Eighth Edition
McGraw-Hill/Irwin
Corporate Finance, 7/e
1-1
CHAPTER
1
Introduction to
Corporate Finance
McGraw-Hill/Irwin
Corporate Finance, 7/e
© 2005 The McGraw-Hill Companies, Inc. All Rights Reserved.
1-2
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 Markets
McGraw-Hill/Irwin
Corporate Finance, 7/e
© 2005 The McGraw-Hill Companies, Inc. All Rights Reserved.
1-3
1.1 What is Corporate Finance?
Corporate Finance addresses the following three questions:
1. What long-term investments should the firm engage in?
 Capital budgeting decision
2. How can the firm raise the money for the required
investments?
 Capital structure decision
3. How much short-term cash flow does a company need to pay
its bills?
 Cash and Working capital management
McGraw-Hill/Irwin
Corporate Finance, 7/e
© 2005 The McGraw-Hill Companies, Inc. All Rights Reserved.
1-4
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
McGraw-Hill/Irwin
Corporate Finance, 7/e
Shareholders’
Equity
© 2005 The McGraw-Hill Companies, Inc. All Rights Reserved.
1-5
The Balance-Sheet Model
of the Firm
The Capital Budgeting Decision
Current
Liabilities
Current Assets
Long-Term
Debt
Fixed Assets
1 Tangible
2 Intangible
McGraw-Hill/Irwin
Corporate Finance, 7/e
What longterm
investments
should the
firm engage
in?
Shareholders’
Equity
© 2005 The McGraw-Hill Companies, Inc. All Rights Reserved.
1-6
The Balance-Sheet Model
of the Firm
The Capital Structure Decision
Current
Liabilities
Current Assets
How can the firm
raise the money
for the required
Fixed Assets
investments?
1 Tangible
2 Intangible
McGraw-Hill/Irwin
Corporate Finance, 7/e
Long-Term
Debt
Shareholders’
Equity
© 2005 The McGraw-Hill Companies, Inc. All Rights Reserved.
1-7
The Balance-Sheet Model
of the Firm
The Net Working Capital Investment Decision
Current Assets
Fixed Assets
1 Tangible
2 Intangible
McGraw-Hill/Irwin
Corporate Finance, 7/e
Current
Liabilities
Net
Working
Capital
How much shortterm cash flow
does a company
need to pay its
bills?
Long-Term
Debt
Shareholders’
Equity
© 2005 The McGraw-Hill Companies, Inc. All Rights Reserved.
1-8
Functions of Financial Markets
Bridging the gap between net borrowers and net savers. Net
borrowers or investors are the deficit sector. They demand loan. Net
savers are surplus sector. They supply loan. The two groups do not
know each other, financial market brings them together.
Providing the equilibrium interest rate. Net savers like to get
more interest and net borrowers like to pay less interest. Financial
market provides the equilibrium rate.
Coordinating the liquidity preference: Net savers like to have
more liquidity and net borrowers offer less liquidity. Financial
market matches the preferences.
Coordinating the risk preferences: Net savers like more return
with less risk and net borrowers often involve in high risk high
return projects. Financial market matches the preferences.
Separation principle: Financial institutions separate the pattern of
current consumption from the pattern of current income by means
of intertemporal consumption function. People in need of more
current consumption than current income borrow money. People
who like to defer consumption lend money.
McGraw-Hill/Irwin
Corporate Finance, 7/e
© 2005 The McGraw-Hill Companies, Inc. All Rights Reserved.
1-9
Equilibrium interest rate:
(Loanable Fund Theory)
i
S (Savings)
k
D (Investment)
Quantity of Loanable Fund
McGraw-Hill/Irwin
Corporate Finance, 7/e
© 2005 The McGraw-Hill Companies, Inc. All Rights Reserved.
1-10
Intertemporal consumption:
Separation Principle
C1
210
Lending
i=10%
100
Borrowing
100
McGraw-Hill/Irwin
Corporate Finance, 7/e
190.9
Co
© 2005 The McGraw-Hill Companies, Inc. All Rights Reserved.
1-11
Intertemporal consumption:
Effects of change in interest rate
C1
Lending
220
i=10%
210
i=20%
Borrowing
100
100
McGraw-Hill/Irwin
Corporate Finance, 7/e
183 190.9
Co
© 2005 The McGraw-Hill Companies, Inc. All Rights Reserved.
1-12
Problem: Suppose, you can invest now in a land by
$70 to sell it by $75 next year. Should you invest?
Draw the intertemporal consumption function.
C1($)
210
208
Lending
i=10%
175
Borrowing
100
30
McGraw-Hill/Irwin
Corporate Finance, 7/e
100 189.1 190.9
Co($)
© 2005 The McGraw-Hill Companies, Inc. All Rights Reserved.
