Corporate Finance, 2e

by Smart, Megginson, Gitman

2007 Thomson South-Western

 Chapter 1
The Scope Of Corporate Finance

Professor XXXXX
Course Name / Number

2007 Thomson South-Western

What is Corporate Finance?

Theactivities involved in
managing cash flows in a
business environment

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 The Core Principles of Finance

The time value of money

The opportunity to earn a return on
invested funds means that a dollar
today is worth more than a dollar in
the future.
Compensation for risk
Investorsexpect compensation for
bearing risk.

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The Core Principles of Finance

Dont put your eggs in one basket

Investorscan achieve a more
favorable trade-off between risk and
return by diversifying their portfolios.
Markets are smart
Competition
for information tends to
make markets efficient.
No arbitrage
Arbitrage opportunities are extremely
scarce.
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The 5 Basic Corporate Finance
Functions
Financing
(Capital-Raising)

Capital Budgeting

Financial Management

Corporate Governance

Risk Management

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 The Financing Function
Businesses can raise money in 2
ways:
externally from investors or creditors
IPOs
Primarymarket transactions
Secondary market transactions

internally by retaining operating cash

flows
Most common method

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Raising Capital: Key Facts

Most financing from internal rather than

external sources
Most external financing is debt
Primary vs. secondary market
transactions or offerings
Financial intermediaries declining as a
source of capital for large firms
Securities markets growing in
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importance
The Total Value of Primary (Capital-Raising)
Corporate Security Issues, 1990 2004

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Growth in Global Security Issues

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The Capital Budgeting Function

Capital Budgeting
selecting the best
projects in which to
invest the firms
resources

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 The Capital Budgeting Function
Thecapital budgeting process
consists of three steps.
Step 1 - identifying potential
investments
Step 2 - analyzing those investments to
identify which will create
shareholder value
Step 3 - implementing and monitoring
the investments selected in
step 2
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The Financial Management Function

Managing daily cash inflows and outflows

Forecasting cash balances

Building a long-term financial plan

Choosing the right mix of debt and equity

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 The Corporate Governance
Function
Hires and promotes qualified, honest
people, and structures employees financial
incentives to motivate them to maximize
firm value
In practice the incentives of stockholders,
managers, and other stakeholders often
conflict.
Dimensions of corporate governance:
Board of directors
Securities and Exchange Commission
Sarbanes-Oxley Act of 2002

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Value of Global Mergers &
Acquisitions

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 The Risk Management Function
Identifying, measuring, and managing all
types of risk exposures
Some risks are insurable, and some risks
can be reduced through diversification.
Financial instruments like forwards,
futures, options, and swaps may also be
used to hedge market risks such as
interest-rate, price, and currency
fluctuations.

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 Business Organizational Forms
in the United States
No Distinction Between Business &
Sole Owner
Proprietorshi Easy To Set Up, Operate; Business
Earnings Taxed As Personal Income
ps Limited Life, Limited Access to Capital,
Unlimited Personal Liability

Two Or More Owners

Partnerships Joint and Several Liability
Limited Life, Limited Access to Capital,
Unlimited Personal Liability

One Or More General Partners with

Limited Unlimited Personal Liability
Most Partners are Totally Passive with
Partnerships Limited Liability - Limited Partners;
Share of Profits Taxed as Partnership
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 Business Organizational Forms
in the United States

Separate Legal Entity With Many of

the Economic Rights &
Responsibilities of Individuals
Unlimited Life, Limited Liability,
Separable Contracting, Unlimited
Corporations Access to Capital
Owned by Shareholders, Who Elect
the Board of Directors
In the U.S., Incorporation is
Executed At State Level and
Governed by State Law
Are there any disadvantages for corporations?
YES! Double taxation

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Taxation of Business Income
AFTER the Jobs and Growth Tax Relief Reconciliation Act of
2003

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 Business Organizational Forms
in the United States

Shareholders are taxed as partners

while still retaining Limited Liability
S as Corporate Shareholders
Corporations Status is Subject to Several
Eligibility Requirements

Limited- Combines the Partnerships Pass-

Liability Through Taxation with the S
Corporations Limited Liability
Companies

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 Forms of Business Organizations
Used by Non-U.S. Companies

Limited- Britain: public limited companies

(PLC)
Liability Germany: Aktiengesellschaft (AG)
Companies France: Socit Gnrale
Spain, Mexico, and elsewhere in
Latin America: Sociedad Annima
Historically, the telephone,
State-Owned television, utility, airline and
railroad companies in many
Enterprises European countries
Privatization programs have
reduced the role of the states
around the world
How much has been raised through Privatization Programs?

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Worldwide Privatization
Revenues

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 What Should a Financial Manager
Try to Maximize?
Maximize Profit?
Earnings per share are backward-looking,
dependent on accounting principles,
Do not fully consider cash flow timing
Ignores risk

Maximize Shareholder Wealth?

Maximize stock price, not profits
Shareholders, as residual claimants, have
better incentives to maximize firm value.

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 World Stock Market
Capitalization
40000

35000

30000
US$ in Billions .

25000

20000

15000

10000

5000

0
1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005
United States United Kingdom Japan Other Developed Emerging Markets
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Agency Costs
Managers act as agents of the owners
who hired them and gave them
decision-making authority to manage
the firm for the owners benefit.
In
practice however, self-interests
may cause managers to pursue
objectives other than shareholder-
wealth maximization.
This
conflict of goals gives rise to
managerial agency problems.

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How Agency Costs Can Be
Controlled

Ways to overcome agency

problems:
Takeovers
Monitoring
and bonding
Compensation contracts
Executive compensation packages

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 Importance of Ethics

Widespread publicity surrounding

numerous ethical violations began with
the Enron collapse in late 2001.
Society
in general and the financial
community in particular are developing
and enforcing ethical standards.
Ethical
behavior is necessary in order
to maximize shareholders wealth.

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