Chapter 1

Introduction to Corporate Finance

McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

Learning Objectives

• What is finance?• Financial manager and financial management• Legal forms of business organization• The goal of financial management• The agency problems• Financial markets and institutions• Principles underlying the financial management

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DEFINITION OF FINANCE• Finance can be defined as the art and science of

managing money.

• Finance is concerned with the process, institutions, markets, and instruments involved in the transfer of money among individuals, businesses, and governments

• Simply finance deals with matters related to money and the markets

The Financial Manager• Financial managers try to answer some or all of

these questions• The top financial manager within a firm is usually

the Chief Financial Officer (CFO)– Treasurer – oversees cash management, credit

management, capital expenditures, and financial planning

– Controller – oversees taxes, cost accounting, financial accounting and data processing

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Financial Management Decisions

• Capital budgeting– What long-term investments or projects should the

business take on?• Capital structure

– How much should the firm borrow to pay for its assets?

• What is the best mixture of debt and equity?• The least expensive sources of funds?

• Working capital management– How do we manage the day-to-day finances of the

firm?

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Forms of Business Organization

• Three major forms – Sole Proprietorship– Partnership

• General• Limited

– Corporation• Limited Liability Company• Limited Liability Partnerships

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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

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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

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Partnership

• Two or more persons come together as co-owners.

General Partnership: – All partners are fully responsible for liabilities incurred by the

partnership.Limited Partnerships:

– One or more partners can have limited liability, restricted to the amount of capital invested in the partnership. There must be at least one general partner with unlimited liability. Limited partners cannot participate in the management of the business and their names cannot appear in the name of the firm.

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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

– May involve double taxation in some countries (income taxed at the corporate rate and then dividends taxed at the personal rate)

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Summary of 3 Business Forms

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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?

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Maximizing Shareholders’ Wealth

• Maximizing the share price is equivalent to maximizing shareholders’ wealth

• Why is this a valid goal?– Decisions are made in shareholders‘ best

interest– Considers cash flows not profits– Incorporates time dimension– Does not consider profitability but also risk

The Agency Problem

• Agency relationship– The relationship exists when a 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

• Agent may not work in the best interest of the principal

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Management Goals

• Management goals may be different from shareholder s’ goals– Management may be more interested in:

• Consuming expensive perks• It’s own survival • It’s independence

• Management may focus on increased growth and size rather than increasing shareholders’ wealth

Agency Costs• Costs due to the conflict of interest between

shareholders and management– Direct

• Corporate expenditure that benefits management but costs shareholders, e.g. country club membership

• Costs to monitor management actions, e.g. auditor costs– Indirect

• Lost opportunity due to management forgoing profitable but risky projects for fear of losing job if project fails

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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 goal• Corporate control

– The threat of a takeover may result in better management• Other stakeholders

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Financial MarketsPrimary market

– A market where the firm sells its securities to public for the first timeSecondary markets

– A market in which the securities issued by firms are traded.Listed securities trade in an organized exchange, e.g. the stock market

(NYSE) or Bursa MalaysiaOver-the-counter securities are bought from or sold to a dealer

Money Market– Market for short-term debt instruments (maturity periods of one year

or less).

Capital Market– Market for long-term financial securities (maturity greater than one

year).

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ROLE OF FINANCIAL MARKET

FIRM

2. Investment

INVESTOR

Secondary Market

GOVERNMENT

CashSecurity

Cash flow Tax

Reinvest3. Dividend,

etc

1. Primary Market

Five Foundational Principles of Finance

Cash flow is what matters Money has a time value Risk requires a reward Market prices are generally right Conflicts of interest cause agency problems

End of Chapter

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