of the share owners are served. 3i)ewise, unless the long-term
interests of the share owners are served, the long-term interests of the sta)eholders will
not be served. The real possibility for conflict, then, is not between share owners and
sta)eholders, but between the long-term and the short-term interests of both. 4ltimately,
everyone benefits when a company ta)es a long-term view. 4ltimately, no one benefits
when a company ta)es a short-term view.
The creation of uni,ue value for all sta)eholders, including share owners, over
the long haul, presupposes a stable, health society. -nly in such an environment can a
company/s profitable growth be sustained. Thus, the e'ercise of what is commonly
referred to as 1corporate responsibility2 is a supremely rational, logical corollary of a
company/s essential responsibility to the long-term interests of its share owners. A
company will only e'ercise this essential responsibility effectively if it promotes that
social well-being necessary for a healthy business environment. It is as irrational to
suppose that a company is primarily a welfare agency as it is to suppose that a company
should not be concerned at all about the social welfare. &oth views sacrifice the long-
term common good to short-term benefits * whether share-owner benefits or sta)eholder
benefits.
1-C
Chapter 01 - Introduction to Corporate Finance
Certainly, harsh competitive situations can sometimes call for harsh medicine.
&ut in the main, our share owners loo) to us to deliver sustained, long-term value. e do
that by building our businesses and growing them profitably.
At The Coca-Cola Company, we have built our business and grown it profitably
for more than 115 years, because we have remained disciplined to our mission.
6ot long ago, we came up with an interesting set of facts: A billion hours ago,
human life appeared on .arth. A billion minutes ago, Christianity emerged. A billion
seconds ago, the &eatles changed music forever. A billion Coca-Colas ago was yesterday
morning.
The ,uestion we as) ourselves now is: hat must we do to ma)e a billion Coca-
Colas ago be this morning! &y as)ing that ,uestion, we discipline ourselves to the long-
term view.
4ltimately, the mission of this Atlanta soft-drin) salesman * and my 78,555
associates * is not simply to sell an e'tra case of Coca-Cola. -ur mission is to create
value over the long haul for the owners of our Company.
That/s what our economic system demands of us. That/s what allows us to
contribute meaningfully to society. That/s what )eeps us from acting shortsighted. As
businessmen and businesswomen, we should never forget that the best way for us to serve
all our sta)eholders * not #ust our share owners, but our fellow employees, our business
partners and our communities * is by creating value over time for those who have hired
us.
That, ultimately, is our #ob.
.o&erto C. +oi"ueta
Chairman; oard of Directors;
and Chief D,ecuti3e !fficer
Fe&ruar' 20; 1CCH
JThis essa' originall' appeared in the Coca-Cola Compan'0s 1CCH annual report.K
1-10