Corporate Finance

Instructor ： Cheng Yin | 尹程

Topic 1 ： Introduction
Outline – Chapter 1
• Corporate Finance and Financial Manager
• Forms of Business Organization
• The Goal of Financial Management
• The Agency Problem and Control of the Corporation
• Financial Markets and the Corporation
Corporate Finance? – IFO
• Some important questions that are answered using finance:

1. What long-term investments should the firm take on?

2. Where will we get the long-term financing to pay for the

investment?

3. How will we manage the everyday financial activities of the firm?

Financial Managers? – CXOs?
• Chief Financial Officer (CFO):The top financial manager within a
firm

• Treasurer (accountant): Oversees cash management, credit

management, capital expenditures, and financial planning

• Controller: Oversees taxes, cost accounting, financial accounting and

data processing
Financial Management Decisions – IFO
again?
• Capital budgeting

• What long-term investments or projects should the business take on?

• Capital structure

• How should we pay for our assets?

• Should we use debt or equity?

• Working capital management

• How do we manage the day-to-day finances of the firm?

Forms of Business Organization in the U.S.
• Capital
Sole • Single Owner
Proprietorship

• General
Partnership • Limited

• C-Corporation
Corporation • S-Corporation
• Limited Liability Company(LLC)
Sole Proprietorship
• Advantages:
• Easiest to start
• Least regulated
• Single owner keeps all the profits
• Taxed once as personal income

• Disadvantages:
• Limited to life of owner
• Equity capital limited to owner’s personal wealth
• Unlimited liability
• Difficult to sell ownership interest
Partnership
• Advantages:
• Two or more owners
• More capital available
• Relatively easy to start
• Income taxed once as personal income

• Disadvantages:
• Unlimited liability| General partnership | Limited partnership
• Partnership dissolves when one partner dies or wishes to sell
• Difficult to transfer ownership
Corporation
• Advantages:
• Limited liability
• Unlimited life
• Separation of ownership and management
• Transfer of ownership is easy
• Easier to raise capital
• Disadvantages:
• Separation of ownership and management
• Double taxation (income taxed at the corporate rate and then dividends taxed
at the personal rate)
Goal of Financial Management
• What should be the goal of a corporation?
• Maximize profits?
• Minimize costs?
• Maximize market share?
• Maximize the current value of the company’s stock?
• Does this mean we should do anything and everything to maximize
owner wealth?
• China vs. US?
The Agency Problem
• Agency relationship
• Principal hires an agent to represent his/her interests
• Stockholders (principals) hire managers (agents) to run the
company

• Agency problem
• Conflict of interest between principal and agent
• Management goals and agency costs
How to tackle it?
• Compensation structure
• Incentives can be used to align management and stockholder interests
• The incentives need to be structured carefully to make sure that they
achieve their goal
• Contract design, tournament effect…

• Corporate control – governance/ exit

• The threat of a takeover may result in better management (litigation, ownership
activism, proposal activism…)
• Other Stakeholders – employees, suppliers, government, creditors,
community …
Financial Markets
• Cash flows to the firm
• Primary vs. secondary markets
• Dealer vs. auction markets (bid-ask spread, market maker, liquidity…)
• Listed vs. over-the-counter securities (counter party risk)
• NYSE
• NASDAQ
Ethics issues
• Is it ethical for tobacco companies to sell a product that is known to be addictive and a
danger to the health of the user? Is it relevant that the product is legal? - personal
information protection

• Should boards of directors consider only price when faced with a buyout offer? –
fiduciary responsibilities

• Is it ethical to concentrate only on shareholder wealth, or should stakeholders as a

whole be considered? – ESG risks

• Should firms be penalized for attempting to improve returns by stifling competition

(e.g., Microsoft)? – product market competition
Take aways
• Role of the financial manager

• Corporation classifications

• Goal of financial management

• Potential conflicts between financial managers and shareholders

Outline – Chapter 2
• The Balance Sheet
• The Income Statement
• Taxes
• Cash Flow
Balance Sheet
The most important relationship you can bring to this class (from
your accounting), is the formula of the “Balance Sheet Identity”:

Total Assets = Total Liabilities + Stockholders Equity

Charts of Accounts
Networking Capital

NWC = Current Assets – Current Liabilities

- Positive when the cash that will be received over the next 12 months exceeds
the cash that will be paid out

- Usually positive in a financially healthy firm

Liquidity
- Ability to convert to cash quickly without a significant
loss in value
- Liquid firms are less likely to experience financial distress
- But liquid assets typically earn a lower return
- Trade-off to find balance between liquid and illiquid assets
A case
Book Value vs. Market Value 1/2
- The balance sheet provides the book value of the assets, liabilities, and
equity.
- Market value is the price at which the assets, liabilities, or equity can
actually be bought or sold.
- Market value and book value are often very different. Why?
- Which is more important to the decision-making process?
Book Value vs. Market Value 2/2
KLINGON CORPORATION
Balance Sheets
Market Value versus Book Value

