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CHAPTER
1
Introduction to Corporate
Finance
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What is Corporate Finance?


Corporate Finance is an area of finance dealing
with the financial decisions corporations make
and the tools and analysis used to make those
decisions.
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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’
2 Intangible Equity
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The Balance-Sheet Model


of the Firm
The Capital Budgeting Decision
Current
Liabilities
Current Assets

Long-Term
Debt

Fixed Assets What long-


term
1 Tangible investments Shareholders’
2 Intangible should the Equity
firm engage
in?
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The Balance-Sheet Model


of the Firm
The Capital Structure Decision
Current
Liabilities
Current Assets

Long-Term
How can the firm Debt
raise the money
Fixed Assets for the required
1 Tangible investments?
Shareholders’
2 Intangible Equity
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The Balance-Sheet Model


of the Firm
The Net Working Capital Investment Decision
Current
Liabilities
Current Assets
Net
Working
Capital
Long-Term
Debt
Fixed Assets How much short-
1 Tangible term cash flow
does a company Shareholders’
2 Intangible need to pay its Equity
bills?
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Capital Structure
The value of the firm can be
thought of as a pie.

The goal of the manager is 70%50%30%


25%
to increase the size of the DebtDebt
Equity
pie.
75%
50%
The Capital Structure Equity
decision can be viewed as
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.
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Hypothetical Organization Chart


Board of Directors

Chairman of the Board and


Chief Executive Officer (CEO)

President and Chief Vice President and


Operating Officer (COO) Chief Financial Officer (CFO)

Treasurer Controller

Cash Manager Credit Manager Tax Manager Cost Accounting

Capital Expenditures Financial Planning Financial Accounting Data Processing


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The Firm and the Financial Markets


Firm Firm issues securities (A) Financial
markets
Invests
Retained
in assets cash flows (F)
(B)
Short-term debt
Current assets Cash flow Dividends and Long-term debt
Fixed assets from firm (C) debt payments (E)
Equity shares

Taxes (D)
The cash flows from
Ultimately, the firm
the firm must exceed
must be a cash the cash flows from the
generating activity. Government
financial markets.
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The Corporate Form


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.
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Forms of Business Organization


The Sole Proprietorship
The Partnership
General Partnership
Limited Partnership
The Corporation
Advantages and Disadvantages
Liquidity and Marketability of Ownership
Control
Liability
Continuity of Existence
Tax Considerations
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A Comparison of Partnership
and Corporations
Corporation Partnership

Liquidity Shares can easily be Subject to substantial


exchanged. restrictions.

Voting Rights Usually each share gets General Partner is in


one vote charge; limited partners
may have some voting
rights.
Taxation Double Partners pay taxes on
distributions.
Reinvestment and Broad latitude All net cash flow is
dividend payout distributed to partners.

Liability Limited liability General partners may


have unlimited liability.
Limited partners enjoy
limited liability.
Continuity Perpetual life Limited life
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Goals of the Corporate Firm


The traditional answer is that the managers of the
corporation are obliged to make efforts to maximize
shareholder wealth.
Other possible goals of management are as follows
Survival of the firm
Avoid financial distress and bankruptcy
Maximize sales or market share
Minimize costs
Maximize Profits
Maintain steady growth of earnings
Maintain steady growth or expansion of the firm
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The Set-of-Contracts Perspective


The firm can be viewed as a set of contracts.
One of these contracts is between shareholders and
managers.
The managers will usually 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.
This contracting and monitoring is costly.
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The Agency Problem
• The agency relationship
• In an agency relationship the members of the
management team are the “agents”.
• The equity investors (shareholders) are the
“principals”.
• Will managers work in the shareholders’ best
interests?
– Agency costs
– The monitoring costs of the shareholders
– The costs of implementing control devices.
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Managerial Goals
Managerial goals may be different from shareholder
goals
Survival: organizational survival means management will
always try to command sufficient resources to avoid the firm’s
going out of business.
Independence and self-sufficiency: This the freedom to take
decisions without encountering external parties or depending
on outside financial markets.
These two basic financial objectives of managers will
lead to the maximization of corporate wealth. Increased
in corporate growth and size are not necessarily the
same thing as increased shareholder wealth.
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Separation of Ownership and Control

Board of Directors

Debtholders

Shareholders
Management

Debt
Assets
Equity
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Do Shareholders Control
Managerial Behavior?
Shareholders vote for the board of directors,
who in turn hire the management team.
Contracts can be carefully constructed better
compensation based on performance.
There is a market for managerial talent—this
may provide market discipline to the
managers—they can be replaced.
If the managers fail to maximize share price,
they may be replaced in a hostile takeover.
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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-the-
counter in a dealer market.
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Financial Markets

Stocks and
Investors
Bonds
Firms securities
Money John Tom
money

Primary Market
Secondary
Market
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Money Market vs. Capital Market


Money Market: The financial markets in which
funds are borrowed or loaned for short periods
(generally one year or less).
Capital Market: The financial markets for stocks
and long-term debt (generally longer than one
year).
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Auction Market vs. Dealer Market


The equity securities of most large corporations
are traded in organized auction markets.
Example: New York Stock Exchange (NYSE),
Dhaka Stock Exchange (DSE), Chittagong Stock
Exchange (CSE), Bombay Stock Exchange
(BSE) etc.
Most debt securities are traded on dealer
markets. Some stocks are also traded in dealer
markets.
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Over The Counter (OTC) Market


In OTC market trading of stocks, bonds, commodities
etc. are conducted directly between two parties.
In February 1971, the National Association of Securities
Dealers made available to dealers and brokers in the
OTC market an automated quotation system called the
National Association of Securities Dealers Automated
Quotation (NASDAQ) system. NASDAQ is an example
of OTC market.
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Listings
Firms that want their equity shares to be traded
on the national stock exchange must apply for
listings. To be listed in the national stock
exchanges a company is expected to satisfy
minimum requirements.
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End of the Chapter