1. Chapter One Overview of Corporate Finance
Principles of Corporate Finance
Canadian Edition
Lawrence J. Gitman and Sean Hennessey
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2. Learning Goals
LG1 – Define finance and describe its three major areas and career opportunities.
LG2 – Review basic forms of business organization, their strengths and weaknesses.
LG3 – Describe managerial finance function and differentiate from economics and accounting.
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3. Learning Goals (continued)
LG4 – Identify key activities of financial manager within the firm.
LG5 – Explain why wealth maximization is firm’s goal.
LG6 – Explain how EVA, stakeholder focus, and ethical behaviour relate to firm’s goal.
LG7 – Discuss agency issue as it relates to owner wealth maximization.
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4. What is Finance?
At the macro level, finance is the study of financial institutions and financial markets and how they operate within the financial system in both the Canadian and global economies.
At the micro level, finance is the study of financial planning, asset management, and fund raising for businesses and financial institutions.
Financial management can be described in brief using the following balance sheet.
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5. What is Finance? Macro Finance Working Working Capital Capital
Investment
Decisions
Financing
Decisions
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6. What is Finance?
A well-developed financial system is a hallmark and essential characteristic of any modern developed nation.
Financial markets, financial intermediaries, and financial management are the important components.
Financial markets and financial intermediaries facilitate the flow of funds from borrowers to savers.
Financial management involves the efficient use of financial resources in the production of goods.
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7. Areas of Specialization in Finance
Financial Markets
Markets of users and savers of funds.
Financial Services
Design and delivery of financial advice and products to individuals, businesses, government.
Managerial Finance
Financial management of business firms.
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8. Areas of Employment in Finance
Financial Analyst
Capital budgeting analyst/manager
Project finance manager
Cash manager
Credit analyst/manager
Pension fund manager
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9. Basic Forms of Business Organization
Sole Proprietorship
Owned by one person, operated for personal profit.
Partnerships
Owned by two or more people, operated for joint profit.
Corporations
“Legal entity”, owned by individuals, operated for joint profit.
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10. Sole Proprietorship STRENGTHS: Low organizational cost
Income taxed once as personal income
Independence
Secrecy
Ease of dissolution
WEAKNESSES:
Unlimited liability
Limited funding
Proprietor must be all
Difficult to develop staff career opportunities
Lack of continuity on death of proprietor
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11. Partnerships STRENGTHS: Improved funding sources
Increased managerial talent
Income split by partnership contract, taxed as personal income
WEAKNESSES:
Unlimited liability to all partners
Partnership dissolved upon death of partner
Difficult to liquidate or transfer ownership
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12. Corporations STRENGTHS: Owners’ liability limited
Large capitalization possible, greater funding
Ownership readily transferable
Indefinite life
Professional management
WEAKNESSES:
Higher tax rates
Expensive organization
Greater government regulation
When publicly traded, lacks secrecy
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13. Corporate Organization Chart
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14. Organization of Finance Functions
CFO – Chief Financial Officer
Treasurer responsibilities:
Financial planning, fund raising, capital expenditure decisions, cash and credit management.
Controller responsibilities:
Corporate accounting, cost accounting, and tax management.
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15. Relationship to Economics
Fundamental Economic Principle:
Marginal Analysis
Financial decisions should be made and actions taken only when the added benefits exceed the added costs.
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16. Relationship to Accounting
Cash Flows
Accrual Basis: recognizes sales revenue and expenses incurred to make sale at time of sale.
Cash Basis: recognizes revenues and expenses as they occur.
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17. Accounting vs. Financial Views
Accounting View
(Accrual Basis)
Income Statement
Peakes Quay, Inc.
For year ended 12/31
Financial View
(Cash Basis)
Cash Flow Statement
Peakes Quay, Inc.
For year ended 12/31
Sales revenue $100,000
Less: Costs ,000
Net Profit $ 20,000
Cash inflow $
Less: Cash outflow 80,000
Net cash flow ($80,000)
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18. Financial Manager–Key Activities
Financial Analysis & Planning
Balance Sheet
Current
Assets
_______________
Fixed
Current
Liabilities
_______________
Long-Term Funds
(Debt & Equity)
Making
Investment
Decisions
Making
Financing
Decisions
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19. Should Firms Maximize Profit?
Corporations commonly define profit as “Earnings per Share” (EPS).
A measure of total earnings divided by total number of ownership shares.
EPS ignores critical factors of
the timing of the returns.
cash flows available to common shareholders.
risk factors facing the firm.
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20. Or Should Firms Maximize Shareholder Wealth?
Evaluating Shareholder Wealth addresses factors of timing, cash flows and risk ignored by the EPS.
Therefore, Maximizing Shareholder Wealth is a more comprehensive goal for the firm, its managers and employees.
This can be explored through “economic valued added” and a focus on stakeholders.
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21. Economic Value Added – EVA®
EVA measures whether an investment contributes to shareholder wealth.
EVA is calculated by subtracting cost of funds used from after-tax operating profits.
While popular, EVA is essentially derived from the concept of “net present value.”
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22. What about Stakeholders?
Stakeholders include groups that have direct economic links to the firm.
Stakeholders include not only owners, but also employees, customers, suppliers, and creditors.
Maintaining positive stakeholder relationships helps maximize long-term benefits to shareholders.
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23. Importance of Ethics The standards of conduct or moral judgment:
Honesty, trustworthiness, fair dealing are foundations of sustainable business relations:
With customers,
With suppliers,
With creditors,
With employees,
With owners.
Ethical behaviour is necessary to achieve the goal of maximizing shareholder wealth.
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24. Internal Ethical Review
Are rights of stakeholders being violated?
Does firm have extra duties to stakeholders?
Will a decision unfairly discriminate benefits among stakeholders?
If stakeholders are harmed, should this be remedied? How?
What is the relationship between shareholders and stakeholders?
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25. Financial Goals of a Company
Maximize sales.
Maximize cash flow.
Maximize market share.
Maximize profit.
Minimize costs.
Maximize return on sales, investment, equity.
Ensure earnings stability.
Achieve target goals for sales, profits, market share or return.
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26. Agency Issues: The Principal-Agent Problem
Whenever ownership is independent of management there exists potential problem of conflicts.
The owner’s goals for the firm are best described as maximizing shareholder wealth.
Managers are also concerned with personal wealth, job security, lifestyle, and benefits. These concerns may conflict with shareholder interests.
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27. Resolving the Agency Problem
Good corporate governance by the Board of Directors is the heart of any resolution.
Agency Costs – the costs of this governance:
Monitoring costs,
Bonding costs,
Structuring compensation costs.
Market forces, such as the potential for hostile takeover provide some deterrence.
Legal forces, fraud, and fiduciary misconduct laws aim to act as deterrents as well.
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28. Current View on Incentive Plans
Executive compensation packages generally include incentive plans that grant stock options, performance-based shares, or cash bonuses upon meeting or exceeding corporate goals.
Such packages may also include long-term benefits that can protect the manager against poor corporate performance.
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29. Overview of Text Part 1: Introduction to Corporate Finance
Part 2: Financial Analysis and Planning
Part 3: Important Financial Concepts
Part 4: Long-Term Financial Decisions
Part 5: Long-Term Investment Decisions
Part 6: Working Capital Management
Part 7: Special Topics in Corporate Finance
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