Chapter 1

INTRODUCTION TO CORPORATE FINANCE

Copyright 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

KEY CONCEPTS AND SKILLS

Know the three main concerns of corporate
financial management
Grasp the goal of financial management
Enumerate the financial benefits and drawbacks
of differing forms of business organization
Understand the conflicts of interest that can arise
between owners and managers
Comprehend that corporate organizations are
enhanced by financial markets

1-2

CHAPTER OUTLINE
1.1 What is Corporate Finance?
1.2 The Corporate Firm
1.3 The Importance of Cash Flows
1.4 The Goal of Financial Management
1.5 The Agency Problem and Control of the
Corporation
1.6 Regulation

1-3

1.1 WHAT IS CORPORATE FINANCE?

Economic resources are required to
establish and maintain a firm:

Funds enable materials and processes for

delivering salable goods and services
Funds are essential for assembling a
workforce
Funds are required to purchase long-lived
assets such as equipment and buildings

The Balance Sheet offers insight into

the array of decisions, activities and
objectives of the Financial Manager
1-4

BALANCE SHEET MODEL OF THE FIRM

Total Value of Assets:

Current Assets

Total Firm Value to Investors:

Current
Liabilities
Long-Term
Debt

Fixed Assets
1 Tangible
2 Intangible

Shareholders
Equity
1-5

THE BALANCE SHEET REVEALS

the top three concerns of

corporate finance:
1. What long-term investments should the firm
choose?
2. How should the firm raise funds for the
selected investments?
3. How should current assets be managed and
financed?

1-6

THE CAPITAL BUDGETING DECISION

Current
Liabilities

Current Assets

Long-Term
Debt
Fixed Assets
1 Tangible
2 Intangible

What long-term
investments
should the firm
choose?

Shareholders
Equity
1-7

THE CAPITAL STRUCTURE DECISION

Current Assets

How should the

firm raise funds
for the selected
Fixed Assets
investments?
1 Tangible
2 Intangible

Current
Liabilities
Long-Term
Debt

Shareholders
Equity
1-8

SHORT-TERM ASSET MANAGEMENT

Current Assets

Fixed Assets
1 Tangible
2 Intangible

Current
Liabilities
Net
Working
Capital

How should
short-term assets
be managed and
financed?

Long-Term
Debt

Shareholders
Equity
1-9

THE FINANCIAL MANAGER

The firms three main financial concerns

are usually handled by a top officer and

aides:
V.P. or Chief Financial Officer
Strategist, coordinator, authority

Treasurer
Cash flow, capital expenditures, capital
structure

Controller
Accounting, information systems, taxes
1-10

HYPOTHETICAL ORGANIZATION
CHART
Board of Directors
Chairman of the Board and
Chief Executive Officer (CEO)
President and Chief
Operating Officer (COO)
Vice President and
Chief Financial Officer (CFO)

Treasurer

Controller

Cash Manager

Credit Manager

Tax Manager

Cost Accounting

Capital Expenditures

Financial Planning

Financial Accounting

Data Processing
1-11

1.2 THE CORPORATE FIRM

First company problem: raise funds
The corporate form of business is the standard
method for solving the problems encountered in
raising large amounts of cash.
However, businesses can take other forms.

1-12

FORMS OF BUSINESS ORGANIZATION

The Sole Proprietorship
The Partnership
General Partnership
Limited Partnership

The Corporation

1-13

A COMPARISON
Corporation

Partnership

Liquidity and
marketability

Shares can be easily

exchanged

Subject to substantial
restrictions

Voting Rights

Usually each share gets one

vote

General Partner is in charge;

limited partners may have
some voting rights

Taxation

Double

Partners pay taxes on

distributions

Reinvestment and dividend

payout

Broad latitude

All net cash flow is

distributed to partners

Liability

Limited liability

General partners may have

unlimited liability; limited
partners enjoy limited
liability

Continuity

Perpetual life

Limited life
1-14

A GLOBAL PHENOMENON
The corporate form of organization is not unique
to the United States:

1-15

1.3 THE IMPORTANCE OF CASH FLOWS

If the firm is to prosper, it must:
Buy assets that generate more cash than they
cost
Sell financial instruments that raise more cash
than they cost

The successful firm generates more cash

than it uses

1-16

THE CONCEPTUAL FLOW OF CASH

Ultimately, the firm

must be a cash
generating activity.

The cash flows from

the firm must exceed
the cash flows from
the financial markets.
1-17

CASH FLOW ACCOUNTING INCOME

Do not confuse cash flow and accounting
income
Non-Cash expense example: Depreciation
Non-Cash revenue example: Sales on Account

1-18

1.4 THE GOAL OF FINANCIAL

MANAGEMENT
What is the correct goal?
Maximize profit?
Minimize costs?
Maximize market share?
Maximize shareholder wealth?

1-19

1.5 THE AGENCY PROBLEM

Agency relationship
Principal hires an agent to represent his/her
interest
Stockholders (principals) hire managers
(agents) to run the company

Agency problem
Conflict of interest between principal and agent

1-20

AGENCY COST
Cost of Conflict of Interest
Example:
Large investment positions firm for long term
positive cash flow but has risk in short run
Owners want this investment Increases firm value
Managers object Risk may have personal cost

If managers prevail, foregone long term cash

flow is the Agency Cost

1-21

MANAGEMENT GOALS
Management goals may be different from
shareholder goals
Expensive perquisites
Survival
Independence

Increased growth and size

Often lead to management reward
Not necessarily in best interest of shareholders

1-22

MANAGING MANAGERS
Managerial compensation
Incentives can be used to align management
and stockholder interests
The incentives need to be structured carefully
to make sure that they achieve their intended
goal

Corporate control
The threat of a takeover may result in better
management

Influence of other stakeholders

1-23

1.6 REGULATION
The Securities Act of 1933 and the Securities
Exchange Act of 1934

Issuance of Securities (1933)

Creation of SEC and reporting requirements
(1934)
Sarbanes-Oxley Act of 2002 (Sarbox)
Increased reporting requirements and responsibility of
corporate directors
Personal consequences for non-compliance

1-24

QUICK QUIZ
What are the three basic questions Financial
Managers must answer?
What are the three major forms of business
organization?
What is the goal of financial management?
What are agency problems, and why do they exist
within a corporation?
What major regulations impact public firms?

1-25