Chapter 1

Advanced Corporate
Finance

McGraw-Hill/Irwin Copyright 2006 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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 Corporate Finance

Some important questions that are

answered using finance
What long-term investments should the firm
take on?
Where will we get the long-term financing to
pay for the investment?
How will we manage the everyday financial
activities of the firm?

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 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 should we pay for our assets?
Should we use debt or equity?
Working capital management
How do we manage the day-to-day finances of
the firm?

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Forms of Business Organization

Three major forms in the United States

Sole proprietorship
Partnership
General
Limited
Corporation
Standard Corporation
Limited liability company

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 Sole Proprietorship

Advantages Disadvantages
Easiest to start Limited to life of owner
Least regulated Equity capital limited to
Single owner keeps all owners personal
the profits wealth
Taxed once as personal Unlimited liability
income Difficult to sell
ownership interest

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 Partnership

Advantages Disadvantages
Two or more owners Unlimited liability
More capital available General partnership
Relatively easy to start Limited partnership

Income taxed once as Partnership dissolves

personal income when one partner dies
or wishes to sell
Difficult to transfer
ownership

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 Corporation

Advantages Disadvantages
Limited liability Separation of
Unlimited life ownership and
Separation of management
ownership and Double taxation
management (income taxed at the
Transfer of ownership is corporate rate and then
easy dividends taxed at the
personal rate)
Easier to raise capital

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 What is corporate finance?

Every decision that a business makes has financial implications, and any
decision which affects the finances of a business is a corporate finance
decision.
Defined broadly, everything that a business does fits under the rubric of
corporate finance.
 First Principles

Invest in projects that yield a return greater than the minimum acceptable
hurdle rate.
The hurdle rate should be higher for riskier projects and reflect the
financing mix used - owners funds (equity) or borrowed money (debt)
Returns on projects should be measured based on cash flows generated
and the timing of these cash flows; they should also consider both
positive and negative side effects of these projects.
Choose a financing mix that minimizes the hurdle rate and matches the
assets being financed.
If there are not enough investments that earn the hurdle rate, return the cash
to stockholders.
The form of returns - dividends and stock buybacks - will depend upon
the stockholders characteristics.
Objective: Maximize the Value of the Firm
 Goal Of Financial Management

What should be the goal of a corporation?

Maximize profit?
Minimize costs?
Maximize market share?
Maximize the current value of the companys
stock?
Does this mean we should do anything and
everything to maximize owner wealth?

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The Objective in Decision Making

In traditional corporate finance, the objective in decision making is to maximize the value
of the firm.
A narrower objective is to maximize stockholder wealth. When the stock is traded and
markets are viewed to be efficient, the objective is to maximize the stock price.

Maximize equity Maximize

Maximize value market estimate
firm value
of equity value
Assets Liabilities
Existing Investments Fixed Claim on cash flows
Generate cashflows today Assets in Place Debt Little or No role in management
Includes long lived (fixed) and Fixed Maturity
short-lived(working Tax Deductible
capital) assets

Expected Value that will be Growth Assets Equity Residual Claim on cash flows
created by future investments Significant Role in management
Perpetual Lives
The Classical Objective Function
STOCKHOLDERS

Hire & fire Maximize

managers stockholder
- Board wealth
- Annual Meeting
Lend Money No Social Costs
BONDHOLDERS Managers SOCIETY
Protect Costs can be
bondholder traced to firm
Interests
Reveal Markets are
information efficient and
honestly and assess effect on
on time value

FINANCIAL MARKETS
 The Agency Problem

Agency relationship
Principal hires an agent to represent his/her
interest
Stockholders (principals) hire managers
(agents) to run the company
Agency problem
Conflict of interest between principal and agent
Management goals and agency costs

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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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 Efficiency of Financial Markets

Randomness in Price Change

Active Vs. Passive Investors

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 Information Asymmetry

Market for Lemons

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