1. The Scope Of Corporate Finance
Instructor Zheng Yu
Financial Management

2. Finance Career Opportunities
Corporate Finance
Budgeting, financial forecasting, cash management, credit administration, investment analysis, fund procurement
Commercial Banking
Consumer banking
Corporate banking
Investment Banking
High income potential
Very competitive industry
Money Management
Opportunities in investment advisory firms, mutual fund companies, pension funds, investment arms of financial departments
Consulting
Advise on business practices and strategies of corporate clients

3. Raising Capital: Key Facts
Most financing comes from internal rather than external sources.
Most external financing issued as debt
Primary vs. secondary market transactions or offerings
The simplest debt instruments to value are U.S. Treasury securities since there is no default risk.
Instead, the discount rate to use, r, is the pure cost of borrowing.
Assume you are asked to value two Treasury securities, when rf is 1.75 percent (r = ):
A (pure discount) Treasury bill with a $1,000 face value that matures in three months, and
A 1.75% coupon rate Treasury note, also with a $1,000 face value, that matures in three years.
For the T-Bill, three months is one-quarter year (n=0.25)
For 3-year bond, n = 3
Most U.S. corporate bonds:
Pay interest at a fixed coupon interest rate
Have an initial maturity of 10 to 30 years, and
Have a par value (also called face or principal value) of $1,000 that must be repaid at maturity.
Bond’s value has two separable parts:
(1) PV of stream of annual interest payments, t=1 to t=10
(2) PV of principal repayment at end of year 10.
Can thus also value bond as the PV of an annuity plus the PV of a single cash flow using PVFA and PVF from tables.
P0 = C x (PVFA5%,10yr) + Par x (PVF5%,10yr)
= $50 (7.7220) + $1,000 (0.6139) = $1,000.00
Bonds with a few cash flows can be valued with Eq 4.1; for bonds with many cash flows, use PVFA/PVF factors, calculator or Excel.
Traditional financial intermediaries (banks) declining as a source of capital for large firms
Securities markets growing in importance

4. Growth in Global Security Issues, 1990-2003
$ Bn
Global debt & equity
U.S. Issuers worldwide

5. Corporate Finance Functions
External Financing
Capital Budgeting
Corporate Finance Functions
Financial Management
Risk Management
Corporate Governance

6. Dimensions of the External Financing Function
Equity vs. debt
Funding via capital market vs. via financial intermediary
Value of any financial asset is the PV of future cash flows
Bonds: PV of promised interest & principal payments
Stocks: PV of all future dividends
Patents, trademarks: PV of future royalties
Valuation is the process linking risk & return
Output of process is asset’s expected market price
A key input is the required [expected] return on an asset
Defined as the return an arms-length investor would require for an asset of equivalent risk
Debt securities: risk-free rate plus risk premium(s)
Required return for stocks found using CAPM or other asset pricing model
Beta determines risk premium: higher beta, higher reqd return
Public vs. private capital markets
Going public 6

7. The Capital Budgeting Function
Capital Budgeting – the process firms use to choose the set of investments that generate the most wealth for shareholders
When r is greater than the coupon interest rate, P0 will be less than par value, and the bond will sell at a discount
For Sun, if r >5%, P0 will be less than $1,000
For practice:
Value Sun Company, 10-year, 5% coupon rate bond if required return, r =6% and again if r = 4%.
Premiums & discounts change systematically as r changes.
Select investments for which the marginal benefits exceed the marginal costs.

