The Scope of Corporate
Finance
Chapter 1
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What Companies Do
Prior to the iPad’s launch, financial experts at Apple:
• evaluated the potential market for such a device,
• estimated the cost of producing it,
• calculated the unit volume that the company would
have to achieve to earn a satisfactory rate of return,
• developed a plan to manage the risks that Apple would
confront when making transactions in foreign
currencies.
© 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.
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Corporate Finance in Modern Business
When contemplating all business decisions,
managers should ask:
Does this action create value for the
firm’s shareholders?
• By taking actions that generate benefits in
excess of costs, firms generate wealth for their
investors.
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Career Opportunities in Finance
Corporate
Finance
• Budgeting, financial forecasting, cash
management, credit administration,
investment analysis, fund procurement
Commercial
Banking
• Consumer banking
• Corporate banking
Investment
Banking
• High income potential
• Very competitive industry
Money
Management
• Opportunities in investment advisory firms,
mutual fund companies, pension funds,
investment arms of financial departments
Consulting
• Advise on business practices and strategies
of corporate clients
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© 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.
Corporate Finance Essentials
• Every business requires money to operate, &
corporate finance seeks to acquire and manage
this money.
• Financial management concepts of companies
• We first anlyze debt & equity capital, the two
principal types of long term funding for all
businesses.
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Debt & Equity: Two Flavors of Capital
Debt
Capital
Equity
Capital
• 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.
© 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.
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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.
© 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.
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Corporate Finance Functions
External Financing
Capital Budgeting
Corporate
Finance
Functions
Financial Management
Corporate Governance
Risk Management
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The External Financing Function
• Raising capital to support companies’
operations and investment programs
externally, from
– either shareholders (equity) or
– creditors (debt).
• Corporations can raise equity capital privately,
• or they may go public by conducting an initial
public offering (IPO) of stock.
© 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.
9
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 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.
© 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.
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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.
© 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.
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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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What Companies Do
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Total Value of Primary Corporate Security Issues,
1990 - 2006
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Business Organizational Forms in the U.S.
Sole
Proprietorships
• No distinction between business and
person
• Easy to set up, operate; taxed as
personal income
• Personal liability, limited life, difficult to
transfer
Partnerships
• Two or more business owners
• Partners - liable for every partner’s
actions
Limited
Partnerships
• One or more general partners & many
limited partners
• Limited liability of corporation, tax
benefits of partnership
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Business Organizational Forms in the U.S.
Corporations
• Legal entity with all the economic rights
and responsibilities of a person
• Incorporation occurs at state level; based
on state law
• Strengths - limited liability for investors,
unlimited business life
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The Finance
Function
in the
Organizational
Structure
of a Typical
Large
Corporation
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Corporations in the U.S.
Double Taxation
Problem
• Taxation of corporate income at both
the company and the personal levels.
• This is the single greatest disadvantage
of the corporate form.
• The Jobs and Growth Tax Relief Reconciliation
Act of 2003 (Tax Relief Act of 2003) dramatically
reduced the double taxation problem.
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Taxation of Business Income for Corporations
and Partnerships
Before the Tax Relief Act of 2003
After the Tax Relief Act of 2003
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Business Organizational Forms in the U.S.
S Corporations
Limited
Liability
Companies
• Allow shareholders to be taxed as
partners yet retain their limited liability
status.
• Must meet certain criteria like having
75 or fewer shareholders.
• Can become regular corporations later.
• Combine partnerships’ pass-through
taxation with S corporations’ limited
liability.
• Popular with professional service firms.
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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?
– 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.
© 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.
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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.
© 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.
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'AGENCY COSTS'
• A type of internal cost that arises from, or
must be paid to, an agent acting on behalf of a
principal.
• Agency costs arise because of core problems
such as conflicts of interest between
shareholders and management.
• Shareholders wish for management to run the
company in a way that increases shareholder
value. But management may wish to grow the
company in ways that maximize their personal
power and wealth that may not be in the best
interests of shareholders.
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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.
© 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.
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