1. Introduction to Corporate Finance
MBAC 6060 Chapter 1
Introduction to Corporate Finance

2. Chapter 1 Outline: 1.1 What is Corporate Finance?
1.2 The Corporate Firm
1.3 The Importance of Cash Flows
1.4 The Goal of Financial Management
1.5 The Agency Problem and Control of the Corporation
1.6 Regulation

3. 1.1 A Quick Look Four Basic Areas of Finance Corporate Finance
Capital Budgeting – Undertake a proposed long-term project?
How do you pay for the project? (Three choices)
Working Capital Management – financing short term assets
Investments
Financial Institutions
International Finance
Lets go over these in more detail 

4. Four Basic Areas of Finance Corporate Finance
Capital Budgeting – Undertake a proposed project?
You have an idea. Will it make money?
In other words: Will the idea Increase the firm’s value?
How many units can we sell? (Marketing)
How much will it cost to make the units? (Operations)
How do you pay for the project? (Three choices)
Sell a piece of the company
Sell an Equity stake a.k.a. sell stock
Borrow the money
Sell Debt securities a.k.a. sell bonds
Retain Earnings
Keep past profits to finance expansion

5. Net Working Capital = Cash + Inv + A/R – (ST Debt + A/P)
Corporate Finance (Continued)
Working Capital Management
Make Sure there is enough cash and inventory on hand.
The BLUE ones are Working Capital Accounts
Too Much Cash? Payoff ST Debt (Lower Interest Expense)
Not Enough cash? Borrow More (Increase Interest Expense)
Net Working Capital = Cash + Inv + A/R – (ST Debt + A/P)
Assets
Liabilities & Equity
Cash
ST Debt
Inventory
A/P
A/R
LT Debt
PPE
Equity

6. The Textbooks Version of the same thing:

7. Investments Firms sell securities (stocks and bonds) Someone buys them
Which ones should you buy?
What are the worth?
This is called Securities Analysis
If I hold a bunch of different securities (which is called a portfolio), how do the different securities combine into portfolios?
This is called Portfolio Analysis

8. Financial Institutions
Types:
Commercial Banks – Chase, Wells Fargo…
Investment Banks – Goldman Sachs, Morgan Stanley…
Insurance Companies – GEICO, Anthem …
Investment Companies
Mutual funds – Janus, Fidelity…
Hedge Funds – Bridgewater Associates, Fortress
The study of financial institutions relates to risk management
This means making sure they don’t blow up
Or at least trying to decrease the likelihood of them blowing up

9. International Finance
More of a specialization than an area of finance
But also must deal with Currency exchange rates and a exchange rate risk
You sell your product for Euros but need Dollars to pay suppliers, employees, bondholders and shareholders

10. Everything a firm does must be paid for
Why Study Finance?
Everything a firm does must be paid for
No matter your chosen profession in the business world
Marketing, Management, Accounting, Systems…
You still have to talk to the finance people
Why?
To get them to pay for your ideas
Another reason to study finance…
You might actually be rich someday
In which case it would be beneficial for you to understand investments
Understanding investments means understanding corporations and corporate finance
The securities you will buy are claims on a corporations earnings and assets

11. 1.2 Business Finance and the Financial Manager
What do corporate financial professionals do?
Decide if a new business venture will be profitable:
Both CURRENT business and potential NEW business
We already make red pens. Should we make blue pens?
We already make pens. Should we make pencils?
We already make pens and pencils. Should we deliver them to stores (buy our own trucks)?
We make and deliver pens and pencils. Should we make hotdogs-on-a-stick?
How to pay for new business?
Take on New Owners (sell stock) or Borrow (sell bonds)
Manage the everyday financial activities of the firm
Called Working Capital Management
Collect from customers, pay suppliers, pay expenses…
Sell stocks, bonds, commercial paper, borrow from banks…

12. Corporate Organization – Figure 1.2 page 3

13. 1.3 Forms of Business Sole Proprietorship Partnership Corporations
Owned by one Person
Pass-through
Unlimited liability
Partnership
General Partnership
Limited Partnership
Also a pass-through
Corporations
Shareholders, Board of Directors, Managers, Employees
A corporation is a separate entity for tax and liability purposes

