Chapter One

Introduction to Corporate Finance

Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

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Chapter Organisation
1.1 Corporate Finance and the Finance Manager 1.2 The Balance Sheet and Corporate Financial Decisions 1.3 The Corporate Form of Business Organisation 1.4 The Goal of Financial Management 1.5 The Agency Problem and Control of the Corporation 1.6 Financial Markets and the Corporation 1.7 The Two-Period Perfect Certainty Model 1.8 Outline of the Text Summary and Conclusions

Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

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Chapter Objectives
Understand the basic idea of corporate finance. Understand the importance of cash flows in financial decision making. Discuss the three main decisions facing financial managers. Know the financial implications of the three forms of business organisation. Explain the goal of financial management and why it is superior to other possible goals. Explain the agency problem, and how it can be can be controlled and reduced. Outline the various types of financial markets. Discuss the two-period certainty model and Fishers Separation Theorem.

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What is Corporate Finance?

Corporate finance attempts to find the answers to the following questions:
What investments should the business take on? THE INVESTMENT DECISION How can finance be obtained to pay for the required investments? THE FINANCE DECISION Should dividends be paid? If so, how much? THE DIVIDEND DECISION

Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

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The Financial Manager

Financial managers try to answer some or all of these questions. The top financial manager within a firm is usually the General ManagerFinance.
Corporate Treasurer or Financial Manageroversees cash management, credit management, capital expenditures and financial planning. Accountantoversees taxes, cost accounting, financial accounting and data processing.

Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

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The Balance Sheet

A convenient means of organising and summarising what a firm owns (its assets), what a firm owes (its liabilities), and the difference between the two (the firms equity) at a given point in time. Assets and liabilities can be classified as current (having a life less than one year) or non-current (having a life longer than one year). The difference between a firms current assets and current liabilities is called net working capital.
Net working capital is usually positive in a healthy firm.

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Balance Sheet Model of the Firm

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The Investment Decision

Capital budgeting is the planning and control of cash outflows in the expectation of deriving future cash inflows from investments in non-current assets. Involves evaluating the:
size of future cash flows timing of future cash flows risk of future cash flows.

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Cash Flow Size

Accounting income does not mean cash flow.

For example, a sale is recorded at the time of sale and a cost is recorded when it is incurred, not when the cash is exchanged.

Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

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Cash Flow Timing

A dollar today is worth more than a dollar at some future date. There is a trade-off between the size of an investments cash flow and when the cash flow is received.

Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

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Cash Flow Timing

Which is the better project?
Future Cash Flows Year Project A Project B

1
2 3 Total

$0
$100 000 $200 000 $300 000

$200 000
$100 000 $0 $300 000

Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

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Cash Flow Risk

The role of the financial manager is to deal with the uncertainty associated with investment decisions. Assessing the risk associated with the size and timing of expected future cash flows is critical to investment decisions.

Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

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Cash Flow Risk

Which is the better project?
Future Cash Flows
Pessimistic Project 1 Project 2 $150 000 $50 000 Expected $200 000 $250 000 Optimistic $250 000 $350 000

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Capital Structure
A firms capital structure is the specific mix of debt and equity used to finance the firms operations.
Decisions need to be made on both the financing mix and how and where to raise the money.

Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

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Working Capital Management

How much cash and inventory should be kept on hand?
Should credit terms be extended? If so, what are the conditions? How is short-term financing acquired?

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Dividend Decision
Involves the decision of whether to pay a dividend to shareholders or maintain the funds within the firm for internal growth. Factors important to this decision include growth opportunities, taxation and shareholders preferences.

Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

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Corporate Forms of Business Organisation

Three different legal forms of business organisation are:
Sole proprietorship Partnership Company

Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

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Sole Proprietorship
The business is owned by one person. The least regulated form of organisation. Owner keeps all the profits but assumes unlimited liability for the businesss debts. Life of the business is limited to the owners life span. Amount of equity raised is limited to owners personal wealth.

Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

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Partnership
The business is formed by two or more owners. All partners share in profits and losses of the business and have unlimited liability for debts. Easy and inexpensive form of organisation. Partnership dissolves if one partner sells out or dies. Amount of equity raised is limited to the combined personal wealth of the partners. Income is taxed as personal income to partners.

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Company
A business created as a distinct legal entity composed of one of more individuals or entities. Most complex and expensive form of organisation. Shareholders and management are usually separated. Ownership can be readily transferred. Both equity and debt finance are easier to raise. Life of a company is not limited. Owners (shareholders) have limited liability.

Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

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Possible Goals of Financial Management

Survival Avoid financial distress and bankruptcy Beat the competition Maximise sales or market share Minimise costs Maximise profits Maintain steady earnings growth.

Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

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Problems with these Goals

Each of these goals presents problems. These goals are either associated with increasing profitability or reducing risk. They are not consistent with the long-term interests of shareholders. It is necessary to find a goal that can encompass both profitability and risk.

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The Firms Objective

The goal of financial management is to maximise shareholders wealth. Shareholders wealth can be measured as the current value per share of existing shares. This goal overcomes the problems encountered with the goals outlined above.

Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

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A More General Goal

What is the appropriate goal for financial management when the firm has no traded shares?
Maximise the market value of the owners equity

Good financial decisions increase the market value of the owners equity, while poor financial decisions decrease it.

Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

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Source and Use of Funds

The source of funds can be broken into new funds raised (the financing decision) and funds from running the operations of the business (part of the investment decisions). The use of funds can be broken into asset and non-asset expenditure (the other part of the investment decision) and payments to the firms owners (the dividend decision). The financial manager cannot make or change one decision without affecting at least one of the other decisions. These decisions are taken in trying to meet the firms objective.
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Interrelationship of the decisions made by a Financial Manager

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Agency Relationships
The agency relationship is the relationship between the shareholders (owners) and the management of a firm.
The agency problem is the possibility of conflict of interests between these two parties.

Agency costs refer to the direct and indirect costs arising from this conflict of interest.

Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

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Do Managers Act in Shareholders Interests?

The answer to this will depend on two factors:
how closely management goals are aligned with shareholder goals the ease with which management can be replaced if it does not act in shareholders best interests.

Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

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Alignment of Goals
The conflict of interests is limited due to:

management compensation schemes

monitoring of management the threat of takeover other stakeholders.

Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

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Cash Flows between the Firm and the Financial Markets

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Financial Markets
Financial markets bring together the buyers and sellers of debt and equity securities. Money markets involve the trading of short-term debt securities. Capital markets involve the trading of long-term debt securities. Primary markets involve the original sale of securities. Secondary markets involve the continual buying and selling of issued securities.

Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

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Structure of Financial Markets

Financial Markets

Money Market

Capital Market

Primary Market

Secondary Market

Primary Market

Secondary Market

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Two-period Perfect Certainty Model

Explains the behaviour of firms and individuals.

Relies on three assumptions:

perfect certainty perfect capital markets rational investors.

Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

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Two-period Perfect Certainty Model

The certainty model uses two periods now (period 1) and the future (period 2). Individuals make consumption choices based on their tastes and preferences and the investment opportunities available to them. Utility curves represent indifference between period 1 (consume now) and period 2 (invest now, consume later) consumption.

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Utility Curves
Period 2 Utility curves

p
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Period 1
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Representation of Opportunities
Opportunities facing firms in a two-period world include:
investment/production payment of dividends.

The production possibility frontier represents attainable combinations of period 1 (pay dividend now) and period 2 (invest now, pay dividend later) dollars from a given endowment of resources.

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Production Possibility Frontier

Period 2

210

Production possibility frontier

160

100

150

Period 1

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Utility Maximisation
Firms should invest funds until they reach a point on the production frontier that is just tangential to the market line. This then places the owner on the highest possible utility curve given the resources available. At this point, the owners utility is maximised. However, a problem exists if there is more than one owner.

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Solution for Multiple Owners

Introduce a capital marketresources can be transferred between the present and the future.
Add the market line. This produces an optimal investment policy where production possibility frontier is tangential to the market line. Consumption decisions can be made using the capital market.

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Optimal Investment Policy

Period 2 Market line

Optimal policy

Period 1
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Fishers Separation Theorem

In a perfect capital market, it is possible to separate the firms investment decisions from the owners consumption decisions.

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Arrows Impossibility Theorem

When there is an imperfect market there is no longer a unique production decision that would be made by any current owner, regardless of the preferences of the owner.

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The Investment Decision

The point of wealth and utility maximisation for all shareholders can be reached through one of two rules:
Net present value rule: invest so as to maximise the net present value of the investment.
Internal rate of return rule: invest up to the point at which the marginal return on the investment is equal to the expected rate of return on equivalent investments in the capital market.

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Implications of Fishers Analysis

It is only the investment decision that affects firm value.
Firm value is not affected by how investments are financed or how the distribution (dividends) are made to the owners.

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Summary and Conclusions

Corporate finance has three main areas of concern: investment, finance and dividend decisions. The goal of financial management in a for-profit firm is to maximise the market value of the equity. The corporate form of organisation is superior to other forms for raising money, transferring ownership interests and perpetual succession. Conflicts between shareholders and management in a large corporation are called agency problems. Financial markets function as both primary and secondary markets for corporate securities. The investment decision alone affects firm value.
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