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Chapter One

Introduction Corporate
to
Finance
Ross Westerfield Jaffe
Corporate Finance

Sixth Edition

Prepared by
Gady Jacoby
University of Manitoba
and
Sebouh Aintablian
American University of
Beirut
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2003 McGrawHill Ryerson Limited

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Chapter Outline
1.1 What is Corporate Finance?

1.2 Corporate Securities as Contingent Claims on

Total Firm Value
1.3 The Corporate Firm

1.4 Goals of the Corporate Firm

1.5 Financial Institutions, Financial Markets, And The
Corporation

1.6 Trends in Financial Markets and Management

1.7 Outline of the Text
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What is Corporate Finance?

Corporate Finance addresses the following
three questions:
1. What long-term investments should the firm
engage in?
2. How can the firm raise the money for the
required investments?
3. How much short-term cash flow does a
company need to pay its bills?
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The Balance-Sheet Model of the Firm

Total Value of Assets:

Current Assets

Total Firm Value to Investors:

Current
Liabilities
Long-Term
Debt

Fixed Assets
1 Tangible
2 Intangible

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Shareholders
Equity

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The Balance-Sheet Model of the Firm

The Capital Budgeting Decision
Current
Liabilities

Current Assets

Long-Term
Debt

Fixed Assets
1 Tangible
2 Intangible

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What longterm
investments
should the
firm engage
in?

Shareholders
Equity

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The Balance-Sheet Model of the Firm

The Capital Structure Decision

Current Assets

How can the firm

raise the money
for the required
Fixed Assets
investments?
1 Tangible
2 Intangible

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Current
Liabilities
Long-Term
Debt

Shareholders
Equity

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The Balance-Sheet Model of the Firm

The Net Working Capital Investment Decision

Current Assets

Fixed Assets
1 Tangible
2 Intangible

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Current
Liabilities
Net
Working
Capital

How much shortterm cash flow

does a company
need to pay its
bills?

Long-Term
Debt

Shareholders
Equity

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Capital Structure
The value of the firm can be
thought of as a pie.
The goal of the manager is
to increase the size of the
pie.
The Capital Structure
decision can be viewed as
how best to slice up the pie.

70%50%30%
25%
DebtDebt
Equity
75%
50%
Equity

If how you slice the pie affects the size of the pie,
then the capital structure decision matters.
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Hypothetical Organization Chart

Board of Directors

Chairman of the Board and

Chief Executive Officer (CEO)

President and Chief

Operating Officer (COO)

Vice President Finance

Treasurer

Controller

Cash Manager

Credit Manager

Tax Manager

Cost Accounting

Capital Expenditures

Financial Planning

Financial Accounting

Data Processing

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The Financial Manager

To create value, the financial manager
should:
1. Try to make smart investment decisions.
2. Try to make smart financing decisions.

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The Firm and the Financial Markets

Firm

Firm issues securities (A)

Invests
in assets
(B)

Retained
cash flows (D)
Short-term debt

Cash flow
from firm (C)

Dividends and
debt payments (F)
Taxes (E)

Current assets
Fixed assets

Ultimately, the firm

must be a cash
generating activity.
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Financial
markets

Government

Long-term debt
Equity shares

The cash flows from

the firm must exceed
the cash flows from
the financial markets.
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1.2 Corporate Securities as Contingent Claims on

Total Firm Value
The basic feature of a debt is that it is a
promise by the borrowing firm to repay a
fixed dollar amount by a certain date.
The shareholders claim on firm value is the
residual amount that remains after the
debtholders are paid.
If the value of the firm is less than the
amount promised to the debtholders, the
shareholders get nothing.
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Debt and Equity as Contingent Claims

Payoff to
debt holders

Payoff to
shareholders

If the value of the firm

is more than $F, debt
holders get a
maximum of $F.

If the value of the

firm is less than $F,
share holders get
nothing.

$F
Value of the firm (X)

$F
Value of the firm (X)

$F

If the value of the firm

Debt holders are promised $F.
is more than $F, share
If the value of the firm is less than $F, they
holders get everything
get whatever the firm is worth.
above $F.
Algebraically, the bondholders
Algebraically, the shareholders
claim is: Min[$F,$X]
claim is: Max[0,$X $F]
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Combined Payoffs to Debt and Equity

Combined Payoffs to debt holders
and shareholders

If the value of the firm is less than

$F, the shareholders claim is:
Max[0,$X $F] = $0 and the debt
holders claim is Min[$F,$X] = $X.

