Chapter 1
Introduction to Corporate Finance
Areas of Financial Management
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Corporate Finance
Investments
Financial Institutions
International Finance
Basic Areas of Financial Management
1- Capital budgeting: What long-term investments should the firm undertake?
(fixed assets)
2- Capital Structure: What is the best way to raise long-term financing for these
investments? (long-term debt and equity)
3- Net Working Capital: How should the firm manage its short-term assets and
liabilities? (short-tem assets and liabilities)
The Financial Manager
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Shareholders are the owners of the firm.
In large firms, shareholders are not involved in the day-to-day operations.
Managers are employed as agents of the shareholders to make decisions on their
behalf.
The treasurer and controller share financial functions of the firm and they report
to the top financial manager within the firm who is usually the Chief Financial
Officer (CFO).
The treasurer oversees cash management, capital expenditures, and financial
planning.
The controller oversees taxes, cost accounting, financial accounting, and data
processing.
Forms of Business Organization
Most of what we do in class is described using the publicly traded manufacturing
corporation as the setting. It is important to keep in mind that other forms of organization
exist as well. There are three basic forms of organization: sole proprietorship,
partnership, and corporation.
Sole Proprietorship: unincorporated business owned by one individual. It is usually very
small, is financed with personal assets of the owner, and is managed strictly by the
owner.
Advantages:
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Easily and inexpensively formed.
Subject to few government regulations.
Owners keep all profits.
Profits are not taxed at the firm level. All profit is passed through and taxed as the
owner’s personal income.
Disadvantages:
1- Difficult for a proprietor to obtain large sums of capital.
2- Proprietor has unlimited liability for the firm’s debt. If the firm goes bankrupt
creditors can demand compensation out of the owner’s personal assets.
3- Life of proprietorship is limited to life of proprietor. So the organization ends
when the owner quits. This means more risk for employees and customers.
4- Difficult to sell ownership interest.
Partnership: an unincorporated business owned by two or more people.
Advantages:
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Low cost and ease of formation.
Few government regulations.
Owners keep all profits.
No taxes at the firm level.
Disadvantage:
1- Unlimited personal liability.
2- General partnership dissolves with death or retirement of any partner (i.e., limited
life)
3- Difficulty in transferring ownership.
4- Difficulty in raising large amounts of capital. Size is limited to what partners can
raise.
General Partnership: All partners share. All have unlimited liability.
Limited Partnership: General partners run business; have unlimited liability. Limited
partners are silent on operations and have limited liability.
Corporation: A legal entity that is separate and distinct from its owners and managers.
Many owners indirectly operate the firm through the board of directors. Owners are not
involved in the day to day operations, but are frequently asked to vote on major
decisions, such as, dividend changes, election of new directors, issuance of new stock,
etc.
Advantages:
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Unlimited life.
Ownership is easily transferred.
Limited liability of owners.
Easier to raise capital.
No limit on size.
Management specialization is allowed and feasible. Allows for increased
efficiency.
Disadvantages:
1- Profit is taxed twice: at firm and personal level.
2- Much government regulation. Little secrecy allowed. Organization costs are high.
3- Agency problem exists due to the separation of ownership and management.
Goals of Financial Management
1- Maximize shareholder wealth
2- Maximize stock price
3- Maximize firm value.
Stock price depends on: earning per share (EPS), level of economic activity, corporate
taxes, dividends, and debt versus equity financing.
Agency Problem
There is a potential conflict of interest between the agent (manager) hired by the principal
(stockholder) to represent the principal’s interest.
Manager-Stockholder Conflict
Shareholders want stock price maximization. Managers want perquisites and job security.
Mechanisms available to control manager-stockholder conflict
1- Managerial compensation (incentives can be used to align management and
stockholder interests by linking compensation to performance).
2- Corporate control (threat of takeover).
3- Direct intervention by stakeholders (stakeholders include shareholders, creditors,
employees, customers, suppliers and the federal and provincial governments).
Financial Markets and the Corporation
Financial markets are markets in which those with surplus funds (households) meet with
those that need funds (corporation).
Money versus capital markets:
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Money markets are financial markets where short-term debt securities are bought
and sold.
Capital markets are financial markets where long-term debt and shares of stock
are traded.
Primary versus secondary markets:
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Primary markets: when a firm first issues a security, the sale takes place in the
primary market. These transactions maybe either public offerings or private
placements.
Secondary markets: security trades after the initial public offering take place in
secondary markets.
Dealer versus auction markets:
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Dealer markets have no physical location. Bonds (debt securities) usually trade in
dealer markets.
Auction markets have a physical location (an exchange) where trading takes place
on the floor of the exchange (e.g., TSE).
Financial Institutions
Financial institutions act as intermediaries between suppliers and users of funds.
Institutions earn income on services provided:
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Indirect finance Earn interest on the spread between loans and deposits.
Direct finance Service fees (i.e., banking acceptance and stamping fees).