Ch 1. Introduction to Corporate Finance

1. Corporate Finance Def: Corporate Finance (Financial Management) is an area dealing with Capital budgeting, Capital structure and working capital Management. Capital budgeting is the process of planning and managing a firm’s long term investments. Capital structure is the mixture of debt and equity maintained by a firm Working capital management is about managing short term assets and liabilities.

2. Forms of Business Organization 1) sole proprietorship: A business is owned by a single owner. Income is taxed as personal income. Advantage: - easy and inexpensive to set up - owner keeps all profits Disadvantage: - unlimited liability - limited to life of owner - limited capability of raising capitals

2) Partnership A business is formed by two or more individuals. Income is taxed as personal income to partners. Advantage: - easy and inexpensive to set up Disadvantage: - unlimited liability - limited life until the partnership is maintained - limited in transferring ownership - limited to raise capitals

3) Corporation: a business created as a distinct legal entity composed of one or more individuals and entities. Ownership is separated from management. Advantage: - easy to raise capital - easy to transfer ownership - limited liability - unlimited life

Disadvantage: - expensive and not easy to set up - double taxation: taxes on corporate and shareholders 4) Limited Liability Company (LLC) A hybrid of partnership and corporation Taxed like partnership but rating limited liability for owners.

3. Goal of Financial Management To maximize the current value per share (stock) of the existing stock. In general, to maximize the market value of the existing owners’ equity. Sarbanes-Oxley in 2002 - company’s annual report must have an assessment of company’s internal control structure and financial reporting. The auditor must evaluate and attest to management’s assessment to these issues. - increase the cost of audit to the companies. To avoid the this cost, public firms have chosen “go dark” – their stocks are no longer traded in the major stock exchange markets. Or to save the compliance costs, US firms decided to go public on the London Stock Exchange’s Alternative Investment Market

4. Agency problem and control of corporation 1) agency relationship: a relation in which one hires others to represent one’s interest. E.g) stock holders and managers 2) agency problem: the possibility of conflict of interest between the stock holders and management of the firm. E.g) a renovation project benefiting managers but costing stockholders. E.g) a very risk project benefiting stockholders but risking the position of the management.

3) agency costs: cost of conflict on interest between stockholders and managers. Two types of agency costs: (1) indirect cost: lost investment opportunities. (2) direct cost: - corporate expenditure benefiting managers but costing stockholders - an expense in order to monitor the managers’ behavior.

4) how to align interest of management with that of share (stock) holders? - Compensation basing on the performance (e,g) stock option to employee (e.g) salaries - Control of the firm: manager replacement (e.g) proxy fight to step down managers (e.g) takeover leading to replace the existing managers with new managers.

5) Stakeholders: someone other than a stockholder or creditor who potentially has a claim on the cash flows of the firm. E.g) employees, customers, suppliers, government. These groups exert control over the firm.

5. Financial markets and corporation Financial markets in which corporations can raise capitals by selling equities or borrowing. Primary market: original sale of equity or debt by corporations or government - public offering registering with SEC - private offering not registering with SEC Secondary market: the market where securities are bought and sold after the original sale. E.g) NYSE

Dealer versus Auction Markets Dealer market (over-the-counter): dealers who own securities are connected electronically. Auction market: it has physical location and match those who wish to sell with those who wish to buy. Trading in corporate securities: NYSE, AMEX, OTC, NASDAQ Listing: stocks that trade on an organized exchange are said to be listed on that exchange. To be listed, firms must meet certain minimum criteria concerning, for example, asset size, number of shareholders, etc.