The Scope of Corporate Finance

Chapter 1

2009 Cengage Learning/South-Western

Corporate Finance in Modern Business

When contemplating all business decisions, managers should ask: Does this action create value for the firms shareholders? By taking actions that generate benefits in excess of costs, firms generate wealth for their investors.
2

Career Opportunities in Finance

Corporate Finance Commercial Banking Investment Banking Money Management
3

Budgeting, financial forecasting, cash management, credit administration, investment analysis, fund procurement Consumer banking Corporate banking High income potential Very competitive industry Opportunities in investment advisory firms, mutual fund companies, pension funds, investment arms of financial departments Advise on business practices and strategies of corporate clients

Consulting

Corporate Finance Functions

External Financing

Capital Budgeting

Corporate Finance Functions

Financial Management

Corporate Governance

Risk Management
4

The External Financing Function

Raising capital to support companies operations and investment programs externally, from
either shareholders (equity) or creditors (debt).

Corporations can raise equity capital privately, or they may go public by conducting an initial public offering (IPO) of stock.

The Capital Budgeting Function

Capital Budgeting selecting the best projects in which to invest the resources of the firm, based on each projects perceived risk and expected return.

Select investments for which the marginal benefits exceed the marginal costs.
6

The Financial Management Function

Managing firms internal cash flows,

and its mix of debt and equity financing,

to maximize the value of the debt and equity claims on firms, and to ensure that companies can pay off their obligations when they come due.
Involves obtaining seasonal financing, managing inventories, paying suppliers, collecting from customers, and investing surplus cash
7

The Corporate Governance Function

Developing ownership and corporate governance structures for companies that ensure that managers behave ethically and make decisions that benefit shareholders.

Dimensions of corporate governance

Boards of directors Compensation packages Auditors Countrys legal environment - in U.S., Sarbanes-Oxley Act of 2002

The takeover market disciplines firms that do not govern themselves.

8

The Risk Management Function

Managing firms exposures to all types of risk,

both insurable (such as loss caused by fire or flood) and uninsurable,

in order to maintain optimum risk-return tradeoffs and thereby maximize shareholder value. Modern risk management focuses on adverse interest rate movements, commodity price changes, and currency value fluctuations.

Debt & Equity: Two Flavors of Capital

Debt Capital
Borrowed money. The borrower is obliged to pay interest, at a specified annual rate, on the full amount borrowed, as well as to repay the principal amount at the debts maturity. An ownership interest usually in the form of common or preferred stock. Common stockholders receive returns on their investments only after creditors and preferred stockholders are paid in full.

Equity Capital

10

Financial Intermediation
Financial Intermediary
An institution that raises capital by issuing liabilities against itself, and then lends that capital to corporate and individual borrowers. Examples: insurance companies, savings and loan institutions, credit unions, commercial banks, pension funds, mutual funds.

Pension funds and mutual funds, have surged to prominence as corporate finance shifts towards greater reliance on market-based external funding.
11

Total Value of Primary Corporate Security Issues, 1990 - 2006

12

Business Organizational Forms in the U.S.

Sole Proprietorships
No distinction between business and person Easy to set up, operate; taxed as personal income Personal liability, limited life, difficult to transfer

Partnerships

Two or more business owners Partners - liable for every partners actions One or more general partners & many limited partners Limited liability of corporation, tax benefits of partnership

Limited Partnerships
13

Business Organizational Forms in the U.S.

Legal entity with all the economic rights and responsibilities of a person Incorporation occurs at state level; based on state law Strengths - limited liability for investors, unlimited business life

Corporations

14

The Finance Function in the Organization al Structure of A Typical Large Corporation

15

Corporations in the U.S.

Double Taxation Problem
Taxation of corporate income at both the company and the personal levels. This is the single greatest disadvantage of the corporate form.

The Jobs and Growth Tax Relief Reconciliation Act of 2003 (Tax Relief Act of 2003) dramatically reduced the double taxation problem.

16

Taxation of Business Income for Corporations and Partnerships

Before the Tax Relief Act of 2003

After the Tax Relief Act of 2003

17

Business Organizational Forms in the U.S.

Allow shareholders to be taxed as partners yet retain their limited liability status. Must meet certain criteria like having 75 or fewer shareholders. Can become regular corporations later. Combine partnerships pass-through taxation with S corporations limited liability. Popular with professional service firms.

S Corporations

Limited Liability Companies

18

The Growth of Stock Market Capitalization

19

The Corporate Financial Managers Goals

What should a financial manager try to maximize? Maximize profit?
Earnings reflect past performance, rather than current or future performance. Ignores the timing of the profits. Ignores cash flows. Ignores risk.

20

The Corporate Financial Managers Goals

What should a financial manager try to maximize? Maximize shareholder wealth?
As measured by the market price of the firms stock. A firms stock price reflects the timing, magnitude, and risk of the cash flows that investors expect a firm to generate over time. Shareholders are the residual claimants of a firm.

21

The Corporate Financial Managers Goals

What should a financial manager try to maximize? Focus on stakeholders?
Many firms seek to preserve the interests of other stakeholders, such as employees, customers, tax authorities, and the communities where the firms operate. Doing so provides long-term benefits to shareholders and is in line with the primary goal of maximizing shareholder wealth.
22

Agency Costs in Corporate Finance

Agency Problems
The conflict between the goals of a firms owners and its managers.

To overcome agency problems:

Rely on market forces to exert managerial discipline; Incur monitoring and bonding costs to supervise managers; and Structure executive compensation packages to align managers interests with stockholders interests. The actual workings of many compensation plans have been harshly criticized in recent years.
23

Ethics in Corporate Finance

Today, society in general and the financial community in particular are developing and enforcing higher ethical standards. The U.S. Congress passed the Sarbanes-Oxley Act in 2002 to enforce higher ethical standards and increase penalties for violators.

24

The Scope of Corporate Finance

Financial managers should seek to maximize shareholders wealth. How?
By performing the five basic duties of corporate finance: External financing, capital budgeting, financial management, risk management, corporate governance.

Select investments for which the marginal benefits exceed the marginal costs.

25