CHAPTER 1 1-1 INTRODUCTION TO CORPORATE FINANCE Brealey, Myers, and Allen Principles of Corporate Finance 13th Edition Slides by Matthew Will Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Learning Objectives 1-2 • Understand the definition of a corporation and how finance fits into the corporate structure. • The role of the financial manager in a corporation. • Functions of financial markets. • Principal-agent problems and agency costs. Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Topics Covered 1-3 • Corporate Investment and Financing Decisions • The Financial Goal of the Corporation Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Corporate Investment and Financing Decisions 1-4 • Real assets oTo carry on business, corporation needs and endless variety of real assets oA corporation pays for its real assets by selling claims on them and on the cash flow that they will generate o Assets used to produce goods and services. • Financial assets oFinancial claims to the income generated by the firm’s real assets. Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Corporate Investment and Financing Decisions 1-5 • Real assets oTo carry on business, corporation needs and endless variety of real assets oA corporation pays for its real assets by selling claims on them and on the cash flow that they will generate o Assets used to produce goods and services. • Financial assets oFinancial claims to the income generated by the firm’s real assets. Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Corporate Investment and Financing Decisions 1-6 Board of Directors (BDO); CEO/President Vice President/ Department Heads First line managers, supervisors Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Corporate Investment and Financing Decisions 1-7 • Financial assets oThe bank provides the corporation with cash in exchange for a financial asset, which is the corporation’s promise to repay the loan with interest. oCorporation sells the bonds to investors in exchange for the promise to pay interest on the bond and to pay off the bond at its maturity. Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Corporate Investment and Financing Decisions 1-8 • Financial assets oThe bond is a financial asset, and also a security because it can be held and traded by many investors in financial markets oSecurities include bonds, shares of stock and a variety of specialized instruments. Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Financial Assets 1-9 Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Financial Assets 1-10 Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. REAL Assets 1-11 Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. REAL Assets 1-12 Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. REAL Assets 1-13 Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. REAL Assets 1-14 Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. REAL Assets 1-15 Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Investment Decisions 1-16 • Investment decision oReferred to as Capital Budgeting or capital expenditure (CAPEX) oPurchase of real assets oInvolves managing assets already in place and deciding when to shut down and dispose of assets when they are no longer profitable. The corporation also has to manage and control the risks of its investments Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Table 1.1 Examples of Recent Investment and Financing Decisions by Major Public Corporations 1-17 Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Corporate Investment and Financing Decisions Continued 1-18 • Financing decision oSale of financial assets oIncludes raising cash today and meeting its obligations to bank, bondholders and stock holders that have contributed financing in the past. Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Investment Decisions 1-19 • Capital budgeting decision o Decision to invest in tangible or intangible assets o Also called the investment decision o Also called capital expenditure or CAPEX decisions because most large corporations prepare an annual capital budget listing the major projects approved for investment. o Ex. GlaxoSmithKline and other major pharmaceutical companies invest billions every year on R&D for new drugs. Procter & Gamble invest huge sums in advertising and marketing their products o These outlays are investment because they build know-how, brand recognition and reputation for the long run. Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Investment Decisions 1-20 • Most investment decisions are smaller and simpler, such as purchase of a truck, machine tool, or computer system. • Corporations make thousands of these smaller investment decisions every year • The cumulative amount of small investments can be just as large as that of the occasional big investments. • Financial mangers do not make major investment decisions in solitary confinement. They may work as part of the team or engineers and managers from manufacturing, marketing, and other business functions. Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Financing Decisions 1-21 • A corporations can raise money from lenders or from shareholders. • If it borrows the lenders contribute the cash and the corporation promises to pay back the debt plus a fixed rate of interest. • If the shareholders put up cash, they do not get a fixed return, but they hold shares of stock and therefore get a fraction of future profits and cash flows. • Shareholders are equity investors, who contribute equity financing. • Capital structure decision o Choice between debt and equity financing o Capital refers to firm’s sources of long-term financing Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Financing Decisions 1-22 • Suppose the firm decides to borrow. • Should it borrow from a bank or borrow by issuing bonds that can be traded by investors? • Should it borrow for 1 year or 20 years? • If it borrows for 20 years, should it reserve the right to pay off the debt early? • Should it borrow in Paris, receiving and promising to repay in euros, or should it borrow dollars in New York? Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Financing Decisions Bob’s Burger Corporation P10M net income 1-23 • Corporations raise equity financing in two ways: - First, they can issue new shares put up cash in exchange for a fraction of the corporation’s future cash flow and profits. - Second, the corporation can take the cash flow generated by its existing assets and reinvest that cash in new assets. In this case the corporation is reinvesting on behalf of existing stockholders. No new shares are issued. Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Financing Decisions 1-24 • Financing decisions may not add much value, compared with good investment decision • They can destroy value if they are ambushed by bad news. Business is inherently risky. The Financial manager needs to identify the risks and make sure they are managed properly. • For example debt has its advantages, too much debt can land the company in bankruptcy. Companies can also be knocked off course by recessions, by changing the commodity prices, interest rates and exchange rates or by adverse political developments. Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Financing Decisions 1-25 • https://youtu.be/iocjY9L6K8w Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. What Is a Corporation? 1-26 • Corporation oA corporation’s board of directors (BOD) are elected by the shareholders oBOD choose and advise top management and must sign off on important corporation actions, such as mergers and payment of dividends to shareholders. oShareholders have limited liability, which they cannot be held personally responsible for the corporation’s debts. oPublic companies which shares are traded in public markets such as the New York Stock Exchange &PSE. Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. What Is a Corporation? 1-27 • Corporation oTwo types of stocks ✓ common-with voting rights - earnings is unlimited based on net income ✓ preferred-without voting rights senior stocks - fixed dividends-hybrid Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. What Is a Corporation? 1-28 • Corporation oIs a legal entity. oIn the view of the law, it is a legal person that is owned by its shareholders oAs a legal person, the corporation can make contracts, carry on a business, borrow or lend money and sue or be sued. oCan make a takeover bid for another and then merge and two businesses oCorporations pay taxes oCorporations are formed under state law, based on articles of incorporation that set out the purpose of the business and how it is to be governed and operated . Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. What Is a Corporation? 1-29 • Corporation oA large public corporation may have hundreds of thousands of shareholders who own the business but cannot possibly manage and control it directly oToday’s stockholders can sell all their shares to new investors without disrupting the operations of the business oIn principle, can live forever Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. What Is a Corporation? 1-30 • Types of Corporations oPublic companiesoPrivate corporations oLimited liability corporations (LLC)- Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Other Forms of Business Organization 1-31 • Types of business organizations o Sole proprietorships o Partnerships o Corporations o Limited liability options ✓ Limited liability partnerships ✓ Limited liability companies ✓ Professional limited liability companies-use by doctors, lawyers, and accountants. The business has limited liability but the professional can still be sued personally-for malpractice • Limited liability: o The owners of a corporation are not personally liable for its obligations. Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. The Role of the Financial Manager 1-32 • Financial manager stands between the firm and outside investors. • Financial manager helps manage the firm’s operations, particularly by helping to make good investment decisions. • Financial manager deals with investors—not just with shareholders but also with financial institutions such as banks and with financial markets such as the NYSE/PSE Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Figure 1.1 Flow of Cash between Financial Markets and the Firm’s Operations 1-33 1) 2) 3) 4) Cash raised by selling financial assets to investors Cash invested in the firm’s operations and used to purchase real assets Cash generated by the firm’s operations (a) Cash reinvested (b) Cash returned to investors Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. The Financial Goal of the Corporation 1-34 • Access to Financial Markets oTo maximize current wealth is a sensible goal when the shareholders have access to well functioning financial markets. oFinancial markets allow them to adjust risks ad transport savings across time. oFinancial markets give them the flexibility to manage their own saving and investments plans, leaving the corporation’s managers with only one task: to increase market value oA corporation’s roster of shareholders usually includes both