Chapter 1 Introduction to Corporate Finance

A perquisite to understanding financial theories, concepts, tools, and techniques is to answer two basic questions: What is finance? What are the functions and goals of the financial manager? Answering these questions will set the stage for an understanding of the important decision areas for the financial manager and the methods he or she uses to resolve problems.

1.1. What Is Corporate Finance?

FINANCE AND ACCOUNTING Many people view the finance and accounting functions within the business as virtually the same. Although there is a close relationship between these two functions, the accounting function is best viewed as a necessary input to the finance function. The accountant, whose primary function is to develop and provide data for measuring the performance of the firm, assessing its financial position, and paying taxes, differs from the financial manager in the way he or she views the firms funds. The accountant, using certain standardized and generally accepted principles, prepares financial statements based on the premise that revenues should be recognized at the point of the sale and expenses when they are incurred. Revenues resulting from the sale of merchandise on credit, for which the actual cash payment has not yet been received, appear on the firms balance sheet as accounts receivable. Expenses are treated in a similar fashion that is, certain liabilities are established to represent goods or services that have been received but have yet to be paid for. These items are usually listed on the balance sheet as accounts payable. The financial manager is more concerned with maintaining a firms solvency by providing the cash flows necessary to satisfy its obligations and to acquire and finance the current and fixed assets needed to achieve the firms goals. Instead of recognizing revenues at the point of sale and expenses when incurred, the financial manager recognizes revenues and expenses only with respect to inflows or outflows of cash. A simple analogy may help to clarify the basic difference in viewpoint between the accountant and the financial manager. If we look at the human body as a business firm in which each pulsation of the hart represents a new sale, the accountant is concerned with each of these pulsations, entering these sales as revenues. The financial manager is concerned with whether the resulting flow of blood through the arteries reaches the right cells and keeps the various organs of the body functioning. It is possible for a body to have a strong heart but cease to function because of the blockages or clots in the circulatory system. Similarly, a firm may be profitable but still fail because it has an insufficient inflow of cash to meet its obligations as they come due. THE BALANCE-SHEET MODEL OF THE FIRM The figure below shows a graphic conceptualization of the balance sheet, and it will help introduce you to corporate finance.

Fixed Assets 1. Tangible fixed assets 2. Intangible fixed assets Shareholders equity

Long-term debt Current assets 1. Inventories 2. Account receivable 3. Cash Net working capital
The balance sheet lists the firms assets and liabilities, providing a snapshot of the firms financial position at a given point in time. Notice that the balance sheet is divided into two parts: the assets on the left side and the liabilities on the right. Before a company can invest in an asset, it must obtain financing, which means that it must raise the money to pay for the investment. The forms of financing are represented on the right-hand side of the balance sheet. From the balance-sheet model of the firm it is easy to see why finance can be thought of as the study of the following three questions: 1. In what long-lived assets should the firm invest? This question concerns the lefthand side of the balance sheet. Of course, the type and proportions of assets the firm needs tend to be set by the nature of business. We use the terms capital budgeting and capital expenditure to describe the process of making and managing expenditures on long-lived assets. 2. How can the firm raise cash for required capital expenditures? This question concerns the right-hand side of the balance sheet. The answer to this involves the firms capital structure, which represents the proportions of the firms financing from current and long-term debt and equity. 3. How should short-term operating cash flows be managed? This question concerns the lower portion of the balance sheet. There is a mismatch between the timing of cash inflows and cash outflows during operating activities. Furthermore, the amount and timing of operating cash flows are not known with certainty. The financial managers must attempt to manage the gaps in cash flow. From an accounting perspective, short-term management of cash flow is associated with a firms net working capital. Net working capital is defined as current assets minus current liabilities. From a financial perspective, the short-term cash flow problem comes from the mismatching of cash inflows and outflows. It is the subject of short-term finance. THE FUNCTIONS OF THE FINANCIAL MANAGER

Current liabilities

The financial managers functions within the firm can be evaluated in terms of the firms basic financial statements. His or her primary functions are: 1. Financial analysis and planning. This function is concerned with the transformation of financial data into a form that can be used to monitor the firms financial position, to evaluate the need for increased productive capacity, and to determine what additional financing is required. 2. Managing the firms asset structure. The financial manager determines both the mix and the type of assets found on the firms balance sheet. The mix refers to the number of dollars of current and fixed assets. Once the mix is determined, the financial manager must determine and attempt to maintain certain optimal levels of each type of current asset. He or she must also decide which are the best fixed assets to acquire and know when existing fixed assets need to be modified or replaced. 3. Managing the firms financial structure. The most appropriate mix of shortterm and long-term financing must be determined. This is an important decision, since it affects the firms profitability and overall liquidity. It is dictated by necessity, but also requires an in-depth analysis of the available alternatives, their costs, and their long-run implications. All three functions are clearly reflected in the firms balance sheet, which shows the current financial position of the firm.

