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Chapter1. Introductionto
CorporateFinance
JRA,UCSur July26,2013
Basedon:FundamentalofCorporativeFinance.Ross,
Westerfield&Jordan.9th.Edition,2010
Prof.Econ.JorgeRamirezArroyo
ManagementDecisions
Operating
SCM
Marketing
HR
Administration
InvestmentDecisions
FinancingDecisions
LiquidityDecisions
RiskManagement
Administration
Lawyers
Security
Marketing
Product,Price,Promotion,Place
Distribution
AdvertisingBudget
Operations
Manufacturing
Choiceoftechnology
ProductPlanningandInventoryControl
QualityControl
SCM
Procurement
Warehousing
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CORPORATE
OBJECTIVE
MANAGEMENT
DECISIONS
VALUE
DRIVERS
VALUATION
COMPONENTS
Cash Flow From
Operations
Discount Rate Debt
Creating Shareholder
Value
Value
Growth
Duration
Cost of
Capital
Working Capital
Investment
Fixed Capital
Investment
Sales Growth
Operating Profit
Margin
Operating Financing Investment
Shareholder Return
Dividends
Capital Gains
HowdoDecisionsAffectFinancialStatements?
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WhatisFinance?
Isthestudyofhowmaximizingthevalueoftheworthinthelongrun(market
value)tomaximizetheutilityofanindividual,firm(stockholders),orcountry.
Why?Tocatchupourwelfare(consumptiononthelungrun).
Frameworkfordecisionmakingunderuncertainty
Corporateapplications,earningspershare EPS.
Personaldecisions,individualsavings.
Financialbusinessmanagementconcernsmanagement,theroleofthefinancial
manageristobeadecisionmaker.andheneedsinputsandjudgment.
Somefundamentalconcepts
Timevalueofmoney:adollartodayisworthmorethanadollartomorrow.
Valueofavoidingrisk:asafedollarisworthmorethanariskydollar.
Netpresentvalue(NPV):isthebasicconceptunderlyingcorporatefinance.
NPVrepresentstheexcessofmarketvalueovercost.
Hoja de clculo
de Microsoft Excel
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TwoCategoriesofDecisions
Investment:Choosebestbusinessopportunities allocationofresources.
Acquisitions
Production
Scaleofinvestment
Financing:Raisemoneytofundthedesiredinvestments financialmarket
leveraging
Debtorequity
Publicorprivatefinancing
Buyorlease
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HowisFinanceUsed?
Hereareafewexamples:
Arealestatedevelopercandecideonanewhousingsubdivision;
Aconstructioncompanycandevelopabudgetandborrowmoneytopay
forsupplies;
Alumbercompanycanreducetheriskitfacesinsellingthetreesitis
growing;
Acommunitycanissuebondstopayforthesewersystemandroads;
Afamilycanborrowmoneyagainsttheirfutureincometobuyahouse.
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RelationshiptoEconomics
FundamentalEconomicPrinciple:
MarginalAnalysis
Financialdecisionsshouldbemadeandactionstakenonlywhentheadded
benefitsexceedtheaddedcosts.
RelationshiptoAccounting
CashFlows
AccrualBasis:recognizessalesrevenueandexpensesincurredtomakesaleat
timeofsale.
CashBasis:recognizesrevenuesandexpensesastheyoccur.
Earningsareanoption,cashisafact. cookiesjaraccounting.
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Accountingvs.FinancialViews
AccountingView
(AccrualBasis)
IncomeStatement
PeakesQuay,Inc.
Foryearended12/31
FinancialView
(CashBasis)
CashFlowStatement
PeakesQuay,Inc.
Foryearended12/31
Salesrevenue $100,000
Less:Costs 80,000
NetProfit $20,000
Cashinflow $0
Less:Cashoutflow80,000
Netcashflow ($80,000)
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The accounting has the option to use some tricky forms to state the income
and costs: Sales on credit/incomes period, writedowns, amortizations,
depreciations, allowances, deferred items.
