1. Prepared by Ingrid McLeod-Dick Schulich School of Business © 2015 McGraw–Hill Ryerson Limited All Rights Reserved Introduction to Corporate Finance Chapter One

2. 1-1 © 2015 McGraw–Hill Ryerson Limited 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

3. 1-2 © 2015 McGraw–Hill Ryerson Limited What is Corporate Finance? Corporate Finance addresses the following three questions: 1.In what long-lived assets should the firm invest? 2.How can the firm raise cash for required capital expenditures? 3.How should short-term operating cash flows be managed? LO 1.1

4. 1-3 © 2015 McGraw–Hill Ryerson Limited The Balance-Sheet Model of the Firm (Figure 1.1) Current Assets Long-term Assets 1 Tangible 2 Intangible Total Value of Assets: Shareholders’ Equity Current Liabilities Long-Term Debt Total Firm Value to Investors: LO 1.1

5. 1-4 © 2015 McGraw–Hill Ryerson Limited The Balance-Sheet Model of the Firm (Figure 1.1) Current Assets Long-term 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

6. 1-5 © 2015 McGraw–Hill Ryerson Limited The Balance-Sheet Model of the Firm (Figure 1.1) How can the firm raise the money for the required investments? The Capital Structure Decision Current Assets Long-term Assets 1 Tangible 2 Intangible Shareholders’ Equity Current Liabilities Long-Term Debt LO 1.1

7. 1-6 © 2015 McGraw–Hill Ryerson Limited The Balance-Sheet Model of the Firm (Figure 1.1) 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 Long-term Assets 1 Tangible 2 Intangible LO 1.1

8. 1-7 © 2015 McGraw–Hill Ryerson Limited Capital Structure (Figure 1.2) 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 LO 1.1

9. 1-8 © 2015 McGraw–Hill Ryerson Limited Hypothetical Organization Chart (Figure 1.3) 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 LO 1.1

10. 1-9 © 2015 McGraw–Hill Ryerson Limited The Financial Manager To create value, the financial manager should: 1.Try to make smart investment decisions –Buy assets that generate more cash than they cost 2.Try to make smart financing decisions –Sell bonds, shares and other financial instruments that raise more cash than they cost LO 1.1

11. 1-10 © 2015 McGraw–Hill Ryerson Limited Cash flow from firm (C) The Firm and the Financial Markets (Figure 1.4) Taxes (E) Firm Government Firm issues securities (A) Retained cash flows (D) Invests in assets (B) Dividends and debt payments (F) Current assets Long-term 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. LO 1.1

12. 1-11 © 2015 McGraw–Hill Ryerson Limited Cash Flows Identification of cash flows –Reporting of sales versus collection of cash –Reporting of expenses versus payment of expenses Timing of cash flows –A dollar received today is worth more than a dollar received next year Risk of cash flows –Amount and timing of future cash flows is not certain –Investors prefer to receive cash flows earlier than later LO 1.1

13. 1-12 © 2015 McGraw–Hill Ryerson Limited Corporate Securities as Contingent Claims on Total Firm Value Debt - 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. LO 1.2

14. 1-13 © 2015 McGraw–Hill Ryerson Limited Debt and Equity as Contingent Claims (Figure 1.5) $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, shareholders 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] LO 1.2

15. 1-14 © 2015 McGraw–Hill Ryerson Limited Combined Payoffs to Debt and Equity (Figure 1.5) $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 LO 1.2

16. 1-15 © 2015 McGraw–Hill Ryerson Limited 1.3 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. LO 1.3

17. 1-16 © 2015 McGraw–Hill Ryerson Limited Forms of Business Organization The Sole Proprietorship The Partnership –General Partnership –Limited Partnership The Corporation The Income Trust Advantages and Disadvantages –Liquidity and Marketability of Ownership –Control –Liability –Continuity of Existence –Tax Considerations LO 1.3

18. 1-17 © 2015 McGraw–Hill Ryerson Limited A Comparison of Partnership and Corporations CorporationPartnership Liquidity and marketabilityShares 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 taxation with dividend tax credit Partnership income is taxable at partner level 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. Continuity of existencePerpetual lifeLimited life LO 1.3

