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Chapter 1 ...._
'
Chapter 2 ...._
'
Introduction to Corporate Finance
Chapter 1 describes the role of the financial manager and the goal of financial
management. It also discusses some key aspects of the financial management
environment
Financial Statements, Cash Flow, and Taxes
Chapter 2 describes the basic accounting statements used by the finn. The chapter
focuses on the critical differences between cash flow and accounting income; it
also discusses why accounting value is generally not the same as market value.
T
im Hortons Inc. has come a long way since its
1964 inception in Hamilton, Ontario under
the title "'Tim Horton Donuts/' Today, the company
is the largest quick-service restaurant chain in Canada,
and is among the most well-recognized brands in
the country. Founded as a sole proprietorship by
Tim Horton, and later run as a partnership with
Ron Joyce, the company began with a specialized
focus on coffee and donuts. Following Horton's
death in 1974, Joyce continued to run the business
under an aggressive expansion strategy. By
February 1987, Tim Hortons had opened 300 stores
across Canada. In 1995, Tim Hortons was acquired
by Wendy's International Inc., which gave new im-
petus to the expansion of the brand in the United
States. Eleven years later in March of 2006, Tim
Hortons held its initial public offering (IPO) and
was fully spun off by Wendy's International in
September of the same year. With over 3000 stores
in Canada and the United States, the majority of
which are franchisee owned, the Tim Hortons story
touches on different business forms, corporate
goals, and corporate control, all topics that are dis-
cussed in this chapter.
Learning
ObJectives .._
After studying this chapter, you should understand:
L01 The ballc types of fln..clal management decisions and the role of tlte
financial manager.
L02 The fln1111clallmpllcatlona of tlte different forma of bu&lneu organization.
L03 The .,_. of financial manacetnent.
L04 The confllct:e of lnteNst that can arlee between mana,prs and ownel8.
LO& The roles of flnanclallnalltutlona and markets.
To begin our study of modern corporate finance and financial management, we need to ad-
dress two central issues: First, what is corporate finance, and what is the role of the financial
manager in the corporation? Second, what is the goal of financial management? To describe the
financial management eDViro.nment, we look at the corporate form of organization and discuss
some conflicts that can arise within the corporation. We also take a brieflook at financial institu-
tions and financial markets in Canada.
1.1 CORPORATE FINANCE AND THE FINANCIAL MANAGER
In this section. we discuss where the financial manager fits in the corporation. We start by look-
ing at what corporate finance is and what the financial manager does.
What Is Corporate Finance?
Imagine that you were to start your own business. No matter what type you started, you would
have to answer the following three questions in some form or another:
1. What long-term investments should you take on? That is, what lines of business will you be
in and what sorts of buildings, machinery. equipment, and research and development
facilities will you need?
For current issues facing CFOs,
see www.do.com
capital budgeting
The process of planning and
managing a firm's investment
in long-term assets.
CHAPTER 1: Introduction to Corporate Finance 3
2. Where will you get the long-tenn financing to pay for your investment? Will you bring in
other owners or will you borrow the money?
3. How will you manage your everyday financial activities, such as collecting from customers
and paying suppliers?
These are not the only questions by any means, but they are among the most important.
Corporate finance, broadly speaking, is the study of ways to answer these three questions.
Accordingly, we'll be looking at each of them in the chapters ahead. Though our discussion fo-
cuses on the role of the financial manager, these three questions are important to managers in all
areas of the corporation. For example, selecting the finn's lines of business (Question 1) shapes
the jobs of managers in production, marketing, and management information systems. As a
result, most large corporations centralize their finance function and use it to measure perfor-
mance in other areas. Most CEOs have significant financial management experience.
The Financial Manager
A striking feature oflarge corporations is that the owners (the shareholders) are usually not di-
rectly involved in making business decisions, particularly on a day-to-day basis. Instead, the cor-
poration employs managers to represent the owners' interests and make decisions on their behalf.
In a large corporation, the fmancial manager is in charge of answering the three questions we
raised earlier.
It is a challenging task because changes in the firm's operations and shifts in Canadian and
global fmancial markets mean that the best answers for each firm are changing, sometimes quite
rapidly. Globalization of markets and advanced communications and computer technology, as
well as increased volatility of interest rates and foreign exchange rates, have raised the stakes in fi-
nancial management decisions. We discuss these major trends and how they are changing the fi-
nancial manager's job after we introduce you to some of the basics of corporate financial
decisions.
The financial management function is usually associated with a top officer of the finn, such as a
vice president of finance or some other chief financial officer (CFO). Figure 1.1 is a simplified orga-
nization chart that highlights the finance activity in a large firm. The CFO reports to the president,
who is the chief operating officer (COO) in charge of day-to-day operations. The COO reports to
the chairman, who is usually chief executive officer (CEO). The CEO has overall responsibility to
the board As shown, the vice president of finance coordinates the activities of the treasurer and the
controller. The controller's office handles cost and financial accounting, tax payments, and manage-
ment information systems. The treasurer's office is responsible for managing the firm's cash, its fi-
nancial planning, and its capital expenditures. These treasury activities are all related to the three
general questions raised earlier, and the chapters ahead deal primarily with these issues. Our study
thus bears mostly on activities usually associated with the treasurer's office.
Financial Management Decisions
As our discussion suggests, the financial manager must be concerned with three basic types of
questions. We consider these in greater detail next.
CAPITAL BUDGETING The first question concerns the firm's long-term investments. The
process of planning and managing a frrm's long-term investments is called capital budgeting. In
capital budgeting, the fmancial manager tries to identify investment opportunities that are worth
more to the firm than they will cost to acquire. Loosely speaking, this means that the value of the
cash flow generated by an asset exceeds the cost of that asset. The types of investment opportuni-
ties that would typically be considered depend in part on the nature of the firm's business. For
example, for a restaurant chain like Tim Hortons, deciding whether or not to open stores would
be a major capital budgeting decision. Some decisions, such as what type of computer system to
purchase, might not depend so much on a particular line of business.
Financial managers must be concerned not only with how much cash they expect to receive,
but also with when they expect to receive it and how likely they are to receive it. Evaluating the
size, timing, and risk of future cash flows is the essence of capital budgeting. We discuss how to
do this in detail in the chapters ahead.
4 PART 1 : OVerview of Corporate Finance
FIGURE 1.1
A simplified organization
chart. The exact titles
and organization differ
from company to
company.
capital SlrUctUre
The mix of debt and equity
maintained by a firm.
working capital
management
Planning and managing the
finn's current assets and
liabilities.
I
Shareholders
I
I
I
Board of Dlt"Ktors
I
I
I Chairmen of the Board and ~ I
Chief Executive OHicer (CEO)
I
I
Pn!sldent and Chief
I
Operating Officer (COO)
I
I I I
Vice President I
Marketing
I Vice President I
Finance (CFO)
I Vlca Prasldant
Production
I
I Treasurer
I
I Controller I
I I I I
Cash Manager Cradlt Mlnagar lUMenager
Cost Acmunting
Manager
I I I I
capital Financial
Financial
D.tl Procesling
Aa:ountlng
Expenditures Planning
Manager
Manager
CAPITAL STRUCTURE The second major question for the financial manager concerns
how the firm should obtain and manage the long-term financing it needs to support its long-term
investments. A firm's capital structure (or financial structure) refers to the specific mixture of
short-term debt.long-tenn debt, and equity the firm uses to finance its operations. The financial
manager has two concerns in this area. First, how much should the firm borrow; that is, what
mixture is best? The mixture chosen affects both the risk and value of the finn. Second, what are
the least expensive sources of funds for the firm?
If we picture the firm as a pie, then the finn's capital structure determines how that pie is
sliced. In other words, what percentage of the finn's cash flow goes to creditors and what percent-
age goes to shareholders? Management has a great deal of flexibility in choosing a finn's financial
structure. Whether one structure is better than any other for a particular firm is the heart of the
capital structure issue.
In addition to deciding on the financing mix, the financial manager has to decide exactly how
and where to raise the money. The expenses associated with raising long-term financing can be
considerable, so different possibilities must be carefully evaluated. Also, corporations borrow
money from a variety of lenders, tapping into both Canadian and international debt markets, in a
number of different-and sometimes exotic-ways. Choosing among lenders and among loan
types is another of the jobs handled by the financial manager.
WORKING CAPITAL MANAGEMENT The third major question concerns working
capital management. The phrase working capital refers to a firm's short-term assets, such as
CHAPTER 1: Introduction to Corporate Finance 5
inventory, and its short-term liabilities, such as money owed to suppliers. Managing the finn's
working capital is a day-to-day activity that ensures the firm has sufficient resources to continue
its operations and avoid costly interruptions. This involves a number of activities, all related to
the firm's receipt and disbursement of cash.
Some of the questions about working capital that must be answered are: (1) How much cash
and inventory should we keep on hand? (2) Should we sell on credit? If so, what terms should we
offer, and to whom should we extend them? (3) How do we obtain any needed short-term financ-
ing? Will we purchase on credit or borrow short-term and pay cash? If we borrow short-term,
how and when should we do it? This is just a small sample of the issues that arise in managing a
firm's working capital
The three areas of corporate financial management we have described-capital budgeting.
capital structure, and working capital management-are very broad categories. Each includes a
rich variety of topics; we have indicated only a few of the questions that arise in the different
areas. The following chapters contain greater detail.
