© 2005 McGraw-Hill Ryerson Limited © 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 1.1

© 2005 McGraw-Hill Ryerson Limited Corporate Finance Some important questions that are answered using finance –What long-term investments should the firm undertake? –Where will we obtain the long-term financing to pay for the long-term investments? –How will we manage the day-to-day financial activities of the firm? 1.3

© 2005 McGraw-Hill Ryerson Limited Financial Manager Financial managers try to answer some or all of these questions The top financial manager within a firm is usually the Chief Financial Officer (CFO) –Treasurer – Oversees cash management, capital expenditures and financial planning –Controller – Oversees taxes, cost accounting, financial accounting and data processing –VP, Corporate Planning/Corporate Development – What projects should the firm undertake to create value for the shareholders? 1.4

© 2005 McGraw-Hill Ryerson Limited Financial Management Decisions Capital budgeting –Provides a framework for making long-term investment decisions Capital structure –The mix of debt and equity securities on the Balance Sheet –Should we use debt or equity (the choice affects both risk and return) Working capital management –How do we manage the day-to-day finances of the firm? 1.5

© 2005 McGraw-Hill Ryerson Limited Forms of Business Organization Three major 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 1.6

© 2005 McGraw-Hill Ryerson Limited Sole Proprietorship Advantages –Easiest to start –Least regulated –Single owner keeps all the profits –Taxed once as personal income Disadvantages –Unlimited liability –Limited to life of owner –Equity capital limited to owner’s personal wealth –Difficult to sell ownership interest 1.7

© 2005 McGraw-Hill Ryerson Limited Partnership Advantages –Two or more owners –More capital available –Relatively easy to start –Income taxed once as personal income Disadvantages –Unlimited liability General partnership Limited partnership –Partnership dissolves when one partner dies or wishes to sell –Difficult to transfer ownership 1.8

© 2005 McGraw-Hill Ryerson Limited Corporation Advantages –Limited liability –Unlimited life –Separation of ownership and management –Transfer of ownership is easy –Easier to raise capital Disadvantages –Separation of ownership and management –Double taxation (corporate income is first taxed at the corporate level. Dividends are taxed again at the personal level) 1.9

© 2005 McGraw-Hill Ryerson Limited Goal Of Financial Management What should be the goal of a corporation? –Maximize profit? –Minimize costs? –Maximize market share? –Maximize the current value of the company’s stock? Does this mean we should do anything and everything to maximize the owner’s wealth? 1.11

© 2005 McGraw-Hill Ryerson Limited Primary Goal of Financial Management Three equivalent goals of financial management: –Maximize shareholder wealth –Maximize share price –Maximize firm value 1.12

© 2005 McGraw-Hill Ryerson Limited The Agency Problem Agency relationship –Principal hires an agent to represent their interests –Shareholders (principals) hire managers (agents) to run the company Agency problem –Conflicts of interest can exist between the principal and the agent Agency costs –Direct agency costs Corporate expenditures that benefit management but not the shareholders (corporate jets & luxurious offices) Expenses incurred to monitor management (hire auditors) –Indirect agency costs Management foregoes a potentially profitable opportunity due to its potential for a loss of management jobs 1.13

© 2005 McGraw-Hill Ryerson Limited Managing Managers Managerial compensation –Incentives can be used to align management and stockholder interests Example: a portion of pay is tied directly to share price (share purchase options) or corporate profitability (bonuses) –The incentives need to be structured carefully to make sure that they achieve their goal Nortel’s incentives led management into making bad decisions Corporate control –The threat of a takeover may result in better management –The use of “poison pills” protects management at the shareholder’s expense Conflicts with other stakeholders –A stakeholder in any body with a potential claim on the cash flows of the organization –Pressure groups may force the corporation to undertake actions that are not in the best, short-term interests of the shareholders (employment equity, environmental issues, etc) 1.14

© 2005 McGraw-Hill Ryerson Limited 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, choose a company and see what information you can find! 1.15

© 2005 McGraw-Hill Ryerson Limited What is the role of financial markets in corporate finance? Cash flows to and from the firm Money vs. capital markets Primary vs. secondary markets How do financial markets benefit society? 1.16

© 2005 McGraw-Hill Ryerson Limited Cash Flows to and from the Firm 1.17

© 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 Traditional banking – take in deposits & make loans Earn interest on the spread between loans and deposits –Direct finance Investment banking – charge a fee in return for performing a service (i.e. bankers acceptance and stamping fees) 1.18

© 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 1.19

© 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? 1.20

© 2005 McGraw-Hill Ryerson Limited Summary 1.9 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 1.21