Introduction to Corporate Finance James R. Garven, Ph.D.

Chapter Outline 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

Corporate Finance Some important questions that are answered using finance: What long-term investments should the firm take on? 2. Where will the firm obtain the long-term financing needed pay for the investment? 3. How will the firm manage its everyday financial activities (e.g., payments to vendors, employees, extending credit customers to customers, etc.?

Financial Managers Chief Financial Officer (CFO): The top financial manager within a firm Treasurer: Oversees cash management, credit management, capital expenditures, and financial planning Controller: Oversees taxes, cost accounting, financial accounting and data processing

Chapter Outline 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

Forms of Business Organization in the U.S. Sole Proprietorship Single Owner Partnership General Limited Corporation C-Corporation S-Corporation Limited Liability Company (LLC)

Sole Proprietorship Advantages of Sole Proprietorship: Easiest to start Least regulated Single owner keeps all the profits Taxed once as personal income Another “feature” is that since the ownership and management of the firm are merged, there are no incentive conflicts between owners and managers since these roles are performed by the same person. As we move from the sole proprietor to the partnership to the corporation, incentive conflicts arise (aka “agency problems”).

Sole Proprietorship Disadvantages of Sole Proprietorship: Limited to life of owner Equity capital limited to owner’s personal wealth Unlimited liability Difficult to sell ownership interest

Forms of Business Organization in the U.S. Sole Proprietorship Single Owner Partnership General Limited Corporation C-Corporation S-Corporation Limited Liability Company (LLC)

Partnership Advantages of Partnerships: Two or more owners More capital available; risks shared between owners Relatively easy to start Income taxed once as personal income

Partnership Disadvantages of Partnerships: Unlimited liability General partnership Limited partnership Partnership dissolves when one partner dies or wishes to sell Difficult to transfer ownership

Forms of Business Organization in the U.S. Sole Proprietorship Single Owner Partnership General Limited Corporation C-Corporation S-Corporation Limited Liability Company (LLC)

Corporation Advantages of Corporation: Limited liability Unlimited life Separation of ownership and management Transfer of ownership is easy Easier to raise capital Separation of ownership and management conveys an advantage through specialization – owners focus on risk bearing and managers focus on creating value for owners.

Corporation Disadvantages: Separation of ownership and management Double taxation (income taxed at the corporate rate and then dividends taxed at the personal rate) Separation of ownership and control also has its downsides – need to worry whether incentives of agents (managers) coincide with interest of principals (owners) – regulate this through compensation schemes, corporate governance, internal auditing, markets for corporate control. By double taxing equity versus debt income, the tax system creates a bias in favor of debt – also true at personal level (e.g., mortgage finance).

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

Goal of Financial Management What should be the goal of a corporation? Maximize profits? Minimize costs? Maximize market share? Maximize the current value of the company’s stock? Here, introduce the Fisher Separation Theorem proof.

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

The Agency Problem Agency relationship Principal hires an agent to represent his/her interests Stockholders (principals) hire managers (agents) to run the company Agency problem Conflict of interest between principal and agent

Ways to Mitigate Agency Problems Managerial compensation Incentives can be used to align management and stockholder interests The incentives need to be structured carefully to make sure that they achieve their goal Corporate control The threat of a takeover may result in better management

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 Markets and the firm Key point here is financial markets provide signals for the most highly valued uses of capital – later in the course this will be where consideration of the cost of capital comes into play.