Concept Questions
1. What is the capital budgeting decision?
2. Into what category of financial management does cash management fall?
3. What do you call the specific mixture of short-term debt, long-term debt, and equity that a firm
chooses to use?
1.2 FORMS OF BUSINESS ORGANIZATION
sola proprtetorshlp
A business owned by a
single individual.
For more information on forms
of business organl?l!tlon, see the
"StartiDgaBustness-sect!Dnat
~ c o m ; also see
www.canadabusineaa.ca
partnerahip
A business formed by two or
more co-owners.
Large firms in Canada, such as CIBC and BCE, are almost all organized as corporations. We
eumine the three different legal fonns of business organization-sole proprietorship, partner-
ship, and corporation-to see why this is so. Each of the three forms has distinct advantages and
disadvantages in the life of the business, the ability of the business to raise cash, and taxes. A key
observation is that. as a firm grows, the advantages of the corporate form may come to outweigh
the disadvantages.
Sole Proprietorship
A sole proprietonhip is a business owned by one person. This is the simplest type of business to
start and is the least regulated form of organization. Depending on where you live, you can start
up a proprietorship by doing little more than getting a business licence and opening your doors.
For this reason, many businesses that later become large corporations start out as sole proprietor-
ships. There are more proprietorships than any other type of business .
.AJ; the owner of a sole proprietorship. you keep all the profits. That's the good news. The bad
news is that the owner has unlimited liability for business debts. This means that creditors can
look beyond assets to the proprietor's personal assets for payment Similarly, there is no distinction
between personal and business income, so all business income is taxed as personal income.
The life of a sole proprietorship is limited to the owner's life span, and, importantly, the amount
of equity that can be raised is limited to the proprietor's personal wealth. This limitation often
means that the business cannot exploit new opportunities because of insufficient capitaL Owner-
ship of a sole proprietorship may be difficult to transfer, since this requires the sale of the entire
business to a new owner.
Partnership
A partnership is similar to a proprietorship. except that there are two or more owners (partners).
In a general partnership, all the partners share in gains or losses, and all have unlimited liability
for all partnership debts, not just some particular share. The way partnership gains (and losses)
are divided is described in the partnership agreement. This agreement can be an informal oral
agreement, or a lengthy, formal written document.
6 PART 1 : OVerview of Corporate Finance
corporation
A business created as a
distinct legal entity owned by
one or more individuals or
entities.
In a limited partnership, one or more general partners has unlimited liability and runs the busi-
ness for one or more limited partners who do not actively participate in the business. A limited
partner's liability for business debts is limited to the amount contributed to the partnership. This
form of organization is common in real estate ventures, for example.
The advantages and disadvantages of a partnership are basically the same as those for a propri-
etorship. Partnerships based on a relatively informal agreement are easy and inexpensive to form.
General partners have unlimited liability for partnership debts, and the partnership terminates
when a general partner wishes to sell out or dies. All income is taxed as personal income to the
partners, and the amount of equity that can be raised is limited to the partners' combined wealth.
Ownership by a general partner is not easily transferred because a new partnership must be
formed. A limited partner's interest can be sold without dissolving the partnership. But finding a
buyer may be difficult, because there is no organized market in limited partnerships.
Based on our discussion, the primary disadvantages of sole proprietorship and partnership as
forms of business organization are (1) unlimited liability for business debts on the part of the
owners, (2) limited life of the business, and (3) difficulty of transferring ownership. These three
disadvantages add up to a single, central problem: the ability of such businesses to grow can be se-
riously limited by an inability to raise cash for investment.
Corporation
In terms of size, the corporation is the most important form of business organization in
Canada. A corporation is a legal entity separate and distinct from its owners; it has many of the
rights, duties, and privileges of an actual person. Corporations can borrow money and own
property, can sue and be sued, and can enter into contracts. A corporation can even be a gen-
eral partner or a limited partner in a partnership, and a corporation can own stock in another
corporation.
Not surprisingly, starting a corporation is somewhat more complicated than starting the other
forms of business organization, but not greatly so for a small business. Forming a corporation in-
volves preparing articles of incorporation (or a charter) and a set of bylaws. The articles of incor-
poration must contain a number of things, including the corporation's name, its intended life
(which can be forever), its business purpose, and the number of shares that can be issued This in-
formation must be supplied to regulators in the jurisdiction where the flrm is incorporated.
Canadian firms can be incorporated under either the federal Canada Business Corpomtion Act or
provincial law.
1
The bylaws are rules describing how the corporation regulates its own existence. For example,
the bylaws describe how directors are elected. These bylaws may be a very simple statement of a
few rules and procedures, or they may be quite extensive for a large corporation. The bylaws may
be amended or extended from time to time by the shareholders.
In a large corporation, the shareholders and the management are usually separate groups. The
shareholders elect the board of directors, which then selects the managers. Management is
charged with running the corporation's affairs in the shareholders' interest. In principle, share-
holders control the corporation because they elect the directors.
As a result of the separation of ownership and management, the corporate form has several
advantages. Ownership (represented by shares of stock) can be readily transferred, and the life of
the corporation is therefore not limited. The corporation borrows money in its own name. As a
result, the shareholders in a corporation have limited liability for corporate debts. The most they
can lose is what they have invested.
2
While limited liability makes the corporate form attractive to equity investors, lenders some-
times view the limited liability feature as a disadvantage. If the borrower experiences financial
distress and is unable to repay its debt, limited liability blocks lenders' access to the owners'
personal assets. For this reason, chartered banks often circumvent limited liability by requiring
that owners of small businesses provide personal guarantees for company debt
1
In some provinces, the legal documents of incorporation are called letters patent or a memorandum of association.
2
An important exception is negligence by a corporate director. If this can be proven, fur example in a case of
environmental damage, the director may be liable fur more than the original investment.
www.bell.ca
www.bombardier.ca
CHAPTER 1: Introduction to Corporate Finance 7
The relative ease of transferring ownership, the limited liability for business debts, and the un-
limited life of the business are the reasons why the corporate form is superior when it comes to
raising cash. If a corporation needs new equity, for example, it can sell new shares of stock and
attract new investors. The number of owners can be huge; larger corporations have many thou-
sands or even millions of shareholders. In a recent year, for example, BCE had more than 191,000
shareholders and Bombardier had about 11,000. In such cases, ownership can change continu-
ously without affecting the continuity of the business.
The corporate form has a significant disadvantage. Because a corporation is a legal entity, it
must pay taxes. Moreover, money paid out to shareholders in dividends is taxed again as income to
those shareholders. This is double taxation, meaning that corporate profits are taxed twice-at the
corporate level when they are earned, and again at the personal level when they are paid out
3
As the discussion in this section illustrates, the need oflarge businesses for outside investors
and creditors is such that the corporate form generally is best for such firms. We focus on cor-
porations in the chapters ahead because of the importance of the corporate form in the
Canadian and world economies. Also, a few important financial management issues, such as
dividend policy, are unique to corporations. However, businesses of all types and sizes need fi-
nancial management, so the majority of the subjects we discuss bear on all forms of business.
A CORPORATION BY ANOTHER NAME Thecorporateformoforganizationhasmany
variations around the world. The exact laws and regulations differ from country to country, of
course, but the essential features of public ownership and limited liability remain. These firms are
often designated as joint stock companies, public limited companies, or limited liability compa-
nies, depending on the specific nature of the firm and the country of origin.
In addition to international variations, there are specialized forms of corporations in Canada and
the U.S. One increasingly common example is the professional corporation set up by architects, ac-
countants, lawyers, dentists and others who are licensed by a professional governing body. A profes-
sional corporation has limited liability but each professional is still open to being sued for malpractice.
Income Trust
Starting in 2001, the income trust, a non-corporate form of business organization, grew in impor-
tance in Canada As of mid-2009, there were 179 income trusts listed on the Toronto Stock Exchange,
with a sector market capitalization of $112.1 billion.
4
Within this sector, the fastest growing compo-
nent is business income trusts that took this form of business organization, traditionally popular in
real estate and oil and gas, and applied it to businesses like telephone listing, container ports, restau-
rant chains and other businesses usually organized as corporations. In response to the growing im-
portance of this sector, recent provincial legislation extended limited liability protection, previously
limited to corporate shareholders, to trust unitholders. Along the same lines, at the end of 2005, the
TSX began to include income trusts in its benchmark S&P I TSX composite index.
Business income trusts (also called income funds) hold the debt and equity of an underlying
business and distribute the income generated to unitholders. Because income trusts are not
corporations, they are not subject to corporate income tax and their income is typically taxed
only in the hands of unitholders. As a result, investors have viewed trusts as tax -efficient and have
been generally willing to pay more for a company after it has converted from a corporation to a
trust. However, this tax advantage largely disappeared on Hallowe'en 2006 when the government
announced plans to tax income trusts at the same rate as corporations starting in 2011. Therefore,
a number of income trusts are converting to corporations, and by 2011 most of the income trusts
will be required by federal legislation to revert to regular corporations.
Table 1.1 reviews the key features of the three main forms of business organization in Canada.
3
The dividend tax credit for individual mareholders and a corporate dividend exclusion reduce the bite of double
taxation for Canadian corporations. These tax provisions are discussed in Chapter 2. Trusts and limited partnerships
are designed to avoid double taxation.
