Chapter 1

Introduction to Corporate Finance

Copyright © 2015 by the McGraw-Hill Education (Asia). All rights reserved.

Key Concepts and Skills
 Know the basic types of financial management
decisions and the role of the Financial Manager
 Know the financial implications of the various
forms of business organization
 Know the goal of financial management
 Understand the conflicts of interest that can
arise between owners and managers
 Understand the various regulations that firms
face
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Chapter Outline
1.1 What is Corporate Finance?
1.2 The Corporate Firm
1.3 The Importance of Cash Flows
1.4 The Goal of Financial Management
1.5 The Agency Problem and Control of the
Corporation
1.6 Regulation

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1.1 What Is Corporate Finance?
Corporate Finance addresses the following
three questions:
1. What long-term investments should the firm
choose?
2. How should the firm raise funds for the selected
investments?
3. How should short-term assets be managed and
financed?

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Balance Sheet Model of the Firm
Total Value of Assets: Total Firm Value to Investors:
Current
Liabilities
Current Assets
Long-Term
Debt

Fixed Assets
1 Tangible
Shareholders’
2 Intangible Equity

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The Capital Budgeting Decision
Current
Liabilities
Current Assets
Long-Term
Debt

Fixed Assets
What long-term
1 Tangible investments Shareholders’
should the firm
2 Intangible Equity
choose?

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The Capital Structure Decision
Current
Liabilities
Current Assets
Long-Term
How should the Debt
firm raise funds
for the selected
Fixed Assets
investments?
1 Tangible Shareholders’
2 Intangible Equity

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Short-Term Asset Management
Current
Liabilities
Current Assets
Net
Working Long-Term
Capital Debt

How should
Fixed Assets
short-term assets
1 Tangible be managed and
financed? Shareholders’
2 Intangible Equity

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The Financial Manager
The Financial Manager’s primary goal is to
increase the value of the firm by:
1. Selecting value creating projects

2. Making smart financing decisions

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Hypothetical Organization Chart
Board of Directors

Chairman of the Board and

Chief Executive Officer (CEO)

President and Chief

Operating Officer (COO)

Vice President and

Chief Financial Officer (CFO)

Treasurer Controller

Cash Manager Credit Manager Tax Manager Cost Accounting

Capital Expenditures Financial Planning Financial Accounting Data Processing

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1.2 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.

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Forms of Business Organization
 The Sole Proprietorship
 The Partnership
 General Partnership
 Limited Partnership
 The Corporation

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A Comparison
Corporation Partnership

Liquidity Shares can be easily Subject to substantial

exchanged restrictions

Voting Rights Usually each share gets one General Partner is in charge;
vote limited partners may have
some voting rights

Taxation Double Partners pay taxes on

distributions
Reinvestment and dividend Broad latitude All net cash flow is
payout distributed to partners

Liability Limited liability General partners may have

unlimited liability; limited
partners enjoy limited
liability
Continuity Perpetual life Limited life

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International Corporations

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1.3 The Importance of Cash Flow
Firm Firm issues securities (A) Financial
markets
Invests
Retained
in assets cash flows (F)
(B)
Short-term debt
Current assets Cash flow Dividends and Long-term debt
Fixed assets from firm (C) debt payments (E)
Equity shares

Taxes (D)

Ultimately, the firm The cash flows from

the firm must exceed
must be a cash Government
the cash flows from
generating activity.
the financial markets.
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1.4 The Goal of Financial Management
 What is the correct goal?
 Maximize profit?
 Minimize cost?
 Maximize market share?
 Maximize shareholder wealth?

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1.4 Goal of Finance
– Maximizing profit?
 Maximizing profit is not a suitable goal
because:
 Profits can be increased by reducing cost.
 This is discussed in the next slide.
 Profits are not cash flows
 Risk is not taken into account

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1.4 Goal of Finance
- Minimizing cost?
 Minimizing cost is not a suitable goal because:
 Minimizing costs may increase current profits but
the future well-being of the company may be
affected, for example,
 Reducing maintenance costs may result in machines
breaking down earlier in the future
 Reducing R&D expenditures may cause the products to
be less competitive
 Reducing headcount may reduce the quality of service

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1.4 Goal of Finance
- Maximizing market share?
 Maximizing market share is not a suitable
goal because:
 In order to increase market the firm may large
amounts in advertising and promotion
 Having a large market share may not translate
into higher profits if the firm cannot increase
revenue much more by increasing prices

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1.4 Goal of Finance
- Maximizing shareholder wealth?
 This is the right goal of finance because:
 It avoids the problems of the other goals by
taking risk into consideration, as well as the
impact on future cash flows of the firm’s actions
 An investment may promise high returns, but if the
risks involved are too high, then the investment may
not be viable.
 As the share price depends not only on current cash
flows but future cash flows as well, any action taken
by the firm would consider not just the short term
effects but the long term effects to the firm
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1.5 The Agency Problem
 Agency relationship
 Principal hires
an agent to represent his/her interest
 Stockholders (principals) hire managers (agents) to
run the company
 Agency problem
 Conflict of interest between principal and agent

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Managerial Goals
 Managerial goals may be different from
shareholder goals
 Expensive perquisites
 Survival
 Independence
 Increased growth and size are not necessarily
equivalent to increased shareholder wealth

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Managing Managers
 Managerial compensation
 Incentivescan be used to align management and
stockholder interests
 The incentives need to be structured carefully to
make sure that they achieve their intended goal
 Corporate control
 The
threat of a takeover may result in better
management
 Other stakeholders

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1.6 Regulation
 Securities Acts
 Each country has its own securities acts to govern
the operations of the securities markets in relation
to
 Trading of securities
 Issue of new securities
 Corporate disclosure and insider trading
 Sarbanes-Oxley (“Sarbox”)
 Increased reporting requirements and
responsibility of corporate directors
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Corporate Governance
 Corporate governance relates to the rights and
responsibilities of various stakeholders in the
firm
 A firm with good corporate governance would
 Respect the rights of the shareholders and other
stakeholders
 Ensure that the board of directors represent the
best interests of shareholders
 Operate in a transparent manner
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Quick Quiz
 What are the three basic questions Financial
Managers must answer?
 What are the three major forms of business
organization?
 What is the goal of financial management?

 What are agency problems, and why do they

exist within a corporation?
 What major regulations impact public firms?

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