FIN 3303 Business
Finance
Chapter 1
© 2009 Cengage Learning/South-Western
Business Finance aka Corporate
Finance
• Primarily concerned with corporations. But most
of what we learn also applies to other legal
forms of business, including:
• Sole Proprietorships
• Partnerships
• Limited Partnerships
• S Corporations
• Limited Liability Companies
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Sole Proprietorships
• Owned by one person.
• Owner bears personal liability for all debts of the
business
• Unlimited liability
• Taxed only once, as an individual --- all income
reported on proprietor’s personal tax return
• Limited lifespan – business ends when proprietor
dies
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General Partnerships
• Two or more owners, each of whom owns a
designated percentage of the firm (not
necessarily equal)
• Owners may be individuals, corporations, or
other partnerships
• Joint and Several liability – each one of the
partners can be held liable for all of the debts of
the firm
• Taxed only once, each partner reports his share
of the profits on his own tax return
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Limited Partnerships
• Must have at least one general partner
• Has one or more limited partners – liability for
the firm’s debts is restricted to the amount of his
investment
• Limited partners may not participate in
management of the company
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Corporations
• One or more owners set up a legal entity that
has many of the same rights as an individual
• Owners buy stock in the corporation – make an
equity investment  known as stockholders or
shareholders
• Stockholders may be individuals, partnerships,
or other corporations
• Stockholders have limited liability
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• Corporate profits are taxed twice. First to the
corporation and then stockholder’s dividends are
S Corporations
• A special type of corporation
• Stockholders have limited liability
• Profits are only taxed once – no corporate
income taxes are paid
• Cannot have more than 75 stockholders
• Stockholders must be individuals or certain types
of trusts
• The Corporation may not hold a controlling
interest in another corporation
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Limited Liability Companies (LLC)
• Similar to S Corporations
• Taxed like a partnership but have limited liability
• May have any number of owners
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Corporate Finance Functions
External Financing
Capital Budgeting
Corporate
Finance
Functions
Financial Management
Corporate Governance
Risk Management
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External Finance
Invest in the company, by buying
its stocks or bonds
Company
Investors
Raise capital from
investors , by selling
its stock or bonds
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The External Financing Function
• Raising capital from investors to support
companies’ operations and investment programs
externally, from
– shareholders (equity) by selling stock to investors
– creditors (debt) by selling bonds to investors or
otherwise borrowing from investors
• Corporations can raise equity capital privately,
• or they may go public by conducting an initial
public offering (IPO) of stock.
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The Capital Budgeting Function
Capital Budgeting – selecting the
best projects in which to invest
the resources of the firm, based
on each project’s perceived risk
and expected return.
Select investments for which the marginal benefits exceed
the marginal costs.
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The Financial Management Function
• Managing firms’ internal cash flows,
• and its mix of debt and equity financing,
• to maximize the value of the debt and equity
claims on firms, and
• to ensure that companies can pay off their
obligations when they come due.
 Involves obtaining seasonal financing, managing
inventories, paying suppliers, collecting from customers,
and investing surplus cash
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The Corporate Governance Function
Developing ownership and corporate governance
structures for companies that ensure that managers
behave ethically and make decisions that benefit
shareholders.
Dimensions of
corporate
governance
•
•
•
•
Boards of directors
Compensation packages
Auditors
Country’s legal environment - in
U.S., Sarbanes-Oxley Act of 2002
The takeover market disciplines firms that do not
govern themselves.
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The Risk Management Function
• Managing firms’ exposures to all types of risk,
• both insurable (such as loss caused by fire or
flood) and uninsurable,
• in order to maintain optimum risk-return tradeoffs and thereby maximize shareholder value.
• Modern risk management focuses on adverse
interest rate movements, commodity price
changes, and currency value fluctuations.
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Debt & Equity: Two Flavors of Capital
Debt
Capital
Equity
Capital
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• Borrowed money.
• The borrower is obliged to pay interest,
at a specified annual rate, on the full
amount borrowed, as well as to repay
the principal amount at the debt’s
maturity.
• An ownership interest usually in the
form of common or preferred stock.
• Common stockholders receive returns
on their investments only after
creditors and preferred stockholders
are paid in full.
Financial Intermediation
Financial
Intermediary
• An institution that raises capital by
issuing liabilities against itself, and
then lends that capital to corporate
and individual borrowers.
• Examples: insurance companies,
savings and loan institutions, credit
unions, commercial banks, pension
funds, mutual funds.
• Pension funds and mutual funds, have surged to
prominence as corporate finance shifts towards
greater reliance on market-based external
funding.
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Total Value of Primary Corporate Security Issues,
1990 - 2006
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The Growth of Stock Market Capitalization
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The Corporate Financial Manager’s Goals
What should a financial manager try
to maximize?
• Maximize profit? (accounting profit)
– Earnings reflect past performance, rather than current
or future performance.
– Ignores the timing of the profits.
– Ignores cash flows.
– Ignores risk.
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The Corporate Financial Manager’s Goals
What should a financial manager try
to maximize?
• Maximize shareholder wealth?
– As measured by the market price of the firm’s stock.
– A firm’s stock price reflects the timing, magnitude,
and risk of the cash flows that investors expect a firm
to generate over time.
– Shareholders are the residual claimants of a firm.
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The Corporate Financial Manager’s Goals
What should a financial manager try
to maximize?
• Focus on stakeholders?
– Many firms seek to preserve the interests of other
stakeholders, such as employees, customers, tax
authorities, and the communities where the firms
operate.
– Doing so provides long-term benefits to shareholders
and is in line with the primary goal of maximizing
shareholder wealth.
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Agency Costs in Corporate Finance
Agency Problems
• The conflict between the goals of a
firm’s owners and its managers.
• To overcome agency problems:
– Rely on market forces to exert managerial discipline;
– Incur monitoring and bonding costs to supervise
managers; and
– Structure executive compensation packages to align
managers’ interests with stockholders’ interests.
The actual workings of many compensation plans have
been harshly criticized in recent years.
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Ethics in Corporate Finance
• Today, society in general and the financial
community in particular are developing and
enforcing higher ethical standards.
• The U.S. Congress passed the Sarbanes-Oxley
Act in 2002 to enforce higher ethical standards
and increase penalties for violators.
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The Scope of Corporate Finance
• Financial managers should seek to maximize
shareholders’ wealth.
• How?
By performing the five basic duties of corporate finance:
External financing, capital budgeting, financial
management, risk management, corporate governance.
• Select investments for which the marginal
benefits exceed the marginal costs.
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