4
For more on income trusts see J. Fenwick and B. Kalymon, A Note on Income 1rusts, Ivey Publishing, 2004 and
Department of Finance, "Tax and Other Issues Related to Publicly Usted Flow-Through Entities (Income Trusts and
Limited Partnerships); September 8, 2005. Data for TSX: Jan S. Koyanagi, "'ncome Trusts on Toronto Stock
Exchange, TSX, January 2007.
8 PART 1 : Overview of Corporate Finance
TABLE 1.1
Forms of business
organi2ation
Sole Proprietorship Partnership Corporation
Definition A business owned by a single A business formed by two or A business created as
P r o ~
Cons
individual. more co-<lWJleB. a distinct legal errtity owned by
one or more individuals or
entitles.
Simplest form of business
to start and is the least
regulated.
OWner keeps all profits.
OWner has unlimited
liability for business debts.
Business income taxed as
personal income.
Ufe of sole-proprietorship
limited to life of owner.
Umited ability to raise
financing.
Dlfflcu lty In transferring
ownership of a sole
proprietorship.
Simple5t form of business Ownership can be easily
to start with little transferred.
regulation. Life of corporation not
OWners keep all profits. limited to lives of owners
Access to more human and or managers.
financial capital. Corporation has limited
Umlted partner(s) have liability.
limited liability. Ability to raise and access
General partner(s) have
unlimited liability for
business debts.
Business income taxed as
personal income.
Ufe of partnership limited
to lives of owners.
Difficulty In transferrl ng
ownership.
Possible disagreements
over partnership.
large sums of capital in
both debt and equity
markets.
Double taxation.
Lenders sometimes view
the limited liability as a
disadvantage and require
the owners of small
corporations to make
personal guarantees.
More complex and
expensive form of
organization to establish.
Concept Questions
1. What are the three forms of business organization?
2. What are the primary advantages and disadvantages of a sole proprietorship or partnership?
3. What Is the difference between a general and a limited partnership?
4. Why is the corporate form superior when it comes to raising cash?
1.3 THE GOAL OF FINANCIAL MANAGEMENT
Assuming that we restrict oursdves to for-profit businesses, the goal of financial management
is to make money or add value for the owners. This goal is a little vague, of course, so we exam-
ine some different ways of formulating it to come up with a more precise defmition. Such a
definition is important because it leads to an objective basis for making and evaluating financial
decisions.
Possible Goals
If we were to consider possible financial goals, we might come up with some ideas like the
following:
Survive in business.
Avoid financial distress and bankruptcy.
Beat the competition.
Maximize sales or market share.
Minimize costs.
Maximize profits.
Maintain steady earnings growth.
CHAPTER 1: Introduction to Corporate Finance 9
These are only a few of the goals we could list. Furthennore, each of these possibilities presents
problems as a goal for a financial manager.
For example, it's easy to increase market share or unit sales; all we have to do is lower our prices or
relax our credit terms. Similarly, we can always cut costs simply by doing away with things such as re-
search and development. We can avoid bankruptcy by never borrowing any money or taking any
risks, and so on. It's not clear that any of these actions would be in the shareholders' best interests.
Profit maximization would probably be the most commonly cited goal, but even this is not a
very precise objective. Do we mean profits this year? If so, then actions such as deferring mainte-
nance, letting inventories run down, and other short-run cost-cutting measures tend to increase
profits now, but these activities aren't necessarily desirable.
The goal of maximizing profits may refer to some sort of long-run or average profits, but it's
still unclear exactly what this means. First, do we mean something like accounting net income or
earnings per share? As we see in more detail in the next chapter, these accounting numbers may
have little to do with what is good or bad for the firm. Second, what do we mean by the long run?
What is the appropriate trade-off between current and future profits?
Although the goals weve just listed are all different, they fall into two classes. The first of these
relates to profitability. The goals involving sales, market share, and cost control all relate, at least
potentially, to different ways of earning or increasing profits. The second group, involving bank-
ruptcy avoidance, stability, and safety, relate in some way to controlling risk. Unfortunately, these
two types of goals are somewhat contradictory. The pursuit of profit normally involves some ele-
ment of risk, so it isn't really possible to maximize both safety and profit. What we need, there-
fore, is a goal that encompasses both these factors.
The Goal of Financial Management
The financial manager in a corporation makes decisions for the shareholders of the firm. Given this,
instead of listing possible goals for the financial manager, we really need to answer a more fundamen-
tal question: From the shareholders' point of view, what is a good financial management decision?
If we assume that shareholders buy stock because they seek to gain fmancially, the answer is
obvious: Good decisions increase the value of the stock, and poor decisions decrease it.
Given our observation, it follows that the financial manager acts in the shareholders' best in-
terests by making decisions that increase the value of the stock. The appropriate goal for the fi-
nancial manager can thus be stated quite easily:
The goal of financial management is to maximize the current value per share of existing
stock.
The goal of maximizing the value of the stock avoids the problems associated with the different
goals we listed earlier. There is no ambiguity in the criterion, and there is no short-run versus long-
run issue. We explicitly mean that our goal is to maximize the current stock value. If this goal
seems a little strong or one-dimensional to you, keep in mind that the shareholders in a firm are
residual owners. By this we mean that they are only entitled to what is left after employees, suppli-
ers, and creditors (and anyone else with a legitimate claim) are paid their due. If any of these
groups go unpaid, the shareholders get nothing. So, if the shareholders are winning in the sense
that the leftover, residual, portion is growing, it must be true that everyone else is winning also.
For example, following its stock split in 2005 to the time of writing, technology giant Apple Inc. has
increased value to its shareholders with a 126 percent rise in its share price. Apple attributes this fi-
nancial success to major improvements in its bottom line and market share through the
development and introduction of innovative products such as the iPod and MacBooks series.
Because the goal of financial management is to maximize the value of the stock, we need to learn
how to identify those investments and financing arrangements that favourably impact the value of
the stock. This is precisely what we are studying. In fact, we could have defined corporate finance as
the study of the relationship between business decisions and the value of the stock in the business.
To make the market value of the stock a valid measure of financial decisions requires an effi-
cient capital market. In an efficient capital market, security prices fully reflect available informa-
tion. The market sets the stock price to give the firm an accurate report card on its decisions. We
return to capital market efficiency in Part Five.
10 PART 1: OVerview of Corporate Finance
A More General Goal
Given our goal of maximizing the value of the stock. an obvious question comes up: What is the
appropriate goal when the firm is privately owned and has no traded stock? Corporations are cer-
tainly not the only type of business, and the stock in many corporations rarely changes hands, so
irs difficult to say what the value per share is at any given time.
To complicate things further, some large Canadian companies such as Irving are privately
owned. Many large firms in Canada are subsidiaries of foreign multinationals, while others are
controlled by a single domestic shareholder.
Recognizing these complications, as long as we are dealing with. for-profit businesses, only a
slight modification is needed. The total value of the stock in a corporation is simply equal to the
value of the owners' equity. Therefore. a more general way of stating our goal is to maximize the
market value of the owners equity. This market value can be measured by a business appraiser or
by investment bankers if th.e firm eventually goes public.
With this in mind. it doesn't matter whether the business is a proprietorship, a partnership, or
a corporation. For each of these. good financial decisions increase the market value of the owner&
equity and poor financial decisions decrease it. In fact. although we choose to focus on corpora-
tions in the chapters ahead, the principles we develop apply to all forms of business. Many of
them even apply to the not-for-profit sector.
Finally, our goal does not imply that the financial manager should take illegal or unethical ac-
tions in the hope of increasing the value of the equity in the firm. What we mean is that the finan-
cial manager best serves the owners of the business by identi.fying opportunities that add to the
firm beause they are desired and valued in the free marketplace.
In fact. truthful financial reporting is incredibly important to the long run viability of capital
markets. The collapse of companies like Enron and Worldcom has illustrated what a dramatic
impact unethical behaviour can have on public trust and confidence in our Bnandal institutions.
The ability of companies to raise capital and of our economies to function efficiently is based on
this trust and confidence. If investors cannot assume that the information they receive is honest
and truthful, many of the models and theories we learn through this textbook no longer apply.
5
Concept Questions
1. What Is the goal offlnandal management?
2. What are some shortcomings of the goal of profit maximization?
3. How would you define corporate finance?
1.4 THE AGENCY PROBLEM AND CONTROL
OF THE CORPORATION
Wt!ve seen that the financial manager acts in the best interest of the shareholders by taking actions
that increase the value of th.e stock. However, w ~ v e also seen that in large corporations ownership
can be spread over a huge number of shareholders. Or a large shareholder may control a block of
shares. In these cases, will management necessarily act in the best interests of the shareholders?
Put another way, might not management pursue its own goals (or those of a small group of share-
holders) at the shareholders expense? We briefly consider some of the arguments next.
Agency Relationships
The relationship between shareholders and management is called an agency relationship. Such a
relationship e:dsts whenever someone (the principal) hires another (the agent) to represent his or
her interests. For example, you might hire someone (an agent) to sell a car that you own. In all
5
For more on e1hics and ftnanda1 reportiDg v18it the web&ite of the Canadian Centre for Bthi:8 and. Corporate Policy at
www.ethicscentre.ca.
agency problem
The possibility of conflicts
of interest between the
shareholders and
management of a firm.
