Ch 1. Introduction to Corporate
Finance
1. Corporate Finance
• Def: Corporate Finance (Financial Management)
is an area dealing with Capital budgeting, Capital
structure and working capital Management.
• Capital budgeting is the process of planning and
managing a firm’s long term investments.
• Capital structure is the mixture of debt and
equity maintained by a firm
• Working capital management is about managing
short term assets and liabilities.
2. Forms of Business Organization
• 1) sole proprietorship:
• A business is owned by a single owner. Income is taxed as
personal income.
• Advantage:
• - easy and inexpensive to set up
• - owner keeps all profits
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Disadvantage:
- unlimited liability
- limited to life of owner
- limited capability of raising capitals
• 2) Partnership
• A business is formed by two or more individuals.
Income is taxed as personal income to partners.
• Advantage:
• - easy and inexpensive to set up
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Disadvantage:
- unlimited liability
- limited life until the partnership is maintained
- limited in transferring ownership
- limited to raise capitals
• 3) Corporation: a business created as a distinct
legal entity composed of one or more
individuals and entities. Ownership is
separated from management.
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Advantage:
- easy to raise capital
- easy to transfer ownership
- limited liability
- unlimited life
• Disadvantage:
• - expensive and not easy to set up
• - double taxation: taxes on corporate and
shareholders
• 4) Limited Liability Company (LLC)
• A hybrid of partnership and corporation
• Taxed like partnership but rating limited
liability for owners.
3. Goal of Financial Management
• To maximize the current value per share (stock) of the existing
stock.
• In general, to maximize the market value of the existing owners’
equity.
• Sarbanes-Oxley in 2002
• - company’s annual report must have an assessment of company’s
internal control structure and financial reporting. The auditor must
evaluate and attest to management’s assessment to these issues.
• - increase the cost of audit to the companies. To avoid the this
cost, public firms have chosen “go dark” – their stocks are no longer
traded in the major stock exchange markets. Or to save the
compliance costs, US firms decided to go public on the London
Stock Exchange’s Alternative Investment Market
4. Agency problem and control of
corporation
• 1) agency relationship: a relation in which one hires
others to represent one’s interest.
• E.g) stock holders and managers
• 2) agency problem: the possibility of conflict of interest
between the stock holders and management of the
firm.
• E.g) a renovation project benefiting managers but
costing stockholders.
• E.g) a very risk project benefiting stockholders but
risking the position of the management.
• 3) agency costs: cost of conflict on interest
between stockholders and managers.
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Two types of agency costs:
(1) indirect cost: lost investment opportunities.
(2) direct cost:
- corporate expenditure benefiting managers but
costing stockholders
• - an expense in order to monitor the managers’
behavior.
• 4) how to align interest of management with that
of share (stock) holders?
• - Compensation basing on the performance
• (e,g) stock option to employee
• (e.g) salaries
• - Control of the firm: manager replacement
• (e.g) proxy fight to step down managers
• (e.g) takeover leading to replace the existing
managers with new managers.
• 5) Stakeholders: someone other than a
stockholder or creditor who potentially has a
claim on the cash flows of the firm. E.g)
employees, customers, suppliers, government.
These groups exert control over the firm.
5. Financial markets and corporation
• Financial markets in which corporations can raise
capitals by selling equities or borrowing.
• Primary market: original sale of equity or debt by
corporations or government
• - public offering registering with SEC
• - private offering not registering with SEC
• Secondary market: the market where securities are
bought and sold after the original sale. E.g) NYSE
• Dealer versus Auction Markets
- Dealer market (over-the-counter): dealers who
own securities are connected electronically.
- Auction market: it has physical location and
match those who wish to sell with those who
wish to buy.
• Trading in corporate securities: NYSE, AMEX, OTC,
NASDAQ
• Listing: stocks that trade on an organized
exchange are said to be listed on that exchange.
To be listed, firms must meet certain minimum
criteria concerning, for example, asset size,
number of shareholders, etc.