Introduction to Corporate Finance

Corporate Finance addresses the following

three questions:
1. What long-term investments should the
firm engage in?
2. How can the firm raise money for the
required investments?
3. How much short-term cash flow does a
company need to pay its bills?
(RWJ ch.1)
Professor Ho-Mou Wu

Corporate Finance

1-1

The Balance-Sheet Model of the Firm

Total Value of Assets:

Total Firm Value to Investors:

Current
Liabilities

Current Assets

Long-Term
Debt
Fixed Assets
1 Tangible

Shareholders
Equity

2 Intangible
Professor Ho-Mou Wu

Corporate Finance

1-2

The Balance-Sheet Model of the Firm

The Capital Budgeting Decision
(Investment Decision)
Current Assets

Current
Liabilities
Long-Term
Debt

Fixed Assets
1 Tangible
2 Intangible
Professor Ho-Mou Wu

What longterm
investments
should the
firm engage
in?
Corporate Finance

Shareholders
Equity
1-3

The Balance-Sheet Model of the Firm

The Capital Structure Decision
(Financing Decision)
Current Assets

How can the firm

raise the money
for the required
Fixed Assets
investments?
1 Tangible
2 Intangible
Professor Ho-Mou Wu

Corporate Finance

Current
Liabilities
Long-Term
Debt

Shareholders
Equity
1-4

The Balance-Sheet Model of the Firm

The Net Working Capital Investment Decision
(Financial Decision)
Current Assets

Fixed Assets
1 Tangible
2 Intangible
Professor Ho-Mou Wu

Net
Working
Capital

How much shortterm cash flow

does a company
need to pay its
bills?
Corporate Finance

Current
Liabilities
Long-Term
Debt

Shareholders
Equity
1-5

Capital Structure
The value of the firm can
be thought of as a pie.
The goal of the manager is
to increase the size of the
pie.

70%50%30%
25%
DebtDebt
Equity

The Capital Structure

50%
75%
decision can be viewed as
Equity
how best to slice up a the
pie.
If how you slice the pie affects the size of the
pie, then the capital structure decision
matters.
Professor Ho-Mou Wu

Corporate Finance

1-6

The Firm and the Financial Markets

Firm

Firm issues securities (A)

Invests
in assets
(B)

Retained
cash flows (F)
Short-term debt
Cash flow
from firm (C)

Dividends and
debt payments (E)
Taxes (D)

Current assets
Fixed assets

Ultimately, the firm

must be a cash
generating activity.
Professor Ho-Mou Wu

Financial
markets

Government
Corporate Finance

Long-term debt
Equity shares

The cash flows from

the firm must exceed
the cash flows from
the financial markets.
1-7

Financial Markets
Primary Market
When a corporation issues securities, cash flows from
investors to the firm.
Usually an underwriter is involved

Secondary Markets
Involve the sale of used securities from one investor
to another.
Securities may be exchange traded or trade over-thecounter in a dealer market.
Professor Ho-Mou Wu

Corporate Finance

1-8

Financial Markets

Firms

Stocks and
Bonds
Money

Investors
Bob

securities

Sue

money
Primary Market
Secondary
Market

Professor Ho-Mou Wu

Corporate Finance

1-9

Investment Environment
Short term
CDs

Financial Long term

Institutions
Loans
(Banks)
$

Consumers
(Savers)

Firms
(Spenders)
Financial Markets

Stocks & $
Bonds
exchange
ownership

Financial Markets
Financial Institutions
Financial Instruments

Primary
market

real investment

Stocks &
Bonds

Professor Ho-Mou Wu

Secondary
market
Corporate Finance

1-10

Two Elements of Investment: Time and Risk

InvestmentActivities that sacrifice present consumption for
future (uncertain) rewards.
Riskless Investment: (1) the asset is default-free.
(2) the maturity of the asset matches the
investment horizon of the investor.
$100

10%

$110

represented by dollar returns

represented by the rate of return

Riskless Investment deals with the time value of money

Professor Ho-Mou Wu

Corporate Finance

1-11

Risky Investment and Capital Budgeting

Pt 1 Pt D t 1
Holding Period Rate of Return rt+1
Pt

$100

$140

40%

$130

30%

$100

0%

$90

-10%

$80

-20%

The Capital Budgeting Decision => How to choose investment

projects?
Professor Ho-Mou Wu

Corporate Finance

1-12

Capital Structure :Debt and Equity

The basic feature of a debt is that it is a promise by
the borrowing firm to repay a fixed dollar amount of
by a certain date.
The shareholders claim on firm value is the
residual amount that remains after the debtholders
are paid.
If the value of the firm is less than the amount
promised to the debtholders, the shareholders get
nothing.

Professor Ho-Mou Wu

Corporate Finance

1-13

Debt and Equity as Options

Payoff to
debt holders
If the value of the firm
is more than $F, debt
holders get a
maximum of $F.
$F

$F
Value of the firm (X)

Payoff to
shareholders
If the value of the
firm is less than $F,
share holders get
nothing.

$F
Value of the firm (X)

If the value of the firm

Debt holders are promised
is more than $F, share
$F.
If the value of the firm is less than $F,
holders get everything
they get the whatever the firm if worth.
above $F.
Algebraically, the bondholders
Algebraically, the shareholders
claim is: Min[$F,$X]
claim is: Max[0,$X $F]
Professor Ho-Mou Wu
Corporate Finance
1-14

Combined Payoffs to Debt and Equity

Combined Payoffs to debt holders
and shareholders

If the value of the firm is less than

$F, the shareholders claim is:
Max[0,$X $F] = $0 and the debt
holders claim is Min[$F,$X] = $X.

The sum of these is = $X

Payoff to shareholders
$F

If the value of the firm is more than

Payoff to debt holders $F, the shareholders claim is:
Max[0,$X $F] = $X $F and the
$F
debt holders claim is:
Value of the firm (X)

Debt holders are promised

$F.

Professor Ho-Mou Wu

Min[$F,$X] = $F.
The sum of these is = $X

Corporate Finance

1-15

Corporate Governance
Separation of Ownership and Control

Board of Directors

Professor Ho-Mou Wu

Shareholders

Assets

Debt

Debtholders

Management

Equity
Corporate Finance

1-16

Asymmetric Information and Agency Costs

There is asymmetric information between shareholders
and managers.
How to induce managers to act in the shareholders
interests ?
The shareholders can devise contracts that align the incentives
of the managers with the goals of the shareholders.
The shareholders can monitor the managers behavior.

(Agency Cost) This contracting and monitoring is costly.

Professor Ho-Mou Wu

Corporate Finance

1-17