CHAPTER 1 : Introduction to Corporate Finance 11
such relationships, there is a possibility of conflict of interest between the principal and the agent.
Such conflict is called an agency problem.
In hiring someone to sell your car, you agree to pay a flat fee when the car sells. The agent's
incentive is to make the sale, not necessarily to get you the best price. If you paid a commission
of, say, 10 percent of the sale price instead of a flat fee, this problem might not exist. This exam-
ple illustrates that the way an agent is compensated is one factor that affects agency problems.
Management Goals
To see how management and shareholders' interests might differ, imagine that the firm has a new
investment under consideration. The new investment favourably impacts the share value, but it is
a relatively risky venture. The owners of the flrm may wish to take the investment because the
stock value will rise, but management may not because of the possibility that things will tum out
badly and management jobs will be lost If management does not take the investment. the share-
holders may have lost a valuable opportunity. This is one example of an agency cost.
More generally, agency costs refer to the costs of the conflict of interests between shareholders
and management. These costs can be indirect or direct. An indirect agency cost is a lost opportu-
nity such as the one we have just described.
Direct agency costs come in two forms: The first is a corporate expenditure that benefits man-
agement but costs the shareholders. Perhaps the purchase of a luxurious and unneeded corporate
jet would fall under this heading. The second direct agency cost is an expense that arises from the
need to monitor management actions. Paying outside auditors to assess the accuracy of financial
statement information is one example.
Some argue that if left to themselves, managers would maximize the amount of resources they
have control over or, more generally, corporate power or wealth. This goal could lead to an
overemphasis on corporate size or growth. For example, cases where management is accused of
overpaying to buy up another company just to increase the size of the business or to demonstrate
corporate power are not uncommon. Obviously, if overpayment does take place, such a purchase
does not beneflt the shareholders.
Our discussion indicates that management may tend to overemphasize organizational survival
to protect job security. Also, management may dislike outside interference, so independence and
corporate self-sufficiency may be important goals.
Do Managers Act in the Shareholders' Interests?
Whether managers do, in fact, act in the best interest of shareholders depends on two factors.
First, how closely are management goals aligned with shareholder goals? This question relates to
the way managers are compensated. Second, can managers be replaced if they do not pursue
shareholder goals? This issue relates to control of the firm. As we discuss, there are a number of
reasons to think that, even in the largest firms, management has a significant incentive to act in
the interest of shareholders.
6
MANAGERIAL COMPENSATION Management frequently has a significant economic
incentive to increase share value for two reasons: First, managerial compensation, particularly at
the top, is usually tied to financial performance in general and often to the share value in particu-
lar. For example, managers are frequently given the option to buy stock at current prices. The
more the stock is worth, the more valuable this option becomes.
7
The second incentive managers
have relates to job prospects. Better performers within the firm get promoted. More generally,
those managers who are successful in pursuing shareholder goals are in greater demand in the la-
bour market and thus command higher salaries.
6
The legal system is another important factor in restraining managers and controlling shareholders. The common law
system in place in Canadll, the U.S., and U.K. offers the greatest protection of shareholder rights =rding to R. La Porta,
F. Lopez-de-Silanes, A Schliefer, and R. W. V!Shny, "Law and Finance;' Journal of Political Econom)l December 1998.
7
Employee stock options llllow the manager to purchase a certain number of shares at a fixed price over a specified period of
time. By providing the !lllll1llger an ownership sWce in the company, the options are meant to lilign the manager's goals and
actions with the shareholders' interests. For more on employee stock options, see Chapter 25.
12 PART 1 : OVerview of Corporate Finance
www.aircanada.com
corporate govemance
Rules for corporate
organization and conduct.
www.jantziresearch.com
stakeholder
Anyone who potentially has a
claim on a firm.
Of course, in management compensation, as with other areas of business, matters some-
times get off track. Many observers believe that top executives are overpaid. For example,
Frank Stronach, the founder of auto parts manufacturer Magna International, was criticized
in 2005 for his $44 million compensation for his role as non-executive chairman. Going fur-
ther, creative forms of excessive corporate compensation at U.S. companies like Worldcom,
Tyco, and Adelphia led to the passage of the Sarbanes-Oxley Act in 2002. The act is intended
to protect investors from corporate abuses. For example, one section prohibits personal loans
from a company to its officers, such as the ones that were received by former Worldcom CEO
Bernie Ebbers.
In addition to diverting funds from his firm, Hollinger International, and making payments to
himself and his associates, Lord Black was also found guilty of obstruction of justice.
8
Excessive management pay and unauthorized management consumption are examples of
agency costs.
9
CONTROL OF THE FIRM Controlofthefirm ultimately rests with shareholders. They elect
the board of directors, who, in turn, hire and fire management. In 2007, frustrated with his man-
agement tactics and overly generous compensation package, shareholders of Home Depot pres-
sured the board of directors into ousting CEO Robert Nardelli.
1
From replacing CEOs to entire
boards to demanding changes in a firm's articles of incorporation, shareholder activism is becom-
ing increasingly prominent worldwide. Another way that management can be replaced is by a
takeover. For example, Canadian Airlines' CEO lost his job when the company was taken over by
Air Canada in 1999. Poorly managed firms are more attractive as acquisitions than well-managed
firms because a greater turnaround potential exists. Thus, avoiding a takeover by another firm
gives management another incentive to act in the shareholders' interest
The available theory and evidence substantiate that shareholders control the firm and that
shareholder wealth maximization is the relevant goal of the corporation. Even so, at times man-
agement goals are undoubtedly pursued at the expense of the shareholders, at least temporarily.
For example, management may try to avoid the discipline of a potential takeover by instituting
"poison pill" provisions to make the stock unattractive. Or the firm may issue non-voting stock to
thwart a takeover attempt Canadian shareholders, particularly pension funds and other institu-
tional investors, are becoming increasingly active in campaigning against such management
actions.U
Large funds like the Ontario Teachers' Pension Plan Board have set up detailed corporate
governance and proxy voting guidelines for the companies in which they invest Smaller funds
may employ the services of firms like Institutional Shareholder Services (ISS) to advise them on
how to vote on proposed governance changes.
STAKEHOLDERS Our discussion thus far implies that management and shareholders are
the only parties with an interest in the firm's decisions. This is an oversimplification, of course.
Employees, customers, suppliers, and various levels of government all have financial interests in
the firm.
Taken together, these various groups are called stakeholders in the firm. In general, a
stakeholder is a shareholder, creditor, or other individual (or group) that potentially has a
claim on the cash flows of the firm. Such groups also attempt to exert control over the firm by
introducing alternate, socially oriented goals such as preserving the environment or creating
employment equity. Even though stakeholder pressures may create additional costs for own-
ers, almost all major corporations pay close attention to stakeholders because stakeholder sat-
isfaction is consistent with shareholder wealth maximization. Table 1.2 summarizes concerns
of various stakeholders.
8
CBCnews.ca, June 25, 2008.
9
Because it requires management to pay out almost all of the cash flow to unitholders, the income trust form of organi-
zation can help to control these agency costs.
1o The New York Times, January 4, 2007.
11
We discuss takeovers and pension managers' activism in monitoring management activities in Chapter 23.
CHAPTER 1: Introduction to Corporate Finance 13
TAB L E 1. 2 Inventory of typical stakeholders and issues
Company
Company
history
Industry
background
Organization
structure
Economic
performance
Competitive
environment
Mission or
purpose
Corporate
codes
Stakeholder
and social
Issues
Management
Employees
General policy Beneftts
Compensation Training and
and development
career Employee
planning assistance
Health program
promotion Absenteeism
Leaves of and turnover
absence Relationships
Dismissal and with unions
appeal Termination,
Retirement and layoff, and
termination redundancy
counselling Employment
Women In equity and
management discrimination
and on the Day care
board and family
Employee accommodation
communication Occupational
Part-time health and
temporary, or safety
contract Other employee
employees or human
resource Issues
Shareholders
General policy
Shareholder
communications
and complaints
Shareholder
advocacy
Shareholder
rights
Other
shareholder
issues
Publ1c
Customers Suppliers Stakeholders Competitors
General policy General Public health, General policy
CUstomer policy safety, and
communica- Relative protection
tions power Environmental
Product safety Other Issues
CUstomer supplier Public policy
complaints issues involvement
Special
customer relations
services Social
Other investment
customer and donations
Issues
Soura:: M. B. R. Cl.ulmao. "An.alyzina Corporate Perfonnmce: A New Apfmluh, Ouuulian Pall1991. p. 70.
www.iC:otlabank.oom
Corporate Social Responsibility and Ethical lnvesti ng
Well-managed large corporations seek to maintain a reputation as good corporate citizens with de-
tailed polic:ies on important social issues. Investors are becoming increasingly concerned with cor-
porate social responsibility (CSR) and may tum to firms lJlc:e Michael Jantzi Resean:h Associates in
Canada. or KID in the US . for information. Jantzi Research provides a social responsibility rating
for corporations based on over 200 indicators of responsible behaviour with respect to stakeholder
issues that dovetail with those in Table 1.2: community and society, customers. corporate gover-
nance, employees, env:ironment, and human rights. Jantzi ratings also assess controversial business
activ.ities; these include, alcohol, gaming. genetic engineering, nuclear power, pornography, tobacco,
and weapons. An example Jantzi rating for Loblaw Companies Limited is shown in Figure 1.2.
