Introduction to Corporate Finance MBAC 6060 Chapter 1 Introduction to Corporate Finance

Chapter 1 Outline: 1.1 What is Corporate Finance? 1.2 The Corporate Firm 1.3 The Importance of Cash Flows 1.4 The Goal of Financial Management 1.5 The Agency Problem and Control of the Corporation 1.6 Regulation

1.1 A Quick Look Four Basic Areas of Finance Corporate Finance Capital Budgeting – Undertake a proposed long-term project? How do you pay for the project? (Three choices) Working Capital Management – financing short term assets Investments Financial Institutions International Finance Lets go over these in more detail 

Four Basic Areas of Finance Corporate Finance Capital Budgeting – Undertake a proposed project? You have an idea. Will it make money? In other words: Will the idea Increase the firm’s value? How many units can we sell? (Marketing) How much will it cost to make the units? (Operations) How do you pay for the project? (Three choices) Sell a piece of the company Sell an Equity stake a.k.a. sell stock Borrow the money Sell Debt securities a.k.a. sell bonds Retain Earnings Keep past profits to finance expansion

Net Working Capital = Cash + Inv + A/R – (ST Debt + A/P) Corporate Finance (Continued) Working Capital Management Make Sure there is enough cash and inventory on hand. The BLUE ones are Working Capital Accounts Too Much Cash? Payoff ST Debt (Lower Interest Expense) Not Enough cash? Borrow More (Increase Interest Expense) Net Working Capital = Cash + Inv + A/R – (ST Debt + A/P) Assets Liabilities & Equity Cash ST Debt Inventory A/P A/R LT Debt PPE Equity

The Textbooks Version of the same thing:

Investments Firms sell securities (stocks and bonds) Someone buys them Which ones should you buy? What are the worth? This is called Securities Analysis If I hold a bunch of different securities (which is called a portfolio), how do the different securities combine into portfolios? This is called Portfolio Analysis

Financial Institutions Types: Commercial Banks – Chase, Wells Fargo… Investment Banks – Goldman Sachs, Morgan Stanley… Insurance Companies – GEICO, Anthem … Investment Companies Mutual funds – Janus, Fidelity… Hedge Funds – Bridgewater Associates, Fortress The study of financial institutions relates to risk management This means making sure they don’t blow up Or at least trying to decrease the likelihood of them blowing up

International Finance More of a specialization than an area of finance But also must deal with Currency exchange rates and a exchange rate risk You sell your product for Euros but need Dollars to pay suppliers, employees, bondholders and shareholders

Everything a firm does must be paid for Why Study Finance? Everything a firm does must be paid for No matter your chosen profession in the business world Marketing, Management, Accounting, Systems… You still have to talk to the finance people Why? To get them to pay for your ideas Another reason to study finance… You might actually be rich someday In which case it would be beneficial for you to understand investments Understanding investments means understanding corporations and corporate finance The securities you will buy are claims on a corporations earnings and assets

1.2 Business Finance and the Financial Manager What do corporate financial professionals do? Decide if a new business venture will be profitable: Both CURRENT business and potential NEW business We already make red pens. Should we make blue pens? We already make pens. Should we make pencils? We already make pens and pencils. Should we deliver them to stores (buy our own trucks)? We make and deliver pens and pencils. Should we make hotdogs-on-a-stick? How to pay for new business? Take on New Owners (sell stock) or Borrow (sell bonds) Manage the everyday financial activities of the firm Called Working Capital Management Collect from customers, pay suppliers, pay expenses… Sell stocks, bonds, commercial paper, borrow from banks…

Corporate Organization – Figure 1.2 page 3

1.3 Forms of Business Sole Proprietorship Partnership Corporations Owned by one Person Pass-through Unlimited liability Partnership General Partnership Limited Partnership Also a pass-through Corporations Shareholders, Board of Directors, Managers, Employees A corporation is a separate entity for tax and liability purposes

