Professor John ZietlowMBA 621

Professor John ZietlowMBA 621

Spring 2006Spring 2006

The Scope Of Corporate FinanceThe Scope Of Corporate Finance

Chapter 1Chapter 1

The Scope Of Corporate FinanceThe Scope Of Corporate Finance

• What Is Corporate Finance?– Can Be Defined By Functions of Corporate Finance– Skills Developed Studying Corp Fin Applicable Everywhere

• Career Opportunities In Finance– Corporate Finance– Investment & Commercial Banking– Money Management & Consulting

• Goals Of The Financial Manager– Why Maximize Shareholder Wealth?

• Basic Forms of Business Organization– In the U.S. and Internationally

The Five Basic Corporate Finance FunctionsThe Five Basic Corporate Finance Functions

• Capital-Raising (Financing)– Obtaining External Funding For Firm’s Operations

• Capital Budgeting– Allocating the Firm’s Resources To Most Productive Use

• Financial Management– Managing Firm’s Cash Flows To Pay Maturing Liabilities– Managing Firms’ Capital Structure (Mix Of Debt & Equity)

• Corporate Governance– Ensuring Firm Is Run Ethically & In Shareholders’ Interest

• Risk Management– Managing Insurable & Uninsurable Risk Exposures

Raising Capital: Basic TerminologyRaising Capital: Basic Terminology

• Primary vs Secondary Market Transactions Or Offerings– Primary: Capital-Raising Transaction

• Funding Via Capital Market vs Via Financial Intermediary– Sell Securities To Investors For Cash On Capital Markets

• Money vs Capital Markets– Money Market: For Short-Term (Max 1 Year) Debt Obligations

• Public vs Private Capital Markets– Public: Security Listed On Regulated Exchange, Freely Traded

• Going Public – Selling Stock To Public Investors & Listing On Exchange

Raising Capital: Key FactsRaising Capital: Key Facts

• Internally-Generated Cash Flow The Dominant Source Of Funding In All Developed Economies – Typically 60-80% For US Firms, 50-60% Other OECD

• Bulk of External Funding Is In The Form Of Debt– Seasoned Equity Issues Only 4-8% Of External Financing

• Profits Re-Invested In A Firm (Retained Earnings) Equal To A New Equity Issue Each Year– This Keeps Leverage Ratio From Rising Too High With Time

• Banks Everywhere Are Declining As A Source Of Capital For Large Firms– Especially True In US; Less So In Europe, Japan

• Huge Increase In Total Security Issuance Volume Since 1990

Growth in Global Security Issues, 1990-2002Growth in Global Security Issues, 1990-2002

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Global debt & equity

U.S. Issuers worldwide

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World Stock Market Capitalization, 1983-2002World Stock Market Capitalization, 1983-2002

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Emerging Markets

Other Developed

Japan

United Kingdom

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The Critical Importance Of Corporate Governance

The Critical Importance Of Corporate Governance

• Historical Experience, Academic Research Both Suggest That Ownership Structure Very Important– Concentrated vs Atomistic Ownership Structure– At Least Three Forms Of Capitalism (US, Japan, Europe)– Country’s History & Legal/Regulatory System Very Important

• Incentives Of Managers, Stockholders, Other Stakeholders Often Conflict– S/Hs Face Collective Action Problem Monitoring Management

• The Role Of Takeovers In Corporate Governance Has Grown Dramatically In Recent Years– Long Important In US, UK; Increasingly In Europe

Value of Global Mergers & Acquisitions, 1991-2002 ($US Billions)

Value of Global Mergers & Acquisitions, 1991-2002 ($US Billions)

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U.S. targets Non-U.S. targets

Career Opportunities In Finance For Finance Graduates

Career Opportunities In Finance For Finance Graduates

• Corporate Finance (Including International)– Financial Analyst, Treasurer, Controller, CFO, Possibly for a

Nonprofit or Governmental Organization• Commercial Banking

– Corporate & Consumer Banking, Operations, International• Investment Banking

– High Salaries, Massive Stress; Mostly In NYC, London• Money Management & Investment Services

– Booming During 1990s; Baby-Boomers Fueling Demand– Now Over 5,000 Mutual Funds; Large Funds Still Dominant

• Consulting– High Salaries; Rapid Recent Growth; Much Traveling

Career Opportunities For Finance Graduates:Prerequisites For Success

Career Opportunities For Finance Graduates:Prerequisites For Success

• All Require Good Communications Skills, Ability To Work In Teams, Computer Expertise – Sound Like Cliches, But True Nonetheless

• Basic Financial Analysis Skills Critically Important– Especially Valuation Skills (Securities, Projects, Firms)

• Finance Now Seen As A Source Of Strategic Advantage– View Firm As Portfolio Of “Growth Options” To Be Developed

• International Business Knowledge Increasingly Important– U.S. Represents Less Than 30% Of “Global GDP”

• Financial Transactions, Trading Moving To Internet– Business-To-Business Marketing, Payment; Securities Trading

Financial Use Of The InternetFinancial Use Of The Internet

• As A Source Of Financial & General Business Information– General Info: CNNFN (money.cnn.com), Yahoo (www.yahoo.com)– Purchased Databases: S&P (www.standardandpoors.com)– Corporate Websites: Deutsche Telekom (www.dtag.de), IBM

(www.ibm.com), Goldman Sachs (www.gs.com)– Business Periodicals: Financial Times (www.ft.com); Wall Street Journal

(www.wsj.com); Investors Business Daily (www.investors.com); Economist (www.economist.com)

– Government: U.S. Federal Reserve (www.federalreserve.gov)– Exchanges: NYSE (www.nyse.com);NASDAQ (www.nasdaq.com)– Financial Sites: Smart Money (www.smartmoney.com)

• Providing Instant, Low-Cost Brokerage Services– Pioneers: Schwab (www.schwab.com);ETrade (www.etrade.com);

Ameritrade (www.ameritrade.com)– Now Merrill Lynch (www.ml.com), others Offering Service

What Should Managers Try To Maximize?What Should Managers Try To Maximize?

