Corporate Finance Study Note @2017

Corporate Finance
Chapter 1
Corporate Finance addresses:
1) Capital Budgeting (Investment decisions)
What long-term investments should the firm choose?
2) Capital Structure: (Financing decisions)
How should the firm raise funds for the selected investments?
3) Liquidity: (Working capital decisions)
How should short-term assets be managed and financed?
Balance Sheet Model of the Firm

2
H

Organization Chart

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Corporate Finance Study Note @2017

Role of Financial Manager

- To increase the value of the firm by:
 Selecting value-creating projects
 Making smart financing decisions
Importance of Cash Flow

Goal of Financial Management

= make profit/add value for owners
[Possible specific goals]
Survive; Avoid financial distress and bankruptcy;
Beat the competition; Maximize sales or market share;
Minimize costs; Maximize profits;
Maintain steady earnings growth

Improper goals of finance

A) Maximizing profit is not a suitable goal
- Profit can be increased by reducing cost
- Accounting profits is NOT cash flows
- Risk is Not taken into account
B) Minimizing cost is not a suitable goal
- Increase current profits but may harm the future profitability
- E.g. R&D, Maintenance and quality control
C) Maximizing market share is not a suitable goal
- Higher advertising and promotion to increase market, resulting to lower profits
- Large market share does NOT promise with high profit if the firm cannot increase
revenue much by increasing prices
D) Maximizing shareholder wealth is a SUITABLE goal
-  avoids problems of other goals by taking risk into account
- i.e. the impact on future cash flows (long term effect)

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Corporate Finance Study Note @2017

Goal of Corporate Firm

= to maximize shareholders’ wealth
After taking the timing, magnitude and risk of future cash flows & opportunity cost
𝐶𝐹𝑡
Shareholders’ wealth (NPV) = ∑
(1+𝑟)𝑡
Agency problem
Agency relationship
= principal-agent relationship to do something on behalf of his/her interest
Stockholders (principals) hire managers (agents) to run the company
Agency problem
- Conflict of interest between principal and agent
- Separation of ownership and control
Managers are responsible for day-day operations but
Usually not own much of the firm
Managerial Goals
- Different from shareholder goals
e.g. expensive perquisites, survival & independence
- increased growth & size X = shareholder wealth
Solution of stockholder-manager conflicts
1) Managerial compensation linked to performance (stock options, bonuses)
2) Regulations
3) The board of directors (surveillance on directors)
4) Threat of takeovers results in better management
5) Managerial labor market (they worry about their reputation)
Agency Costs
= costs incurred to motivate agent to act in the principal’s best interest
- Incremental cost of working through others
1) Direct contracting costs
2) Monitoring costs
3) Loss of principal’s wealth due to residual, unresolved agency problems
Regulation
- Securities Acts governing operations of securities markets to trade, issuance of
securities, corporate disclosure and insider trading
- Sarbanes-Oxley(SOX) 2002 increased reporting requirement and responsibility of
corporate directors
i. Prohibits personal loan from co. to officers
ii. Require independent outside director on audit committee

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Corporate Finance Study Note @2017

Debt & Equity as contingent claims

• When Value of Firm (X) > F (Total debt)
Debtholders get F and equityholders get (F-X)
• When X < F
Debtholders get X and equityholders get 0.
• Hence, claims are contingent on X.

Valuation Framework
Stock/bond (discounted cash flow model)
CF1 CF2 CF3
V0    ...
1  r 1  r  1  r 3
2

Constant Growth Model (Gordon’s Model)

CF1 CF1 1  g  CF2 1  g 
2 3
CF1
V0    ...  , gr
1 r 1  r 2
1  r 3
rg
Perpetuity
CF1
V0  when g = 0
r