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TheFourBasicAreasofBusinessFinance
1. CorporateFinance:Broadestfield,specifictooperationsofabusiness,
1. Capitalbudgeting managinglongterminvestments.
2. Capitalstructure themixtureofequityanddebt.
3. Workingcapitalmanagement shorttermassetsandliabilities.
2. InvestmentAnalysis Dealswithfinancialassetssuchasstocksandbonds.Some
ofthemoreimportantquestionsinclude,
1. Whatdeterminesthepriceofafinancialassetsuchasashareofstock?
2. Whatarethepotentialrisksandrewardsassociatedwithinvestingin
financialassets?
3. Whatisthebestmixtureofthedifferenttypesoffinancialassetstohold?
3. FinancialInstitutions: MoneyandCapitalMarkets,
1. Workingsofthefinancialsystem(banksandinsuranceco.).
2. Segmentationoffinancialmarkets.
3. Moneyandcapitalmarkets,instruments(bonds,stocks,derivatives).
4. InternationalFinance: Internationalmonetarysystem,exchangerates,political
andexchangerisk,corporatefinanceonglobalmarkets.
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WhatisCorporateBusinessFinance?
CorporateFinanceaddressesthefollowingthreequestions:
1. Whatlongterminvestmentsshouldthefirmengagein?
2. Howcanthefirmraisethemoneyfortherequiredinvestments?
3. Howmuchshorttermcashflowdoesacompanyneedtopayitsbills?
Corporatefinanceisaspecificareaoffinancethatanalyzesthefinancialdecisionsof
corporations.
1. Investmentorcapitalbudgetingdecisions
2. Financingdecision
3. Daytodayoperations(workingcapitaldecisions).
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FinancialManagementDecisions
1.Whatlongterminvestmentsshouldthefirmundertake?
Capitalbudgetingdecision
2.Whatisthebestwaytofinancetheselongterminvestments?Debtorequity?
Capitalstructuredecision(financingdecisions).
3.Howshouldthefirmmanageitsshorttermassetsandliabilities,suchascash?
Workingcapitalmanagement
4.HowshouldthefirmIdentify,measureandhedgetheriskexposure?
FinancialRiskManagement
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1.CapitalBudgeting
Capitalbudgetingistheplanningandcontrolofcashoutflowsintheexpectation
ofderivingfuturecashinflowsfrominvestmentsinnoncurrentassets.
TheProcessofplanningandmanagingafirmslongterminvestments:
evaluatingthesize,timingandriskoffuturecashflowsarethekey
componentsofcapitalbudgeting
overallobjectiveistoidentifyandinvestinprojects&assetsthatwillgenerate
areturngreaterthanthefirmscostofcapital
Financialmanageridentifiesinvestmentopportunitiesthatareworthmoretothe
firmthantheycosttoacquire.
KeyQuestions
Howmuchcashdoesthefirmexpecttoreceive?
Sizeoffuturecashinflowsandoutflows
Whendoesthefirmexpecttoreceiveit?
Timingoffuturecashflows
Howlikelyisthefirmtoreceiveit?
Riskinessoffuturecashflows
Thepointofwealthandutilitymaximizationforallshareholderscanbereached
throughoneoftworules:Netpresentvaluerule&Internalrateofreturnrule
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TheCapitalBudgetingDecision
Whatlongterm
investments
shouldthefirm
choose?
Current Assets
FixedAssets
1Tangible
2Intangible
Shareholders
Equity
CurrentLiabilities
LongTermDebt
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CashFlowTiming Size
1
st
. Finance Principle
A dollar today is worth more than a dollar at some future date.
There is a tradeoff between the size of an investments cash flow and when the
cash flow is received.
Which is the better project?
The size of the amounts define the size of the project.
Future Cash Flows
Year Project A Project B
1 $0 $20 000
2 $10 000 $10 000
3 $20 000 $0
Total $30 000 $30 000
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CashFlowRisk
2
nd
.FinancePrinciple
Theroleofthefinancialmanageristodealwiththeuncertaintyassociatedwith
investmentdecisions.
Assessingtheriskassociatedwiththesizeandtimingofexpectedfuturecash
flowsiscriticaltoinvestmentdecisions.
Whichisthebetterproject?
KeyIssues:
Appraisethecontingentscenarios theworstcase,thebestcase,thenormalcase
(threeplansormaybemore.)
