0 Corporate Finance Ross  Westerfield  Jaffe Seventh Edition 1 Chapter One Introduction to Corporate Finance

1 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

2 What is Corporate Finance? Corporate Finance addresses the following three questions: 1. What long-term investments should the firm engage in? 2. How can the firm raise the money for the required investments? 3. How much short-term cash flow does a company need to pay its bills?

3 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:

4 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

5 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

6 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 Long-Term Debt Current Assets Fixed Assets 1 Tangible 2 Intangible

7 Capital Structure The value of the firm can be thought of as a pie. The goal of the manager is to increase the size of the pie. The Capital Structure decision can be viewed as how best to slice up a the pie. If how you slice the pie affects the size of the pie, then the capital structure decision matters. 50% Debt 50% Equity 25% Debt 75% Equity 70% Debt 30% Equity

8 Hypothetical Organization Chart Chairman of the Board and Chief Executive Officer (CEO) Board of Directors President and Chief Operating Officer (COO) Vice President and Chief Financial Officer (CFO) TreasurerControllerCash Manager Capital Expenditures Credit ManagerFinancial PlanningTax Manager Financial Accounting Cost AccountingData Processing

9 The most important job of a financial manager: To create value from the firm ’ s capital budgeting, financing, and net working- capital activities.

10 Cash flow from firm (C) The Firm The Firm and the Financial Markets Taxes (D) Firm Government Firm issues securities (A) Retained cash flows (F) Invests in assets (B) Dividends and debt payments (E) Current assets Fixed assets Financial markets Short-term debt Long-term debt Equity shares Ultimately, the firm must be a cash generating activity. The cash flows from the firm must exceed the cash flows from the financial markets.

11  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.

12  Promised payoff to debtholders at year-end: $100  The value of the firm at year-end:$75, $100, $200.  How much will debtholders and equity shareholders get, respectively, then?

13 Debt and Equity as Contingent Claims $F Payoff to debt holders Value of the firm (X) Debtholders are promised $F. If the value of the firm is less than $F, they get the whatever the firm if worth. If the value of the firm is more than $F, debt- holders get a maximum of $F. $F Payoff to shareholders Value of the firm (X) If the value of the firm is less than $F, shareholders get nothing. If the value of the firm is more than $F, share-holders get everything above $F. Algebraically, the bondholder’s claim is: Min[$F,$X] Algebraically, the shareholder’s claim is: Max[0,$X – $F]

14 Combined Payoffs to Debt and Equity $F Combined Payoffs to debtholders and shareholders Value of the firm (X) Debtholders are promised $F. Payoff to debt holdersPayoff to shareholders If the value of the firm is less than $F, the shareholder’s claim is: Max[0,$X – $F] = $0 and the debt- holder’s claim is Min[$F,$X] = $X. The sum of these is = $X If the value of the firm is more than $F, the shareholder’s claim is: Max[0,$X – $F] = $X – $F and the debtholder’s claim is: Min[$F,$X] = $F. The sum of these is = $X

Goals of the Corporate Firm  The traditional answer is that the managers of the corporation are obliged to make efforts to maximize shareholder wealth.

16 The Set-of-Contracts Perspective  The firm can be viewed as a set of contracts.  One of these contracts is between shareholders and managers.  The managers will usually not act in the shareholders ’ interests.  The shareholders can devise contracts that align the incentives of the managers with the goals of the shareholders.  The shareholders can monitor the managers behavior.  This contracting and monitoring is costly.

17 Agency Costs and the Set-of- Contracts Perspective  One of the contract claims is a residual claim (equity) on the firm ’ s assets and cash flows.  Equity contract: a principal-agent relationship. The managers and the shareholders will each attempt to act in his or her own self-interest.  Agency costs: the sum of the monitoring costs and the costs of implementing control devices.  Agency problems can never be perfectly solved and shareholders may experience residual losses.

18 Managerial Goals  Managerial goals may be different from shareholder goals  Expensive perquisites  Survival  Independence  Increased growth and size are not necessarily the same thing as increased shareholder wealth.

19 SeparationSeparation of Ownership and Control  In the modern large corporation, which has diffuse ownership, who control the firm?

20 Do Shareholders Control Managerial Behavior?  Several control devices used by shareholders:  Board of directors  Contracts with management and arrangements for compensation, such as stock option plans, performance shares  Takeover  Competition in the managerial labor market

Financial MarketsFinancial 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.

22  Money market  for debt securities that will pay off in the short term (usually less than one year)  Capital market  for long-term debt (with a maturity at over one year) and for equity shares

23 Separation of Ownership and Control Board of Directors Management Assets Debt Equity Shareholders Debtholders

24 Financial Markets Firms Investors Secondary Market money securities SueBob Stocks and Bonds Money Primary Market

25

26

27

28