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CHAPTER

1

Introduction to Corporate

Finance

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Key Concepts and Skills

Know the basic types of financial

management decisions and the role of

the Financial Manager

Know the financial implications of the

various forms of business organization

Know the goal of financial management
Understand the conflicts of interest that

can arise between owners and managers

Understand the various types of financial

markets

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Chapter Outline

1.1 What is Corporate Finance?
1.2 The Corporate Firm
1.3 The Goal of Financial Management
1.4 The Agency Problem and Control of

the Corporation

1.5 Financial Markets

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1.1 What is Corporate

Finance?

Corporate Finance addresses the
following three questions:

1. What long-term investments should

the firm choose?

2. How should the firm raise funds for

the selected investments?

3. How should short-term assets be

managed and financed?

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Balance Sheet Model of the

Firm

Current

Assets

Fixed

Assets

1 Tangible

2

Intangible

Total Value of Assets:

Shareholde

rs’ Equity

Current

Liabilities

Long-Term

Debt

Total Firm Value to

Investors:

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The Capital Budgeting

Decision

Current

Assets

Fixed

Assets

1 Tangible

2

Intangible

Shareholde

rs’ Equity

Current

Liabilities

Long-Term

Debt

What long-

term

investments

should the

firm

choose?

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The Capital Structure

Decision

How should
the firm raise
funds for the
selected
investments?

Current

Assets

Fixed

Assets

1 Tangible

2

Intangible

Shareholde

rs’ Equity

Current

Liabilities

Long-Term

Debt

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Short-Term Asset

Management

How should

short-term

assets be

managed and

financed?

Net

Working

Capital

Shareholde

rs’ Equity

Current

Liabilities

Long-Term

Debt

Current

Assets

Fixed

Assets

1 Tangible

2

Intangible

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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.

The Capital Structure
decision can be
viewed as how best to
slice the pie.

If how you slice the pie affects the size
of the pie, then the capital structure
decision matters.

50%

Debt

50%

Equity

25%

Debt

75%

Equity

70%

Debt

30%

Equity

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The Financial Manager

The Financial Manager’s primary goal
is to increase the value of the firm by:
1. Selecting value creating projects
2. Making smart financing decisions

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Hypothetical Organization

Chart

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

Capital Expenditures

Credit Manager

Financial Planning

Tax Manager

Financial Accounting

Cost Accounting

Data Processing

Board of Directors

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Cash flow

from firm (C)

The Firm and the Financial

Markets

Ta

xe

s

(D

)

Government

Retained

cash flows (F)

Invests

in assets

(B)

Dividends and

debt payments (E)

Current assets
Fixed assets

Short-term
debt

Long-term
debt

Equity shares

Ultimately, the
firm must be a
cash generating
activity.

The cash flows
from the firm
must exceed the
cash flows from
the financial
markets.

Firm

Firm issues securities (A)

Financial

markets

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1.2 The Corporate Firm

• 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

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A Comparison

 

Corporation

Partnership

Liquidity

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

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1.3 The Goal of Financial

Management

• What is the correct goal?

– Maximize profit?
– Minimize costs?
– Maximize market share?
– Maximize shareholder wealth?

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1.4 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

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Managerial Goals

• Managerial goals may be different

from shareholder goals

– Expensive perquisites
– Survival
– Independence

• Increased growth and size are not

necessarily equivalent to increased
shareholder wealth

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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

• Other stakeholders

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1.5 Financial Markets

• Primary Market

– Issuance of a security for the first time

• Secondary Markets

– Buying and selling of previously issued

securities

– Securities may be traded in either a

dealer or auction market

•

NYSE

•

NASDAQ

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Financial Markets

Firms

Investors

Secondary

Market

money

securiti

es

Su

e

Bob

Stocks

and

Bonds

Mone

y

Primary

Market

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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 is the difference between a primary

market and a secondary market?