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 regulations that firms face

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Chapter 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

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1.1 What Is Corporate Finance?
Suppose you decide to start a firm to do a
business, how do you run it?

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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?

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Balance Sheet Model of the Firm
Total Value of Assets: Total Firm Value to Investors:
Current
Liabilities
Current Assets
Long-Term
Liabilities

Fixed Assets
1 Tangible
Shareholders’
2 Intangible Equity

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The Capital Budgeting Decision
Current
capital budgeting to Liabilities
Current Assets describe the process
of making and Long-Term
managing
expenditures on long- Liabilities
lived assets

Fixed Assets
What long-term
1 Tangible investments Shareholders’
2 Intangible
should the firm Equity
choose?

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The Capital Structure Decision
capital structure,
represents the Current
proportions of the firm’ Liabilities
Current Assets s financing from
current and long-term Long-Term
debt and equity
How should the Liabilities
firm raise funds
for the selected
Fixed Assets
investments?
1 Tangible Shareholders’
2 Intangible Equity

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Short-Term Asset Management
Net working capital is defined
as current assets minus Current
current liabilities Liabilities
Current Assets
Net
Working Long-Term
Capital Liabilities

How should
Fixed Assets short-term assets
be managed and
1 Tangible financed? Shareholders’
2 Intangible short-term cash flow problems Equity
come from the mismatching of
cash inflows and outflows
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1.1 What Is Corporate Finance?
Corporate Finance has three main area of
concern:
1. Capital Budgeting
2. Capital Structure
3. Working capital management

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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

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 Hypothetical Organization Chart
The treasurer Board of Directors The controller
is responsible deals will
for handling the accounting
Chairman of the Board and
cash flows, Chief Executive Officer (CEO) function, which
managing includes taxes,
capital President and Chief cost and financial
Operating Officer (COO) accounting, and
expenditure
decisions, and information
making Vice President and systems
Chief Financial Officer (CFO)
financial plans

Treasurer Controller

Cash Manager Credit Manager Tax Manager Cost Accounting

Capital Expenditures Financial Planning Financial Accounting Data Processing

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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.

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

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Forms of Business Organization
 The Sole Proprietorship
 The cheapest business to form
 No formal charter and few government
regulations
 Individual income taxes
 Unlimited liability
 Life of the sole proprietor
 The proprietor’s personal wealth

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Forms of Business Organization
 The Partnership
 Be inexpensive and easy to form
 Unlimited liability vs limited liability
 Terminating and dissolving
 Difficult to raise large amounts of capital
 Personal income taxes
 Management control

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Forms of Business Organization
 The Corporation Disadvantages of Sole
Proprietorship and
 A distinct legal entity Partnership:
(1) unlimited liability, (2)
 Complicated establishment limited life of the enterprise,
 Three distinct interests and (3) difficulty of
transferring ownership.
 Ease of ownership transfer
 Limited liability
 Perpetual succession

The potential separation of ownership from

management

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A Comparison
Corporation Partnership

Liquidity Subject to substantial

restrictions

Voting Rights Usually each share gets one

vote

Taxation Partners pay taxes on

distributions
Reinvestment and dividend Broad latitude
payout

Liability Limited liability

Continuity Limited life

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A Comparison
Corporation Partnership

Liquidity Shares can be easily Subject to substantial

exchanged restrictions

Voting Rights Usually each share gets one General Partner is in charge;
vote limited partners may have
some voting rights

Taxation Double Partners pay taxes on

distributions
Reinvestment and dividend Broad latitude All net cash flow is
payout distributed to partners

Liability Limited liability General partners may have

unlimited liability; limited
partners enjoy limited
liability
Continuity Perpetual life Limited life

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A Corporation by another name

Joint stock companies (JSC) ,

public limited companies
(PLC) , or limited liability
companies (LLC)

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1.3 The Importance of Cash Flow
Firm invests in Firm issues securities (A)
assets (B) Financial
markets
Invests
Retained
in assets cash flows (F)
(B)
Short-term debt
Current assets Cash flow Dividends and Long-term debt
Fixed assets from firm (C) debt payments (E)
Equity shares

Taxes (D)
Ultimately, the firm The cash flows from
must be a cash the firm must exceed
Government
generating activity. the cash flows from
the financial markets.
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Accounting profit vs Cash flows
The ABC Company
Accounting View Income Statement
Year ended December 31
Sales $ 1,000,000
Costs $ 900,000
Profit $ 100,000

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Accounting profit vs Cash flows
The ABC Company
Financial View Income Statement
Year ended December 31
Cash inflow $0
Cash outflow - $ 900,000
Profit - $ 900,000

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Timing of Cash flows
Year Product A Product B
1 0 4,000
2 0 4,000
3 0 4,000
4 20,000 4,000
Total 20,000 16,000

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Timing of Cash flows
Pessimistic Most Optimistic
Likely
Europe 75,000 100,000 125,000

Japan 0 150,000 200,000

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1.4 The Goal of Financial Management
 What is the correct goal?

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1.4 The Goal of Financial Management
 What is the correct goal?
 Maximize profit?
 Minimize costs?
 Maximize market share?
 Maximize the current value per share of the existing stock
 Maximize the shareholders’ wealth

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1.4 The Goal of Financial Management
 What is the correct goal?
 Maximize the existing owners’ equity

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1.5 The Agency Problem
 Agency relationship
 Principalhires 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
 Agency cost

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

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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

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1.6 Regulation
 The Securities Act of 1933 and the Securities Exchange Act of
1934
 Issuance of Securities (1933)
 Creation of SEC and reporting requirements (1934)
 Sarbanes-Oxley (“Sarbox”)
 Increased reporting requirements and responsibility of corporate
directors

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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 major regulations impact public firms?

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