risk-averse and risk-tolerant investors Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. The Financial Goal of the Corporation 1-35 • Stockholders want three things oTo maximize current wealth oTo transform wealth into most desirable time pattern of consumption either by borrowing to spend now or investing to spend later oTo manage risk characteristics of chosen consumption plan Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. The Financial Goal of the Corporation Continued 1-36 • Stockholders do not need the financial manager’s help to achieve the best time pattern of consumption. They can do that on their own, provided they have free access to competitive markets. They can choose the risk characteristics of their consumption plan by investing in more-or less-risky securities • How then can financial manager help the firm’s stockholders? There is only one way: by increasing their wealth. That means increasing the market value of the firm and current price of its shares Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. A Fundamental Result 1-37 • Profit maximization oNot a well-defined financial objective ✓Which year’s profits? ▪ Shareholders will not welcome higher shortterm profits if long-term profits are damaged ✓Company may increase future profits by cutting year’s dividend, investing freedup cash in firm ▪ Not in shareholders’ best interest if company earns less than opportunity cost of capital Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. A Fundamental Result 1-38 • Each Stockholder wants three things: a. To be as rich as possible, that is, to maximize his or her current wealth. b. To transform that wealth into the most desirable time pattern of consumption either by borrowing to spend now or investing to spend later. c. To manage the risk characteristics of that consumption plan. Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. A Fundamental Result 1-39 • Stockholders do not need the financial manger’s help to achieve the best time patten of consumption. They can do that on their own, provided they have free access to competitive financial markets. • They can also choose the risk characteristics of their consumption plan by investing in moreor less-risky securities. Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. A Fundamental Result 1-40 • How then can the financial manager help the firm’s stockholders? There is only one way: by increasing their wealth. That means increasing the market value of the firm and the current price of its shares. Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. The Investment Trade-off 1-41 • Shareholders desire wealth maximization • Managers have many constituencies, “stakeholders” • “Agency problems” represent the conflict of interest between management and owners Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Figure 1.2 Investment Trade-Off 1-42 Arrows represent possible cash flows or transfers. Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. The investment trade-off 1-43 oHurdle rate/cost of capital ✓Minimum acceptable rate of return on investment oOpportunity cost of capital ✓Investing in a project eliminates other opportunities to use invested cash ✓Corporations increase value by accepting all investment projects that earn more than the opportunity cost of capital. ✓Shareholders are not just risk averse, also they have to trade off risk against return when they invest on their own. Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. The investment trade-off 1-44 oManagers look to the financial markets to measure the opportunity cost of capital for the firm’s investment projects. oThey observe the opportunity cost of capital for safe investments by looking up current interest rates on safe debt securities. For risky investments, the opportunity cost of capital has to be estimated. Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Agency Problem and Corporate Governance 1-45 • The owner (shareholders) cannot control what the managers do, except indirectly through the board of directors. • This separation is necessary but also dangerous. • Managers maybe tempted to buy sumptuous corporate jets or to schedule business meeting at expensive resorts. • They may shy away from attractive but risky projects because they are worried more about the safety of their jobs than about maximizing shareholder value. Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Agency Problem and Corporate Governance 1-46 • Managers may work just to maximize their own bonuses, and therefore redouble their efforts to make and resell flawed subprime mortgages. Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Agency Problem and Corporate Governance 1-47 • Conflicts between shareholders’ and managers’ objectives create agency problems. • Agency problem arise when agents do not work for principals. • The shareholders are the principals; the managers are their agents. Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Agency Problem and Corporate Governance 1-48 • Agency costs are incurred when 1. Managers do not attempt to maximize the firm value 2. Shareholders incur costs to monitor the managers and constrain their actions Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Agency Problem Concluded 1-49 • Corporate governance oThe laws, regulations, institutions, and corporate practices that protect shareholders and other investors Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. References 1-50 • https://businessmirror.com.ph/2021/11/04/jollibee-acquirestaiwans-milkshop/ Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