Book Market Book Market

Assets Liabilities and Shareholders’ Equity

NWC $ 400 $ 600 LTD $ 500 $ 500

NFA 700 1,000 SE 600 1,100
1,100 1,600 1,100 1,600
Income Sheet
Taxes
- The one thing we can rely on with taxes is that they are always
changing!
- Marginal vs. average tax rates
- Marginal tax rate – the percentage paid on the next dollar earned (The tax rate
you would pay if you had one more taxable dollar)
- Average tax rate – the tax bill / taxable income (The tax rate you are paying on
all of your taxable income which averages across all of your corporate tax
categories)
- Other taxes
- State
- Local (City or Town)
Corporate Progressive Taxes
• Just like personal tax rates in the United States, corporations pay taxes
on their taxable earnings
• A significant difference is that corporate tax rates fit into just 8
categories
• A significant difference between individual tax rates and corporate tax
rates is that there are only 8 categories:
Example: Marginal Vs. Average Rates
• Suppose your firm earns $4 million in taxable income.
• What is the firm’s tax liability?
• What is the average tax rate?
• What is the marginal tax rate?

• If you are considering a project that will increase the firm’s taxable
income by $1 million, what tax rate should you use in your analysis?
Corporate Tax Rates
• Each major industry has different tax incentives provided by the US
Government and as such, may actually pay a different average tax rate:
The Concept of Cash Flow
• Cash flow is one of the most important pieces of information that a
financial manager can derive from financial statements
• The “Statement of Cash Flows” does not provide us with the same
information that we are looking at here
• We will look at how cash is generated from utilizing assets and how it
is paid to those that finance the purchase of the assets.
Example of Cash Flow
Cash Flow From Assets
• Cash Flow From Assets (CFFA) = Cash Flow to Creditors + Cash
Flow to Stockholders

CFFA = CF to creditors + CF to Stockholders

Example of CFFA - 1
• CF to Creditors (B/S and I/S) = interest paid – net new borrowing =
$24
• CF to Stockholders (B/S and I/S) = dividends paid – net new equity
raised = $63
• CFFA = CF to creditors + CF to Stockholders
• CFFA = 24 + 63 = $87
Cash Flow From Assets
• Cash Flow From Assets = Operating Cash Flow – Net Capital
Spending – Changes in NWC

CFFA = OCF – NCS - ∆NWC

Example of CFFA - 2
OCF (I/S) = EBIT + depreciation – taxes = $547

NCS ( B/S and I/S) = ending net fixed assets – beginning net fixed
assets + depreciation = $130
Changes in NWC (B/S) = ending NWC – beginning NWC = $330

CFFA = OCF – NCS - ∆NWC

CFFA = 547 – 130 – 330 = $87
A Closer Look at A=L+E
Balance Sheet – Income Sheet – Cash Flow
Some Questions
• What is the difference between book value and market value? Which
should we use for decision-making purposes?
• What is the difference between accounting income and cash flow?
Which do we need to use when making decisions?
• What is the difference between average and marginal tax rates? Which
should we use when making financial decisions?
• How do we determine a firm’s cash flows? What are the equations,
and where do we find the information?
Ethics Issues
• Why is manipulation of financial statements not only unethical and
illegal, but also bad for stockholders?
Take aways
• Identify the difference between book value and market value
• Identify the difference between accounting income and cash flow
• Differentiate between average and marginal tax rates
• Calculate a firm’s cash flow from its financial statements
Problem Set 1/3
• Current Accounts
• 2009: CA = 3625; CL = 1787
• 2008: CA = 3596; CL = 2140
• Fixed Assets and Depreciation
• 2009: NFA = 2194; 2008: NFA = 2261
• Depreciation Expense = 500
• Long-term Debt and Equity
• 2009: LTD = 538; Common stock & APIC = 462
• 2008: LTD = 581; Common stock & APIC = 372
• Income Statement
• EBIT = 1014
• Taxes = 368
• Interest Expense = 93
• Dividends = 285
Problem Set 2/3
1. OCF
2. NCS
3. Changes in NWC
4. CFFA
5. CF to Creditors
6. CF to Stockholders
7. CFFA
8. Does the CF identity hold?
Problem Set 3/3
1. OCF = 1,014 + 500 – 368 = 1,146
2. NCS = 2,194 – 2,261 + 500 = 433
3. Changes in NWC = (3,625 – 1,787) – (3,596 – 2,140) = 382
4. CFFA = 1,146 – 433 – 382 = 331
5. CF to Creditors = 93 – (538 – 581) = 136
6. CF to Stockholders = 285 – (462 – 372) = 195
7. CFFA = 136 + 195 = 331