McGraw-Hill/Irwin Corporate Finance, 7/e Eighth Edition

McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 1-1 CHAPTER 1 Introduction to Corporate Finance

McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 1-2 Chapter Outline 1.1 What is Corporate Finance? 1.2 Corporate Securities as Contingent Claims on Total Firm Value 1.3 The Corporate Firm 1.4 Goals of the Corporate Firm 1.5 Financial Markets 1.1 What is Corporate Finance? 1.2 Corporate Securities as Contingent Claims on Total Firm Value 1.3 The Corporate Firm 1.4 Goals of the Corporate Firm 1.5 Financial Markets

McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved What is Corporate Finance? Corporate Finance addresses the following three questions: 1. What long-term investments should the firm engage in?  Capital budgeting decision 2. How can the firm raise the money for the required investments?  Capital structure decision 3. How much short-term cash flow does a company need to pay its bills?  Cash and Working capital management Corporate Finance addresses the following three questions: 1. What long-term investments should the firm engage in?  Capital budgeting decision 2. How can the firm raise the money for the required investments?  Capital structure decision 3. How much short-term cash flow does a company need to pay its bills?  Cash and Working capital management

McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 1-4 The 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/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 1-5 The Balance-Sheet Model of the Firm Current Assets Fixed Assets 1 Tangible 2 Intangible Shareholders’ Equity Current Liabilities Long-Term Debt What long- term investments should the firm engage in? The Capital Budgeting Decision

McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 1-6 The Balance-Sheet Model of the Firm How can the firm raise the money for the required investments? The Capital Structure Decision Current Assets Fixed Assets 1 Tangible 2 Intangible Shareholders’ Equity Current Liabilities Long-Term Debt

McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 1-7 The Balance-Sheet Model of the Firm How much short- term cash flow does a company need to pay its bills? The Net Working Capital Investment Decision Net Working Capital Shareholders’ Equity Current Liabilities Current Assets Fixed Assets 1 Tangible 2 Intangible Long-Term Debt

McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 1-8 Functions of Financial Markets Bridging the gap between net borrowers and net savers. Net borrowers or investors are the deficit sector. They demand loan. Net savers are surplus sector. They supply loan. The two groups do not know each other, financial market brings them together. Providing the equilibrium interest rate. Net savers like to get more interest and net borrowers like to pay less interest. Financial market provides the equilibrium rate. Coordinating the liquidity preference: Net savers like to have more liquidity and net borrowers offer less liquidity. Financial market matches the preferences. Coordinating the risk preferences: Net savers like more return with less risk and net borrowers often involve in high risk high return projects. Financial market matches the preferences. Separation principle: Financial institutions separate the pattern of current consumption from the pattern of current income by means of intertemporal consumption function. People in need of more current consumption than current income borrow money. People who like to defer consumption lend money. Bridging the gap between net borrowers and net savers. Net borrowers or investors are the deficit sector. They demand loan. Net savers are surplus sector. They supply loan. The two groups do not know each other, financial market brings them together. Providing the equilibrium interest rate. Net savers like to get more interest and net borrowers like to pay less interest. Financial market provides the equilibrium rate. Coordinating the liquidity preference: Net savers like to have more liquidity and net borrowers offer less liquidity. Financial market matches the preferences. Coordinating the risk preferences: Net savers like more return with less risk and net borrowers often involve in high risk high return projects. Financial market matches the preferences. Separation principle: Financial institutions separate the pattern of current consumption from the pattern of current income by means of intertemporal consumption function. People in need of more current consumption than current income borrow money. People who like to defer consumption lend money.

McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 1-9 Equilibrium interest rate: (Loanable Fund Theory) i i D (Investment) S (Savings) k Quantity of Loanable Fund

McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved Intertemporal consumption: Separation Principle C 1 CoCo Lending Borrowing i=10%

McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved Intertemporal consumption: Effects of change in interest rate C 1 CoCo Lending Borrowing i=10% i=20%

McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved Problem: Suppose, you can invest now in a land by $70 to sell it by $75 next year. Should you invest? Draw the intertemporal consumption function. C 1 ($) C o ($) Lending Borrowing i=10%

McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved Problem: Suppose, you can invest now in a land by $70 to sell it by $80 next year. Should you invest? Draw the intertemporal consumption function. What is the NPV of land investment? [Hint:(80/1.1)-70=2.7] C 1 ($) C o ($) Lending Borrowing i=10%

McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved Corporate Securities as Contingent Claims on Total Firm Value The basic feature of a debt is that it is a promise by the borrowing firm to repay a fixed dollar amount of by a certain date. The shareholder’s claim on firm value is the residual amount that remains after the debtholders are paid. If the value of the firm is less than the amount promised to the debtholders, the shareholders get nothing. The basic feature of a debt is that it is a promise by the borrowing firm to repay a fixed dollar amount of by a certain date. The shareholder’s claim on firm value is the residual amount that remains after the debtholders are paid. If the value of the firm is less than the amount promised to the debtholders, the shareholders get nothing.

McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved Forms of Business Organization The Sole Proprietorship The Partnership The Corporation Advantages and Disadvantages Liquidity and Marketability of Ownership Control Liability Continuity of Existence Tax Considerations The Sole Proprietorship The Partnership The Corporation Advantages and Disadvantages Liquidity and Marketability of Ownership Control Liability Continuity of Existence Tax Considerations

McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved The Goal of Financial Management What is the correct goal? Maximize sales? Maximize profit? Minimize costs? Minimize Risk? Avoid Bankruptcy? Maximize shareholder wealth? What is the correct goal? Maximize sales? Maximize profit? Minimize costs? Minimize Risk? Avoid Bankruptcy? Maximize shareholder wealth?

McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved The Agency Problem Board of director and managers of the corporation are obliged to make efforts to maximize shareholder wealth. In an ideal situation the goal of profit maximization and of wealth maximization are not conflicting to each other. In reality there is considerable conflict. The separation of ownership and control is a property of company. (Why?) However, quite often this is a source of agency cost.

McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved Agency Cost Managers are naturally inclined to act in their own best interests. Expensive perquisites like high salaries and allowances of the agency (rationalized on motivational point) increases cost. High short term profit adds to the credentials of board of directors. High scale investment makes the firm dependent on the present agency. Risky investment. If successful, credit goes to the agency, if failure loss goes to the shareholders. High investment: This makes the firm dependent on the present board. High retention of earnings: Capital gain tax is less than dividend tax. Such an argument allows the management to distribute less dividend and retain more earnings and thereby, to finance big and risky investment. Managers are naturally inclined to act in their own best interests. Expensive perquisites like high salaries and allowances of the agency (rationalized on motivational point) increases cost. High short term profit adds to the credentials of board of directors. High scale investment makes the firm dependent on the present agency. Risky investment. If successful, credit goes to the agency, if failure loss goes to the shareholders. High investment: This makes the firm dependent on the present board. High retention of earnings: Capital gain tax is less than dividend tax. Such an argument allows the management to distribute less dividend and retain more earnings and thereby, to finance big and risky investment.

McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved Solution to agency problem Performance shares Hostile takeover Formal contract Market effects Performance shares Hostile takeover Formal contract Market effects

McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved Other kind of Agency cost It is the increased rate of interest on debt for a highly levered firm. In that case, the creditor needs to employ some agencies to monitor the firm to ensure that their interest is not affected with regard to: Investment decision Distribution of dividends Creating new debt Handling of mortgaged property It is the increased rate of interest on debt for a highly levered firm. In that case, the creditor needs to employ some agencies to monitor the firm to ensure that their interest is not affected with regard to: Investment decision Distribution of dividends Creating new debt Handling of mortgaged property

McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved Financial Markets Primary Market When a corporation issues securities, cash flows from investors to the firm. Usually an underwriter is involved Secondary Markets Involve the sale of “used” securities from one investor to another. Securities may be exchange traded or trade over-the- counter in a dealer market. Primary Market When a corporation issues securities, cash flows from investors to the firm. Usually an underwriter is involved Secondary Markets Involve the sale of “used” securities from one investor to another. Securities may be exchange traded or trade over-the- counter in a dealer market.

McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 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/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved Secondary market: Auction vs. OTC markets Auction market has a single physical location where trading is done through bidding. Both DSE and CSE are auction markets. Shares in USA are traded mostly (around 85%) in auction market. NYSE is an auction market. The other form of secondary market is over-the-counter (OTC) or dealers market where communication between buyers and sellers with dealers are done through electronic media. Mostly bonds and some shares are traded in OTC markets. NASDAQ (National Association of Securities Dealers Automated Quotation) is an OTC market. Auction markets are different from dealer markets in two ways: Trading in a given auction exchange takes place at a single site on the floor of the exchange whereas dealers market is spread out. Most of the transaction in OTC markets are done with dealers with a bid and ask spread. The primary purpose of auction market, on the other hand, is to match the buyers and sellers at a single price. Auction market has a single physical location where trading is done through bidding. Both DSE and CSE are auction markets. Shares in USA are traded mostly (around 85%) in auction market. NYSE is an auction market. The other form of secondary market is over-the-counter (OTC) or dealers market where communication between buyers and sellers with dealers are done through electronic media. Mostly bonds and some shares are traded in OTC markets. NASDAQ (National Association of Securities Dealers Automated Quotation) is an OTC market. Auction markets are different from dealer markets in two ways: Trading in a given auction exchange takes place at a single site on the floor of the exchange whereas dealers market is spread out. Most of the transaction in OTC markets are done with dealers with a bid and ask spread. The primary purpose of auction market, on the other hand, is to match the buyers and sellers at a single price.