Marshall School of Business
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 regulations that firms
face
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Chapter Outline
1.1 What is Corporate Finance?
1.2 The Corporate Firm
1.3 The Importance of Cash Flows
1.4 The Goal of Financial Management
1.5 The Agency Problem and Control of the
Corporation
1.6 Regulation
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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
Total Value of Assets:
Current Assets
Total Firm Value to Investors:
Current
Liabilities
Long-Term
Debt
Fixed Assets
1 Tangible
2 Intangible
Shareholders’
Equity
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The Capital Budgeting Decision
Total Value of Assets:
Current Assets
Total Firm Value to Investors:
Current
Liabilities
Long-Term
Debt
Fixed Assets
1 Tangible
2 Intangible
What long-term
investments
Shareholders’
should the firm
Equity
choose?
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The Capital Structure Decision
Total Value of Assets:
Total Firm Value to Investors:
Current
Liabilities
Current Assets
Fixed Assets
1 Tangible
2 Intangible
How should the
firm raise funds
for the selected
investments?
Long-Term
Debt
Shareholders’
Equity
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Short-Term Asset Management
Total Value of Assets:
Total Firm Value to Investors:
Current
Liabilities
Current Assets
Net
Working
Capital
Fixed Assets
1 Tangible
2 Intangible
Long-Term
Debt
How should
short-term assets
be managed and Shareholders’
Equity
financed?
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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?
Board of Directors
Chairman of the Board and
Chief Executive Officer (CEO)
President and Chief
Operating Officer (COO)
Vice President and
Chief Financial Officer (CFO)
Treasurer
Cash Manager
Capital Expenditures
Credit Manager
Controller
Tax Manager
Financial Planning Financial Accounting
Cost Accounting
Data Processing
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Hypothetical Organization re-do
Board of Directors
Chairman of the Board and
Chief Executive Officer (CEO)
Vice President and
Chief Financial Officer (CFO)
Treasurer
Cash Manager
Capital Expenditures
Credit Manager
Controller
Tax Manager
Financial Planning Financial Accounting
Cost Accounting
Data Processing
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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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3 Forms of Business Organization
• 1. The Sole Proprietorship
• 2. The Partnership
– General Partnership
– Limited Partnership
• 3. The Corporation
– Single person LLC
– C versus S Corp.
• Consult a lawyer, I am not one.
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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
Taxation
Double
General Partner is in
charge; limited partners
may have some voting
rights
Partners pay taxes on
Reinvestment and
dividend payout
Broad latitude
Liability
Limited liability
Continuity
Perpetual life
distributions
All net cash flow is
distributed to partners
General partners may
have unlimited liability;
limited partners enjoy
limited liability
Limited life
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1.3 The Importance of Cash Flow
Firm issues securities (A)
Firm
Short-term
debt
Retained
cash flows (F)
Cash flow
Current assets from firm (C)
Fixed assets
Ultimately, the firm
must be a cash
generating activity.
Taxes (D)
Invests
in assets
(B)
Financial
markets
Long-term
Dividends and
debt
debt payments (E)
Equity
shares
Government
The cash flows from
the firm must exceed
the cash flows from
the financial markets.
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1.4 The Goal of Financial Management
• What is the correct goal?
–
–
–
–
Maximize profit?
Minimize costs?
Maximize market share?
Maximize shareholder wealth?
• In the corporate form - business is based on
OPM, other people’s money.
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1.5 The Agency Problem
• Agency relationship
– Principal hires an agent to represent his/her interest
– Stockholders (principals) hire managers (agents) to
run the company
– Shareholders elect directors, directors pick managers
• Agency problem
– Conflict of interest between principal and agent
• Agency costs
– Cost of this Conflict versus perfect alignment
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1.5 A Mental Model of Agents
• Real estate Agents
– Wonderful people
– Principal hires an agent to represent his/her interest
– Sell the home for the greatest price.
– Contract pays agent 5% to sell the home
• What’s the problem with this incentive?
– Sell fast now or sell for a little more later?
• What’s the solution?
– Better contracts
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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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1.6 Regulation
• The Securities Act of 1933 and the Securities
Exchange Act of 1934
– Issuance of Securities (1933)
– Creation of SEC and reporting requirements
(1934)
• Sarbanes-Oxley (“Sarbox”)
– Increased reporting requirements and
responsibility of corporate directors
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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 major regulations impact public firms?