McGraw-Hill/IrwinCopyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Introduction to Corporate Finance Chapter 1

McGraw-Hill/IrwinCopyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. 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 various 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

McGraw-Hill/IrwinCopyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter Outline 1.1 What is Corporate Finance? 1.2 The Corporate Firm 1.3 The Goal of Financial Management 1.4 The Agency Problem and Control of the Corporation 1.5 Financial Markets

McGraw-Hill/IrwinCopyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. 1.1 What is Corporate Finance? Corporate Finance addresses the following three questions: 1. What long-term investments should the firm choose? 2. How should the firm raise funds for the selected investments? 3. How should short-term assets be managed and financed?

McGraw-Hill/IrwinCopyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Balance Sheet Model of the Firm Current Assets Fixed Assets 1 Tangible 2 Intangible Total Value of Assets: Shareholders’ Equity Current Liabilities Long-Term Debt Total Firm Value to Investors:

McGraw-Hill/IrwinCopyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. The Capital Budgeting Decision Current Assets Fixed Assets 1 Tangible 2 Intangible Shareholders’ Equity Current Liabilities Long-Term Debt What long-term investments should the firm choose?

McGraw-Hill/IrwinCopyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. The Capital Structure Decision How should the firm raise funds for the selected investments? Current Assets Fixed Assets 1 Tangible 2 Intangible Shareholders’ Equity Current Liabilities Long-Term Debt

McGraw-Hill/IrwinCopyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Short-Term Asset Management How should short-term assets be managed and financed? Net Working Capital Shareholders’ Equity Current Liabilities Long-Term Debt Current Assets Fixed Assets 1 Tangible 2 Intangible

McGraw-Hill/IrwinCopyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Capital Structure The value of the firm can be thought of as a pie. The goal of the manager is to increase the size of the pie. The Capital Structure decision can be viewed as how best to slice the pie. If how you slice the pie affects the size of the pie, then the capital structure decision matters. 50% Debt 50% Equity 25% Debt 75% Equity 70% Debt 30% Equity

McGraw-Hill/IrwinCopyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. The Financial Manager The Financial Manager’s primary goal is to increase the value of the firm by: 1. Selecting value creating projects 2. Making smart financing decisions

McGraw-Hill/IrwinCopyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Hypothetical Organization Chart Chairman of the Board and Chief Executive Officer (CEO) Board of Directors President and Chief Operating Officer (COO) Vice President and Chief Financial Officer (CFO) TreasurerControllerCash Manager Capital Expenditures Credit ManagerFinancial PlanningTax Manager Financial Accounting Cost AccountingData Processing

McGraw-Hill/IrwinCopyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Cash flow from firm (C) The Firm and the Financial Markets Taxes (D) Firm Government Firm issues securities (A) Retained cash flows (F) Invests in assets (B) Dividends and debt payments (E) Current assets Fixed assets Financial markets Short-term debt Long-term debt Equity shares Ultimately, the firm must be a cash generating activity. The cash flows from the firm must exceed the cash flows from the financial markets.

McGraw-Hill/IrwinCopyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. 1.2 The Corporate Firm  The corporate form of business is the standard method for solving the problems encountered in raising large amounts of cash.  However, businesses can take other forms.

McGraw-Hill/IrwinCopyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Forms of Business Organization  The Sole Proprietorship  The Partnership General Partnership Limited Partnership  The Corporation

McGraw-Hill/IrwinCopyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. A Comparison CorporationPartnership LiquidityShares can be easily exchanged Subject to substantial restrictions Voting RightsUsually each share gets one vote General Partner is in charge; limited partners may have some voting rights TaxationDoublePartners pay taxes on distributions Reinvestment and dividend payout Broad latitudeAll net cash flow is distributed to partners LiabilityLimited liabilityGeneral partners may have unlimited liability; limited partners enjoy limited liability ContinuityPerpetual lifeLimited life

McGraw-Hill/IrwinCopyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. 1.3 The Goal of Financial Management  What is the correct goal? Maximize profit? Minimize costs? Maximize market share? Maximize shareholder wealth?

McGraw-Hill/IrwinCopyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. 1.4 The Agency Problem  Agency relationship Principal hires an agent to represent his/her interest Stockholders (principals) hire managers (agents) to run the company  Agency problem Conflict of interest between principal and agent

McGraw-Hill/IrwinCopyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Managerial Goals  Managerial goals may be different from shareholder goals Expensive perquisites Survival Independence  Increased growth and size are not necessarily equivalent to increased shareholder wealth

McGraw-Hill/IrwinCopyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Managing Managers  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 intended goal  Corporate control The threat of a takeover may result in better management  Other stakeholders

McGraw-Hill/IrwinCopyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. 1.5 Financial Markets  Primary Market Issuance of a security for the first time  Secondary Markets Buying and selling of previously issued securities Securities may be traded in either a dealer or auction market  NYSE NYSE  NASDAQ NASDAQ

McGraw-Hill/IrwinCopyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Financial Markets Firms Investors Secondary Market money securities SueBob Stocks and Bonds Money Primary Market

McGraw-Hill/IrwinCopyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Quick Quiz  What are the three basic questions Financial Managers must 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?