Scope of Corporate

Finance

What is Corporate Finance?

Corporate Finance addresses the
following three questions:
1.

2.

3.

What long-term investments should the firm

engage in?
How can the firm raise the money for the
required investments?
How much short-term cash flow does a
company need to pay its bills?

The Balance-Sheet Model

of the Firm

Total Value of Assets:

Current Assets

Total Value of Liabilities:

Current
Liabilities
Long-Term
Debt

Fixed Assets
1 Tangible
2 Intangible

Shareholders
Equity

The Balance-Sheet Model

of the Firm
The Capital Budgeting Decision

Current
Liabilities

Current Assets

Long-Term
Debt
Fixed Assets
1 Tangible
2 Intangible

What longterm
investments
should the
firm engage
in?

Shareholders
Equity

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

Current
Liabilities
Long-Term
Debt

Shareholders
Equity

The Balance-Sheet Model

of the Firm

The Net Working Capital Investment Decision

Current Assets

Fixed Assets
1 Tangible
2 Intangible

Current
Liabilities
Net
Working
Capital

How much shortterm cash flow

does a company
need to pay its
bills?

Long-Term
Debt

Shareholders
Equity

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.

The Financial Manager

To create value, the financial manager
should:
1. Try to make smart investment
decisions.
2. Try to make smart financing
decisions.
3. Try to optimally manage short-term
cash flows to meet day to day
business requirements.

The Firm and the Financial

Markets
Firm

Firm issues securities (A)

Invests
in assets
(B)

Retained
cash flows (F)
Short-term debt
Cash flow
from firm (C)

Ultimately, the firm

must be a cash
generating activity.

Dividends and
debt payments (E)
Taxes (D)

Current assets
Fixed assets

Financial
markets

Government

Long-term debt
Equity shares

The cash flows from the

firm must exceed the
cash flows from the
financial markets.

Corporate Securities as Contingent

Claims on Total Firm Value

The basic feature of debt is that it is a promise

by the borrowing firm to repay a fixed amount
of money 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.

Debt and Equity as Contingent

Claims
Payoff to
debt holders

Payoff to
shareholders

If the value of the firm is

more than D, debt
holders get a maximum
of D.

If the value of the firm

is less than D, share
holders get nothing.

D
Value of the firm (V)

D
Value of the firm (V)

Debt holders are promised D.

If the value of the firm is less than D, they get
whatever the firm if worth.
Algebraically, the debt holders claim is:
Min[D, V]

If the value of the firm is

more than D, share
holders get everything
above D.

Algebraically, the shareholders claim is:

Max[0, V D]

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.

Forms of Business Organization

Sole

Proprietorship
Partnership
Corporation
Advantages and Disadvantages of
Corporation

Liquidity and Marketability of Ownership

Limited Liability
Continuity of Existence
Separation of ownership and control
Tax Considerations

Separation of Ownership and

Control
Board of Directors

Assets
Equity

Shareholders

Debt

Debtholders

Management

Goals of the Corporate Firm

Managers

of the corporation are expected

to make efforts to maximize shareholder
wealth

Agency Problem
Agency

relationship

Relationship between shareholders and

management

Managerial

goals may be different from

shareholder goals

Expensive perquisites
Survival
Independence

Do Shareholders Control
Managerial Behavior?
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.

Financial Markets
Primary

Market

When a corporation issues securities, cash

flows from investors to the firm.

Secondary

Markets

Involve the sale of already issued securities

from one investor to another.

Financial Markets

Firms

Stocks and
Bonds
Money

Investors
A

securities

money
Primary Market
Secondary Market