Sixty companies that avoid controversial business activities and score well on other aiteria
are ind.uded in its Jantzi Social Index. Ethical investment mutual funds such as Ethical Growth and
Investors Summa offer an opportunity to buy a portfolio of Canadian companies that meet criteria
similar to Jantr.fs. Similar funds exist in the U.S. and Europe.
You might wonder about the performance of such funds: Can investors '"do well by doing
good"? The results to date are mixed. A Canadian study suggests that socially responsible in-
vesting during the 1990s produced returns similar to those of the overall market after adjust-
ing for risk and concludes that "investing for the soul may not hurt the bottom line."' However,
because ethical funds tend to invest more heavily in "clean" tech companies, it remains an
open question whether this finding applies in other periods. A more recent U.S. study argues
that socially responsible investing imposes a heavy penalty on return.
12
Given the mixed evi-
dence, major Canadian institutional investors Wee the Ontario Teachers' Pension Plan and the
Ontario Municipal Employees Retirement System pay careful attention to corporate social
12
P. Amundson and S.R. Foerster, "Sodall.y Ruponalble Inve.ung: Better fur Your Soul or Your Bottom IJne! Omadfan
btvestment .Review, Winter 2001, pp. 26-34 &lid. C. Gec:zy, R. E Stambaugh and D. LeviD., "'nvestlng In Sod.ally
Mutual Funda!' Odober 2005, awilable at SSRN: hnp:l/ssrn.corn/abastrtut=416380.
14 PART 1 : OVerview of Corporate Finance
fiGURE 1.2
Canadian Social Investment Database
Loblaw Companies Limited (l)
1 Presidenfs Choice Circle, Suite 1500, Brampton, ON L6Y 5S5
www.!Qblaw.oom
lndlc.: TSX Comp., JSI, S&P/TSX 60
Sector: Consumer Staple
lnduatry: Food & Staples Retailing
1!1 PMr-Group: Food & Drug Retailing
FY 2tXf1 RVMutt ($ mnnona): 29,384.0
Number of Employeee: 140,000
Rating Summary
OVERALL SCORE
COMMUNITY AND SOCIETY
HUMAN RIGHTS
CONTROVERSIAL
BUSINESS ACT'IvmES

1 2 3 & 8 7 8 9

!
!!!! -company
- average
February 2008
Oytra!! Score;
.Bill&
Indexed Score:
5.3
1 of7
1.13
Given the prevalence of parttime employment in the food and drug retail industry, erratic scheduling, lower wages, and fewer benefits
are the norm. As such, labour relations are a key area of exposure for food and drug retailers. Working conditions at franchises and
affiliates, where corporate ESG standards typically do not apply, is an area of particular concern. Managing supply chain exposure is
another challenge for food and drug retailers, particularly for Loblaw, given its recent launch of the clothing label, Joe Fraeh Styles.
An Industry leader In environmental management, Loblaw Is the largest retailer and distributor of organic food In Canada. With
women representing six of 29 senior OffiC$$ and two of 13 boaro members in FY 2007, it is a Ieeder in employee diversity. It also
ranks above its peers for employee benefits and health and safety. A significant majority of Loblaw's employees are unionized, yet
collective bargaining is at the discretion of individual franchise owners rather than Loblaw. In the face of increased competition, the
company has been forced to Jeopardize Its favourable labour relations. Accompanying Increased layoffs Is the contentious pradlce of
"wage-tiering"', which Involves hiring new employees as second-tier workers under different Job dasslflcatlons who receive lower
wages and fewer benefits than existing employees.
Loblaw is an ESG leader among food and drug retailers, and Jantzi Research considers it eligible for SRI portfolios managed in
accordance with a broad range of ESG criteria.
Company Description IB
El
Loblaw Companies Limited (Loblaw) is Canada'slargest retail and wholesale food distributor. Its subsidiaries include Atlantic
Wholesalers Ltd., Fortino's Supermarket Ltd., Kelly Douglas & Company, Loblaws Inc., National Grocers Co. Ltd., Provigo Inc.,
Westfalr Foods Ltd., and Zehrmart Inc. Across Canada, the company and Its subsidiaries operate 628 corporate stores and 25
warehouses, as well as 807 franchised and associated stores, under a variety of banners. A number of these stores also provide
additional servicils such as photo finishing, pharmacy, dry deaning, and financial products and services. The company has gas
bars adjacent to a number of its stores.
Source: Jntzi Resear1:h. Used with permission.
WHAT CAN WE learn from the roots of organizational ethics?
In the dim mists of the past. Jimmy Carter introduced various
pieces of ethics legislation to clean up after the scandals of Rich-
ard Nixon's presidency, and the defense industry undertook a
major ethics initiative to keep Pentagon contracts rolling in. We
now live in world where organizations of all sectors--public,
private and voluntary-often haw to justify themselves if they
do not have an active ethics program in place.
Over the intervening years, we have seen public inter-
est in ethics mushroom in Canada. Ethics stories from every
sector of life used to generate perhaps a newspaper story
per week, often with the word HethicsH not used at all. Then
it began to generate a story a day, and now we often see
whole pages of ethics-related stories in a single day. TV is
not far behind. Where once the word Hethics" was seldom
used; now it is everywhere.
Unfortunately, as evinced by a myriad of recent public
opinion surveys, this exposure has led to a palpable increase
in public cynicism about ethics in Canadian organizations.
However, something encouraging is also emerging: the be-
ginnings of a strong, continuing demand for real reform.
CHAPTER 1: Introduction to Corporate Finance 15
People are increasingly embracing measures such as
fraud awareness, legal compliance, and disclosure of wrong-
doing and whistleblower protection. But even more encour-
agingly, people are also talking about integrity in leadership,
and examining accountability and assessment of ethical per-
formance. Organizations need ethics programs to help the
vast majority of employees and managers to do the right
thing the first time around. And that is predsely the insight
that drove the creation of the Ethics Practitioners' Associa-
tion of Canada (EPAQ.
The ethical dimate could be improved but is not terri-
ble, and there are some solid achievements in ethics pro-
grams, particularly in parts of the federal and Quebec public
sectors, and in some large Canadian corporations. Virtue is
its own reward, but the price of not improving is also sure to
get higher and higher.
Source: EPAC/.APfC Magozlne, );mu;111y 2006, vol. 6, no. 1. Used with
penn 15slon.
Cornelius I'WI Boeyer Is Past Chair of the Ethics Prac!1t/onm' Association of
Canada.
responsibility in selecting investments but do not eliminate companies from their portfolios
based solely on environmental and other social issues.
13
Concept Questions
1. What is an agency relationship?
2. What are agency problems and how do they come about? What are agency costs?
3. What incentives do manage13 in large corporations hiM! to maximize share value?
4. What role do stakeholders play in determining corporate goals?
1.5 FINANCIAL MARKETS AND THE CORPORATION
Weve seen that the primary advantages of the corporate form of organization are that ownership
can be transferred more quickly and easUy than with other forms and that money can be raised
more readily. Both of these advantages are significantly Cllhanced by the existence of financial in-
stitutions and markets. Financial. markets play an extremely important role in corporate finance.
,, For a detailed BWilDlli1'Y of arguments in favour of oclally responsible lnvuting by pension funds, 1ee A legal
framework for the Integration of enviroamental. 80dal. and governance .lasue1 into .lnstitutionallllvestment,"
by Freahftel.dl Bruckhaua Derillger and the UNEP Flllance Initiative. October 2005, avallable at

16 PART 1: OVerview of Corporate Finance
FIGURE 1.3
Cash flows between
the firm and the
financial markets
money markele
Financial markets where
short-tenn debt securities are
bought and sold.
capital ma.rkeiS
Financial markets where
long-tenn debt and equity
securities are bought and
sold.
'lbtal Value of
Flnn's.Auets
B. Firm Invests
in asse'ts
A. Firm Issues securttles
E. Reinvested cash flows F. Dividends and
lbtal value of the Finn
to lnveston In
1he Financial Markets
Financial
markets
Current assets
Fixed asse'ts 1---------'
debt payments
Short-term debt
Long-term debt
Equity shares
c. cash flow from
firm's assets
A. Firm issues securities to raise cash.
B. Finn invests in assets.
C. Finn's operations generate cash
flow.
D. cash is paid to government as taxes. Other
stakeholders may receive cash.
E. Reinvested cash flows are plowed back into firm.
F. cash is paid out to investors in the form of interest
and dividends.
Cash Flows to and from the Firm
The interplay between the corporation and the financial markets is illustrated in Figure 1.3. The
arrows in Figure 1.3 trace the passage of cash from the financial markets to the firm and from the
firm back to the financial markets.
Suppose we start with the firm selling shares of stock and borrowing money to raise cash. Cash
flows to the firm from the financial market (A). The firm invests the cash in current and fixed
assets (B). These assets generate some cash (C), some of which goes to pay corporate taxes (D).
After taxes are paid, some of this cash flow is reinvested in the firm (E). The rest goes back to the
financial markets as cash paid to creditors and shareholders (F).