Corporation vs. Partnership (Table 1.1, Page 6)   Corporation Partnership Liquidity Shares can be easily 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 Partners pay taxes on distributions Reinvestment and dividend payout 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

1.4 Goals of Financial Management First talk about Stakeholders: Owners (Stockholders also called Shareholders) Debtors (Bondholders, CP holders, banks…) Employees Suppliers Customers Community So what is the goal of financial management? Maximize Shareholder Value (Help the Owners) What about the rest of the stakeholders? Ignore them At least for the purposes of our value decisions

1.4 Goals of Financial Management (continued) So how do you maximize shareholder value? Generate Cash Flows! Cash Flows are not the same as Net Income (Why?) Sell stocks and bonds that raise more cash than they cost Buy assets that generate more cash than they cost Process: Sell stocks and bonds to financial markets to raise money Invest money in assets which generate cash Pay some of the cash to bondholders (interest payments) and stockholders (dividends) If cash generated by assets exceeds cash raised from financial markets, the firm increases in value

Managers vs. Stockholders: 1.5 Agency Problem and Corporate Control Managers vs. Stockholders: Stockholders want to maximize wealth Maximize share price Or maybe maximize income from shares (dividends) What do managers want to maximize? Perquisites (perks): jets, cars, apartments… Control: size of their division: assets, employees…

1.5 Agency Problem and Corporate Control (cont.) So try to align manager and stockholder incentives: Bonuses ESOPs (Employee Stock Ownership Plans) Stock sold to the employees by the company (new shares issued) Has the effect of diluting the existing shareholder’s stake Stock Options A stock option is the ability to buy company stock two years from now (for example) at the current stock price (say $25) The Options will only be valuable if the stock’s price increases in the next two years (above $25) Again, shares sold to the employee by the company (dilution) Problems with these three: Short term vs. Long term Employees only care about price being high in two years This caused many of the recent accounting scandals

The Securities Exchange Act of 1934 1.6 Regulation The Securities Act of 1933 Issuance of Securities Registration and Disclosure The Securities Exchange Act of 1934 Creation of SEC Set Reporting Requirements (List of SEC filings) Filings are available on the SEC EDGAR site Sarbanes-Oxley (“Sarbox”) After Enron, WorldCom, Tyco Increased reporting requirements and responsibility of corporate directors

Financial Markets and Liquidity Firms raise money by selling securities: Sell Stocks Percentage of Ownership - dilution Stock holders have rights to a percent of profits and assets After “borrowers” have been paid Residual claim Sell bonds or other debt instruments (like CP) Sell Debt or borrowing money Coupon Bonds or Zero-Coupon Bonds Paid BEFORE profits are paid to stock holders Primary claim Investors value securities based on: Expected payments: dividends, coupons, price appreciation Risk: Volatility of payments or price, probability of default Liquidity: Can’t sell the security  pay less for it

Securities Markets Increase Liquidity Liquidity is the ability to convert an asset to cash (sell it) Two Components of Liquidity: How quickly can I get “full price”? How much do I have to drop the price to get cash right now? Note: The word “Liquidity” can also refer to a company’s ability to meet it’s current payment obligations Often through short-term borrowing Recall the definition of working capital management

Consider the liquidity of: Brokers versus Dealers Broker introduces buyer and seller Earns a commission Dealer buys the asset from the seller and then sells is to the buyer Earns the “spread” Consider the liquidity of: A used car Sell using a newspaper or internet add Used car Dealer A house 1,000 shares of IBM 100,000 shares of IBM 10% ownership of McGuckin’s What kind of markets have brokers? What kind have dealers?

Back to Securities Markets: Primary Markets The issuing firm sells the stocks or bonds for the first time (like new cars) The issuing firm gets the money The transactions are done through an investment bank The transaction is called underwriting Done by an investment banker Secondary Markets Secondary market transactions involve an owner selling to a different owner (like used cars) The issuing firm does NOT get the money The transaction is done through a market Stocks (NYSE, NASDAQ, OTC), Bonds, Currency, Futures, Options…