Professor John Zietlow MBA 621 Spring 2006 The Scope Of Corporate Finance Chapter 1

The Scope Of Corporate Finance What Is Corporate Finance? –Can Be Defined By Functions of Corporate Finance –Skills Developed Studying Corp Fin Applicable Everywhere Career Opportunities In Finance –Corporate Finance –Investment & Commercial Banking –Money Management & Consulting Goals Of The Financial Manager –Why Maximize Shareholder Wealth? Basic Forms of Business Organization –In the U.S. and Internationally

The Five Basic Corporate Finance Functions Capital-Raising (Financing) –Obtaining External Funding For Firm’s Operations Capital Budgeting –Allocating the Firm’s Resources To Most Productive Use Financial Management –Managing Firm’s Cash Flows To Pay Maturing Liabilities –Managing Firms’ Capital Structure (Mix Of Debt & Equity) Corporate Governance –Ensuring Firm Is Run Ethically & In Shareholders’ Interest Risk Management –Managing Insurable & Uninsurable Risk Exposures

Raising Capital: Basic Terminology Primary vs Secondary Market Transactions Or Offerings –Primary: Capital-Raising Transaction Funding Via Capital Market vs Via Financial Intermediary –Sell Securities To Investors For Cash On Capital Markets Money vs Capital Markets –Money Market: For Short-Term (Max 1 Year) Debt Obligations Public vs Private Capital Markets –Public: Security Listed On Regulated Exchange, Freely Traded Going Public –Selling Stock To Public Investors & Listing On Exchange

Raising Capital: Key Facts Internally-Generated Cash Flow The Dominant Source Of Funding In All Developed Economies –Typically 60-80% For US Firms, 50-60% Other OECD Bulk of External Funding Is In The Form Of Debt –Seasoned Equity Issues Only 4-8% Of External Financing Profits Re-Invested In A Firm (Retained Earnings) Equal To A New Equity Issue Each Year –This Keeps Leverage Ratio From Rising Too High With Time Banks Everywhere Are Declining As A Source Of Capital For Large Firms –Especially True In US; Less So In Europe, Japan Huge Increase In Total Security Issuance Volume Since 1990

Growth in Global Security Issues, Global debt & equity U.S. Issuers worldwide $ Bn

World Stock Market Capitalization,

The Critical Importance Of Corporate Governance Historical Experience, Academic Research Both Suggest That Ownership Structure Very Important –Concentrated vs Atomistic Ownership Structure –At Least Three Forms Of Capitalism (US, Japan, Europe) –Country’s History & Legal/Regulatory System Very Important Incentives Of Managers, Stockholders, Other Stakeholders Often Conflict –S/Hs Face Collective Action Problem Monitoring Management The Role Of Takeovers In Corporate Governance Has Grown Dramatically In Recent Years –Long Important In US, UK; Increasingly In Europe

Value of Global Mergers & Acquisitions, ($US Billions)

Career Opportunities In Finance For Finance Graduates Corporate Finance (Including International) –Financial Analyst, Treasurer, Controller, CFO, Possibly for a Nonprofit or Governmental Organization Commercial Banking –Corporate & Consumer Banking, Operations, International Investment Banking –High Salaries, Massive Stress; Mostly In NYC, London Money Management & Investment Services –Booming During 1990s; Baby-Boomers Fueling Demand –Now Over 5,000 Mutual Funds; Large Funds Still Dominant Consulting –High Salaries; Rapid Recent Growth; Much Traveling

Career Opportunities For Finance Graduates: Prerequisites For Success All Require Good Communications Skills, Ability To Work In Teams, Computer Expertise –Sound Like Cliches, But True Nonetheless Basic Financial Analysis Skills Critically Important –Especially Valuation Skills (Securities, Projects, Firms) Finance Now Seen As A Source Of Strategic Advantage –View Firm As Portfolio Of “Growth Options” To Be Developed International Business Knowledge Increasingly Important –U.S. Represents Less Than 30% Of “Global GDP” Financial Transactions, Trading Moving To Internet –Business-To-Business Marketing, Payment; Securities Trading

Financial Use Of The Internet As A Source Of Financial & General Business Information –General Info: CNNFN (money.cnn.com), Yahoo ( –Purchased Databases: S&P ( –Corporate Websites: Deutsche Telekom ( IBM ( Goldman Sachs ( –Business Periodicals: Financial Times ( Wall Street Journal ( Investors Business Daily ( Economist ( –Government: U.S. Federal Reserve ( –Exchanges: NYSE ( ( –Financial Sites: Smart Money ( Providing Instant, Low-Cost Brokerage Services –Pioneers: Schwab ( ( Ameritrade ( –Now Merrill Lynch ( others Offering Service