Companies like Tim Horton.s routinely make decisions that create such cash flows to and from
the firm. For example, in 2005 the company used increased cash flow from assets to pay down a
portion of the firrrls debt.
A financial market, like any market, is just a way ofbringing buyers and seDers together. In financial
markets. it is debt and equity securities that are bought and sold. Financial markt:ts differ in detail,
however. The most important differences concern the types of securities that are traded, how trading
is conducted, and who the buyers and sdlers are. Some of these differences ~ d i s c u s s e d next.
Money versus Capital Markets
Financial markets can be classified as either money m.aikets or c:apital m.aikets. Short-term debt
securities of many varieties are bought and sold in money markets. These short-term debt securities
are often called money market instnunents and are essentially IOUs. For example, a bankers accep-
tance represents short-term borrowing by large corporations and is a money-market instrument.
Treasury bills are an IOU of the government of Canada. Capital markt:ts are the markt:ts for long-
term debt and shares of stock. so the Toronto Stock Exchange, for e:mmple, is a capital market.
The money market is a dealer markt:t. Generally, dealers buy and sell something for them-
selves, at their own risk. A car dealer, for example, buys and sells automobiles. In contrast, brokers
and agents match buyers and sellers, but they do not actually own the commodity. A real estate
agent or broker, for example. does not normally buy and sell houses.
www.rbcem.com
www.osc.gov.on.ca
www.tmx.com
www.nyse.com
CHAPTER 1: Introduction to Corporate Finance 17
The largest money-market dealers are chartered banks and investment dealers. Their trading
facilities, like those of other market participants, are connected electronically via telephone and
computer, so the money market has no actual physical location.
Primary versus Secondary Markets
Financial markets function as both primary and secondary markets for debt and equity securities.
The term primary markets refers to the original sale of securities by governments and corpora-
tions. The secondary markets are where these securities are bought and sold after the original sale.
Equities are, of course, issued solely by corporations. Debt securities are issued by both govern-
ments and corporations. In the following discussion, we focus only on corporate securities.
PRIMARY MARKETS In a primary market transaction, the corporation is the seller, and the
transaction raises money for the corporation. Corporations engage in two types of primary mar-
ket transactions: public offerings and private placements. A public offering, as the name suggests,
involves selling securities to the general public. For example, in 1999 and early 2000, investors
were snapping up new issues providing equity funding to untested dot-com IPOs (initial public
offerings). A private placement, on the other hand, is a negotiated sale involving a specific buyer.
These topics are covered in some detail in Part 6, so we only introduce the bare essentials here.
Most publicly offered debt and equity securities are underwritten. In Canada, underwriting is
conducted by investment dealers specialized in marketing securities. Examples are RBC Capital
Markets, Scotia Capital, BMO Capital Markets, and CIBC World Markets.
When a public offering is underwritten, an investment dealer or a group of investment dealers (called
a syndia:ae) typically purchase the securities from the firm and market them to the public. The under-
writers hope to profit by reselling the securities to investors at a higher price than they pay the finn.
By law, public offerings of debt and equity must be registered with provincial authorities, of
which the most important is the Ontario Securities Commission (OSC). Registration requires the
firm to disclose a great deal of information before selling any securities. The accounting, legal,
and underwriting costs of public offerings can be considerable.
Partly to avoid the various regulatory requirements and the expense of public offerings, debt
and equity are often sold privately to large financial institutions such as life insurance companies
or mutual funds. Such private placements do not have to be registered with the OSC and do not
require the involvement of underwriters.
SECONDARY MARKETS A secondary market transaction involves one owner or creditor sell-
ing to another. Therefore, the secondary markets provide the means for transferring ownership of
corporate securities. There are two kinds of secondary markets: auction markets and dealer markets.
Dealer markets in stocks and long-term debt are called over-the-counter (OTC) markets. Trad-
ing in debt securities takes place over the counter. The expression over-the-counter refers to days
of old when securities were literally bought and sold at counters in offices around the country.
Today, like the money market, a significant fraction of the market for stocks and all of the market
for long-term debt have no central location; the many dealers are connected electronically.
TRADING IN CORPORATE SECURITIES Theequitysharesofmostofthelargefirmsin
Canada trade in organized auction and dealer markets. The largest stock market in Canada is the
Toronto Stock Exchange (TSX). Table 1.3 shows the top ten stock markets in the world in 2008,
Toronto ranked number seven based on market value. The TSX also runs the Venture Exchange
for listing smaller, emerging companies. The four main industries represented on the Venture Ex-
change are biotechnology, information technology, mining, and oil and gas.
Auction markets differ from dealer markets in two ways: First, an auction market or exchange,
unlike a dealer market, has a physical location (like Wall Street}. Second, in a dealer market, most of
the buying and selling is done by the dealer. The primary purpose of an auction market, on the other
hand, is to match those who wish to sell with those who wish to buy. Dealers play a limited role.
In addition to the stock exchanges, there is a large OTC market for stocks. In 1971, the U.S.
National Association of Securities Dealers (NASD) made available to dealers and brokers an
electronic quotation system called NASDAQ (NASD Automated Quotation system, pro-
nounced "naz-dal(> and now spelled "Nasdaq,). In January 2006, Nasdaq took the next step
forward when its application to be registered as a national stock exchange was accepted by the
18 PART 1: OVerview of Corporate Finance
TABLE 1.3
Largest stoc:k markets Market C.frtalrzatlon
______________ __ ______________ __ _
capitalization m 2008 1 NYSE Group $13,567.1
www.miaosoft.c:om
www.lntel.c:om
2 Tokyo SE 3751.1
3 Nasdaq 3693.0
4 Euronext 3268.6
5 London SE 3057.3
6 Hong Kong Exchanges 1960.7
7 TSX Group 1878.3
8 Shanghai SE 1 858.5
9 Deutsche Barse 1 664.6
10 BME Spanish Exchanges 1514.4
U.S. Securities and Exchange Commission. There are roughly three times as many companies
on Nasdaq as there are on NYSE, but they tend to be much smaller in size and trade less ac-
tively. There are exceptions, of course. For example, tech giants Microsoft and Intel trade on
Nasdaq. Nonetheless, the total value ofNasdaq stocks is considerably less than the total value
of the NYSE stocks.
LISTING Stocks that trade on an organized exchange are said to be listed on that exchange. To
be listed. firms must meet certain minimum criteria concerning, for example, asset size and num-
ber of shareholders. These criteria differ for various exchanges.
The requirements for listing on the TSX Venture are not as strict as those for listing on the
TSX. although the listing process is quite similar. The TSX. Venture. however, has two different
tiers that companies can register under. Companies can list shares on the second tier with as little
as $500,000 in net tangible assets and $50,000 in pre-tax earnings. Both tiers require that there
exist 300 public shareholders, holding one board lot or more; Tier 1 also requires that there be
1 million free trading shares with a market value of $1 million or more. and Tier 2 requires at
least 500,000 free trading shares with a market value of $500,000 or more. These requirements
make it possible for smaller companies that would not normally be able to obtain listing on the
TSX to acquire equity finandng.
The TSX has the most stringent requirements of the exchanges in Canada. For example, to be
listed on the TSX. a company is expected to have a market value for its publicly held shares of at
least $2 million and a total of at least 300 shareholders with at least 100 shares each. There are
additional minimums on earnings, assets, and number of shares outstanding. Research suggests
that listing on exchanges adds valuable liquidity to a company's shares.
14
In November 2002, the
TSX itself went public and listed its shares for the first time. With an offering of just under
19 million shares at an initial offering price of $18, the TSX. easily exceeded its own listing
requirements.
1.6 FINANCIAL INSTITUTIONS
Financial institutions act as intermediaries between iD:vestors (funds suppliers) and firms raising
funds. (Federal and provincial governments and individuals also raise funds in financial markets, but
our examples focus on firms.) Financial institutions justify their existence by providing a variety of
services that promote dte efficient allocation of funds. These institutions also serve as intermediaries
14
RdevaD.t stu& includeS. R. Foerater and G. A. Karolyi. The F..tfeas of.t.Wtet Segmentation and IJm:stor Reoogni
tion on Asset Price: !Mdenc:efrom ForeiJnStocb Ll81inpin the U.S.: JIJIU"'UilujPifUlfl, S4:3, 1999,981-1013 and
U.R. Mittoo, The Wmnen and Losers of Listings in the U.s.; Omadian bwe.stmmt Review, Fall 1998, 17.
TABLE 1.4
Largest financial
institutions in
Canada, by market
capitalization,
October 2008
Rank
2
3
4
5
6
7
8
9
10
11
CHAPTER 1: Introduction to Corporate Finance 19
Company
Royal Bank of canada
Toronto Dominion
Manulife Financial Corp.
Bank of Nova Scotia
Great-West Lifeco
Power Financial Corp.
Canadian Imperial Bank of Commerce
Bank of Montreal
Sun Life Financial Inc.
IGM Financial
National Bank of canada
Market Cpltallzatfon
$61.6
47.7
45.5
44.0
25.6
22.2
21.3
21.3
17.2
9.6
7.1
for households and indMduals-providing a medium where individuals can save and borrow money.
Individuals and households may choose to save not only in the traditional savings and chequing ac-
counts, but also in savings plans such as a Registered Retirement Savings Plan (RRSP), Registered Ed-
ucation Savings Plan (RESP), or 'lax-Free Savings Account (TFSA). Canadian financial institutions
include chaTtered banks and other depository institutions-trust companies, credit unions, investment
dealers, insurtusce companies, pension funds, and mutual funds.
