CHAPTER 1

Introduction to Corporate
Finance

What is finance?
Book, market, and intrinsic values
Forms of business organizations
Financial goals of the corporation
Separation of ownership and control
Risk and investor attitudes toward risk
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Introduction to Finance?

A foremost concept in finance concerns how individuals

interact in order to allocate resources (capital) and/or shift
consumption across time by borrowing or investing.

If you receive $1 million today then what decision would you

make regarding consumption and investment?

Suppose you spend (consume) $100,000 now.

This leaves you with $900,000. You can postpone consumption to

future time periods by investing the $900,000 today.

On the other hand, what if you have $20,000 but need to

consume $30,000. You can borrow the $10,000 and pay it
back in a future period along with the interest.
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Two examples of common corporate

financial decisions

A firm must spend $100 million for the required assets if a

proposed project is approved. Important issues are:

Should the project be accepted or rejected? What do investors

demand as a (minimum acceptable) project rate of return?
What are the projects forecasted future cash flows? How risky are
these forecasted cash flows?
Where will the $100 million come from, i.e., what mix of equity and
debt financing should be used?

If a firm has $200 million of cash flow, but needs reinvest

$120 million, what should be done with the remaining $80
million of cash.

Pay it out as a dividend or repurchase some stock?

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Example of common investments

type financial decisions

A mutual fund manager that manages a fund

with $10 billion portfolio receives an
additional $100 million in cash from new
investors.

Which stocks or bonds to purchase?

How will any proposed new investments affect
the expected return and risk of the overall
portfolio?
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Forms of business organization

Sole proprietorship
Partnership
Corporation
Most large firms are organized as corporations.
Advantages: unlimited life, easy transfer of ownership (stock), limited
liability for owners, relative ease of raising capital, and can use stock
for acquisitions
Disadvantages: Double taxation of earnings, cost of set-up and report
filing, and issues relating to the separation of ownership and control
Hybrid forms; Limited Liability Corporations (LLC), S Corporations,
etc., firms having characteristics of the three forms above.

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Book versus Market values

The book value of an asset is determined based on

accounting rules.
The book value is at best a rough approximation of
the assets replacement cost.
The market value of an asset is that investors are
willing to pay today for stocks and bonds in order to
receive a risky stream of future expected cash flows.

Market values are forward looking.

Stocks and bonds represent claims on the future cash
flows that a firms assets generate.

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Book versus market values

Market value of a firm

Assets

Liabilities + Equity

Market value of the

assets earning power
(as a going concern)

Mkt. value of debt

Mkt. value of equity

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Book versus market values

The Book value of a firm often contrasts

sharply with the Market value.
Assets

Liabilities + Equity

Physical assets at
historical book value

Book debt
Book equity

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Book versus market values: a

hypothetical example

A firm begins with $2000 of debt and $4000 of

equity in order to purchase $6000 of assets. These
become the original accounting book values.
In contrast, Market values are based on todays
expectations of future performance, i.e., what cash
amounts are expected to be paid out and the
perception of risk. Assume the following:

Investors are willing to pay $2000 for the bonds.

Investors are willing to pay $10,000 for the equity.

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Book versus market values for the

hypothetical example

Book values of firm:

Assets

Liabilities + Equity

$6,000 physical assets $2,000 Book debt

$4,000 Book equity

Market values of firm:

Assets

Liabilities + Equity

$12,000 M.V. as a
going concern

$2,000 M.V. debt

$10,000 M.V. equity

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Intrinsic (fundamental) values

Market values are what investors are willing to

either buy or sell an asset for, based on investors
expectations of future performance.

Market values are very often publicly observed, e.g., the

transactions in the stock markets.

In contrast, intrinsic values are usually considered as

private estimates of what something, e.g., a common
stock, is actually worth.

Intrinsic value is not something that you can prove.

If ten analysts are asked to value IBM stock, then there
will likely be ten different intrinsic value estimates!
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Intrinsic (fundamental) values

Assume that a New York Stock Exchange listed firm

has an equity market value of $10 billion.
However, those that manage the firm (insiders)
believe the firm is actually worth $12 billion
(intrinsic value), based on their private or inside
forecasts of future cash flow performance.
For the most part, market prices are driven by public
expectations and consensus, while intrinsic values
represent private forecasts.
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Financial goals of the corporation

The primary financial goal is shareholder

wealth maximization a function of future
cash flow and risk.
In reality, this is maximizing intrinsic value

For now we will assume that this is synonymous

with maximizing the market value, i.e., stock price
maximization.

Warren Buffett states that his goal is to

maximize Berkshire Hathaways intrinsic
value, and hopefully, the stocks market value
will be close to the intrinsic value.

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Stock price maximization is NOT

profit or earnings maximization?

Market (and intrinsic) values are driven by risk and

expectatons (forecasts) of future cash flows.
Earnings and other accounting profitability
measures are not cash flows and have limited use in
estimating financial values.
Some actions may cause an increase in reported
earnings, yet cause the stock price to decrease (and
vice versa).

