Introduction to Corporate Finance 1 Introduction to Corporate Finance

1-1 Corporate Investment and Financing Decisions Real Assets Used to produce goods and services Financial Assets/Securities Financial claims on income generated by firm’s real assets Capital Budgeting/Capital Expenditure (CAPEX) Decision to invest in tangible or intangible assets This slide is an overview of the upcoming topics. There is no need to spend too much time here, other than to explain that each of these topics are related to the bigger picture of investments and financing. The relationship to investments and financing should be restated many times during the chapter and even the entire course. Try to cite examples of both real and financial assets. It is often a good idea to identify a student who likes to participate and ask her what kind of business she wants to start. Use the student’s business idea to create actual examples. If, for example, the student wants to start a pie-baking business, you can use the oven, building, and other equipment as real assets. Assume the student raised money via a loan from a bank and an equity investment from family members. These can be cited as financial assets.

1-1 Corporate Investment and Financing Decisions Investment Decision Purchase of real assets Financing Decision Sale of financial assets Capital Structure Choice between debt and equity financing Continue the example provided in the previous slide and begin to identify the relationship between investment and financing decisions. Use the pie-baking example, or whichever one you develop in class, to draw the students into the world of financing terminology by connecting the dots between the steps in starting the pie business and the theoretical concepts in finance.

1-1 Corporate Investment and Financing Decisions Capital Budgeting Examples Tangible Assets i.e. Expanding stores Intangible Assets i.e. Research and development for new drug This is where you begin the process of introducing more abstract concepts and formal terminology. CAPEX is a first step in showing the students terms commonly used in the profession. This moves the students away from the big picture of investments and into the more specific finance phase of capital budgeting. If the example presented is too abstract for the students, return to the example used earlier. As with a pie-baking company, point out the difference between investing in more ovens versus something abstract like the expanse of experimenting with a new recipe or expanding your business by purchasing a brand-name pie company.

Table 1.1 Recent Investment/ Financing Decisions Company Recent Investment Decisions Recent Financing Decisions Boeing (U.S.) Delivers first Dreamliner after investing a reported $30 billion in development costs. Reinvests $1.7 billion of profits. ExxonMobil (U.S.) Spends $7 billion to develop oil sands at Fort McMurray in Alberta. Spends $12 billion buying back shares. GlaxoSmith-Kline (UK) Spends $4 billion on research and development for new drugs. Pays $3.2 billion as dividends. LVMH (France) LVMH acquires the Italian Jeweler, Bulgari, for $5 billion. Pays for the acquisition with a mixture of cash and shares. Procter & Gamble (U.S.) Spends $8 billion on advertising. Raises 100 billion Japanese yen by an issue of 5-year bonds. Tata Motors (India) Opens a plant in India to produce the world's cheapest car, the Nano. The facility costs $400 million. Raises $400 million by the sale of new shares. Union Pacific (U.S.) Invests $330 million in 100 new locomotives and 10,000 freight cars and chassis. Repays $1.4 billion of debt. Vale (Brazil) Opens a copper mine at Salobo in Brazil. The project cost nearly $2 million. Maintains credit lines with its banks that allow the company to borrow at any time up to $1.6 billion. Walmart (U.S.) Invests 12.7 billion, primarily to open 458 new stores around the world. Issues $5 billion of long-term bonds in order to repay short-term commercial paper borrowings. This table is taken directly from the book and shows examples of investment and financing decisions. It is highly encouraged to take examples for the current news and add them as topics of discussion in class. Students relate much better when they can reference an event for which they are familiar.

1-1 Corporate Investment and Financing Decisions What Is a Corporation? Legal entity, owned by shareholders Can make contracts, carry on business, borrow, lend, sue, and be sued Shareholders have limited liability and cannot be held personally responsible for corporation’s debts This slide explains corporations and the concept of limited liability. Most students will already be familiar with these concepts.

Figure 1.1 Cash Flow between Financial Markets and Firm’s Operations manager Firm's operations markets (1) Cash raised from investors (1) (2) Cash invested in firm (2) (3) Cash generated by operations (3) (4a) Cash reinvested (4a) (4b) Cash returned to investors (4b) Explain the critical role of the financial manager in obtaining funds from financial markets to fulfill the needs of the firm. Be certain to provide the big picture. Explain the cash flows shown in the slide. Explain how cash is generated from operations. Explain how this slide helps in understanding the role of the financial manager. The financial manager must learn to value real and financial assets. The financial manager must understand how financial markets work, for it is there that value is ultimately determined. Also explain the cash flow cycle as given in the diagram.