8. The Financial Management Function
Managing daily cash inflows and outflows
Forecasting cash balances
Building long-term financial plans
-Yield to Maturity (YTM) is the rate of return investors earn if they buy the bond at P0 and hold it until maturity.
The YTM on a bond selling at par (P0 = Par) will always equal the coupon interest rate.
When P0  Par, the YTM will differ from the coupon rate.
YTM is the discount rate that equates the PV of a bond’s cash flows with its price. If P0, CFs, n known, can find YTM
Use T-Bond with n=2 years, 2n=4, C/2=$20, P0=$992.43
Choosing the right mix of debt and equity

9. The Risk Management Function
Managing the firm’s exposure to significant risks:
Interest rate risk
Exchange rate risk
-Yield to Maturity (YTM) is the rate of return investors earn if they buy the bond at P0 and hold it until maturity.
The YTM on a bond selling at par (P0 = Par) will always equal the coupon interest rate.
When P0  Par, the YTM will differ from the coupon rate.
YTM is the discount rate that equates the PV of a bond’s cash flows with its price. If P0, CFs, n known, can find YTM
Use T-Bond with n=2 years, 2n=4, C/2=$20, P0=$992.43
Commodity price risk

10. The Corporate Governance Function
Ensuring that managers pursue shareholders’ objectives
Dimensions of corporate governance
Boards of directors
Ownership structures
Capital structures
Compensation plans
Country’s legal environment - in U.S., Sarbanes-Oxley Act of 2002
The relationship between nominal (observed) and real (inflation-adjusted) interest rates and expected inflation called the Fisher Effect (or Fisher Equation)
Fisher said the nominal rate (r) is approximately equal to the real rate of interest (a) plus a premium for expected inflation (i).
If real rate equals 3% (a = 0.03) and expected inflation equals 2% (i = 0.02):
r  a + i   0.05  5%
The true Fisher Effect is multiplicative, rather than additive:
(1+r) = (1+a)(1+i) = (1.03)(1.02) = ; so r = 5.06%
Takeover market disciplines firms that don’t govern themselves.

11. What Should Managers Maximize?
Profit maximization as goal:
Does not account for timing of returns
Profits - not necessarily cash flows
Ignores risk
Maximize shareholder wealth
Maximize stock price, not profits
Accounts for risk
As “residual claimants,” shareholders have better incentives to force management to maximize firm value than do other stakeholders.

12. Agency Costs In Corporate Finance
Due to separation of ownership and control
Divergence between interests of managers and shareholders—called agency costs
Ways to deal with agency costs
Possibility of takeover
Monitoring and bonding
Compensation contracts
Controversial method: executive compensation
Average pay in 2003 for CEOs of large U.S. companies: $8.1 million

13. Forms Of Business Organization In The U.S.
Proprietorship
No distinction between business and person
Easy to set up, operate; taxed as personal income
Personal liability, limited life, difficult to transfer
Partnership
Two or more business owners
Partners - liable for every other partner’s actions
Limited Partnership
One general & many limited partners
Limited liability of corporation,tax benefits of partnership
Real-estate, R&D companies

14. Forms Of Business Organization - Corporations
Legal entity with all the economic rights and responsibilities of a person
Incorporation occurs at state level; based on state law
Strengths - limited liability to investors, unlimited business life
What was the major weakness for corporations before passage of the Tax Relief Act of 2003?
Double taxation
The Job and Growth Tax Relief Reconciliation Act of 2003 reduced the double taxation problem.

15. The Double Taxation of Dividends
Taxation of Business Income: Corporations vs Partnerships (Corporate Tax Rate (tc) = 0.35; Personal Tax Rate (tp) = 0.38)

16. The Tax Relief Act of 2003
Dividends are treated as capital gains, dividend tax rate = 0.15 (Corporate Tax Rate (tc) = 0.35; Personal Tax Rate (tp) = 0.35)

17. Non-U.S. Forms Of Business Organization
Limited-Liability Companies
PLC In Britain, SA In Spain, Latin America
GMBH or AG In Germany, Austria, Switzerland
Limited liability companies can be traded publicly or be privately held.
Limited liability companies play an important role in many economies.

18. Corporate Form of Organization
Financial managers – should seek to maximize shareholders’ wealth
How? Perform the 5 basic duties of corporate finance: external financing, capital budgeting, financial management, risk management, corporate governance.
Select investments for which the marginal benefits exceed the marginal costs.