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Wealth maximization and societal

welfare

Is the general welfare of society advanced when

individual agents pursue wealth maximization?

Is intrinsic or market value maximization good or bad for

society. Should firms behave ethically?

The following slide contains a quote is from Adam

Smiths Inquiry into the Nature and Causes of the
Wealth of Nations, 1776.

Adam Smith believed that an economic system in which

individual agents strive to increase their market value
results in the most efficient level of general welfare, as it
facilitates the allocation of resources to their most
productive use.
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Wealth maximization and societal

welfare (Adam Smith, 1776)
As every individual, endeavours as much as he can both
to employ his capital in the industry, and to direct that
industry that its produce may be of the greatest value,
every individual necessarily labours to render the annual
revenue of the society as great as he can. In doing so he
generally, indeed, neither intends to promote the public
interest, nor knows how much he is promoting it. By
directing that industry in such a manner as its produce
may be of the greatest value, he intends only his own
gain, and he is in this, as in many other cases, led by an
invisible hand to promote an end which was no part of
his intention. Thus, by pursuing his own interest he
frequently promotes that of the society more effectually
than when he really intends to promote it. I have never
known much good done by those who pretended to trade
for the public good.
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Agency relationships the

separation of ownership and control

An agency relationship exists whenever a principal

(owner of a resource) hires an agent to act on their
behalf. Examples are:

Citizen (principal) and elected official (agent)

Stockholder (principal) and corporate manager (agent)

Within a corporation, agency relationships exist

between:

Shareholders and managers

Shareholders and creditors

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Shareholders versus Managers

Managers are naturally inclined to act in their

own best interests.
But the following factors affect managerial
behavior:

Managerial compensation plans

Direct intervention by shareholders
The threat of firing
The threat of corporate takeover
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Shareholders versus Creditors

Shareholders (through managers) could take

actions to maximize stock price that are
detrimental to creditors, i.e., actions that
result in a wealth transfer from creditors to
stockholders.

In the long run, such actions will raise the

cost of debt and ultimately lower the stock
price. We return to this issue in Chapter 16.
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Factors that affect stock prices

As implied in earlier slides, stock prices are a

function of:

Projected cash flows to shareholders

Timing of the cash flow stream

Riskiness of the cash flows

The basic financial valuation model on the next slide

will be addressed in detail in Chapters 4 and 5 of the
textbook.
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Basic financial valuation model

Value

CF1
CF2
CFn

(1 k)1 (1 k)2
(1 k)n
n

CFt

.
t
t 1 (1 k)

To estimate any assets value, one must estimate the

cash flow for each period t (CFt), the life of the asset
(n), and the appropriate discount rate or cost of capital
(k), based on the level of estimated risk.
Throughout this course, we discuss how to estimate the
models inputs and how financial management is used
to improve them and thus maximize a firms value.
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Factors that affect the level and

riskiness of future cash flows

Decisions made by financial managers:

Investment decisions, i.e., decisions concerning

the firms assets.
Financing decisions; the combination of debt and
equity financing used to finance the assets.

The external environment

Capital markets
Industry and economic events
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Understanding risk and investor

attitudes toward risk

The following two slides illustrate two possible investments

that can be made today. The payoff of each will occur
exactly one year from today. Investment #1 costs $100
today. The current cost of Investment #2 is not given.
Assume that one of three possible states of the
macroeconomy will prevail next year. Today, we can only
assign probabilities to these future economic states.

Good economy, probability of 30%

Average economy, probability of 40%
Bad economy, probability of 30%

Probabilities must sum up to 100%.

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Investment #1, an apparently riskless

investment

Investment #1: next years payoff is identical (all

result in $110) in each future economic state.
$110
Good economy,
probability=30%

Investment costs
$100 today

Average economy,
probability=40%

$110

Bad economy,
probability=30%

$110
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Investment #2, an apparently risky

investment

Investment #2: next years payoff varies with

future state of the economy.
$130
Good economy,
probability=30%

Todays cost = ?

Average economy,
probability=40%

$110

Bad economy,
probability=30%

$90
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Summarizing riskless Investment #1

and risky Investment #2

Investment #1 costs $100 today and has a certain $110 payoff

in any economic state next year. It thus currently offers a
riskless one year investment return of 10%
Investment #2, on the other hand, offers a risky payoff next
year. However, a glance at the payoff pattern does reveal
that the expected payoff is $110.
Now, if riskless Investment #1 costs $100 today, then what
would you be willing to pay today for risky Investment #2,
given that each both investments offer an expected payoff of
$110 next year?
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Summarizing riskless Investment #1

and risky Investment #2

Most individuals are averse to risk and would pay less than
$100 for Investment #2, e.g., $85, $90, or $95, etc.
Most risk averse individuals will accept risk, but only if they
expect to earn a higher return than what they can already
make on the riskless investment.
The only way for Investment #2 to offer expected return
greater than 10% is to pay less than $100 today for
Investment #2.
Practical example: Any corporations common stock is more
risky that its bonds (and also U.S. Treasury bonds). Investors
therefore expect to earn a higher return on the corporations
common stock.

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