19. 1-18 © 2015 McGraw–Hill Ryerson Limited Forms of Business Organization Corporate structure separates ownership from management –Advantages: Ease of ownership changes Perpetual life and succession Limited liability LO 1.3

20. 1-19 © 2015 McGraw–Hill Ryerson Limited Goals of the Corporate Firm What are firm decision-makers hired to do? –Managers of the corporation are obliged to make efforts to maximize shareholder wealth LO 1.4

21. 1-20 © 2015 McGraw–Hill Ryerson Limited 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. –These costs are agency costs that arise from conflicts f interest between managers and shareholders LO 1.4

22. 1-21 © 2015 McGraw–Hill Ryerson Limited Managerial Goals Managerial goals may be different from shareholder goals –Expense preferences –Survival –Independence –Self-sufficiency Increased growth and size of firm are not necessarily the same thing as increased shareholder wealth. LO 1.4

23. 1-22 © 2015 McGraw–Hill Ryerson Limited Separation of Ownership and Control Board of Directors Management Assets Debt Equity ShareholdersDebtholders LO 1.4

24. 1-23 © 2015 McGraw–Hill Ryerson Limited The Agency ProblemO1. 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)? LO 1.4

25. 1-24 © 2015 McGraw–Hill Ryerson Limited 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. LO 1.4

26. 1-25 © 2015 McGraw–Hill Ryerson Limited Stakeholders In addition to shareholders and management, employees, customers, suppliers, and the public all have a financial interest in the firm and its decisions. Different stakeholders may have different goals. What’s ethical or socially responsible investing? –Does it create value? LO 1.4

27. 1-26 © 2015 McGraw–Hill Ryerson Limited Direct finance Loans Financial intermediaries Deposits Financial Institutions, Financial Markets, and the Corporation(Figure 1.6) Financial Institutions Indirect finance Funds suppliers Funds demanders Financial intermediaries Funds suppliers Funds demanders LO 1.5

28. 1-27 © 2015 McGraw–Hill Ryerson Limited Financial Markets Money versus Capital Markets Money Markets –For short-term debt instruments Capital Markets –For long-term debt and equity LO 1.5

29. 1-28 © 2015 McGraw–Hill Ryerson Limited 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. LO 1.5

30. 1-29 © 2015 McGraw–Hill Ryerson Limited Financial Markets Firms Investors Secondary Market money securities SueBob Stocks and Bonds Money Primary Market LO 1.5

31. 1-30 © 2015 McGraw–Hill Ryerson Limited Listing Listing on an organized exchange Enhances trading liquidity cross list on domestic and foreign exchanges Facilitates raising equity To be listed, firms must meet certain minimum criteria. Listing on Canadian exchange – “comply or explain” regime Listing on U.S. exchange– significant disclosure requirement (SOX) and compliance costs LO 1.5

32. 1-31 © 2015 McGraw–Hill Ryerson Limited Foreign Exchange Market Foreign exchange market is the world’s largest financial market for trading currencies Is an over-the-counter market. Many different types of participants: Importers and exporters Portfolio managers Foreign exchange brokers Traders LO 1.5

33. 1-32 © 2015 McGraw–Hill Ryerson Limited Trends in Financial Markets and Management Integration and globalization Increased risk from volatility Financial Engineering reduces costs related to –Risk –Taxes –Financing costs Improved computer technology allows economies of scale and scope LO 1.6

34. 1-33 © 2015 McGraw–Hill Ryerson Limited Trends in Financial Markets and Management (cont.) Deregulation is opening the possibility for further changes. Recent financial crisis: causes and recovery. These trends have made financial management a much more complex and technical activity. LO 1.6

35. 1-34 © 2015 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.Short-Term Finance VIII.Special Topics LO 1.7

36. 1-35 © 2015 McGraw–Hill Ryerson Limited 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?

37. 1-36 © 2015 McGraw–Hill Ryerson Limited Chapter Summary Introduces: Ways for financial managers to increase the value of the firm by managing: –investments in assets; –capital structure - debt and equity; and –net working capital. Different forms of business organization Role and classification of financial markets Latest trends in financial management