1.2. What are the Functions and Goals of the Financial Manager?
The most important job of a financial manager is to create value from the firms capital budgeting, financing, and liquidity activities. Thus the firm must create more cash flow than it uses. To see how this is done, we can trace the cash flows from the firm to the financial markets and back again. The interplay of the firms finance with the financial markets is illustrated in figure below. The arrows trace cash flows from the firm to the financial markets and back again.

Firm issues securities (F)

Firm invests in assets

Retained cash flows (C) Dividends and cash payments

Financial markets

Current assets Fixed assets (A)

Cash flow from firm (B)

Short-term debt Long-term debt Equity shares (E)

Government (D)

A. B. C. D. E. F.

Firm invests in assets (capital budgeting). Firms operations generate cash flow. Retained cash flows are reinvested in firm. Cash is paid to government as taxes. Cash is paid out to investors in the form of interests and dividends. Firm issues securities to raise cash (the financing decision).

In theory, the goal of a firm should be determined by the firms owners. Many corporations have thousands of owners (shareholders). Each owner is likely to have different interests and priorities. Whose interests and priorities determine the goals of a firm? The goal of the financial manager should be to achieve the objectives of the firms owners. In the case of corporations, the owners of a firm are normally distinct from the managers. The managers function is not to fulfill their own objectives (which may include increasing their wages, becoming famous, or maintaining their positions). It is, rather, to maximize the owners (stakeholders) satisfaction. Presumably, if the managers are successful in this endeavor, they will also achieve their personal objectives. Some people believe that the owners objective is always the maximization of profits; others believe it is the maximization of wealth. Wealth maximization is the preferred approach for five basic reasons: it considers (1) the owners realizable return, (2) a long-run viewpoint, (3) the timing of returns, (4) risk, and (5) the distribution of returns. Owners realizable return. The owner of a share of stock can expect to receive a return in the form of periodic cash dividend payments, through increases in the stock price, or both. The market price of share of stock reflects a perceived value of expected future dividends as well as actual current dividends; a shareholders wealth in the firm at any point is measured by the market price of his or her shares. If a stockholder in a firm wishes to liquidate his or her ownership, he or she has to sell the stock at or near the prevailing market

Taxes

price. Because it is the market price of the stock, and not the profits, that reflects an owners wealth in a firm at any time, the financial managers goal should be to maximize the market price of the stock, and thus the stockholders wealth. Long-run viewpoint. Profit maximization is a short-run approach; wealth maximization considers the long-run. A firm wishing to maximize profits could purchase lowgrade machinery and use low-grade raw materials while making a strong sales effort to market its products at a price that yields a high profit per unit. This short-term strategy could result in high profits for the current year, but the profits in subsequent years might decline significantly due to the low quality and the high maintenance costs associated with low-grade machinery. The potential consequences of short-run profit maximization are likely to be reflected in the current stock price, which will probably be lower than it would have been if the firm had pursued a long-run strategy. Timing of returns. The profit maximization approach fails to reflect differences in the timing of returns, whereas wealth maximization tends to consider such differences. Use of the profit maximization goal places greater value on an investment that provides the highest total returns, while the wealth maximization approach explicitly considers the timing of returns and their impact on the stock price. Risk. Profit maximization does not consider risk; wealth maximization gives explicit consideration to differences in risk. A basic premise of financial management is that a tradeoff exists between risk and return: stockholders expect to receive higher returns from investments with higher risk, and vice versa. Financial managers must therefore consider risk when evaluating potential investments. Distribution of returns. The profit maximization goal fails to consider that stockholders may wish to receive a portion of the firms returns in the form of periodic dividends. In the absence of any preference for dividends, the firm could maximize profits from period to period by reinvesting all earnings to acquire new assets that will boost future profits. The wealth maximization strategy takes into consideration the fact that many owners place a value on the receipt of the regular dividend, regardless of its size. This clientele effect is used to explain the influence of dividend policy on the market value of shares. Making sure that stockholders receive the return they expect is believed to have a positive effect on stock prices. Since each stockholders wealth at any time is equal to the market value of all his or her assets less the value of his or her liabilities, an increase in the market price of the firms shares should increase the stockholders wealth. A firm interested in maximizing owners wealth may therefore pay dividends on a regular basis. A firm that wishes to maximize profits may opt to pay no dividends. But stockholders would certainly prefer an increase in wealth to the generation of an increasing flow of profits without concern for the market value of their holdings. Because the stock price explicitly reflects the owners realizable return, considers the firms long-run prospects, reflects differences in the timing of returns, considers risk, and recognizes the importance of the distribution of returns, maximization of wealth as reflected in share price is viewed as the proper goal of financial management. Profit maximization can be part of a wealth maximization strategy. Quite often, the two objectives can be pursued simultaneously. But maximization of profits should never be permitted to overshadow the broader objective of wealth maximization.