Chapter 1 Introduction to Corporate Finance

Key Concepts Know the basic types of financial management decisions and the role of the financial manager Know the financial implications of the different 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 markets

The Four Basic Areas of Finance Corporate Finance Investments Financial Institutions International Finance

Corporate Finance 1. What is Corporate Finance? 2. Corporate Securities as Contingent Claims on Total Firm Value 3. Goals of the Corporate Firm 4. Financial Markets

Why is corporate finance important to all managers? Corporate finance provides the skills managers need to: Identify and select the corporate strategies and individual projects that add value to their firm. Forecast the funding requirements of their company, and devise strategies for acquiring those funds.

Corporate Finance Corporate Finance addresses the following three questions: Capital budgeting What long-term investments should the firm engage in? Capital structure How can the firm raise the money for the required investments? Working capital management How much short-term cash flow does a company need to pay its bills? How do we manage the day-to-day finances of the firm?

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

Goals of the Corporate Firm What are firm decision-makers hired to do? Three equivalent goals of financial management: Maximize shareholder wealth Maximize share price Maximize firm value

The Firm and Society Often, a corporation’s decisions that increase the value of the firm’s equity benefit society as a whole. As long as nobody else is made worse off by a corporation’s decisions, increasing the value of the firm’s equity is good for society. It becomes a problem when increasing the value of the firm’s equity comes at the expense of others.

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 of by a certain date. The shareholder’s 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.

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.

Ethics and Incentives within Corporations Agency Problems Managers may act in their own interest rather than in the best interest of the shareholders. One potential solution is to tie management’s compensation to firm performance. How should performance be measured?

CEO Performance If a CEO is performing poorly, shareholders can express their dissatisfaction by selling their shares. This selling pressure will drive the stock price down. Hostile Takeover Low stock prices may entice a Corporate Raider to buy enough stock so they have enough control to replace current management. The stock price will rise after the new management team “fixes” the company.

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 talent—this may provide market discipline to the managers—they can be replaced. If the managers fail to maximize share price, they may be replaced in a hostile takeover.

The Stock Market The stock market provides liquidity to shareholders. The ability to easily sell an asset for close to the price at which you can currently buy it.

Financial Markets Primary vs. secondary markets Public Company Stock is traded by the public on a stock exchange. Private Company Stock may be traded privately. Dealer vs. auction markets Listed vs. over the counter securities NYSE NASDAQ

Financial Markets Traditional Trading Venues New York Stock Exchange (NYSE) Market Makers/Specialists Each stock has only one market maker. NASDAQ Does not meet in a physical location May have many market makers for a single stock Bid Price versus Ask Price Bid-Ask Spread Transaction cost

New Competition and Market Changes Limit Order An order to buy or sell a set amount at a fixed price Limit Order Book The collection of all limit orders Market Orders Orders that trade immediately at the best outstanding limit order High Frequency Traders (HFTs) A class of traders who, with the aid of computers, execute trades many times per second in response to new information

Stock Markets Dark Pools With exchange trading, the limit book orders are public, allowing investors to trade at the current bid or ask price, and transactions are visible to all traders when they occur. Dark pools do not make their limit order books visible. Instead, they offer investors the ability to trade at a better price with the tradeoff being that their order might not be filled if an excess of either buy or sell orders is received.