Introduction to Corporate Finance

Chapter One

FIN 6301 Financial Management

Instructor:

Mary Chaffin SOM 2.208 972-883-2646 [email protected]

Monday 4:00-6:30 p.m. Wednesday 2:00-3:30 p.m.

Office Hours:

Corporate Finance

Ross, Westerfield and Jaffee, 7th Edition www.utdallas.edu/~chaf

Copies of the transparencies. Solutions to end of chapter problems. Old exams. Appendix D: Using a Financial Calculator. Review material and practice quizzes.

www.mhhe.com/rwj

Grading

Exam I 30% or 15% Exam II 30% or 15% Final Exam 40% Assignments 15% Formula sheet allowed on exams - not quizzes. Notice of Policy on Cheating

Other Resources

Wall Street Journal Barrons Financial Calculator

The Four Basic Areas of Finance

Corporate Finance

Broadest field Specific to operations of a business Interrelation on a smaller scale then money and capital markets
Workings of the financial system Broad flow of money

Investments

Money and Capital Markets

International Finance

Areas of Finance

Financial Markets

The Firm
Financial Intermediaries

Investors

Financial Calculators

HP 10B ($30) HP 17B II ($80) HP 12C ($70) HP 19B II ($100+) TI BA II + ($30)

Financial Calculators

HP 10B TI BA II+ Tips on using calculator:

Set p/y=1 (This comes set at 12 on a new calculator) Clear registers before each use Set decimals to 4 places

Solution Methods

Numerical using regular calculator without financial functions. Interest Tables - end of text. Financial Calculator using five specific keys which correspond to the five most commonly used DCF variables:

PV

PMT

FV

What is Corporate Finance?

Corporate Finance addresses the following three questions:
1.

2.

3.

What long-term investments should the firm engage in? How can the firm raise the money for the required investments? How much short-term cash flow does a company need to pay its bills?

Microsoft to Dole Out Its Cash Hoard

In an extraordinary move to shower its cash hoard upon shareholders, Microsoft Corp. said it will make a one-time dividend payment this year of $32 billion and buy back up to $30 billion of the company's stock over the next four years. The company also said it will double the dividend it pays out annually to $3.5 billion, or 32 cents a share. The plans, which Microsoft valued at up to $75 billion over four years, are believed to represent the largest corporate cash disbursement in history. They mark a turning point for high technology's most successful company.

Capital Structure
The value of the firm can be thought of as a pie. The goal of the manager is to increase the size of the pie. 70% 30% 25%50% DebtDebt Equity 75% 50% Equity

The Capital Structure decision can be viewed as how best to slice up a the pie. If how you slice the pie affects the size of the pie, then the capital structure decision matters.

The Financial Manager

To create value, the financial manager should: 1. Try to make smart investment decisions. 2. Try to make smart financing decisions.

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 shareholders 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.

Debt and Equity as Contingent Claims

Payoff to debt holders If the value of the firm is more than $F, debt holders get a maximum of $F. $F Payoff to shareholders If the value of the firm is less than $F, share holders get nothing.

$F Value of the firm (X)

$F Value of the firm (X)

If the value of the firm Debt holders are promised $F. is more than $F, share If the value of the firm is less than $F, they holders get everything get the whatever the firm if worth. above $F. Algebraically, the bondholders Algebraically, the shareholders claim is: Min[$F,$X] claim is: Max[0,$X $F]

Combined Payoffs to Debt and Equity

Combined Payoffs to debt holders and shareholders If the value of the firm is less than $F, the shareholders claim is: Max[0,$X $F] = $0 and the debt holders claim is Min[$F,$X] = $X.

The sum of these is = $X Payoff to shareholders $F

If the value of the firm is more than Payoff to debt holders $F, the shareholders claim is: Max[0,$X $F] = $X $F and the $F debt holders claim is: Value of the firm (X)
Min[$F,$X] = $F. The sum of these is = $X

Debt holders are promised $F.

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.

Forms of Business Organization

The Sole Proprietorship The Partnership

General Partnership Limited Partnership

The Corporation Advantages and Disadvantages

Liquidity and Marketability of Ownership Control Liability Continuity of Existence Tax Considerations

Goals of the Corporate Firm

The traditional answer is that the managers of the corporation are obliged to make efforts to maximize shareholder wealth.

The Set-of-Contracts Perspective

The firm can be viewed as a set of contracts. One of these contracts is between shareholders and managers. The managers will usually act in the shareholders interests.

The shareholders can devise contracts that align the incentives of the managers with the goals of the shareholders. The shareholders can monitor the managers behavior.

This contracting and monitoring is costly.

Managerial Goals

Managerial goals may be different from shareholder goals

Expensive perquisites Survival Independence

Increased growth and size are not necessarily the same thing as increased shareholder wealth.

Do Shareholders Control Managerial Behavior?

Shareholders vote for the board of directors, who in turn hire the management team. Contracts can be carefully constructed to be incentive compatible. There is a market for managerial talent this may provide market discipline to the managersthey can be replaced. If the managers fail to maximize share price, they may be replaced in a hostile takeover.

Financial Markets

Primary Market

When a corporation issues securities, cash flows from investors to the firm. Usually an underwriter is involved
Involve the sale of used securities from one investor to another. Securities may be exchange traded or trade overthe-counter in a dealer market.

Secondary Markets

Exchange Trading of Listed Stocks

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. Transaction prices of shares are communicated almost immediately to the public.