Table 1.4 ranks the top eleven publicly traded financial institutions in Canada by market capi-
talization in 2008. They include the Big Six chartered banks,. three life insurance companies, one
financial holding company, and a diversified financial services company. Beause they are al-
lowed to diversify by operating in all provinces, Canada's chartered banks are of a reasonable size
on an international scale.
Chartered banks operate under federal regulation, accepting deposits from suppliers of funds and
making commercial loans to mid-sized businesses, corporate loans to large oompanies, and personal
loans and mortgages to indMduals. Banks make the majority of their income from the spread between
the interest paid on deposits and the higher rate earned on loans. This is indirect finance.
Chartered banks also provide other services that generate rees instead of spread income. For
example, a large corporate customer seeking short-term debt funding can borrow directly from
another large corporation with funds supplied through a bankers acceptance. This is an interest-
bearing IOU stamped by a bank guaranteeing the borrower'S credit Instead of spread income, the
bank receives a stamping fee. Bankers acceptances are an example of direct finance. Notice that the
key difference between direct finance and indirect finance is that in direct finance funds do not
pass through the banks balance sheet in the fonn of a deposit and loan. Often called securitiza-
tion because a security (the bankers acceptance) is created, direct finance is growing rapidly.
Trust companies also accept deposits and make loans. In addition, trust companies engage in
fiduciary activities-managing assets for estates, registered retirement savings plans, and so on.
Like trust companies, credit unions also accept deposits and make loans. Caisses Desjardins du
Quebec is a major Quebec credit union, but does not appear in Table 1.4 because it is member-
owned and not publicly traded.
Investment dealers are non-depository institutions that assist firms in issuing new securities in
exchange for fee income. Investment dealers also aid investors in buying and selling securities.
Chartered banks own majority stakes in five of Canadas top 15 investment dealers.
Insurance companies include property and casualty insurance and health and life insurance
companies. Life insurance companies engage in indirect finance by accepting funds in a fonn
similar to deposits and making loans. Manulife Financial and Sun Life Financial are major life in-
surance companies that have expanded aggressively to become rivals of the chartered banks.
Fuelled by the aging of the Canadian population and the longest bull market in history, assets
in pension and mutual funds grew rapidly in the 1990s. Pension funds invest contributions from
employers and employees in securities offered by financial markets. Mutual funds pool individual
20 PART 1 : OVerview of Corporate Finance
TABLE l.S
Total net usets by
fund type in
September 2008
canadian Equity
Global and International Equity
U.S. Equity
Sector Equity
Domestic Balanced
Global Balanced
canadian Fixed Income
Global and High Yield Fixed Income
Money Martcet Funds
Total
Net Assets ($ billions)
s 151
81.3
20.4
13.8
142.1
91.1
so.s
7.4
70.6
s 628
invertments to purchase divemified portfolios of securities. There are many different types of mu-
tual funds. Table 1.5 shows the totals of mutual fund assets by fund type. In September 2008, the
two largest categories were Canadian and foreign equity.
Hedge funds are another growing group of financial institutions. According to the 2008
Hedge Fund Asset Flows & Trends report published by HedgeFund.net, the industry had ap-
proximately US$2.68 trillion under management worldwide in the third quarter of 2007. Hedge
funds are largely unregulated and privately managed investment funds catering to sophisticated
investors, which look to earn high returns using aggressive financial strategies prohibited by
mutual funds. These strategies may include arbitrage,
15
high levels of leverage,
16
and active
involvement in the derivatives market. However, hedge funds are not restricted to investing in
financial instruments-some hedge fund strategies involve acquiring stakes in public or private
companies and pressuring the board to sell the business. Canadian hedge funds experienced
annual growth of 25 percent with roughly $40 billion of assets under management in nearly
300 hedge funds at the summer of2008 peak in the market.
17
There is a high risk associated with
hedge funds as these are highly unregulated and subject to fraud. In 2009, Bernard Madoff, a
prominent money manager and former chairman of the NASDAQ was sentenced to 150 years of
imprisonment for his involvement in a US$50 billion hedge fund scandal.
We base this survey of the principal activities of financial institutions on their main activities
today. Recent deregulation now allows chartered banks, trust companies, insurance companies,
and investment dealers to engage in most of the activities of the others with one exception:
Chartered banks are not allowed to sell life insurance through their branch networks. Although
not every institution plans to become a one-stop financial supermarket, the different types of
institutions are likely to continue to become more alike.
Concept Questions
1. What are the principal flnanclallnstltutlons ln canada? What Is the principal role of each?
2. What are direct and indirect finance? How do they differ?
a. How are money and capital markets different?
4. What is a dealer market? How do dealer and auction markebi differ?
&. What is the largest auction market in Canada?
15
The pn.cfu:e of taking advaumge of a prite differential between two or more marltets.
1
' The uae of debt to the pokntial return of an investment.
17 Aa:ordll!g to Terrapm. argan1zen! F1mds World Canada 2008. Soim:e: http-J/www.ll!mlplnn.com/200B/Irjwr:tmat
'lb learn more about hedge fund developments, vWt HedgeFund.net <www.hedgefund.net>.
1.7
ftnanclal engineering
Creation of new securities or
financial processes.
derivative aacurities
Options, futures, and other
securities whose value derives
from the price of another,
undertying, .wet.
regulatory dialectic
The pressures financial
institutions and regulatory
bodies exert on each other.
CHAPTER 1: Introduction to Corporate Finance 21
TRENDS IN FINANCIAL MARKETS AND
FINANCIAL MANAGEMENT
Like all markets, financial markets are experiencing rapid globalization. Globalization also makes
it harder for investors to shelter their portfolios from financial shocks in other countries. In the
summer of 1998, the Asian financial crisis shook financial markets around the world. With in-
creasing globalization, interest rates, foreign exchange rates, and other macroeconomic variables
have become more volatile. The toolkit of available financial management techniques has ex-
panded rapidly in response to a need to control increased risk from volatility and to track com-
plexities arising from dealings in many countries. Computer technology improvements are
making new financlal engineering applications practical.
When financial managers or investment dealers design new securities or financial processes, their
efforts are referred to as financial engineering. Successful financial engineering reduces and controls
risk and minimizes taxes. Financial engineering creates a variety of debt and equity securities andre-
inforces the trend toward securitization of credit introduced earlier. A controversial example is the
invention and rapid growth of trading in options, futures, and other dertfatlve securities. Derivative
securities are very useful in controlling risk, but they have also produced large losses when mishan-
dled. At the time of writing, the largest financial accident with derivatives was the loss that triggered
a $3.5 billion US. bailout ofdte U.S. fund Long Term Capital Management in 1998.
Financial engineering also seeks to reduce financing costs of issuing securities as well as the
costs of complying with rules laid down by regulatory authorities. An example is the Short Form
Prospectus Distribution (SFPD) allowing firms that frequently issue new equity to bypass most of
the OSC registration requirements.
In addition to financial engineering. advances in technology have created e-business, bringing
new challenges for the financial manager. For example, consumers ordering products on a com-
pants website expect rapid delivery and failure to meet these expectations can damage a compa-
n:y's image. This means that companies doing e-business with consumers must invest in supply
chain management as well as in additional inventory.
Technological advances have also created opportunities to combine different types of financial
institutions to take advantage of economies of scale and scope. For example, Royal Bank, Canada's
largest chartered bank. owns Royal Trust and RBC Dominion Securities. Such. large institutions op-
erate in all provinces and internationally and enjoy more lax regulations in some jurisdictions than
in others. Financial institutions pressure authorities to deregulate in a push-pull process called the
regulatory dlaledic.
For example, in 1998 and again in 2002, banks planned mergers in an effort to pressure the
federal government to grant approvaL Although the federal government turned down the merg-
ers, we believe this issue is dormant, not dead, and will reemerge in the not too distant future.
Not all trends are driven by technology. In the aftermath of the technology bubble of the late
1990s, stakeholders and regulators have become very interested in corporate governance reform,
a topic we introduced earlier in the chapter. For example, proponents of such reform argue that a
stronger, independent board of directors can prevent management excesses such as ocurred at
Hollinger.
Another trend underlying the global financial crisis starting in 2007 was excessive financial
leverage. Following the technology bubble and September 11, the United States Federal Reserve
looked to aggressively lower interest rates in order to restore confidence in the economy. In the
U.S., individuals with bad credit ratings, sub-prime borrowers, looked to banks to provide loans
at historically low interest rates for home purchases. Investors also reacted to these low rates by
seeking higher returns. The financial industry responded by manufacturing sub-prime mortgages
and asset-backed securities. However, once housing prices began to cool and interest rates rose,
sub-prime borrowers started defaulting on their loans and the collapse of the sub-prime market
ensued. With mortgages serving as the underlying asset supporting most of the financial instru-
ments that investment banks, institutions, and retail buyers had acquired, these assets lost much
of their value and hundreds of billions of dollars of write-downs followed.
These trends have made financial management a much more complex and technical activity.
