Chapter 1: Introduction to
corporate finance
Corporate Finance
Ross, Westerfield &
Jaffe
Outline
1.1 What is corporate finance?
1.2 The goal of financial management
1.3 The agency problem and control of the
corporation
1.4 Ethics and corporate governance
1.5 Financial markets
Main tasks of corporate finance
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Capital budgeting: the process of planning
and managing a firm’s long-term
investments  fixed assets.
Capital structure: the mixture of debt and
equity maintained by the firm  S-T and LT debt and equity.
Working capital management: a firm’s shortterm assets and liabilities  current assets
and current liabilities.
The Capital Budgeting Decision
Current
Liabilities
Current
Assets
Fixed Assets
1 Tangible
2 Intangible
Long-Term
Debt
What long-term
investments
should the firm
choose?
Shareholders
’ Equity
Modern form of firms
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Corporation: a business created as a distinct legal
entity composed of one or more individuals or
entities, e.g., IBM.
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Separation of control (shareholders) and management
(professionals).
Ownership can be easily transferred.
Limited liability.
Double taxation.
Rather expensive to form.
Agency problems.
Who make the decisions?
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Owners (typically in small businesses).
Professional managers.
Financial managers
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Frequently, financial managers try to address
these tasks.
The top financial manager within a firm is
usually the Chief Financial Officer (CFO).
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Treasurer – oversees cash management, credit
management, capital expenditures and financial
planning.
Controller – oversees taxes, cost accounting,
financial accounting and data processing.
Possible goals of financial
management
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Survive
Beat the competition
Maximize sales
Maximize net income
Maximize market share
Minimize costs
Maximize the value of (stock) shares
The “appropriate” goal of financial
management
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Maximize the (fundamental or economic) value of
(stock) shares is the right goal.
Why? Shareholders own shares. Managers, as
agents, ought to act in a way to benefit
shareholders; i.e., to enhance the value of the
shares.
A limitation of this goal is that value is not directly
observable.
Home Depot CEO gets $210 million
severance for sucking at job
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Robert L. Nardelli, the CEO of Home Depot,
who came under heavy criticism for his pay
package and failure to lift the chain ’s
stagnant stock price, has abruptly resigned.
He will receive about $210 million in
compensation from the company, including
the current value of retirement and other
benefits. Who would blame him for quitting?
Source:digg.com; submitter: tennova.
Value vs. price
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The value of shares are not observable. In contrast,
the price of shares can be observable.
If one believes that share price is an accurate/good
estimate of share value, the appropriate goal would
be to maximize the price of shares.
This belief/assumption is, however, questionable.
But the previous slide (Home Depot ex-CEO),
nevertheless, showed that investors care about
stock price, and that stock price performance is very
important to the tenure of managers.
The agency problem
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Agency relationship:
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Principals (citizens) hire an agent (the president) to
represent their interest.
Principles (stockholders) hire agents (managers) to run the
company.
Agency problem:
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Conflict of interest between principals and agents.
This occurs in a corporate setting whenever the agents do
not hold 100% of the firm’s shares.
The source of agency problems is the separation of
(owners’) control and management.
Agency costs
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Direct costs: (1) unnecessary expenses,
such as a corporate jet, and (2) monitoring
costs.
Indirect costs. For example, a manager
may choose not to take on the optimal
investment. She/he may prefer a less risky
project so that she/he has a higher
probability keeping her/his tenure.
Managerial incentives
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Managerial goals are frequently different
from shareholders’ goals.
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Expensive perks.
Survival.
Independence.
Growth and size (related to compensation)
may not relate to shareholders’ wealth.
Corporate governance
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Compensation:
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Corporate control:
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Incentives ($$$, options, threat of dismissal, etc.) used to
align management and stockholder interests.
Managers may take the threat of a takeover seriously and
run the business in the interest of shareholders.
Pressure from other stakeholders (e.g., CalPERS, a
powerful corporate police).
Sarbanes-Oxley Act (2002)
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“Sarbox.”
10K must have an assessment of the firm’s
internal control structure and financial
reporting.
The officers must explicitly declare that 10K
does not contain any false statements or
material omissions.
The officers are responsible for all internal
controls.
Ethics
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Managers are expected to behave in an ethical
manner.
The province of ethics is to sort out what is good and
bad.
But, what is the criterion or guideline for doing so?
Philosophers came up with some criteria, but none
of them makes sorting out what is good and bad an
easy task.
Here, we introduce two of these criteria.
Principle 1
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Golden rule: Do unto others as you would
have others do onto you.
But the next example, the so-called
Sopranoism, shows the limitation of this
principle: Whack the next guy with the same
respect you’d like to be whacked with, you
know? (Source: Cathcart and Klein, 2007).
Principle II
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Confucianism: Do not do to others what you
do not want done to yourself.
This is a rather robust (but passive) criterion.
But its limitation is that it says nothing about
what you should do.
Dilemma
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Ethical decisions often yield a dilemma.
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Suppose that you were the CEO of investment bank
XYZ in 2005. The debt/equity ratio of the bank was
20. All of your competitors raised their debt/equity
ratios to 30 to please the stock market so that their
stock prices could be higher than otherwise would
be. You knew that raising the debt/equity ratio to 30
was rather risky and could destroy the bank if
business went wrong. But you knew the investors
would be disappointed by the otherwise lower share
price if you did not raise the debt/equity ratio.
So, what is the answer?
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I do not have an answer for this kind of
ethical question because it is a dilemma;
otherwise, I would not use the word
“dilemma.”
All I know is that you, as professional
managers, are expected to behave ethically.
One thing I know for sure is that never do
anything that will put you in a prison cell; you
are too cute for a prison cell.
Financial markets
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Cash flows (i.e., financing and
payoffs/dividends/interests) between firms
and financial markets.
Primary markets.
Secondary markets.
NYSE.
Nasdaq.
Info about financial markets
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Yahoo! Finance.
End-of-chapter
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Concept questions: 1-10.