1. Hong Kong Polytechnic University AF3303 Business Finance Lecture 1 Introduction to Corporate Finance Instructor: Dr. Jacqueline Wang

2. Key Concepts and Skills  Know the basic types of financial management decisions and the role of the Financial Manager  Know the financial implications of the various forms of business organization  Know the goal of financial management  Understand the conflicts of interest that can arise between owners and managers  Understand the various types of financial markets

3. Chapter Outline 1.1 What is Corporate Finance? 1.2 The Corporate Firm 1.3 The Goal of Financial Management 1.4 The Agency Problem and Control of the Corporation 1.5 Financial Markets

4. 1.1 What is Corporate Finance? Corporate Finance addresses the following three questions: 1. What long-term investments should the firm choose? 2. How should the firm raise funds for the selected investments? 3. How should short-term assets be managed and financed?

5. 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:

6. The Capital Budgeting Decision Current Assets Fixed Assets 1 Tangible 2 Intangible Shareholders’ Equity Current Liabilities Long-Term Debt What long-term investments should the firm choose?

7. The Capital Structure Decision How should the firm raise funds for the selected investments? Current Assets Fixed Assets 1 Tangible 2 Intangible Shareholders’ Equity Current Liabilities Long-Term Debt

8. Short-Term Asset Management How should short-term assets be managed and financed? Net Working Capital Shareholders’ Equity Current Liabilities Long-Term Debt Current Assets Fixed Assets 1 Tangible 2 Intangible

9. 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 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

10. The Financial Manager The Financial Manager’s primary goal is to increase the value of the firm by: 1. Selecting value creating projects 2. Making smart financing decisions

11. Hypothetical Organization Chart Chairman of the Board and Chief Executive Officer (CEO) 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 ProcessingBoard of Directors

12. Cash flow from firm (C) The Firm and the Financial Markets Taxes (D) Government Retained cash flows (F) Invests in assets (B) Dividends and debt payments (E) Current assets Fixed assets 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. Firm Firm issues securities (A) Financial markets

13. 1.2 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.

14. Forms of Business Organization  The Sole Proprietorship  The Partnership General Partnership Limited Partnership  The Corporation

15. A Comparison CorporationPartnership LiquidityShares can be easily exchanged Subject to substantial restrictions Voting RightsUsually each share gets one vote General Partner is in charge; limited partners may have some voting rights TaxationDoublePartners pay taxes on distributions Reinvestment and dividend payout Broad latitudeAll net cash flow is distributed to partners LiabilityLimited liabilityGeneral partners may have unlimited liability; limited partners enjoy limited liability ContinuityPerpetual lifeLimited life

16. 1.3 The Goal of Financial Management  What is the correct goal? Maximize profit? Minimize costs? Maximize sales (to be the biggest)? Maximize employee welfare? Be socially responsible? => Maximize shareholders ’ wealth

17. 1.4 The Agency Problem  Agency relationship Principal hires an agent to represent his/her interest Stockholders (principals) hire managers (agents) to run the company  Agency problem Conflict of interest between principal and agent

18. Managerial Goals  Managerial goals may be different from shareholder goals Expensive perquisites Survival Independence  Increased growth and size are not necessarily equivalent to increased shareholder wealth

19. Managing Managers  Managerial compensation Incentives can be used to align management and stockholder interests The incentives need to be structured carefully to make sure that they achieve their intended goal  Corporate control The threat of a takeover may result in better management  Other stakeholders

20. 1.5 Financial Markets  Primary Market Issuance of a security for the first time  Secondary Markets Buying and selling of previously issued securities Securities may be traded in either a dealer or auction market  NYSE NYSE  NASDAQ NASDAQ

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

22. Quick Quiz  What are the three basic questions Financial Managers must answer?  What are the three major forms of business organization?  What is the goal of financial management?  What are agency problems, and why do they exist within a corporation?  What is the difference between a primary market and a secondary market?