Future Cash Flows
Pessimistic Expected Optimistic
Project 1 $100 000 $300 000 $500 000
Project 2 $200 000 $400 000 $600 000
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2.CapitalStructure
Addressesthequestionofhowafirmshouldobtainandmanagethelongterm
financingneededtosupportitslongterminvestments:
itisthespecificmixtureoflongtermdebtandequitycapital
thedecisiononhowmuchdebtvs.Equityimpactstherisklevelforthefirmand
thefirmscostofcapital
CapitalStructureisthespecificmixofshorttermdebt,longtermdebtandequity.
Raisinglongtermfinancingcanbeexpensive,sothedifferentpossibilitiesmust
consideredcarefully.
Afirmscapitalstructureisthespecificmixofdebtandequityusedtofinancethe
firmsoperations.
Decisionsneedtobemadeonboththefinancingmixandhowandwheretoraisethe
money.
KeyQuestions
Howshouldthefirmpayforitsassets?Debtorequity?
Howmuchshouldthefirmborrow?
Whatistheleastexpensivesourceoffunds?
How,whenandwheretoraisethemoney?
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TheCapitalStructureDecision
Howshouldthefirm
raisefundsforthe
selectedinvestments?
Shareholders
Equity
CurrentLiabilities
LongTermDebt
Current Assets
FixedAssets
1Tangible
2Intangible
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CapitalStructure
Thevalueofthefirmcanbethoughtofas
apie.
Thegoalofthemanageristoincrease
thesizeofthepie.
TheCapitalStructuredecisioncanbeviewedashowbestto
sliceupathepie.
Ifhowyoursliceofthepieaffects
thesizeofthepie,thenthecapital
structuredecisionmatters.
50%
Debt
25%
Debt
75%
Equity
70%Debt
30%Equity
50%
Debt
50%
Equity
50%
Equity
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CorporateSecuritiesasContingentClaims
onTotalFirmValue
Thebasicfeatureofadebtisthatitisapromisebytheborrowingfirmtorepaya
fixeddollaramountofbyacertaindate.
Theshareholdersclaimonfirmvalueistheresidualamountthatremainsafterthe
debtholdersarepaid.
Ifthevalueofthefirmislessthantheamountpromisedtothedebtholders,the
shareholdersgetnothing.
Remember:Thevalueofthefirmisnotwhatithas,iswhatitearnsinthefuture
periods,plusitssalvagevalue.
IP =
ECF
(1 + r)
t
+
S. I. Asscts
(1 + r)
h
h
t=1
Itdoesntdependondebt%,dependsonfutureeconomiccashflowandon
minimumrequiredreturn.
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DebtandEquityasContingentClaims
$F
$F
Payoffto
debtholders
Valueofthefirm(X)
Debtholdersarepromised$F. Ifthe
valueofthefirmislessthan$F,they
getthewhateverthefirmifworth.
Ifthevalueofthefirmis
morethan$F,debtholders
getamaximumof$F.
$F
Payoffto
shareholders
Valueofthefirm(X)
Ifthevalueofthefirmis
lessthan$F,share
holdersgetnothing.
Ifthevalueofthefirmismorethan
$F,shareholdersgeteverything
above$F.
Algebraically,thebondholdersclaimis:
Min[$F,$X]
Algebraically,theshareholdersclaimis:
Max[0,$X $F]
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CombinedPayoffstoDebtandEquity
$F
$F
CombinedPayoffstodebtholders
andshareholders
Valueofthefirm(X)
Debtholdersarepromised$F.
Payofftodebtholders
Payoffto
shareholders
Ifthevalueofthefirmisless than$F,
theshareholdersclaimis:Max[0,$X
$F]=$0andthedebtholdersclaimis
Min[$F,$X]=$X.
Thesumoftheseis=$X
Ifthevalueofthefirmismore than$F,
theshareholdersclaimis:Max[0,$X
$F]=$X $F andthedebtholders
claimis:
Min[$F,$X]=$F.
Thesumoftheseis=$X
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3.WorkingCapitalManagement
Workingcapitalreferstothefirmsshorttermassetsincludinginventoryand
liabilities,suchascashowedtosuppliers.
includesaccountsreceivable,inventoryandaccountspayable
howmuchcashtokeeponhand,inventorytocarry,credittermstoofferto
customersareexamplesofworkingcapitalmanagementdecisions
Managingworkingcapitalisadaytodayactivityrelatedtothefirmsreceiptand
disbursementofcash.