The sum of these is = $X

Payoff to shareholders
$F

If the value of the firm is more than

Payoff to debt holders $F, the shareholders claim is:
Max[0,$X $F] = $X $F and the
$F
debt holders claim is:
Value of the firm (X)

Debt holders are promised $F.

Min[$F,$X] = $F.
The sum of these is = $X

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1.3 The Corporate Firm

The corporate form of business is the
standard method for solving the problems
encountered in raising large amounts of cash.
However, businesses can take other forms.

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Forms of Business Organization

The Sole Proprietorship
The Partnership
General Partnership
Limited Partnership

The Corporation
Advantages and Disadvantages

Liquidity and Marketability of Ownership

Control
Liability
Continuity of Existence
Tax Considerations

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A Comparison of Partnership and Corporations

Corporation

Partnership

Liquidity

Shares can easily be

exchanged

Subject to substantial
restrictions.

Voting Rights

Usually each share gets one

vote

General Partner is in charge;

limited partners may have
some voting rights.

Taxation

Double with dividend tax

credit

Partnership income is
taxable.

Reinvestment

Broad latitude

All net cash flow is

distributed to partners.

Liability

Limited liability

General partners may have

unlimited liability. Limited
partners enjoy limited
liability.

Continuity

Perpetual life

Limited life

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1.4 Goals of the Corporate Firm

What are firm decision-makers hired to do?
The traditional answer is that the managers of
the corporation are obliged to make efforts to
maximize shareholder wealth.

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The Set-of-Contracts Perspective

The firm can be viewed as a set of contracts.
One of these contracts is between shareholders and
managers.
The managers will usually act in the shareholders
interests.
The shareholders can devise contracts that align the
incentives of the managers with the goals of the
shareholders.
The shareholders can monitor the managers behaviour.

This contracting and monitoring is costly.

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Managerial Goals
Managerial goals may be different from
shareholder goals
Expensive perquisites
Survival
Independence

Increased growth and size are not necessarily

the same thing as increased shareholder
wealth.

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Separation of Ownership and Control

Board of Directors
Shareholders

Assets

Debt

Debtholders

Management

Equity
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The Agency Problem

The agency relationship
Will managers work in the shareholders best
interests?
Agency costs
Direct agency costs
Indirect agency costs

Control of the firm

How do agency costs affect firm value (and
shareholder wealth)?
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Do Shareholders Control Managerial Behaviour?

Shareholders vote for the board of directors,
who in turn hire the management team.
Contracts can be carefully constructed to be
incentive compatible.
There is a market for managerial talentthis
may provide market discipline to the
managersthey can be replaced.
If the managers fail to maximize share price,
they may be replaced in a hostile takeover.
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1.5 Financial Institutions, Financial

Markets, and the Corporation
Financial Institutions
Indirect finance
Funds
suppliers

Deposits

Financial
intermediaries

Loans

Funds
demanders

Direct finance
Funds
suppliers

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Financial
intermediaries

Funds
demanders

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Financial Markets
Money versus Capital Markets
Money Markets
For short-term debt instruments
Capital Markets
For long-term debt and equity

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Financial Markets
Primary versus Secondary Markets
Primary Market
When a corporation issues securities, cash flows
from investors to the firm.
Usually an underwriter is involved

Secondary Markets
Involve the sale of used securities from one
investor to another.
Securities may be exchange traded or trade overthe-counter in a dealer market.
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Financial Markets

Firms

Stocks and
Bonds
Money

Investors
securities
Bob

Sue

money
Primary Market
Secondary
Market

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1.6 Trends in Financial Markets and

Management
Integration and globalization
Increased volatility
Financial Engineering reduces costs related to
Risk
Taxes
Fnancing costs
Improved computer technology allows
Economies of scale and scope
Regulatory dialectic
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1.7 Outline of the Text

I.

Overview

II.

Value and Capital Budgeting

III. Risk
IV. Capital Structure and Dividend Policy

V.

Long-Term Financing

VI. Options, Futures, and Corporate Finance

VII. Financial Planning and Short-Term Finance
VIII.Special Topics

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