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Introduction To Finance

The document provides an overview of key concepts in corporate finance including the financial goal of maximizing shareholder wealth, investment and financing decisions, and the risk-return tradeoff. It also outlines 10 principles of corporate finance such as the time value of money, that cash flow rather than profits should be considered, and that not all risks can be diversified away.

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Лера Аношина
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110 views18 pages

Introduction To Finance

The document provides an overview of key concepts in corporate finance including the financial goal of maximizing shareholder wealth, investment and financing decisions, and the risk-return tradeoff. It also outlines 10 principles of corporate finance such as the time value of money, that cash flow rather than profits should be considered, and that not all risks can be diversified away.

Uploaded by

Лера Аношина
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Business Finance I

Chapter 1

Introduction to Corporate Finance

Book Used and copyrighted by:


Brealey,Myers, and Allen
Principles of Corporate Finance
11th Global Edition
Professor: Michael Epping

1-1 Corporate Investment and Financing Decisions


What Is a Corporation?
Legal entity, owned by shareholders
Can make contracts, carry on business, borrow, lend, sue, and be sued
Shareholders have limited liability and cannot be held personally
responsible for corporations debts

1-2 The Financial Goal of the Corporation


Stockholders Want Three Things
To maximize current wealth
To transform wealth into most desirable time pattern of consumption
To manage risk characteristics of chosen consumption plan

Profit Maximization
Not a well-defined financial objective
Which years profits?
Shareholders will not welcome higher short-term profits if long-term profits are
damaged

Company may increase future profits by cutting years dividend, investing


freed-up cash in firm
Not in shareholders best interest if company earns less than opportunity
cost of capital

1-2 The Financial Goal of the Corporation


Shareholders desire wealth maximization
Managers have many constituencies, stakeholders
Agency Problems represent the conflict of interest between management
and owners

1-1 Corporate Investment and Financing Decisions


Real Assets
Used to produce goods and services

Financial Assets/Securities
Financial claims on income generated by firms real assets

Capital Budgeting/Capital Expenditure (CAPEX)


Decision to invest in tangible or intangible assets

Financing Decision
Sale of financial assets

Capital Structure
Choice between debt and equity financing

Table 1.1 Recent Investment/ Financing Decisions


Company

Recent Investment Decisions

Recent Financing Decisions

Boeing (U.S.)

Delivers first Dreamliner after investing a


reported $30 billion in development costs.
Spends $7 billion to develop oil sands at Fort
McMurray in Alberta.

Reinvests $1.7 billion of profits.

ExxonMobil
(U.S.)

Spends $12 billion buying back shares.

GlaxoSmith-Kline Spends $4 billion on research and development Pays $3.2 billion as dividends.
(UK)
for new drugs.
LVMH (France)
LVMH acquires the Italian Jeweler, Bulgari, for $5 Pays for the acquisition with a mixture of cash and
billion.
shares.

Procter &
Gamble (U.S.)
Tata Motors
(India)
Union Pacific
(U.S.)
Vale (Brazil)
Walmart (U.S.)

Spends $8 billion on advertising.

Raises 100 billion Japanese yen by an issue of 5-year


bonds.
Raises $400 million by the sale of new shares.

Opens a plant in India to produce the world's


cheapest car, the Nano. The facility costs $400
million.
Invests $330 million in 100 new locomotives and Repays $1.4 billion of debt.
10,000 freight cars and chassis.
Opens a copper mine at Salobo in Brazil. The
project cost nearly $2 million.
Invests 12.7 billion, primarily to open 458 new
stores around the world.

Maintains credit lines with its banks that allow the


company to borrow at any time up to $1.6 billion.
Issues $5 billion of long-term bonds in order to repay
short-term commercial paper borrowings.

Principle 1:
The Risk-Return Trade-off
Would you invest your savings in the stock market if it offered the
same expected return as your bank?
We wont take on additional risk unless we expect to be
compensated with additional return.

The higher the risk of an investment, the higher will be its expected
return.

The Risk-Return Trade-off

Principle 2:
The Time Value of Money
A dollar received today is worth more than a
dollar to be received in the future.
Because we can earn interest on money received
today, it is better to receive money earlier rather than
later.

Principle 3:
CashNot ProfitsIs King
In measuring wealth or value, we use cash Flow,
not accounting profit, as our measurement tool.
Cash flows are actually received by the firm and can
be reinvested. On the other hand, profits are recorded
when they are earned rather than when money is
actually received.
It is possible for a firm to show profits on the books
but have no cash!

10

Principle 4:
Incremental Cash Flows
The incremental cash flow is the difference
between the projected cash flows if the project is
selected, versus what they will be, if the project is
not selected.
This difference reflects the true impact of a decision.

11

Principle 5:
The Curse of Competitive Markets
It is hard to find exceptionally profitable
projects.
If an industry is generating large profits, new entrants
are usually attracted. The additional competition and
added capacity can result in profits being driven
down to the required rate of return.
Product Differentiation (through Service, Quality)
and cost advantages (through economies of Scale)
can insulate products from competition.

12

Principle 6:
Efficient Capital Markets
The values of securities at any instant in time
fully reflect all publicly available information.
Prices reflect value and are right.

Price changes reflect changes in expected cash


flows (and not cosmetic changes such as
accounting policy changes). Good decisions drive
up the stock prices and vice versa.
13

Principle 7:
The Agency Problem
The separation of management and the ownership
of the firm creates an agency problem.
Managers may make decisions that are not in line with
the goal of maximization of shareholder wealth.
Agency conflict reduced through monitoring (ex.
Annual reports), compensation schemes (ex. stock
options), and market mechanisms (ex. Takeovers).

14

Principle 8:
Taxes Bias Business Decisions
The cash flows we consider for decision making are the aftertax incremental cash flows to the firm as a whole.

15

Principle 9:
All Risk is Not Equal
Some risk can be diversified away, and some
cannot.
The process of diversification can reduce risk, and as
a result, measuring a projects or an assets risk is
very difficult. A projects risk changes depending on
whether you measure it standing alone or together
with other projects the company may take on.

16

All Risk is Not Equal

17

Principle 10:
Ethical Behavior Is Doing the Right Thing, and Ethical
Dilemmas Are Everywhere in Finance

Ethical dilemma Each person has his or her


own set of values, which forms the basis for
personal judgments about what is the right thing.
Ethics are relevant in business and unethical
decisions can destroy shareholder wealth (ex.
Enron Scandal).

18

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