© 2003 The McGraw-Hill Companies, Inc. All rights reserved. Introduction To Corporate Finance Chapter One

© 2005 McGraw-Hill Ryerson Limited Key Concepts and Skills 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 and financial institutions Understand current trends in Canadian financial markets

© 2005 McGraw-Hill Ryerson Limited 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 Corporation Financial Institutions Trends in Financial Markets and Financial Management

© 2005 McGraw-Hill Ryerson Limited Areas of Financial Management Corporate Finance Investments Financial Institutions International Finance

© 2005 McGraw-Hill Ryerson Limited Financial Management Decisions Capital budgeting: What long-term investments should the firm undertake? (fixed assets) Capital Structure: What is the best way to raise long-term financing for these investments? (long-term debt and equity) Net Working Capital: How should the firm manage its short-term assets and liabilities (i.e., manage the day-to-day finances)? (short- tem assets and liabilities)

© 2005 McGraw-Hill Ryerson Limited Financial Manager Shareholders are the owners of the firm. In large firms, shareholders are not involved in the day-to-day operations. Managers are employed as agents of the shareholders to make decisions on their behalf. The treasurer and controller share financial functions of the firm and they report to the top financial manager within the firm who is usually the Chief Financial Officer (CFO).

© 2005 McGraw-Hill Ryerson Limited Forms of Business Organization Most of what we do in class is described using the publicly traded manufacturing corporation as the setting. It is important to keep in mind that other forms of organization exist as well. Three major business forms in Canada –Sole proprietorship –Partnership General Limited –Corporation In other countries, corporations are also called joint stock companies, public limited companies and limited liability companies

© 2005 McGraw-Hill Ryerson Limited Sole Proprietorship Unincorporated business owned by one individual Advantages –Easiest to start –Least regulated –Single owner keeps all the profits –Profits are taxed once as personal income Disadvantages –Unlimited liability –Limited to life of owner –Equity capital limited to owner’s personal wealth (difficulty in raising capital) –Difficult to sell ownership interest

© 2005 McGraw-Hill Ryerson Limited Partnership Unincorporated business owned by two or more people Advantages –Few government regulations –More capital available (since there are two or more owners) –Relatively easy to start –Profits taxed once as personal income Disadvantages –Unlimited personal liability –Partnership dissolves when one partner dies or wishes to sell (i.e., limited life) –Difficult to transfer ownership

© 2005 McGraw-Hill Ryerson Limited Partnership types General Partnership: All partners share. All have unlimited liability. Limited Partnership: General partners run business; have unlimited liability. Limited partners are silent on operations and have limited liability.

© 2005 McGraw-Hill Ryerson Limited Corporation A legal entity that is separate and distinct from its owners and managers. Many owners indirectly operate the firm through the board of directors. Owners are not involved in the day to day operations, but are frequently asked to vote on major decisions, such as, dividend changes, election of new directors, issuance of new stock, etc.

© 2005 McGraw-Hill Ryerson Limited Corporation Advantages –Limited liability –Unlimited life –Management specialization allows for increased efficiency –Ownership is easily transferred –Easier to raise capital –No limit on size Disadvantages –Agency problems due to separation of ownership and management –Double taxation (profits are taxed at the corporate level and then dividends are taxed at the personal level) –Much government regulation –High organization costs

© 2005 McGraw-Hill Ryerson Limited Goals of Financial Management –Maximize shareholder wealth –Maximize share price –Maximize firm value Stock price depends on: earning per share (EPS), level of economic activity, corporate taxes, dividends, and debt versus equity financing.

© 2005 McGraw-Hill Ryerson Limited The Agency Problem There is a potential conflict of interest between the agent (manager) hired by the principal (stockholder) to represent the principal’s interest. Stockholders want stock price maximization Managers want perquisites and job security

© 2005 McGraw-Hill Ryerson Limited Managing the agency problem Managerial compensation (incentives can be used to align management and stockholder interests by linking compensation to performance). Corporate control (threat of takeover). Direct intervention by stakeholders (stakeholders include shareholders, creditors, employees, customers, suppliers and the federal and provincial governments).

© 2005 McGraw-Hill Ryerson Limited Financial Markets and the Corporation Financial markets are markets in which those with surplus funds (households) meet with those that need funds (corporation).

© 2005 McGraw-Hill Ryerson Limited Types of Financial Markets Money versus capital markets: -Money markets are financial markets where short-term debt securities are bought and sold. - Capital markets are financial markets where long-term debt and shares of stock are traded.

© 2005 McGraw-Hill Ryerson Limited Types of Financial Markets Primary versus secondary markets: Primary markets: when a firm first issues a security, the sale takes place in the primary market. These transactions maybe either public offerings or private placements. Secondary markets: security trades after the initial public offering take place in secondary markets.

© 2005 McGraw-Hill Ryerson Limited Types of Financial Markets Dealer versus auction markets: Dealer markets have no physical location. Bonds (debt securities) usually trade in dealer markets. Auction markets have a physical location (an exchange) where trading takes place on the floor of the exchange (e.g., TSX).

© 2005 McGraw-Hill Ryerson Limited Cash Flows to and from the Firm

© 2005 McGraw-Hill Ryerson Limited Financial Institutions Financial institutions act as intermediaries between suppliers and users of funds Institutions earn income on services provided: –Indirect finance – Earn interest on the spread between loans and deposits –Direct finance – Service fees (i.e. bankers acceptance and stamping fees)

© 2005 McGraw-Hill Ryerson Limited Trends in Financial Markets and Management Financial Engineering Derivative Securities Advances in Technology – i.e. E-business Deregulation Corporate Governance Reform

© 2005 McGraw-Hill Ryerson Limited Quick Quiz What are the three types of financial management 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 market and a secondary market?

© 2005 McGraw-Hill Ryerson Limited Summary You should know: –The advantages and disadvantages between a sole proprietorship, partnership and corporation –The primary goal of the firm –What an agency relationship and cost are –The role of financial markets