Lecture 1 Introduction to corporate finance Corporate Finance Lecturer: Quan, Qi Winter 2010

2 Topics Covered What is corporate finance about? What is a corporation? What do financial managers do? Separation of ownership and management Financial markets

3 What is corporate finance about? The difference between accounting and corporate finance – Accounting mainly involves recording and summarizing business and financial transactions, and analyzing, verifying and reporting the results (the Merriam-webster definition of accounting) Suppose you are about to start a business on your own, where do you start?

4 What is corporate finance about? Two major decisions faced by corporations: investment and financing – Investment: real assets (both tangibles and intangibles) – Financing: financial assets (securities)

5 What is corporate finance about? The relationship between different stakeholders – Jensen and Meckling (1976): Firm can be viewed as a set of contracts – Debtholders and shareholders Imagine the whole firm value to be a big pie – Debtholders get a fixed piece of the pie by a certain date – Shareholders get what is left from the pie – The objective of the firm is to maximize shareholder wealth – But what about other stakeholders?: employees, customers, suppliers and the government Corporate finance gives you the concepts and general rules about how to deal with the corporate issues

6 What is a corporation? Sole proprietorship and partnership – The sole proprietorship is a business owned by one person; easiest form to start a business – The partnership is built up by two or more people Corporation – A corporation is a distinct legal entity; can be viewed as a “resident” – Incorporated based on articles of incorporation (including e.g. name of the corporation; intended life; business purpose; number of shares of stock; the number of directors to be appointed) – Closely held vs. public firm (the shares are traded on the stock exchanges)

7 What is a corporation? Sole proprietorships Partnerships Unlimited Liability Personal tax on profits Have a limited life Corporations Limited Liability Corporate tax on profits+ Personal tax on dividends Could be perpetual

8 What is a corporation? The typical corporate structure of a corporation

9 What is a corporation? Pros and cons of setting up a corporation 1)Able to satisfy growing financing needs 2)Unlimited life 3)Limited Liabilities 1)Operation of the legal machinery and communication with the shareholders can be time-consuming and costly 2)Tax drawback

10 What do financial managers do?

11 Separation of ownership and management The advantages of the separation – Even if the managers quit or are replaced, the corporation can survive – The stockholders can sell their shares without disrupting the operations of the business The disadvantages of the separation – The principal-agent problem especially when the ownership structure is diverse – Any implications for state-owned firms (SOEs)?

12 Financial markets Money market vs. capital market – Money market: for debt securities that pay off in the short term (usually less than one year) – Capital market: for long-term debt (with a maturity of over one year) and for equity shares Primary market vs. secondary market – Primary market: where new issues of securities are offered to the public – Secondary market: already-existing securities are bought and sold on the exchanges or in the over-the-counter market Market efficiency – Prices fully and instantaneously reflect all available relevant information

13 Market efficiency 1) The capital market makes the separation of ownership and management possible – The firm does not have to make investment plans that match its shareholders’ preferred time patterns of consumption – Shareholders can shift funds forward and back over time on their own The purpose of capital markets is to transfer funds between lenders (savers) and borrowers (producers) efficiently

14 Market efficiency 2) What is the difference between an efficient market and a perfect market? – The definition of a perfect capital market The market is frictionless: no transaction costs or taxes; all assets are perfectly divisible and marketable; no constraining regulations There is a perfect competition in securities market: all participants are price takers The market is informationally efficient: information is costless and is received simultaneously by all individuals All individuals are rational expected utility maximizers – Market efficiency is less restrictive than the notion of a perfect capital market Prices fully and instantaneously reflect all available relevant information