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Introduction to Corporate Finance

Chapter I

The Balance-Sheet Model of the Firm


Net working capital

Current liabilities

Current assets

Fixed assets 1. Tangible fixed assets 2. Intangible fixed assets


Total Value of Assets

Long-term debt

Shareholders equity
Total Value of the Firm to Investors

Basic Concerns of Corporate Finance


What long-term investment strategy should a company take on? Investment Decisions How can cash be raised for the required investments? Financial Decisions How much short-term cash flow does a company need to pay its bills? Working Capital Decisions
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Capital Budget & Capital Structure


Capital Budgeting & Capital Expenditures: The process of making & managing expenditures on long-lived (term) assets Capital Structure: Represents the proportions of the firms financing from current & long term debt and equity Net Working Capital: Short term management of cash flow during operating activities Current Assets minus Current Liabilities
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The Value Of The Firm


Value of the firm = Value of Debt + Value of Equity V=B+S Creditors / debtholders / bondholders: Lenders of funds at the predetermined cost (interest) & the predetermined time of repayment / buyer of debt (bonds) from the firm Shareholders: The holders of equity shares

Shareholders equity = Value of assets Value of debt = residual claim


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Pie Model of the Firm


25% debt
75% equity

50% debt

50% equity

Capital Structure 1

Capital Structure2

Cash flows between the Firm & the Financial Markets


Firm issues securities to raise cash

Firm invests in assets


Retained cash flows Dividends & debt payments

Financial markets

Current assets Fixed assets

Short-term debt Long-term debt Equity shares

Cash flow from firms operations

Taxes

Total value of assets Government

Total value of the Firm to investors in the financial markets

Value Creation Issues


Value Creation is generating more cash through firms operations than raising through financial markets

Identification of Cash Flows


Timing of Cash Flows Risk of Cash Flows
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Accounting Profit versus Cash Flows


ABC Limited Income Statement for Year Ended June 30 $1,000,000 - 900,000 $ 100,000

Sales Costs Profit

Cash inflow Cash outflow

0 -900,000 $ - 900,000

Cash Flow Timing


Year 1 2 3 4 Product A 0 0 0 20,000 20,000 Product B 4000 4000 4000 4000 16,000
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Risk
Pessimistic Europe $ 75,000 Japan $ 0 Most Likely $ 100,000 150,000 Optimistic $ 125,000 200,000

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The Corporate Firm


The firm is a way of organizing the economic activity of many individuals Three basic legal forms of organizing firms
The Sole Proprietorship The Partnership The Corporation
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The Sole Proprietorship


1. 2. 3. 4. Business owned by one person It is the cheapest business form Minimum legal requirements All profits of the business are taxed as personal income (No corporate tax) 5. Unlimited liability for business debts & obligations. No distinction is made between personal and business assets.

6. Life is limited by the life of the owner 7. Opportunities to raise funds limited
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The Partnership
1. Any two or more persons can get together and form a partnership. 2. Two categories: 1) General partnership 2) Limited partnership 3. Easy & inexpensive to form 4. Written documents are required in complicated arrangements 5. General partners have unlimited liability for all debts 6. The general partnership is terminated when a general partner dies or withdraws 7. It is difficult for a partnership to transfer ownership 8. Difficult to raise large amount of cash 9. Income from a partnership is taxed as personal income to the partners ( No corporate taxes) 10. Management control resides with general partners 11. Usually a majority vote is required on important matters

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The Corporation (Company)


Incorporated Association Artificial Legal Existence Perpetual Existence Common Seal Extensive Membership Separation of Management from Ownership Limited Liability Transferability of Shares
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A Comparison of Partnership & Corporation


Corporation Partnership
Units are subject to substantial restrictions on transferability. There is usually no established trading market for partnership unit. Some voting rights by limited partners. However, general partner has exclusive control & management of operations.

Liquidity & marketability

Shares can be exchanged without termination of the corporation. Common stock can be listed on stock exchange. Usually each share of common stock entitles the holder to one vote per share on matters requiring a vote & on the election of the directors. Directors determines top management. Corporations have double taxation: Corporate income is taxable, and dividends to shareholders are also taxable. Corporations have broad latitude on dividend payout decisions.

Voting rights

Taxation

Partnerships are not taxable. Partners pay personal taxes on partnership profits. Partnerships are generally prohibited from reinvesting partnership cash flow. All net cash flow is distributed to partners. Limited partners are not liable for obligations of partnerships. General partners may have unlimited liability Partnerships have limited life. 16

Reinvestment & dividend payout Liability

Shareholders are not personally liable for obligations of the corporation. Corporations have a perpetual life.

Continuity of existence

Goals of the Corporate Firm


To add value for the stockholders Set-of-contracts view point: The corporate firm will attempt to maximize the shareholders wealth by taking actions that increase the current value per share of existing stock of the firm

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Agency Problem & Control of the Corporation


Principal Agent Relationship: Shareholders are the principals and the management team are the agents Conflict of Interest between principal and agent = Agency Problem Agency Costs: The costs of the conflict of interest between stockholders and management. 1. The monitoring cost (Direct Cost) 2. Expenditures that benefits management (Direct Cost) 3. Opportunity Cost (Indirect Cost)
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Managerial Goals
Expense Preference Survival: Organizational survival means that management will always try to command sufficient resources to avoid the firms going out of business. Independence & Self-sufficiency: This is freedom to make decisions without encountering external parties or depending on outside financial markets.
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Separation of Ownership and Control


Diffuse shareholder ownership Shareholders select the members of the board of directors Board of directors select the management team Contracts with management and arrangements for compensation Fear of takeover gives managers an incentive to take actions that will maximize stock prices Competition in the managerial labor market fear to be replaced
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Financial Markets
Classification According To Maturity Of Securities Money Markets: The markets for debt securities that will pay off in short term (usually less than one year)

Capital Markets: The markets for longterm (with a maturity at over one year) debt securities and for equity shares
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Financial Markets
Further Classified as: The primary market The secondary markets

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Financial Markets
The Primary Market: New Issues Where governments and corporations will initially sell securities Corporations engage in two types:
Initial Public Offering Private Placement
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Financial Markets
Secondary Markets
After debt & equity securities are originally sold, they are traded in the secondary markets. Types: Auction Markets & Dealer Markets The Auction Market: Mostly for equity securities, e.g. Karachi Stock Exchange, NYSE The Dealer Markets: Mostly debt securities Over-the-counter (OTC) market: Dealer market for equity securities, e.g. NASDAQ
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