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In the name of Allah

Amirkabir University of Technology Industrial Engineering Department

Corporate Finance

Introduction to Corporate Finance

By: Akbar Esfahanipour

In this chapter
What is Corporate Finance? The Corporate Firm The Goal of Financial Management The Agency Problem and Control of the Corporation Financial Markets

Corporate Finance

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What is Corporate Finance?

The Balance Sheet Model of the Firm

Corporate Finance

What is Corporate Finance?

A firms Assets
Current assets
Those that have short lives, such as inventory.

Fixed assets
Those that will last a long time, such as buildings.

A firms Liabilities
Current liability
A short-term debt. Loans and other obligations that must be repaid within one year.

Long-term debt
Debt that does not have to be repaid within one year.

Shareholders equity
Difference between value of the assets and debt of the firm.
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What is Corporate Finance?

Corporate Finance concerns about the following 3 questions:
In what long-lived assets should the firm invest?
Capital budgeting: process of making & managing expenditures on these assets. Left side of the balance sheet.

How can the firm raise cash for required capital expenditures?
Firms capital structure: proportions of a firms financing from current & longterm debt & equity. Right side of the balance sheet

How should short-term operating cash flows be managed?

Net working capital = current assets - current liabilities. (short-term finance) Upper portion of the balance sheet.
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What is Corporate Finance?

Capital Structure
Shareholders
The holders of equity shares.

Creditors, debt-holders or bond-holders

The people or institutions that buy debt from (i.e., lend money to) the firm.

Two Pie Models of the Firm

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What is Corporate Finance?

Capital Structure
V=B+S where
V: value of the firm in the financial markets. B: market value of the debt. S: market value of the equity.

Goal of a financial manager

To choose the ratio of debt to equity that makes the value of the firm (V) as large as it can be. (How?)
Try to buy assets that generate more cash than they cost. Sell bonds, stocks & other financial instruments that raise more cash than they cost.
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What is Corporate Finance?

Board of Directors Chairman of the Board and Chief Executive Officer (CEO) President and Chief Operations Officer (COO)

Hypothetical Organization Chart

Vice President and Chief Financial Officer (CFO)

Treasurer

Controller

Cash Manager
Capital Expenditures 8

Credit Manager Financial Planning

Tax Manager
Financial Accounting Manager

Cost Accounting Manager Data Processing Manager

Corporate Finance

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What is Corporate Finance?

Cash Flows between the Firm and the Financial Markets

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What is Corporate Finance?

Identification of cash flows
It is not easy to observe cash flows directly. Financial analysis involves to extract cash flow information from accounting statements.

An example: Accounting Profit vs Cash Flows

Midland Co. 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. It has yet to collect from the customer to whom the gold was sold.

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Corporate Finance

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What is Corporate Finance?

Timing of Cash Flows
One of the most important principles of finance is that
Individuals prefer to receive cash flows earlier rather than later

An example: Cash flow timing

Two proposals for new product will provide additional cash flows over a 4-year period and will initially cost $10,000.

Without more information, we cannot decide which set of cash flows would create the most value for the bondholders and shareholders
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What is Corporate Finance?

Risk of Cash Flows
The amount and timing of cash flows arent known with certainty. Most investors have an aversion to risk.

An example: Risks
The Midland Company is considering expanding operations overseas.
After doing a complete financial analysis, Midland has come up with the following cash flows:

Corporate finance cannot avoid coping with risky alternatives.

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The Corporate Firm

A basic problem of a firm:
How to raise large amounts of money.

Three basic legal forms of organizing firms

The sole proprietorship
A business owned by one person.

The partnership
Any two or more people can get together and form a partnership:
1. 2.

general partnerships limited partnerships.

The corporation
It is a distinct legal entity and can have a name and enjoy many of the legal powers of natural persons.
They can acquire & exchange property, enter contracts, may sue & be sued. They are citizens, but they can not vote.
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The Corporate Firm

The corporation comprises (at least) following distinct interests
The shareholders (the owners)
control the corporations direction, policies, and activities elect a board of directors

The directors (members of board)

select top management

The corporation officers (the top management)

manage the operations of the corporation in the best interest of the shareholders

Advantages of separation of ownership from management in corporations over proprietorships and partnerships:
Ownership can be transferred to new owners by shares of stock. The corporation has unlimited life. Shareholders liability is limited by the ownership shares.
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The Corporate Firm

A Comparison of Partnerships and Corporations

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The Goal of Financial Management

For for-profit businesses, the goal of financial management
To make money or add value for the owners.

Possible goals
Survive. Avoid financial distress and bankruptcy. Beat the competition. Maximize sales or market share. Minimize costs. Maximize profits. Maintain steady earnings growth

Two aspects of the above goals: profitability and risk

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The Goal of Financial Management

The goal of financial management is to maximize the current value per share of the existing stock. Stockholders in a firm are residual owners. That means:
They are entitled only to what is left after employees, suppliers, and creditors (and everyone else with legitimate claims) are paid their due.
How to identify investments and financing arrangements that favorably impact the value of the stock.

Definition of corporate finance

Study of the relationship between business decisions and the value of the stock in the business
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The Goal of Financial Management

The total value of the stock in a corporation:
The value of the owners equity.

Good financial decisions increase the market value of the owners equity, and poor financial decisions decrease it. Financial manager should not take illegal or unethical actions
in the hope of increasing the value of the equity in the firm.

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Corporate Finance

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The Agency Problem and Control of the Corporation

Will management necessarily act in the best interests of the stockholders? Agency Relationships
The relationship between stockholders and management

Agency problem
Possibility of a conflict of interest between the principal and the agent.

Agency cost
Costs of the conflict of interest between stockholders and management.
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The Agency Problem and Control of the Corporation

Board of Directors Shareholders Debtholders

Management

Debt Assets Equity

Separation of Ownership and Control

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The Agency Problem and Control of the Corporation

Indirect agency cost
A lost opportunity.

Direct agency cost

Corporate expenditure
Those that benefits management but costs the stockholders.

Expense that arises from the need to monitor management actions.

Paying outside auditors to assess the accuracy of financial statement information.

Do managers act in the stockholders interests?

Managerial compensation Control of the firm
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The Agency Problem and Control of the Corporation

Agency problem
Mechanisms to mitigate potential agency problems:
Compensation plans tie the income of managers to the success of the firm e.g., stock options. While boards of directors become defenders of top management, they can force out management teams that are underperforming. Outsiders (e.g., security analysts) monitor the firm closely and make the life of poor performers at the least uncomfortable. Bad performers are subject to the threat of takeover through
Launching a proxy contest or By other firms

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Corporate Finance

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Financial Markets
Firms offer two basic types of securities to investors.
Debt securities
Contractual obligations to repay corporate borrowing.

Equity securities
Shares of common stock and preferred stock that represent non-contractual claims to the residual cash flow of the firm.

Financial markets
Money markets
For debt securities that will pay off in the short term (usually less than 1 year)

Capital markets
For long-term debt (with a maturity of over one year) and for equity shares.
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Financial Markets
The Primary Market: New Issues
Is used when governments and corporations initially sell securities.
Public offerings Private placements

Secondary Markets
Dealer markets
Dealers buy and sell for themselves, at their own risk. Over-the-counter (OTC) markets

Auction markets
Brokers and agents match buyers and sellers, but they do not actually own the commodity that is bought or sold.

Exchange Trading of Listed Stocks

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