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?
 The
activities involved in managing
cash flows in a business
environment
1-3
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
 Investors
risk.
for risk
expect compensation for bearing
1-4
The Core Principles of Finance
 Don’t
put your eggs in one basket
 Investors
can 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
scarce.
opportunities are extremely
1-5
The 5 Basic Corporate Finance Functions
Financing
(Capital-Raising)
Capital Budgeting
Financial Management
Corporate Governance
Risk Management
1-6
The Financing Function
 Businesses
 externally
can raise money in 2 ways:
from investors or creditors
 IPOs
 Primary
market transactions
 Secondary market transactions
 internally
 Most
by retaining operating cash flows
common method
1-7
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
1-8
Securities markets growing in importance
The Total Value of Primary (Capital-Raising)
Corporate Security Issues, 1990 –2004
1-9
Growth in Global Security Issues
1 - 10
The Capital Budgeting Function
Capital Budgeting –
selecting the best projects
in which to invest the firm’s
resources
1 - 11
The Capital Budgeting Function
 The
capital 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
1 - 12
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
1 - 13
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
1 - 14
Value of Global Mergers & Acquisitions
1 - 15
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.
1 - 16
Business Organizational Forms
in the United States
Sole
Proprietorships
Partnerships
Limited
Partnerships
• No Distinction Between Business & Owner
• Easy To Set Up, Operate; Business Earnings
Taxed As Personal Income
• Limited Life, Limited Access to Capital,
Unlimited Personal Liability
• Two Or More Owners
• Joint and Several Liability
• Limited Life, Limited Access to Capital,
Unlimited Personal Liability
• One Or More General Partners with Unlimited
Personal Liability
• Most Partners are Totally Passive with
Limited Liability - Limited Partners; Share of
Profits Taxed as Partnership Income
1 - 17
Business Organizational Forms
in the United States
Corporations
• Separate Legal Entity With Many of the
Economic Rights & Responsibilities of
Individuals
• Unlimited Life, Limited Liability,
Separable Contracting, Unlimited 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
1 - 18
Taxation of Business Income
AFTER the Jobs and Growth Tax Relief Reconciliation Act of 2003
1 - 19
Business Organizational Forms
in the United States
S Corporations
LimitedLiability
Companies
• Shareholders are taxed as partners while
still retaining Limited Liability as
Corporate Shareholders
• Status is Subject to Several Eligibility
Requirements
• Combines the Partnership’s PassThrough Taxation with the S
Corporation’s Limited Liability
1 - 20
Forms of Business Organizations
Used by Non-U.S. Companies
LimitedLiability
Companies
State-Owned
Enterprises
•
•
•
•
Britain: public limited companies (PLC)
Germany: Aktiengesellschaft (AG)
France: Société Générale
Spain, Mexico, and elsewhere in Latin
America: Sociedad Anónima
• Historically, the telephone, television,
utility, airline and railroad companies in
many European countries
• Privatization programs have reduced the
role of the states around the world
How much has been raised through Privatization Programs?
1 - 21
Worldwide Privatization Revenues
1 - 22
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.
1 - 23
World Stock Market Capitalization
40000
35000
US$ in Billions .
30000
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
1 - 24
Agency Costs
act as agents of the owners
who hired them and gave them
decision-making authority to manage
the firm for the owners’ benefit.
 Managers
 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.
1 - 25
How Agency Costs Can Be Controlled
 Ways
to overcome agency problems:
 Takeovers
 Monitoring
and bonding
 Compensation contracts
 Executive
compensation packages
1 - 26
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 shareholder’s wealth.
1 - 27