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Chapter One
IntroductionCorporate
to Finance
Ross Westerfield Jaffe
Corporate Finance   1
Sixth Edition

Prepared by
Gady Jacoby
University of Manitoba
and
Sebouh Aintablian
American University of
Beirut
McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited
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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 Institutions, Financial Markets, And The
Corporation
1.6 Trends in Financial Markets and Management
1.7 Outline of the Text

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What is Corporate Finance?

Corporate Finance addresses the following

three questions:

1. What long-term investments should the firm

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

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The 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 Balance-Sheet Model of the Firm

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

Fixed Assets What long-

term
1 Tangible investments Shareholders’
2 Intangible should the Equity
firm engage
in?
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The Balance-Sheet Model of the Firm

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

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The Balance-Sheet Model of the Firm

The Net Working Capital Investment Decision
Current
Liabilities
Current
Net
Assets Working Long-Term
Capital Debt

How much short-

Fixed Assets
term cash flow
1 Tangible does a company
need to pay its Shareholders’
2 Intangible bills? Equity

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Capital Structure

The value of the firm can be

thought of as a pie.

The goal of the manager is 70%50%30%

25%
to increase the size of the DebtDebt
Equity
pie.
75%
50%
The Capital Structure Equity
decision can be viewed as
how best to slice up the pie.

If how you slice the pie affects the size of the

pie, then the capital structure decision matters.

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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 Finance

Treasurer Controller

Cash Manager Credit Manager Tax Manager Cost Accounting

Capital Expenditures Financial Planning Financial Accounting Data Processing

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The Financial Manager

To create value, the financial manager

should:
1. Try to make smart investment decisions.
2. Try to make smart financing decisions.

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The Firm and the Financial Markets

Firm Firm issues securities (A) Financial

markets
Invests
Retained
in assets cash flows (D)
(B)
Short-term debt
Current assets Cash flow Dividends and Long-term debt
Fixed assets from firm (C) debt payments (F)
Equity shares

Taxes (E)

Ultimately, the firm The cash flows from

must be a cash the firm must exceed
Government
generating activity. the cash flows from
the financial markets.
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1.2 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 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.

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Debt and Equity as Contingent Claims

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

$F $F
Value of the firm (X) Value of the firm (X)

Debt holders are promised If the value of the firm

$F. is more than $F, share
If the value of the firm is less than $F,
holders get everything
they get whatever the firm is worth.
above $F.
Algebraically, the bondholder’s Algebraically, the shareholder’s
claim is: Min[$F,$X] claim is: Max[0,$X – $F]
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Combined Payoffs to Debt and Equity

Combined Payoffs to debt holders If the value of the firm is less than
and shareholders $F, the shareholder’s claim is:
Max[0,$X – $F] = $0 and the debt
holder’s claim is Min[$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 $F, the shareholder’s claim is:
Max[0,$X – $F] = $X – $F and the
$F debt holder’s claim is:
Value of the firm (X)
Min[$F,$X] = $F.
Debt holders are promised
$F. The sum of these is = $X

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1.3 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

• Advantages and Disadvantages

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

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A Comparison of Partnership and Corporations

  Corporation Partnership

Liquidity Shares can easily be 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 with dividend tax Partnership income is

credit taxable.

Reinvestment Broad latitude All net cash flow is

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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1.4 Goals of the Corporate Firm

• What are firm decision-makers hired to do?

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

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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’ behaviour.
• This contracting and monitoring is costly.

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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
the same thing as increased shareholder
wealth.

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Separation of Ownership and Control

Board of Directors

Debtholders

Shareholders
Management

Debt
Assets
Equity

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The Agency Problem

• The agency relationship

• Will managers work in the shareholders’ best
interests?
– Agency costs
– Direct agency costs
– Indirect agency costs
• Control of the firm
• How do agency costs affect firm value (and
shareholder wealth)?
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Do Shareholders Control Managerial Behaviour?

• 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
managers—they can be replaced.
• If the managers fail to maximize share price,
they may be replaced in a hostile takeover.
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1.5 Financial Institutions, Financial
Markets, and the Corporation
• Financial Institutions
Indirect finance
Funds Deposits Financial Loans Funds
suppliers intermediaries demanders

Direct finance

Funds Financial Funds

suppliers intermediaries demanders

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Financial Markets

Money versus Capital Markets

• Money Markets
– For short-term debt instruments
• Capital Markets
– For long-term debt and equity

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Financial Markets

Primary versus Secondary 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-
the-counter in a dealer market.
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Financial Markets

Stocks and
Investors
Bonds
Firms securities
Money Bob Sue
money

Primary Market
Secondary
Market

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1.6 Trends in Financial Markets and
Management
• Integration and globalization
• Increased volatility
• Financial Engineering reduces costs related to
– Risk
– Taxes
– Fnancing costs
• Improved computer technology allows
Economies of scale and scope
• Regulatory dialectic
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1.7 Outline of the Text

I. Overview
II. Value and Capital Budgeting
III. Risk
IV. Capital Structure and Dividend Policy
V. Long-Term Financing
VI. Options, Futures, and Corporate Finance
VII. Financial Planning and Short-Term Finance
VIII. Special Topics

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