• Though Plausible, Profit Maximization Has Problems– Does Not Account For Timing Of Returns– Profits Are Not Necessarily Cash Flows– Most Important: Ignores Risk

• Proper Management Objective: Maximize Shareholder Wealth– Maximize Stock Price, Not Profits– Accounts For Risk, Timing, Maximizing Value Of Cash Flows– As “Residual Claimants,” S/Hs Have Better Incentives To

Maximize Firm Value than Other Stakeholders– S/Hs Can Benefit Only Once Other Claims Paid In Full– Historical Justification: Success Of Financial Capitalism

The Importance of Agency Costs In Corporate Finance

The Importance of Agency Costs In Corporate Finance

• Agency Costs Due To Separation of Ownership And Control– Managers Are The Agents Of S/Hs, But Are Also Human– Interests of Managers & S/Hs Inevitably Diverge

• Three Ways To Deal With Agency Costs; Cannot Truly Solve– Can Rely On Market Forces: Takeovers, Proxy Contests– Can Incur Monitoring & Bonding Costs– Align Manager & S/H Interests Via Compensation Contracts

• Most Controversial Method: Executive Compensation– Bull Market Has Led To Huge Payments– Average Total S&P 500 CEO Pay In 2001: $9.7 Million – Bulk Of This Pay Comes From Stock Options– Sometimes non-cash perks as well: Gulfstream for Jobs

Forms Of Business Organization In The U.S.Proprietorships & Partnerships

Forms Of Business Organization In The U.S.Proprietorships & Partnerships

• Proprietorship Is A Business That Is Owned By One Person– No Distinction Between Business & Person– Benefits: Easy To Set Up, Operate; Taxed As Personal Income– Drawbacks: Personal Liability, Limited Life, Difficult To Transfer

• A Partnership Has Two Or More Business Owners– Similar Benefits & Drawbacks As Proprietorships– Partners Are Liable For Every Other Partner’s Actions– Goldman Sachs Became Corporation, Went Public May 1999

• A Limited Partnership Has One General & Many Limited Partners, But Only General Partner Has Unlimited Liability– Tax Benefits Of Partnership, Limited Liability Of Corporation– Attractive For Funding Real Estate, Certain Types Of R&D

Forms Of Business Organization In The U.S.Corporations & LLCs

Forms Of Business Organization In The U.S.Corporations & LLCs

• A Corporation Is A Separate Legal Entity With All The Economic Rights & Responsibilities Of A Person – Can Sue & Be Sued, Own Property, Execute Contracts– Incorporation Occurs At State Level; Based On State Law

• Corporate Form Has Decisive Strengths– Offers Limited Liability To Investors; Unlimited Business Life– Most Businesses Become Corps As They Mature

• Key Weakness Is Double Taxation Of Dividends [next slide]– S Corporation Overcomes This, But Its Use Is Restricted

• Limited Liability Company (LLC) The Newest Form– Combines Corp’s Limited Liability & Partnership’s Taxation– Allowed In All 50 States; Can Choose Finite Or Infinite Life

• Franchising a Specialized Form

The Double Taxation of Dividends:Corporate Tax Rate (c) = 0.35Personal Tax Rate (p) = 0.40

The Double Taxation of Dividends:Corporate Tax Rate (c) = 0.35Personal Tax Rate (p) = 0.40

Corporation Partnership

Operating income $100,000 $100,000

Corporate profits tax (c = 0.35) (35,000) 0

Net income available for dividends 65,000 100,000

Cash dividends or distributions 65,000 100,000

Personal tax, owner income (p=0.4) (26,000) (40,000)

After-tax disposable income $39,000 60,000

Taxation of Business Income: Corporations vs Partnerships

Non-U.S. Forms Of Business OrganizationNon-U.S. Forms Of Business Organization

• Almost All Countries Allow Limited-Liability Companies--In Some Form--And Promote Stock Market Listings– Called PLC In Britain, SA In Spain, Latin America– GMBH or AG In Germany, Austria, Switzerland– Mid-Sized Firms The Backbone Of All Advanced Economies

• Most Countries Besides U.S. Have State-Owned Enterprises– SOEs Have Traditionally Operated Utilities, Airlines, Banks– Account For 5% GDP In OECD; about 7% In non-OECD

• Privatization Programs Have Reduced Role Of SOEs and Raised Almost $1.5 Trillion For Governments Since 1980– Began In Margaret Thatcher’s UK In Early 1980s– Usually Over $100 Bn Annually, Mostly Via Share Offerings

Privatization Proceeds$US Billions, 1988-2001

Privatization Proceeds$US Billions, 1988-2001

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Organization of Course Textbook:Divided Into Eight Parts

Organization of Course Textbook:Divided Into Eight Parts

I. Introduction

II. Risk, Return and Valuation

III. Capital Budgeting Processes and Techniques

IV. Capital Structure and Dividend Policy

V. Long-Term Financing

VI. Options, Derivatives and International

Financial Management

VII. Short-Term Financing Decisions

VII. Special Topics