CORPORATE FINANCE CORPORATE FINANCE J.D. Han King’s College, UWO

CHAPTER ONE Financial Management and the Financial Objectives of the Firm

1.1 Learning Objectives 1) Define financial management, and give reasons why it is important. 2) Name examples/reasons why simple profit maximization is not a satisfactory economic objective for financial managers. 3) Discuss the main categories of criticisms of simple share price maximization as a corporate objective. 4.Examine agency relationships, and outline the potential associated costs.

1.2 What is Finance? Finance has 3 aspects: 1) Making long-term investment decisions: “Capital Budgeting Decisions” 2) Making long-term financing decisions: “Capital Structure Decision” – Bonds, Loans or Equities? 3) Managing day-to-day activities: “Working Capital or Liquidity Management”

1.3 Forms of Business Organizations 1) Sole Proprietorship 2) Partnerships 3) Corporations

1) Sole Proprietorship Easy to establish Owned and operated by one individual Income generated is taxed at the proprietor’s personal tax rate Not recognized as a separate legal entity Owner faces unlimited liability with respect to his/her business

2) Partnerships Involves two or more owners Not recognized as a separate legal entity Partnership income taxed as personal income Details of each partners responsibilities are outlined in a partnership agreement

* Two Types of Partnerships General Partnerships - partners face unlimited liability - partners are involved in the day-to-day operation of the business - partners are jointly liable for all the obligations of the partnership Limited Partnerships - must have at least one general partner involved in business - limited partners cannot be involved in business operations - liability is limited to the amount invested in the partnership

3) Corporations Profits are taxed based on corporate tax rates Separation of Ownership and Management Shareholders(Principals) exert influence over the corporation by electing board of directors and thereby management(Agents) Shareholders have limited liabilities

*Advantages versus Disadvantages of Corporations Advantages Easy to raise funds: Risk-Sharing Easy to transfer ownership: Stock Market Limited Liability of Owners: Risk-Taking Venture Tax Advantages Disadvantages Principal-Agent Problem –Agency Cost; “Bad Corporate Governance” – Social Cost Hostile Take-Over: Transactions Cost

1. 4 Importance of Good Financial Management Provide long range financial planning Participate in formulating and implementing broad corporate strategy Analyze the risk and profitability of a firm

Qualifications of Financial ManagersQualifications of Financial Managers Because financial officers are oriented towards the future performance of an organization, they must: 1. be familiar with financial and accounting theory 2. be involved in the development of information systems 3. have analytical techniques 4. have a background in economics

1. 6 Objectives of Financial Management: Maximizing Shareholder Wealth The objective of financial management is to maximize shareholder wealth as reflected in share prices.

three issues of financial managementthree issues of financial management 1) Profit Versus Return On Capital: no particular ratio (index) tells all about the company 2) Timing of Capital Flows: Time value of money 3) Uncertainty: Risk Evaluation and Management

Profits must be viewed in relation to capital invested in order to guide financial decision-making: Ratio Analysis The return on capital invested by the firm should always be commensurate with reasonable shareholders’ expectations 1) Profit Versus Return On Capital

2) Timing of Cash Flows The occurrence of profits is not a one-time event operational objectives should incorporate the "time value of money“ to allow profits to be compared across different time periods: Long-Term Analysis.

3) Risk Profits are subject to risk Investors generally demand a higher expected return, or risk premium in order to invest in risky securities: Risk Evaluation( Expected Returns; Risk Premium Theories; Certainty Equivalence Theory); Risk Management (Portfolio Diversification Strategy; Hedging Strategy)

1.7 Role of Management in Imperfect Information Management serves as an arbitrator and moderator between conflicting interest groups or stakeholders and objectives. Creditors, managers, employees and customers hold contractual claims against the firms revenues Shareholders have residual claims against the company

* Information Asymmetry and Principal-Agent Problem Separation of Ownership from Management Principal (Owners=Shareholders) versus Agents(Managers) Principal-Agent Problem is due to Information Asymmetry (about what is going on in the firm) between the two Agency costs incurs to resolve Principal-Agent Problem through Monitoring and Instituting Incentive Compatibility

Agency CostsAgency Costs Recognizes that agency relationship does not work without friction and shareholders may incur losses Occurs when managers choose not to maximize shareholders’ wealth for their own self-gains

*Specific Types of Agency Costs Stock option compensation - Example: Management is given the opportunity to buy shares in the company at a given price Cost from Conflict of interests - Example: Potential conflict of interest between shareholders and debt holders whose best interests may conflict at times -Lender’s Liability Equitable Subordination Clause in U.S. Corporate Law (and way to go for Canada)

1.9 Summary 1.With the increasing complexity and uncertainty in the marketplace, finance is emerging as the business function that holds the corporation together at the top management level. 2.If markets are "perfect", (perfect competition, perfect information, rational market participants, no externalities), economic theory has demonstrated that an efficient allocation of resources will result.

1.9 Summary 3. Profits have to be viewed in relation to capital invested because the general theory of profit maximization ignores the amount of capital invested to generate a given profit, different patterns of profits across time, and the risks inherent in future profit projections. 4. Market preferences are expressed in prices— share prices in our case. The issue of valuation is concerned with establishing what determines the value of shares in capital markets.

Summary 5.Maximization of share prices can be criticized on the grounds that real markets are not perfect, that management also has responsibilities to other groups that have legitimate interests in the firm (employees, customers, and various sectors of government), and that the objective of economic efficiency is too narrow. 6.In a competitive market environment, profitability and good shareholder relations are a prerequisite to the pursuit of many additional concerns, and high share prices will assure the firm's continued access to financial markets for further expansion.