Chapter 1

Principles of Corporate Finance, Concise

Second Edition

Goals and Governance of the Firm

Slides by Matthew Will

McGraw-Hill/Irwin Copyright 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

Topics Covered
Corporate Investment and Financing Decisions The Role of the Financial Manager and the Opportunity Cost of Capital Goals of the Corporation Agency Problems and Corporate Governance

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Investment and Financing Decisions

Common Finance Terminology
Real assets Financial assets / Securities Capital markets and financial markets Investment / capital budgeting Financing

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Investment and Financing Decisions

Real Assets
Assets used to produce goods and services.

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Financial Assets
Financial claims to the income generated by the firms real assets.

Investment and Financing Decisions

Investment decision
purchase of real assets

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Financing decision
sale of financial assets

Investment and Financing Decisions

Capital Budgeting Decision
Decision to invest in tangible or intangible assets.

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also called the Investment Decision also called Capital Expenditures or (CAPEX)

Investment and Financing Decisions

Capital Budgeting

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Tangible Assets Expand Stores @ $800 million

Intangible Assets New Drug R&D @ $800 million

Investment and Financing Decisions

Company (revenue in billions for 2007 or 2008) Boeing ($61 billion) Recent Investment Decision Began production of its 787 Dreamliner Recent Financing Decision The cash flow from Boeings

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aircraft, at a forecast cost of more than

$10 billion.

operations allowed it to repay some

of its debt and repurchase $2.8 billion of stock.

Royal Dutch Shell ($458 billion)

Invests in a $1.5 billion deepwater oil and gas field.

In 2008 returned $13.1 billion of cash to its stockholders by buying back their shares.

GlaxoSmithKline (24

Spent 3.7 billion in 2008 on research

Financed R&D expenditures

billion)

and development of new drugs.

largely with reinvested cash flow

generated by sales of pharmaceutical products.

Wal-Mart ($379billion)

In 2008 announced plans to invest over a In 2008 raised $2.5 billion by an billion dollars in 90 new stores. issue of 5-year and 30-year bonds. Largely financed its investment in locomotives by long-term leases.

Union Pacific ($18 billion)

Acquired 315 new locomotives in 2007.

Role of The Financial Manager

(2) (1)

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Firm's operations
(3)

Financial manager

(4a)

Financial markets

(4b)

(1) Cash raised from investors (2) Cash invested in firm (3) Cash generated by operations (4a) Cash reinvested (4b) Cash returned to investors

Who is The Financial Manager?

Chief Financial Officer

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Treasurer

Controller

The Investment Trade-off

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The Investment Trade-off

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Hurdle rate
Cost of capital Opportunity cost of capital

Goals of The Corporation

Each stockholder wants three things:

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1. To be as rich as possible, that is, to maximize his or her current wealth. 2. To transform that wealth into the most desirable time pattern of consumption either by borrowing to spend now or investing to spend later. 3. To manage the risk characteristics of that consumption plan.

Goals of The Corporation

Profit maximization is not a well-defined financial objective, for at least two reasons: 1. Maximize profits? Which years profits? A corporation may be able to increase current profits by cutting back on outlays for maintenance or staff training, but that may add value. Shareholders will not welcome higher short-term profits if longterm profits are damaged. 2. A company may be able to increase future profits by cutting this years dividend and investing the freed-up cash in the firm. That is not in the shareholders best interest if the company earns less than the opportunity cost of capital.

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Whose Company Is It?

** Survey of 378 managers from 5 countries
Japan Germany France United Kingdom United States
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Shareholders All Stakeholders

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3 17 22 71 76 40 60 80

97 83 78 29 24 20

100

120

% of responses

Dividends vs. Jobs

3 40 41

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** Survey of 399 managers from 5 countries. Which is more important...jobs or paying dividends?
Japan Germany France United Kingdom United States
0
Dividends Job Security

97 60 59 89 89 40 60 80 100 120

11 11 20

% of responses

Goals of The Corporation

Shareholders desire wealth maximization Do managers maximize shareholder wealth? Mangers have many constituencies; stakeholders Agency Problems represent the conflict of interest between management and owners

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Agency Problem
Ownership vs. Management
Difference in Information Stock prices and returns Issues of shares and other securities Dividends Financing

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Different Objectives Managers vs. stockholders Top mgmt vs. operating mgmt Stockholders vs. banks and lenders

Agency Problem
Agency costs are incurred when:
1. managers do not attempt to maximize firm value, and 2. shareholders incur costs to monitor the managers and constrain their actions.

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Agency Problem
Agency Problems
Managers, acting as agents for stockholders, may act in their own interests rather than maximizing value.

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Stakeholder
Anyone with a financial interest in the firm.

Agency Problem
Tools to Ensure Management Pays Attention to the Value of the Firm

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Mangers actions are subject to the scrutiny of the board of directors. Shirkers are likely to find they are ousted by more energetic managers. Financial incentives such as stock options

Agency Problem
Agency Problem and Corporate Governance Solutions
1. Legal and Regulatory Requirements 2. Compensation plans 3. Board of Directors 4. Monitoring 5. Takeovers 6. Shareholder pressure

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Additional Web Resources

Click to access web sites Internet connection required

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www.corpgov.net www.thecorporatelibrary.com www.riskmetrics.com