What Should Managers Try To Maximize? Though Plausible, Profit Maximization Has Problems –Does Not Account For Timing Of Returns –Profits Are Not Necessarily Cash Flows –Most Important: Ignores Risk Proper Management Objective: Maximize Shareholder Wealth –Maximize Stock Price, Not Profits –Accounts For Risk, Timing, Maximizing Value Of Cash Flows –As “Residual Claimants,” S/Hs Have Better Incentives To Maximize Firm Value than Other Stakeholders –S/Hs Can Benefit Only Once Other Claims Paid In Full –Historical Justification: Success Of Financial Capitalism

The Importance of Agency Costs In Corporate Finance Agency Costs Due To Separation of Ownership And Control –Managers Are The Agents Of S/Hs, But Are Also Human –Interests of Managers & S/Hs Inevitably Diverge Three Ways To Deal With Agency Costs; Cannot Truly Solve –Can Rely On Market Forces: Takeovers, Proxy Contests –Can Incur Monitoring & Bonding Costs –Align Manager & S/H Interests Via Compensation Contracts Most Controversial Method: Executive Compensation –Bull Market Has Led To Huge Payments –Average Total S&P 500 CEO Pay In 2001: $9.7 Million –Bulk Of This Pay Comes From Stock Options –Sometimes non-cash perks as well: Gulfstream for Jobs

Forms Of Business Organization In The U.S. Proprietorships & Partnerships Proprietorship Is A Business That Is Owned By One Person –No Distinction Between Business & Person –Benefits: Easy To Set Up, Operate; Taxed As Personal Income –Drawbacks: Personal Liability, Limited Life, Difficult To Transfer A Partnership Has Two Or More Business Owners –Similar Benefits & Drawbacks As Proprietorships –Partners Are Liable For Every Other Partner’s Actions –Goldman Sachs Became Corporation, Went Public May 1999 A Limited Partnership Has One General & Many Limited Partners, But Only General Partner Has Unlimited Liability –Tax Benefits Of Partnership, Limited Liability Of Corporation –Attractive For Funding Real Estate, Certain Types Of R&D

Forms Of Business Organization In The U.S. Corporations & LLCs A Corporation Is A Separate Legal Entity With All The Economic Rights & Responsibilities Of A Person –Can Sue & Be Sued, Own Property, Execute Contracts –Incorporation Occurs At State Level; Based On State Law Corporate Form Has Decisive Strengths –Offers Limited Liability To Investors; Unlimited Business Life –Most Businesses Become Corps As They Mature Key Weakness Is Double Taxation Of Dividends [next slide] –S Corporation Overcomes This, But Its Use Is Restricted Limited Liability Company (LLC) The Newest Form –Combines Corp’s Limited Liability & Partnership’s Taxation –Allowed In All 50 States; Can Choose Finite Or Infinite Life Franchising a Specialized Form

The Double Taxation of Dividends: Corporate Tax Rate (  c ) = 0.35 Personal Tax Rate (  p ) = 0.40 Taxation of Business Income: Corporations vs Partnerships

Non-U.S. Forms Of Business Organization Almost All Countries Allow Limited-Liability Companies--In Some Form--And Promote Stock Market Listings –Called PLC In Britain, SA In Spain, Latin America –GMBH or AG In Germany, Austria, Switzerland –Mid-Sized Firms The Backbone Of All Advanced Economies Most Countries Besides U.S. Have State-Owned Enterprises –SOEs Have Traditionally Operated Utilities, Airlines, Banks –Account For 5% GDP In OECD; about 7% In non-OECD Privatization Programs Have Reduced Role Of SOEs and Raised Almost $1.5 Trillion For Governments Since 1980 –Began In Margaret Thatcher’s UK In Early 1980s –Usually Over $100 Bn Annually, Mostly Via Share Offerings

Privatization Proceeds $US Billions,

Organization of Course Textbook: Divided Into Eight Parts I. Introduction II. Risk, Return and Valuation III. Capital Budgeting Processes and Techniques IV. Capital Structure and Dividend Policy V. Long-Term Financing VI. Options, Derivatives and International Financial Management VII. Short-Term Financing Decisions VII. Special Topics