1-2 The Financial Goal of the Corporation Stockholders Want Three Things To maximize current wealth To transform wealth into most desirable time pattern of consumption To manage risk characteristics of chosen consumption plan Begin this section with a review of the traditional role of the firm in maximizing the value of stockholders. Spend time pointing out the role and rights of owners of a company to have their goals achieved. It is important to make sure students know the link between ownership of the company and the legitimate desire to maximize stock price.

1-2 The Financial Goal of the Corporation Profit Maximization Not a well-defined financial objective Which year’s profits? Shareholders will not welcome higher short-term profits if long-term profits are damaged Company may increase future profits by cutting year’s dividend, investing freed-up cash in firm Not in shareholders’ best interest if company earns less than opportunity cost of capital Leap from the concept of maximizing stock price to the concept of how it is done. Point out that the natural tendency to achieve high profits may not necessarily accomplish this task. Long-term versus short-term profits can be introduced and maybe even a discussion of the short-term mindset of the capital markets.

1-2 The Financial Goal of the Corporation Shareholders desire wealth maximization Managers have many constituencies, “stakeholders” “Agency Problems” represent the conflict of interest between management and owners An excellent follow-up to the debate between shareholders and stakeholders is the debate between shareholders and managers. Here it is worth noting the source of true power. In fact, it is important to highlight the fact that owners of a public corporation have very little power relative to managers. Examples of state corporate law can be presented to show the limited influence shareholders have over managers.

1-2 The Financial Goal of the Corporation The Investment Trade-off Hurdle Rate/Cost of Capital Minimum acceptable rate of return on investment Opportunity Cost of Capital Investing in a project eliminates other opportunities to use invested cash Here is an important concept check. While not much is written on this slide, take time to draw out the student’s understanding of opportunity cost from their economics course. Some will refer to it as what an investor gives up. Alert students will define it as the value of the next best alternative. Take that definition and explain to them that in the world of finance we add a vital few words, “…at the same level of risk.” If you have an example of how companies you know use different hurdle rates, or examples where companies improperly use only one rate for every decision, cite these as dos and don’ts.

Figure 1.2 The Investment Trade-off Taken directly from the book, emphasize the decision managers must make. This shows the flow of cash as determined by the financial manager. Continue to point out that this is a capital budgeting or investment decision. That theme was introduced earlier and should be constantly reinforced.

1-2 The Financial Goal of the Corporation Agency Problems Managers, acting as agents for stockholders, may act in their own interests rather than maximizing value Stakeholder Anyone with a financial interest in the firm This slide is more of a summary slide to bring the prior discussion back into focus. It is easy to get distracted with details. This is a chance to remind everyone the issue being discussed and the core topic of stakeholders.

Agency Problems—Ownership versus Management 1-2 THE FINANCIAL GOAL OF THE CORPORATION Agency Problems—Ownership versus Management Difference in Information Stock prices and returns Issues of shares and other securities Dividends Financing Different Objectives Managers vs. stockholders Top mgmt vs. operating mgmt Stockholders vs. banks and lenders Explain the concept of separation of ownership and management. Discuss advantages and disadvantages this has, the potential for conflict of interests between shareholders and managers. Explain agency costs, principal-agent problems, and information asymmetries. 1-14

1-2 The Financial Goal of the Corporation Agency costs are incurred when: Managers do not attempt to maximize firm value Shareholders incur costs to monitor managers and constrain their actions Not only do managers not necessarily respond to the needs of shareholders, the owners incur costs related to protecting their interests. Plenty of current news stories exist to illustrate this point.

1-2 The Financial Goal of the Corporation Tools to Ensure Management Pays Attention to the Value of the Firm Manager’s actions subject to the scrutiny of board of directors Shirkers are likely to find they are ousted by more energetic managers Financial incentives provided, such as stock options Now we begin talking about how to force managers to focus on value creation. We can begin with some theoretical concepts and go over why the managers are not always looking out for the interests of the shareholders. Review the financial incentives that exist.