14. Corporation vs. Partnership (Table 1.1, Page 6)
Corporation
Partnership
Liquidity
Shares can be easily exchanged
Subject to substantial restrictions
Voting Rights
Usually each share gets one vote
General Partner is in charge; limited partners may have some voting rights
Taxation
Double
Partners pay taxes on distributions
Reinvestment and dividend payout
Broad latitude
All net cash flow is distributed to partners
Liability
Limited liability
General partners may have unlimited liability; limited partners enjoy limited liability
Continuity
Perpetual life
Limited life

15. 1.4 Goals of Financial Management First talk about Stakeholders:
Owners (Stockholders also called Shareholders)
Debtors (Bondholders, CP holders, banks…)
Employees
Suppliers
Customers
Community
So what is the goal of financial management?
Maximize Shareholder Value (Help the Owners)
What about the rest of the stakeholders?
Ignore them
At least for the purposes of our value decisions

16. 1.4 Goals of Financial Management (continued)
So how do you maximize shareholder value?
Generate Cash Flows!
Cash Flows are not the same as Net Income (Why?)
Sell stocks and bonds that raise more cash than they cost
Buy assets that generate more cash than they cost
Process:
Sell stocks and bonds to financial markets to raise money
Invest money in assets which generate cash
Pay some of the cash to bondholders (interest payments) and stockholders (dividends)
If cash generated by assets exceeds cash raised from financial markets, the firm increases in value

17. Managers vs. Stockholders:
1.5 Agency Problem and Corporate Control
Managers vs. Stockholders:
Stockholders want to maximize wealth
Maximize share price
Or maybe maximize income from shares (dividends)
What do managers want to maximize?
Perquisites (perks): jets, cars, apartments…
Control: size of their division: assets, employees…

18. 1.5 Agency Problem and Corporate Control (cont.)
So try to align manager and stockholder incentives:
Bonuses
ESOPs (Employee Stock Ownership Plans)
Stock sold to the employees by the company (new shares issued)
Has the effect of diluting the existing shareholder’s stake
Stock Options
A stock option is the ability to buy company stock two years from now (for example) at the current stock price (say $25)
The Options will only be valuable if the stock’s price increases in the next two years (above $25)
Again, shares sold to the employee by the company (dilution)
Problems with these three:
Short term vs. Long term
Employees only care about price being high in two years
This caused many of the recent accounting scandals

19. The Securities Exchange Act of 1934
1.6 Regulation
The Securities Act of 1933
Issuance of Securities
Registration and Disclosure
The Securities Exchange Act of 1934
Creation of SEC
Set Reporting Requirements (List of SEC filings)
Filings are available on the SEC EDGAR site
Sarbanes-Oxley (“Sarbox”)
After Enron, WorldCom, Tyco
Increased reporting requirements and responsibility of corporate directors

20. Financial Markets and Liquidity
Firms raise money by selling securities:
Sell Stocks
Percentage of Ownership - dilution
Stock holders have rights to a percent of profits and assets
After “borrowers” have been paid
Residual claim
Sell bonds or other debt instruments (like CP)
Sell Debt or borrowing money
Coupon Bonds or Zero-Coupon Bonds
Paid BEFORE profits are paid to stock holders
Primary claim
Investors value securities based on:
Expected payments: dividends, coupons, price appreciation
Risk: Volatility of payments or price, probability of default
Liquidity: Can’t sell the security  pay less for it

21. Securities Markets Increase Liquidity
Liquidity is the ability to convert an asset to cash (sell it)
Two Components of Liquidity:
How quickly can I get “full price”?
How much do I have to drop the price to get cash right now?
Note:
The word “Liquidity” can also refer to a company’s ability to meet it’s current payment obligations
Often through short-term borrowing
Recall the definition of working capital management

22. Consider the liquidity of:
Brokers versus Dealers
Broker introduces buyer and seller
Earns a commission
Dealer buys the asset from the seller and then sells is to the buyer
Earns the “spread”
Consider the liquidity of:
A used car
Sell using a newspaper or internet add
Used car Dealer
A house
1,000 shares of IBM
100,000 shares of IBM
10% ownership of McGuckin’s
What kind of markets have brokers? What kind have dealers?

23. Back to Securities Markets:
Primary Markets
The issuing firm sells the stocks or bonds for the first time (like new cars)
The issuing firm gets the money
The transactions are done through an investment bank
The transaction is called underwriting
Done by an investment banker
Secondary Markets
Secondary market transactions involve an owner selling to a different owner (like used cars)
The issuing firm does NOT get the money
The transaction is done through a market
Stocks (NYSE, NASDAQ, OTC), Bonds, Currency, Futures, Options…