Corporate Chapter 1

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Introduction to corporate finance

CORPORATE FINANCE

Corporate finance the


involves
management of a corporation’sfinancial
assets
and corporate financing decisions.
1. Financial Management of Assets
•Capital budgeting decisions, including the analysis of asset,

investment, acquisition and replacement proposals.

•Credit (accounts receivable) policy

•Cash management
CORPORATE FINANCE (Cont..)

2. Corporate Financing Decisions


λ Managing capital structure: the ratio of debt and equity

λ Raising new equity capital either through profit retention or new


share issues

λ Dividend policy

λ Borrowing decisions and liability Management


CORPORATE FINANCE (Cont..)

Corporate Finance addresses the


following three questions:
1. What long-term investments
should the engage in? fir
2. How can the firm raise the moneym
for the
required investments?
3. How much short-term cash flow
does a company need to pay its bills?
Main tasks of corporate finance

Capital
• budgeting: the process of
planning and managing a firm’s long-
term investments ⇒ fixed assets.
Example:
• deciding whether or not to open a new
restaurant.
Capital
• structure: the mixture of debt
and equity maintained by the firm ⇒ S-T
and L- T debt and equity.
Working
• capital management: a firm’s
short- term assets and liabilities ⇒
current assets and current liabilities.
The Balance-Sheet Model of the Firm

Current
Curre
Liabiliti
nt
es
Assets
Long-
Fixed
Term
Assets Debt
1
Shareh
Tangible olders

2 Equity
The Capital Budgeting Decision

Current
Curre
Liabiliti
nt
es
Assets
Long-
Fixed
Term
Assets What long- Debt
term
1 investment Sharehol
s should
Tangible ders

the firm
choose? Equit
2 y
The Capital Structure Decision

Curre
nt
Crr ent
Liabilit
Assets How Long-
ies
can the TermDe
firm raise bt
the
Fixed
money for
Assets the
required Shareh
1 olders
investment
Tangible s? ’
Equity
The Net Working Capital Decision

Curr
Net ent
Liabilit
Crrent Worki ies
Assets ng Long-
Capit Term
al
De
bt
How much
Fixed short-term
Assets cash flow
1 does a
Tangibl company Sharehol
2 ders

e need to pay
Intangib Equit
le
its bills?
y
Capital Structure

The value of the firm


can be thought of as a
pie. 70% 30%
Debt Equity
The goal of the manager
is to increase the size of
the pie.
can be viewed as how
The
best Capital
to sliceStructure
up the pie.
decision
If how you slice the pie affects the size of
the pie, then the capital structure
decision matters.
Hypothetical Organization Chart
Modern form of firms

Three
λ major forms in the United States

Sole Proprietorship

Partnership
General

Limited

Corporation

C-Corp

S-Corp

Limited Liability Company
Sole Proprietorship

Disadvantages
Advantages
Limited to life of owner
Easiest to start Equity capital limited
Least regulated to owner’s personal
Single owner keeps all wealth
the profits Unlimited liability
Taxed once as Difficult to sell
personal income ownership interest
Partnership

Advantages Disadvantages
Unlimited liability
Two or more owners Partnership dissolves when
More capital available one partner dies or wishes
Relatively easy to to sell
start Difficult to transfer
Income taxed once as ownership
personal income
Disadvantages
Advantages
Separation of ownership
Limited liability and management
Unlimited life Double taxation
Separation of ownership (income taxed at the
and management corporate rate and then
Transfer of ownership is dividends taxed at the
easy personal rate)
Easier to raise capital
Who make the decisions

λ Owners (typically in small businesses).

λ Professional managers.
Financial managers

λ Frequently, financial managers try to address these tasks.

λ The top financial manager within a firm is usually the Chief


Financial Officer (CFO).

– Treasurer – oversees cash management, credit management, capital


expenditures and financial planning.

Controller – oversees taxes, cost


–accounting, financial accounting and
data processing.
Possible goals of financial
management

λ Survive

λ Beat the competition

λ Maximize sales

λ Maximize net income

λ Maximize market share

λ Minimize costs

λ Maximize the value of (stock) shares


The “appropriate” goal of
financial management

λ Maximize the (fundamental or economic)


value of (stock) shares is the right goal.
λ Why? Shareholders own shares.
Managers, as agents, ought to act in a
way to benefit shareholders; i.e., to
enhance the value of the shares.
λ A limitation of this goal is that value is
not directly observable.
The Firm and the Financial Markets
Value maximization and sustainability

λ Business sustainability: often viewed as

managing the triple bottom line - a process

bywhich companies manage th


eir economic/financial, ecological,
and social and risks.
opportunities
λ Sustainability and value maximization are somewhat

different.
3 aspects of sustainability

λ Economic/financial – here is more about economic viability and


profitability, and not directly about value maximization.