(*)DividendDecision
Involvesthedecisionofwhethertopayadividendtoshareholdersormaintainthe
fundswithinthefirmforinternalgrowth.Factorsimportanttothisdecision
includegrowthopportunities,taxationandshareholderspreferences.
KeyQuestions
Howshouldthefirmmanagethereceiptanddisbursementofcash currentassets
andcurrentliabilities?
Whatisthebestwaytomanagedaytoday,shorttermassetssuchasinventory?
Howshouldthefirmobtainshorttermfinancing?
Shouldthefirmsellorpurchaseoncredit?Onwhatterms?
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ShortTermAssetManagement
Howshouldshort
termassetsbe
managedand
financed?
Net
Working
Capital
Shareholders
Equity
CurrentLiabilities
LongTermDebt
Current Assets
FixedAssets
1Tangible
2Intangible
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4.FinancialRiskManagement
Theprocessofidentifying,quantifyinganddecisionstomanagecertaintypesofrisk:
currencyrisks
interestraterisks
commoditypricerisk
Otherriskssuchasstrategic,operatingandcommercialrisksneedtobeconsideredby
thefirmasawhole ideallylookingatriskonanenterprisewidebasis(holisticrisk
management)
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Strategic
technology&information
knowledgemanagement
industryvaluechaintransformation
CrisisManagement
environmentaldisasters
brandcrisis/computersystemfailure
OperatingRisks
distributionnetworks
manufacturing
CommercialRisks
newcompetitor(s)
customerserviceexpectations
newpricingmodels
supplychainmanagement
FinancialRisk
price interest&fx.rate
commodityprice
Organizationwide
AFrameworkforIntegratedRiskManagement
Risk
Identification Impact Response
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EquilibriuminConsumptionandInvestment
TwoperiodPerfectCertaintyModel
Explainsthebehavioroffirmsandindividuals.
Reliesonthreeassumptions:
perfectcertainty
perfectcapitalmarkets
rationalinvestors.
Thecertaintymodelusestwoperiodsnow(period0)andthefuture(period1).
Individualsmakeconsumptionchoicesbasedontheirtastesandpreferencesand
theinvestmentopportunitiesavailabletothem.
Utilitycurvesrepresentindifferencebetweenperiod0(consumenow)andperiod
1(investnow,consumelater)consumption.
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UtilityCurvesandConsumptionRationality
uHg =
JuI
Jq
> u ; u < q < o
uHg =
JuI
Jq
< u ; q > o
uHg =
Ju(o)
Jq
= u
J
2
u
(Jq)
2
=
JuHg
Jq
< u
Ut
a
0
U
q
q
U(q)
q
U
U(a)
UMg
a
0
q
UMg(q)
q
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UtilitiesCurvesandConsumptionRationalitybyeachperiod.
Onlyinthepresent,.
Theninthefuture,andonboth.
Rcsourccs
0
= y
-1
+w + y
0
c
ConsumptionC
0

0
ConsumptionC
0
>
0
, only
witb oiJ or crcJit
uHgC
0
=
ouI
oC
0
> u ;
ouHgC
o
oC
0
< u
c
1
A
0
Y
1
c
o
B
Y
o
U
1
U
0
U
2
C
A
A
InterTemporalConsumptionIndifferenceCurves
J(uI)
J(C
1
)
_
J(uI)
J(C
u
)
_
=
uHg(C
1
)
uHg(C
u
)
= -
Jy
Jx
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InterTemporalConsumptionPreferenceRate
Weguesstheagentsarerational,thereisnouncertainty,taxes,transaction
costs,norinflationontheintertemporal(presentvs.future)coordinates.
Eachagenthasitsownrateofintertemporalconsumptionpreference,thatis
hisminimumrequiredreturnforinvesting OpportunityCostofCapital.

C
1
0
C
o
c
o
U
0
A
B
c
o
c
1
c
1
IHgS A =
JC
1
JC
0
= tg 0 =
c
o
-c
u
< u
IHgS A B =
C
1
C
0
=
C
1
-C
0
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RepresentationofOpportunities:PPF
Opportunities facing firms in a twoperiod world include: reinvestment in
production capital gains , payment of dividends, or invest in other business.
The production possibility frontier represents attainable combinations of period
0 (pay dividend now) and period 1 (invest now, pay dividend + capital gains
later) dollars from a given endowment of resources.