For this reason, many students of business find introductory finance one of their most challeng-
ing subjects. The trends we reviewed have also increased the stakts. In the face of increased global
22 PART 1: OWrvlew of Corporate Finance
competition, the payoff for good finandal management is great. The finance function is also be-
coming important in corporate strategic planning. The good news is that career opportunities
(and compensation) in :financial positions are quite attractive.
1.8 OUTLINE OF THE TEXT
Now that wive completed a quick tour af the concerns of corporate finance, we can take a closer
look at the organization of this book. The text is organized into the following nine parts:
Part 1: Overview af Corporate Finance
Part 2: Financial Statements and Long-Term Financial Planning
Part 3: Valuation of Future Cash Flows
Part 4: Capital Budgeting
Part 5: Risk and Return
Part 6: Cost of Capital and Long-Term Financial Policy
Part 7: Short-Term Financial Planning and Management
Part 8: Topics in Corporate Finance
Part 9: Derivative Securities and Corporate Finance
Part 1 of the text contains some introductory material and goes on to explain the relationship be-
tween accounting and cash flow. Part 2 explores financial statements and how they are used in fi-
nance in greater depth.
Parts 3 and 4 contain our core discussion on valuation. In Part 3, we develop the basic proce-
dures for valuing future cash flows with particular emphasis on stocks and bonds. Part 4 draws on
this material and deals with capital budgeting and the effect of long-term investment decisions on
the firm.
In Part 5, we develop some tools for evaluating risk. We then disC'WIS how to evaluate the risks
associated with long-term investments by the fum. The emphasis in this section is on coming up
with a benchmark for making investment decisions.
Part 6 deals with the related issues of long-term financing, dividend policy, and capital struc-
ture. We discuss corporate securities in some detail and describe the procedures used to raise
capital and sell securities to the public. We also introduce and describe the important concept of
the cost of capital. We go on to examine dividends and dividend policy and important consider-
ations in determining a capital structure.
The working capital question is addressed in Part 7. The subjects of short-term financial plan-
ning. cash management, and credit management are covered.
Part 8 contains the important special topic of international corporate finance. Part 9 covers
risk management and derivative securities.
1.9 SUMMARY AND CONCLUSIONS
This chapter has introduced you to some of the basic ideas in corporate finance. In it. we saw that;
I. Corporate finance has three main areas of concern:
a. What long-term investments should the firm take? This is the capital budgeting decision.
b. Where will the firm get the long-term financing to pay for its investment? In other
words. what mixture of debt and equity should we use to fund our operations? This is the
capital structure decision.
c. How should the fum manage its everyday financial activities? This is the working capital
decision.
2. The goal of financial management in a for-profit business is to make decisions that increase
the value af the stock or, more generally, increase the market value of the equity.
3. The corporate form of organization is superior to other forms when it comes to raising
money and transferring ownership interest, but it has the disadvantage of double taxation.
Key Terms
CHAPTER 1: Introduction to Corporate Finance 23
4. There is the possibility of conflicts between shareholders and management in a large
corporation. We called these conflicts agency problems and discussed how they might
be controlled and reduced.
5. The advantages of the corporate form are enhanced by the existence of financial markets.
Financial institutions function to promote the efficiency of financial markets. Financial
markets function as both primary and secondary markets for corporate securities and
can be organized as either dealer or auction markets. Globalization, deregulation, and
financial engineering are important forces shaping financial markets and the practice of
financial management
Of the topics weve discussed thus far, the most important is the goal of financial management:
Maximizing the value of the stock. Throughout the text, as we analyze financial decisions, we
always ask the same question: How does the decision under consideration affect the value of
the shares?
agency problem (page 11)
capital budgeting (page 3)
capital markets (page 16)
capital structure (page 4)
corporate governance (page 12)
corporation (page 6)
financial engineering (page 21)
money markets (page 16)
partnership (page 5)
regulatory dialectic (page 21)
sole proprietorship (page 5)
stakeholder (page 12)
derivative securities (page 21) working capital management (page 4)
Concepts Review and Critical Thinking Questions
1. The Financial Management Decision Process ( L01) What are the three types of financial management decisions?
For each type of decision, give an example of a business transaction that would be relevant.
2. Sole Proprietorships and Partnerships (L02) What are the three primary disadvantages to the sole proprietorship and
partnership forms ofbusiness organization? What benefits are there to these types ofbusiness organization as opposed to
the corporate form?
3. Corporate Organization (L02) What is the primary disadvantage of the corporate form of organization? Name at least
two advantages of corporate organization.
4. Corporate Finance Organizational Structure (L04) In a large corporation, what are the two distinct groups that report
to the chief financial officer? Which group is the focus of corporate finance?
5. The Goal of Financial Management (L03) What goal should always motivate the actions of the firm's financial
manager?
6. Corporate Agency Issues {L04) Who owns a corporation? Describe the process whereby the owners control the firm's
management. What is the main reason that an agency relationship exists in the corporate form of organization? In this
context, what kind of problems can arise?
7. Financial Markets (LOS) An initial public offering (IPO) of a company's securities is a term you've probably noticed in
the financial press. Is an IPO a primary market transaction or a secondary market transaction?
8. Financial Markets {LOS) What does it mean when we say the Toronto Stock Exchange is both an auction market and a
dealer market? How are auction markets different from dealer markets? What kind of market is Nasdaq?
9. Not-for-Profit Firm Goals (L03) Suppose you were the financial manager of a not-for-profit business (a not-for-profit
hospital, perhaps). What kinds of goals do you think would be appropriate?
10. Firm Goals and Stock Value (L03) Evaluate the following statement: "Managers should not focus on the current stock
value because doing so will lead to an overemphasis on short-term profits at the expense oflong-term profits.D
11. Firm Goals and Ethics (L03) Can our goal of maximizing the value of the stock conflict with other goals, such as
avoiding unethical or illegal behaviour? In particular, do you think subjects like customer and employee safety, the envi-
ronment and the general good of society fit in this framework, or are they essentially ignored? Try to think of some spe-
cific scenarios to illustrate your answer.
12. Firm Goals and Multinational Firm11 {L03) Would our goal of maximizing the value of the stock be different if we
were thinking about financial management in a foreign country? Why or why not?
24 PART 1 : Overview of Corporate Finance
13. Agenq-Iuues and Corporate Control (L04) Suppose you own shares in a company. The current price per
share is $25. Another company has just announced that it wants to buy your company and will pay $35 per
share to acquire all the outstanding shares. Your company's management immediately begins fighting off this
hostile bid. Is managmwrt acting in the shareholders' best interests? Why or why not?
14. Agen<:y Iuues and Intemational Finance (L04) Corporate ownership varies around the world. Historically,
individuals have owned the majority of shares In public corporations in the United States. In Canada this Ia also
the case. but ownership Ia more often concentrated In the hands of a majority shareholder. In Germany and Ja-
pan. banks, other financial institutions. and large companies own most of the shares in public corporations.
How do you think these ownership differences affect the severity of agency costs in different countries?
15. Major m.tl.tutione and Markets (LOS) What are the major types of financial institutions and financial mar-
kets in Canada?
16. Direct venusln.dlrect Finance (L05) What Ia the difference between direct and indirect finance? Give an ex-
ample of each.
17. Current Major Trends (LOB) What are some of the major trends in Canadian financial markets? Explain how
these trends affect the practice of :6nancial management in Canada.
S&P Problem
1. Industry Comparison On the Market Insight homepage, follow the .. Industry" link at
the top of the page to the industry page. You can use the drop down menu to select
different industries. Answer the following questious for these industries: Airlines, Auto-
--
STANDARD
&POOR'S
mobiles, Biotechnology, Computers (Software & Services), Homebuilding, Manufacturing (Diversified),
Restaurants, Retail (General Merchandise), and Telecommunications (Cellular/Wireless).
a. How many companies are in each industry?
b. What are the total sales for each industry?
c. Do the industries with the largest total sales have the most companies in the industry? What does this tell
you about competition in the various industries?
Internet Application Questions
1. Equity markets are an Important source of capital for private firms in Canada. Take a tour of the
Toronto Stock El:change at www.tlm.com. What Ia the TSX Composite IndeJ:? Check. out Index Lists/
Information under Investor Information. What does a change in the TSX Composite Index tell you?
2. Canadian banks are actively involved in financing home mortgages. Descn"be the role played by the Canada
Mortgage and Housing Corporation in home mortgages (www.cmhc.ca/). What is the National Housing kt1 Can an
investor participate in the mortgage "pool" represented by housing loans insured by the CMHCt Click on the
Investment Opportunities menu on the CMHC homepage and describe Mortgage Backed Securities offered by the
CMHC.
3. The choice of business organization form depends on many factors. The following site from British Columbia outlines
the pros and cons of a sole proprietorship, partnership. and corporation: www.sb.gov.bc.ca/blzstart-prop.php.
Can you SUBBest a few reason& why some firms that were organized as partnerships decided to incorporate
(e.g,, Goldman Sachs (www.goldmanli8chs.com) with shares traded on the NYSE (www.nyse.com)t
4.. Ethical investing following socially responsible principles is gaining popularity. The Social Investment
Organization website provides information about these principles and on Canadian ethical mutual funds at
www.socialinvestmentca. Michael Jantzi Research Associates offers research services to support socially responsible
investing at www.jantziresearch.com. How does Investing in ethical funds differ from investing in generalr What has
been the performance record of Canadian ethical funds?