Chapter 1

Introduction to Cor
porate Finance

McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
 Key Concepts and Skills
• Know the basic types of financial manageme
nt decisions and the role of the financial man
ager
• Know the financial implications of the differe
nt forms of business organization
• Know the goal of financial management
• Understand the conflicts of interest that can
arise between owners and managers
• Understand the various types of financial ma
rkets

1-1
 Chapter Outline

• Corporate Finance and the Financial

Manager
• Forms of Business Organization
• The Goal of Financial Management
• The Agency Problem and Control of
the Corporation
• Financial Markets and the Corporati
on
1-2
What Is Corporate Finance?

• Corporate finance provides answers t

o some important questions:
– What long-term investments should the f
irm take on?
– Where will the firm get the long-term fina
ncing to pay for the investments?
– How will the firm manage its everyday fi
nancial activities?

1-3
 The Financial Manager
• Financial managers try to answer some or all
of these questions
• The top financial manager within a firm is us
ually the Chief Financial Officer (CFO)
– Treasurer – oversees cash management, credit
management, capital expenditures, and financial
planning
– Controller – oversees taxes, cost accounting, fin
ancial accounting and data processing

1-4
Financial Management Decisions
• Capital budgeting
– What long-term investments or projects
should the business take on?
• Capital structure
– How much should the firm borrow to pay
for its assets?
• What is the best mixture of debt and equity?
• The least expensive sources of funds?
• Working capital management
– How do we manage the day-to-day finan
ces of the firm? 1-5
Forms of Business Organization

• Three major forms

– Sole Proprietorship
– Partnership
• General
• Limited
– Corporation
• Limited Liability Company
• Limited Liability Partnerships

1-6
 Sole Proprietorship
• Advantages • Disadvantages
– Easiest to start – Limited to life of ow
– Least regulated ner
– Single owner keeps – Equity capital limite
all the profits d to owner’s person
– Taxed once as pers al wealth
onal income – Unlimited liability
– Difficult to sell owne
rship interest

1-7
 Partnership
• Advantages • Disadvantages
– Two or more owner – Unlimited liability
s • General partnership
– More capital availab • Limited partnership
le – Partnership dissolv
– Relatively easy to st es when one partne
art r dies or wishes to s
– Income taxed once ell
as personal income – Difficult to transfer o
wnership

1-8
 Corporation
• Advantages • Disadvantages
– Limited liability – Separation of owner
– Unlimited life ship and managem
– Separation of owner ent
ship and managem – May involve double
ent taxation in some co
– Transfer of ownersh untries (income tax
ip is easy ed at the corporate
rate and then divide
– Easier to raise capit nds taxed at the per
al sonal rate)

1-9
 Summary of
3 Business Forms

1-10
Goal of Financial Management
• What should be the goal of a corporation?
– Maximize profits?
– Minimize costs?
– Maximize market share?
– Maximize the current value of the company’s sto
ck?

1-11
Maximizing Shareholders’ Wealth
• Maximizing the share price is equivale
nt to maximizing shareholders’ wealth
• Why is this a valid goal?
– Decisions are made in shareholders‘
best interest
– Considers cash flows not profits
– Incorporates time dimension
– Does not consider profitability but als
o risk
 The Agency Problem
• Agency relationship
– The relationship exists when a principal
hires an agent to represent his/her intere
sts
– Stockholders (principals) hire managers
(agents) to run the company
• Agency problem
– Conflict of interest between principal and
agent
• Agent may not work in the best interest of the
principal
1-13
 Management Goals
• Management goals may be different fr
om shareholder s’ goals
– Management may be more interested in:
• Consuming expensive perks
• It’s own survival
• It’s independence
• Management may focus on increased
growth and size rather than increasing
shareholders’ wealth
 Agency Costs
• Costs due to the conflict of interest betw
een shareholders and management
– Direct
• Corporate expenditure that benefits managemen
t but costs shareholders, e.g. country clu
b membership
• Costs to monitor management actions, e.g
. auditor costs
– Indirect
• Lost opportunity due to management forgoing pr
ofitable but risky projects for fear of losing job if
project fails
1-15
 Managing Managers
• Managerial compensation
– Incentives can be used to align management an
d stockholder interests
– The incentives need to be structured carefully to
make sure that they achieve their goal
• Corporate control
– The threat of a takeover may result in better ma
nagement
• Other stakeholders

1-16
 Work the Web Example
• The Internet provides a wealth of information
about individual companies
• One excellent site is finance.yahoo.com
• Click on the web surfer to go to the site, cho
ose a company and see what information yo
u can find!

1-17
 Financial Markets

• Primary market
– A market where the firm sells its securiti
es to public for the first time
• Secondary markets
– A market in which the securities issued
by firms are traded
• Listed securities trade in an organized excha
nge, e.g. the stock market (NYSE)
• Over-the-counter securities are bought from
or sold to a dealer
1-18
 Quick Quiz
• What are the three types of financial manage
ment decisions and what questions are they
designed to answer?
• What are the three major forms of business
organization?
• What is the goal of financial management?
• What are agency problems and why do they
exist within a corporation?
• What is the difference between a primary ma
rket and a secondary market?

1-19
 Ethics Issues
• Is it ethical for tobacco companies to sell a produ
ct that is known to be addictive and a danger to t
he health of the user? Is it relevant that the prod
uct is legal?
• Should boards of directors consider only price w
hen faced with a buyout offer?
• Is it ethical to concentrate only on shareholder w
ealth, or should stakeholders as a whole be cons
idered?
• Should firms be penalized for attempting to impr
ove returns by stifling competition (e.g., Microsof
t)? 1-20
End of Chapter

1-21