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Chapter One
Introduction Corporate
to
Finance
Ross Westerfield Jaffe
Corporate Finance


1
Sixth Edition
Prepared by
Gady Jacoby
University of Manitoba
and
Sebouh Aintablian
American University of
Beirut
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Chapter Outline
1.1 What is Corporate Finance?
1.2 Corporate Securities as Contingent Claims on
Total Firm Value
1.3 The Corporate Firm
1.4 Goals of the Corporate Firm
1.5 Financial Institutions, Financial Markets, And The
Corporation
1.6 Trends in Financial Markets and Management
1.7 Outline of the Text
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What is Corporate Finance?
Corporate Finance addresses the following
three questions:
1. What long-term investments should the firm
engage in?
2. How can the firm raise the money for the
required investments?
3. How much short-term cash flow does a
company need to pay its bills?
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The 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
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Shareholders’
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
1 Tangible
2 Intangible
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What longterm
investments
should the
firm engage
in?
Shareholders’
Equity
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The Balance-Sheet Model of the Firm
The Capital Structure Decision
Current Assets
How can the firm
raise the money
for the required
Fixed Assets
investments?
1 Tangible
2 Intangible
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Current
Liabilities
Long-Term
Debt
Shareholders’
Equity
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The Balance-Sheet Model of the Firm
The Net Working Capital Investment Decision
Current Assets
Fixed Assets
1 Tangible
2 Intangible
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Current
Liabilities
Net
Working
Capital
How much shortterm cash flow
does a company
need to pay its
bills?
Long-Term
Debt
Shareholders’
Equity
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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 up the pie.
70%50%30%
25%
DebtDebt
Equity
75%
50%
Equity
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
Operating Officer (COO)
Vice President Finance
Treasurer
Controller
Cash Manager
Credit Manager
Tax Manager
Cost Accounting
Capital Expenditures
Financial Planning
Financial Accounting
Data Processing
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The Financial Manager
To create value, the financial manager
should:
1. Try to make smart investment decisions.
2. Try to make smart financing decisions.
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The Firm and the Financial Markets
Firm
Firm issues securities (A)
Invests
in assets
(B)
Retained
cash flows (D)
Short-term debt
Cash flow
from firm (C)
Dividends and
debt payments (F)
Taxes (E)
Current assets
Fixed assets
Ultimately, the firm
must be a cash
generating activity.
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Financial
markets
Government
Long-term debt
Equity shares
The cash flows from
the firm must exceed
the cash flows from
the financial markets.
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1.2 Corporate Securities as Contingent Claims on
Total Firm Value
• The basic feature of a debt is that it is a
promise by the borrowing firm to repay a
fixed dollar amount by a certain date.
• The shareholder’s claim on firm value is the
residual amount that remains after the
debtholders are paid.
• If the value of the firm is less than the
amount promised to the debtholders, the
shareholders get nothing.
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Debt and Equity as Contingent Claims
Payoff to
debt holders
Payoff to
shareholders
If the value of the firm
is more than $F, debt
holders get a
maximum of $F.
If the value of the
firm is less than $F,
share holders get
nothing.
$F
Value of the firm (X)
$F
Value of the firm (X)
$F
If the value of the firm
Debt holders are promised $F.
is more than $F, share
If the value of the firm is less than $F, they
holders get everything
get whatever the firm is worth.
above $F.
Algebraically, the bondholder’s
Algebraically, the shareholder’s
claim is: Min[$F,$X]
claim is: Max[0,$X – $F]
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Combined Payoffs to Debt and Equity
Combined Payoffs to debt holders
and shareholders
If the value of the firm is less than
$F, the shareholder’s claim is:
Max[0,$X – $F] = $0 and the debt
holder’s claim is Min[$F,$X] = $X.
The sum of these is = $X
Payoff to shareholders
$F
If the value of the firm is more than
Payoff to debt holders $F, the shareholder’s claim is:
Max[0,$X – $F] = $X – $F and the
$F
debt holder’s claim is:
Value of the firm (X)
Debt holders are promised $F.
Min[$F,$X] = $F.
The sum of these is = $X
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1.3 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
• 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
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 with dividend tax
credit
Partnership income is
taxable.
Reinvestment
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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1.4 Goals of the Corporate Firm
• What are firm decision-makers hired to do?
• The traditional answer is that the managers of
the corporation are obliged to make efforts to
maximize shareholder wealth.
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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’ behaviour.
• This contracting and monitoring is costly.
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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
the same thing as increased shareholder
wealth.
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Separation of Ownership and Control
Board of Directors
Shareholders
Assets
Debt
Debtholders
Management
Equity
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The Agency Problem
• The agency relationship
• Will managers work in the shareholders’ best
interests?
– Agency costs
– Direct agency costs
– Indirect agency costs
• Control of the firm
• How do agency costs affect firm value (and
shareholder wealth)?
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Do Shareholders Control Managerial Behaviour?
• Shareholders vote for the board of directors,
who in turn hire the management team.
• Contracts can be carefully constructed to be
incentive compatible.
• 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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1.5 Financial Institutions, Financial
Markets, and the Corporation
• Financial Institutions
Indirect finance
Funds
suppliers
Deposits
Financial
intermediaries
Loans
Funds
demanders
Direct finance
Funds
suppliers
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Financial
intermediaries
Funds
demanders
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Financial Markets
Money versus Capital Markets
• Money Markets
– For short-term debt instruments
• Capital Markets
– For long-term debt and equity
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Financial Markets
Primary versus Secondary 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 overthe-counter in a dealer market.
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Financial Markets
Firms
Stocks and
Bonds
Money
Investors
securities
Bob
Sue
money
Primary Market
Secondary
Market
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1.6 Trends in Financial Markets and
Management
• Integration and globalization
• Increased volatility
• Financial Engineering reduces costs related to
– Risk
– Taxes
– Fnancing costs
• Improved computer technology allows
Economies of scale and scope
• Regulatory dialectic
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1.7 Outline of the Text
I.
Overview
II.
Value and Capital Budgeting
III. Risk
IV. Capital Structure and Dividend Policy
V.
Long-Term Financing
VI. Options, Futures, and Corporate Finance
VII. Financial Planning and Short-Term Finance
VIII.Special Topics
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