λ Ecological – reaching your financial goals should not impose

burden on the current natural environment.

λ Social – reaching your financial goals should not damage the


well-being of the society (employees, etc.).
Shareholders and other stakeholders

– Custom
– ers
– Supplier
– s
– Employees (human capital and
– assets) Creditors (bondholders,
– banks, debtholders) Government:
tax and regulations Community
(local / global) Owner/shareholder
Separation of Ownership and Control

Board of Directors

Management D S
e h
b a
Debt t r
Assets
Equity e
h h
o o
The agency problem

λ Agency relationship:
– Principals (citizens) hire an agent (the president) to represent their
interest.

–Principles
(stockholders) hire agents (managers) to
run the company.
λ Agency problem:
– Conflict of interest between principals and
– agents.
This occurs in a corporate setting whenever the
– agents do not hold 100% of the firm’s shares.
The source of agency problems is the
separation of (owners’) control and
management.
Agency costs

λ Direct costs: (1) unnecessary


expenses, and (2) monitoring
λ costs.
Indirectcosts.
may choose not For to
example, a the
take on
manager
optimal investment. She/he may
prefer a less risky project so that
she/he has a higher probability
keeping her/his tenure.
Financial Institutions, Financial
Markets, and the Corporation

λ Financial Institutions

Indirect finance

Funds Depos Financial Loa Funds


supplie its intermediar ns demande
rs ies rs

Direct
Finance
Funds Financia Funds
supplie l demande
rs intermedia rs
ries
Financial markets

λ Money versus Capital Markets

• Money Markets

– For short-term debt instruments Capital Markets


– For long-term debt and equity
Financial markets

λ 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.
Financial markets

Firms Stock
Invest
s and
ors
Bonds
Mon
ey Bob Su
e
Primary Market
Secondary Market
Overview of Corporate Securities

Common stock (equity)


λ Cash Flows: Receives all corporate payouts, after every other
claimant has been paid. Payments to the equity holders are called

dividends.

λ Larger firms have their common stock traded on stock exchange.


There investors can purchase and sell shares.
Overview of Corporate Securities

Common stock (equity)


λ Tax Status:

Individuals- Dividends arc taxed as "ordinary income"


(just like wage income). Capital Gains have
historically been taxed at a rate below that of
ordinary income. (A shareholder who purchases a
share of stock for 520, and sells it for $22, realizes a
$2 capital gain.)
Company - Payments to equity are not tax deductible
from corporate profit.
λ Corporate Rights: Can hire and fire management, its voting power allows its owners to
control corporate decision making.
Overview of Corporate Securities

Preferred stock
λ Cash Flows: The firm agrees to give the holder of this security a
set dividend every period (for example 52.25 per quarter per

share).

λ Like common stock, preferred stock may be traded on a stock


exchange. There investors can purchase and sell shares.
Overview of Corporate Securities

Preferred stock
λ Tax Status: Same as common stock.

Individuals- Dividends arc taxed as "ordinary income"


(just like wage income). Capital Gains have
historically been taxed at a rate below that of
ordinary income.
Company - Payments to equity are not tax deductible
from corporate profit.
λ Corporate Rights: Paid before common equity, but after all other claimants.

Generally, cannot vote. If the company fails to make a payment preferred

stockholders cannot force any immediate action, .


Overview of Corporate Securities

λ Corporate Debt (Bonds)

Cash Flows: First in line for payment. Contracts


require a fixed coupon payment every 6 months.
At maturity the firm then pays $1000 which
equals the face value of the bond.
Larger firms have their bonds traded on a major
bond exchange. There investors can purchase
and sell bonds.
Overview of Corporate Securities

λ Corporate Debt (Bonds)

λ Tax Status:

Individuals - Coupon payments are taxed as "ordinary


income" (just like wage income).
Capital Gain - The difference 'between what an investor
pays for the bond and its price when sold. If the investor
hold the bond to maturity then the difference between the
purchase price and the face amount is considered a
capital gain.
Company - Payments to debt are tax deductible.
Corporate Rights: When the firm misses a payment the
bondholders have the right to force a bankruptcy
proceeding. In principle this allows them to take over the
Overview of Corporate Securities

λ Types of Debt

a. Maturity
1. Funded. any debt repayable in more than One
year.
2. Unfunded. debt repayable in less than one
year.
b. Repayment provisions.
1. Sinking fund. The company contributes money
to the fund which then repurchases the bonds.
2. Call options give the firm the right to
repurchase "the debt at a specified price.
Overview of Corporate Securities

λ Types of Debt

c. Seniority
1. Senior Debt: Paid prior to all other claimants.
2. Subordinate Debt: Paid after the senior debt
holders.
3. Secured Debt: Can claim the asset used as
security if payments are not satisfied. A lease
agreement is essentially the same as secured
debt.

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