McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited 1-0 Corporate Finance Ross  Westerfield  Jaffe Sixth Edition 1 Chapter One Introduction to Corporate Finance Prepared by Gady Jacoby University of Manitoba and Sebouh Aintablian American University of Beirut

McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited 1-1 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 Institutions, Financial Markets, And The Corporation 1.6 Trends in Financial Markets and Management 1.7 Outline of the Text

McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited 1-2 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?

McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited 1-3 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:

McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited 1-4 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

McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited 1-5 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

McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited 1-6 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

McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited 1-7 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 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

McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited 1-8 Hypothetical Organization Chart Chairman of the Board and Chief Executive Officer (CEO) Board of Directors President and Chief Operating Officer (COO) TreasurerControllerCash Manager Capital Expenditures Credit ManagerFinancial PlanningTax Manager Financial Accounting Cost AccountingData ProcessingVice President Finance

McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited 1-9 The Financial Manager To create value, the financial manager should: 1.Try to make smart investment decisions. 2.Try to make smart financing decisions.

McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited 1-10 Cash flow from firm (C) The Firm and the Financial Markets Taxes (E) Firm Government Firm issues securities (A) Retained cash flows (D) Invests in assets (B) Dividends and debt payments (F) 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.

McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited 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 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 Ryerson © 2003 McGraw–Hill Ryerson Limited 1-12 Debt and Equity as Contingent Claims $F Payoff to debt holders Value of the firm (X) Debt holders are promised $F. If the value of the firm is less than $F, they get whatever the firm is 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, share holders 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]

McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited 1-13 Combined Payoffs to Debt and Equity $F Combined Payoffs to debt holders and shareholders Value of the firm (X) Debt holders 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 – $F and the debt holder’s claim is: Min[$F,$X] = $F. The sum of these is = $X

McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited The Corporate Firm The corporate form of business is the standard method for solving the problems encountered in raising large amounts of cash. However, businesses can take other forms.

McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited 1-15 Forms of Business Organization The Sole Proprietorship The Partnership –General Partnership –Limited Partnership The Corporation Advantages and Disadvantages –Liquidity and Marketability of Ownership –Control –Liability –Continuity of Existence –Tax Considerations

McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited 1-16 A Comparison of Partnership and Corporations CorporationPartnership LiquidityShares can easily be exchanged Subject to substantial restrictions. Voting RightsUsually each share gets one vote General Partner is in charge; limited partners may have some voting rights. TaxationDouble with dividend tax credit Partnership income is taxable. ReinvestmentBroad latitudeAll net cash flow is distributed to partners. LiabilityLimited liabilityGeneral partners may have unlimited liability. Limited partners enjoy limited liability. ContinuityPerpetual lifeLimited life

McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited Goals of the Corporate Firm What are firm decision-makers hired to do? The traditional answer is that the managers of the corporation are obliged to make efforts to maximize shareholder wealth.

McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited 1-18 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 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’ behaviour. This contracting and monitoring is costly.

McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited 1-19 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.

McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited 1-20 Separation of Ownership and Control Board of Directors Management Assets Debt Equity ShareholdersDebtholders

McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited 1-21 The Agency Problem The agency relationship Will managers work in the shareholders’ best interests? –Agency costs –Direct agency costs –Indirect agency costs Control of the firm How do agency costs affect firm value (and shareholder wealth)?

McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited 1-22 Do Shareholders Control Managerial Behaviour? Shareholders vote for the board of directors, who in turn hire the management team. Contracts can be carefully constructed to be incentive compatible. There is a market for managerial talent—this may provide market discipline to the managers—they can be replaced. If the managers fail to maximize share price, they may be replaced in a hostile takeover.

McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited 1-23 Direct finance Loans Financial intermediaries Deposits Financial Institutions Indirect finance 1.5 Financial Institutions, Financial Markets, and the Corporation Funds suppliers Funds demanders Financial intermediaries Funds suppliers Funds demanders

McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited 1-24 Financial Markets Money versus Capital Markets Money Markets –For short-term debt instruments Capital Markets –For long-term debt and equity

McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited 1-25 Financial Markets Primary versus Secondary 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.

McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited 1-26 Financial Markets Firms Investors Secondary Market money securities SueBob Stocks and Bonds Money Primary Market

McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited Trends in Financial Markets and Management Integration and globalization Increased volatility Financial Engineering reduces costs related to –Risk –Taxes –Fnancing costs Improved computer technology allows Economies of scale and scope Regulatory dialectic

McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited Outline of the Text I.Overview II.Value and Capital Budgeting III.Risk IV.Capital Structure and Dividend Policy V.Long-Term Financing VI.Options, Futures, and Corporate Finance VII.Financial Planning and Short-Term Finance VIII.Special Topics