CHAPTER 1
INTRODUCTION TO CORPORATE FINANCE
CHAPTER OUTLINE
• Corporate Finance and Financial Manager
• Forms of Business Organization
• Goal of Financial Management
• Agency Problem and Solutions
• Financial Markets
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1.1 CORPORATE FINANCE
Corporate finance is the study of ways to answer the
following three questions:
 What long-term investments? What lines of business?
 Capital Budgeting
 Where to get the long-term financing to pay for the investment?
 Capital Structure
 How to manage the everyday financial activities of the firm?
 Working Capital Management（有点像现金流的管理）
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FINANCIAL MANAGER
• Financial managers try
to answer these three
questions.
Abbot Labs CFO defines the
role of the CFO and Abbot's
Finance Org Structure (Video):
https://www.viddler.com/embe
d/e9cfea22/
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FINANCIAL MANAGEMENT
DECISIONS
• Capital budgeting
 What long-term investments?
NPV>0 project
• Capital structure
 What debt/equity ratio is best?
• Working capital（NWC营运资金） management
 Cash + inventory + accounts receivable − accounts
payable
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1.2 FORMS OF BUSINESS
ORGANIZATION
Three forms of business organization:
• Sole Proprietorship: owned by one person
• Easy to form, taxed once
• Unlimited liability, limited life, difficult to transfer  insufficient capital
• Partnership: two or more owners
• General partnership
• Limited partnership
• Corporation: a legal entity
• Difficult to form (charter and bylaws) and have double taxation
• limited liability, unlimited life, easy to transfer  sufficient capital
• Limited Liability Company: taxed like a partnership + limited liability
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SOLE PROPRIETORSHIP
• Advantages
 Single owner keeps all
the profits
 Easiest to start
 Least regulated
 Taxed once as personal
income
• Disadvantages
 Unlimited liability
 Limited to life
of owner
 Difficult to sell
ownership interest
 Equity capital limited to
owner’s personal wealth
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PARTNERSHIP
• Advantages
 Two or more owners to
share liability
 Relatively easy to start
 Taxed once as personal
income
 Slightly more capital
available
• Disadvantages
 Unlimited liability (except
limited partnership)
 Partnership dissolves
when one partner dies or
wishes to sell
 Difficult to transfer
ownership
 Equity capital limited to
the partners’ combined
wealth
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CORPORATION
• Advantages
 Separation of ownership
and management
 Limited liability
 Unlimited life
 Transfer of ownership is
easy
 Easier to raise capital
• Disadvantages
 Double taxation (income
taxed at the corporate
rate and then dividends
taxed at the personal
rate)
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1.3 GOAL OF FINANCIAL
MANAGEMENT
Shareholders  Board directors  Managers
• What should be the goal of financial management?
 Maximize return?
 Maximize profit?  current or future profits?
 Maximize sales or market share?  reduce price
 Minimize costs?  cut R&D
 Minimize risk?
 Survive?
 Avoid financial distress and bankruptcy?  never borrow
 Maintain steady earnings growth?
• Maximize the current stock value
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SARBANES-OXLEY
• In response to corporate scandals like Enron,
Congress enacted the Sarbanes-Oxley Act in 2002.
 Prevent personal loans from company to its officers.
 Audit the internal control structure.
 Managers responsible for the accuracy of financial
statements.
• Costly reporting requirements cause many pubic
firms to “go dark”.
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1.4 THE AGENCY PROBLEM
• Agency costs: Conflict of interests between
stockholders (principal) and management (agency).
• Direct agency costs:
• executive perks (e.g., corporate jets); overpay to buy companies
• monitoring costs
• Indirect agency costs:
• forgo investment opportunity for job security
An example of conflict of interest:
If you hire a real estate broker (agency) to buy an
apartment, he may hide the best deal price (your interest)
to earn more commission fees (agency’s interest).
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MITIGATING AGENCY COSTS
• Managerial compensation
 Incentives can be used to align management and
stockholder interests:
 stock options, job prospects
 clawbacks, deferred compensation
• Corporate control
 The threat of replacing managers through proxy fight or
takeover may result in better management.
Other stakeholders beyond shareholder/creditor and managers:
employees, customers, suppliers, government.
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1.5 CASH FLOWS BETWEEN
FIRMS AND MARKETS
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FINANCIAL MARKETS
• Primary market: original issues (IPO, private placement)
• Secondary market: trade of already issued securities
• Dealer market:
 trade for themselves (have inventory)
 no central location
Dr. Richard Sanders defines Public and
 OTC securities: NASDAQ
• Auction market:
Corporate financial markets (Video):
https://www.viddler.com/embed/c3510b77
 trade for others (no inventory)
 converge at an exchange
 Listed securities: NYSE
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SUMMARY
• Corporate finance and financial managers concern:
• Capital budgeting
• Capital structure
• Working capital management
• Three major forms of business organization
• Sole Proprietorship
• Partnership
• Corporation (LLC)
• Goal of financial management: max current stock value
• Mitigating direct/indirect agency costs:
• Manager compensation
• Corporate control (manager replacement)
• Primary vs. secondary market; dealer vs. auction market
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