1-13
Problem: Suppose, you can invest now in a land by $70 to
sell it by $80 next year. Should you invest? Draw the
intertemporal consumption function. What is the NPV of land
investment? [Hint:(80/1.1)-70=2.7]
C1($)
213
210
Lending
180
i=10%
Borrowing
100
30
McGraw-Hill/Irwin
Corporate Finance, 7/e
100
190.9 193.6
Co($)
© 2005 The McGraw-Hill Companies, Inc. All Rights Reserved.
1-14
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 of 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.
McGraw-Hill/Irwin
Corporate Finance, 7/e
© 2005 The McGraw-Hill Companies, Inc. All Rights Reserved.
1-15
1.2 Forms of Business Organization
The Sole Proprietorship
The Partnership
The Corporation
Advantages and Disadvantages
Liquidity and Marketability of Ownership
Control
Liability
Continuity of Existence
Tax Considerations
McGraw-Hill/Irwin
Corporate Finance, 7/e
© 2005 The McGraw-Hill Companies, Inc. All Rights Reserved.
1-16
1.3 The Goal of Financial Management
What is the correct goal?
Maximize sales?
Maximize profit?
Minimize costs?
Minimize Risk?
Avoid Bankruptcy?
Maximize shareholder wealth?
McGraw-Hill/Irwin
Corporate Finance, 7/e
© 2005 The McGraw-Hill Companies, Inc. All Rights Reserved.
1-17
1.4 The Agency Problem
Board of director and managers of the corporation are
obliged to make efforts to maximize shareholder wealth.
In an ideal situation the goal of profit maximization and
of wealth maximization are not conflicting to each other.
In reality there is considerable conflict. The separation
of ownership and control is a property of company.
(Why?) However, quite often this is a source of agency
cost.
McGraw-Hill/Irwin
Corporate Finance, 7/e
© 2005 The McGraw-Hill Companies, Inc. All Rights Reserved.
1-18
Agency Cost
Managers are naturally inclined to act in their own best interests.
Expensive perquisites like high salaries and allowances of the
agency (rationalized on motivational point) increases cost.
High short term profit adds to the credentials of board of
directors. High scale investment makes the firm dependent on the
present agency.
Risky investment. If successful, credit goes to the agency, if
failure loss goes to the shareholders.
High investment: This makes the firm dependent on the present
board.
High retention of earnings: Capital gain tax is less than dividend
tax. Such an argument allows the management to distribute less
dividend and retain more earnings and thereby, to finance big and
risky investment.
McGraw-Hill/Irwin
Corporate Finance, 7/e
© 2005 The McGraw-Hill Companies, Inc. All Rights Reserved.
1-19
Solution to agency problem
Performance shares
Hostile takeover
Formal contract
Market effects
McGraw-Hill/Irwin
Corporate Finance, 7/e
© 2005 The McGraw-Hill Companies, Inc. All Rights Reserved.
1-20
Other kind of Agency cost
It is the increased rate of interest on debt for a highly
levered firm. In that case, the creditor needs to employ
some agencies to monitor the firm to ensure that their
interest is not affected with regard to:
Investment decision
Distribution of dividends
Creating new debt
Handling of mortgaged property
McGraw-Hill/Irwin
Corporate Finance, 7/e
© 2005 The McGraw-Hill Companies, Inc. All Rights Reserved.
1-21
1.5 Financial 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 over-thecounter in a dealer market.
McGraw-Hill/Irwin
Corporate Finance, 7/e
© 2005 The McGraw-Hill Companies, Inc. All Rights Reserved.
1-22
Financial Markets
Firms
Stocks and
Bonds
Investors
securities
Money
Bob
Sue
money
Primary Market
Secondary
Market
McGraw-Hill/Irwin
Corporate Finance, 7/e
© 2005 The McGraw-Hill Companies, Inc. All Rights Reserved.
1-23
Secondary market:
Auction vs. OTC markets
Auction market has a single physical location where trading is done
through bidding. Both DSE and CSE are auction markets. Shares in
USA are traded mostly (around 85%) in auction market. NYSE is an
auction market. The other form of secondary market is over-the-counter
(OTC) or dealers market where communication between buyers and
sellers with dealers are done through electronic media. Mostly bonds
and some shares are traded in OTC markets. NASDAQ (National
Association of Securities Dealers Automated Quotation) is an OTC
market. Auction markets are different from dealer markets in two ways:
Trading in a given auction exchange takes place at a single site on
the floor of the exchange whereas dealers market is spread out.
Most of the transaction in OTC markets are done with dealers with a
bid and ask spread. The primary purpose of auction market, on the
other hand, is to match the buyers and sellers at a single price.
McGraw-Hill/Irwin
Corporate Finance, 7/e
© 2005 The McGraw-Hill Companies, Inc. All Rights Reserved.