When there is a PPF in the two period temporal horizon, considering the
individual preferences, it is possible for anyone allocate the resources in an
efficient way: Strategic Financial Decisions...
Period1
FPP
A
0
Y
o
Y
1
MgSR
b
c
a e
U
1
U
0
M
m
Period0
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TemporalSubjectPreferencesandFinancial
Market
c
1
A
0
=c
0
c
1
=
TMS
c
o
B
y
o
U
3
U
1
S
0
C
1
y
1
c
o
c
o
D
U
2
L
0
C
1
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Agent One, doesnt save nor lend. Number Two, consume more than he earns
today using future earns, then borrows. Number Three, consume less than he
earns creating savings to be used in the future, he save/lends.
All depends on the subject preferences of the agents.
The one having savings, put them in the financial markets, intermediaries, firms,
business, projects or simply does nothing
r
0
r
o
M
o
S
(lenders)
D
(borrowers)
CostofFunds
M/P
Funds
PrincipalActorsandMarketsonFinance
The Firms
Investors
Financial
markets
Financial
Intermediates
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IncreasingUtilitywithFinancialMarkets
Ifonemoveoutpartofthepresentincometothefuture,throughthecapital
marketline,atthemarketrateofr ,itcouldmaximizetheutilityinthepossibility
consumptionline,I
0
I
1
, intheindifferencecurveu
1
.
V
1
CML
A
0
Y
1
(1+r)
c
o
B
Y
o
U
1
U
0
c
o
c
1
V
0
c
1
w =
0
= C
0
+
C
1
-
1
(1 +r)
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I
1
= 1 +r I
0
; I
0
=
I
1
1 + r
ReturnMaximizationwithFinancialMarkets
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c
1
A
0
c
0
Y
1
c
o
P
F
B
Y
o
U
0
S
0
c
1
U
1
CML
tg 0 =
+c
o
-c
u
;
+c
o
-c
u
> - 1 + r = 1
ReturnisgreaterthanInvestment
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SolutionforMultipleOwners
Howcantheyagree?Multiplepreferences
Introduceacapitalmarketresourcescanbetransferredbetweenthepresent
andthefuture.
Addthemarketline.
Thisproducesanoptimalinvestmentpolicywhereproductionpossibility
frontieristangentialtothemarketline.
Consumptiondecisionscanbemadeusingthecapitalmarket.
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OptimalInvestmentPolicy
Firmsshouldinvestfundsuntiltheyreachapointontheproductionfrontierthat
isjusttangentialtothemarketline.
Thisthenplacestheowneronthehighestpossibleutilitycurvegiventhe
resourcesavailable.Atthispoint,theownersutilityismaximized.
However,aproblemexistsifthereismorethanoneowner.
7/26/2013 Prof. Econ. Jorge Ramirez Arroyo 36
Optimalpolicy
MarketLine
c
1
MSR
RAL=PPF
0
c
0
c
1
(1+r) c
o
d Y
0
B
Y
1
e
U
0
U
1
A
U
2
S
0
S
0
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FishersSeparationTheorem
In a perfect capital market, it is possible to separate the firms investment decisions
from the owners consumption decisions.
The theorem can be broken down into three key assertions:
First, a firm's investment decisions are separate from the preferences of the
firm's owners.
Second, a firm's investment decisions are separate from a firm's financing
decisions (bonds or shares).
And, third, the value of a firm's investments is separate from the mix of methods
used to finance the investments (bonds or shares).
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FishersSeparationTheorem
It stipulates that the goal of any firm is to increase its value to the fullest
extent, regardless of the preferences of the firm's owners. The theorem is
named after American economist Irving Fisher, who first proposed this idea.
Thus, the attitudes of a firm's owners are not taken into consideration in the
process of selecting investments, and the goal of maximizing the firm's value
is the primary consideration for making investment decisions.
Fisher's separation theorem concludes that a firm's value is not determined
by the way it is financed or the dividends paid to the firm's owners.
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SeparationofOwnershipandControl
Board of Directors
Management
Assets
Debt
Equity
S
h
a
r
e
h
o
l
d
e
r
s
D
e
b
t
h
o
l
d
e
r
s
7/26/2013 Prof. Econ. Jorge Ramirez Arroyo 39