Chapter 1
INTRODUCTION TO CORPORATE FINANCE
CHAPTER WEB SITES
Section Web Address
1.1 www.mhhe.com/rwj
www.cfo.com
1.2 http://www.incorporate.com
www.llc.com
1.3 www.soxlaw.com
1.4 www.business-ethics.com
finance.yahoo.com
1.5 www.sec.gov
www.nyse.com
www.nasdaq.com
SUGGESTED VIDEOS
The Role of the Chief Financial Officer
Financial Markets
CHAPTER ORGANIZATION
1.1 Corporate Finance and the Financial Manager
What Is Corporate Finance?
The Financial Manager
Financial Management Decisions
1.2 Forms of Business Organization
Sole Proprietorship
Partnership
Corporation
A Corporation by Another Name…
1.3 The Goal of Financial Management
Possible Goals
The Goal of Financial Management
A More General Goal
Sarbanes-Oxley
1.4 The Agency Problem and Control of the Corporation
Agency Relationships
Management Goals
Do Managers Act in the Stockholders’ Interests?
Stakeholders
1.5 Financial Markets and the Corporation
Cash Flows to and from the Firm
Primary versus Secondary Markets
1.6 Summary and Conclusions
ANNOTATED CHAPTER OUTLINE
1.1. Corporate Finance and The Financial Manager
A. What Is Corporate Finance?
Corporate finance addresses several important questions:
1. What long-term investments should the firm take on? (Capital
budgeting)
2. Where will we get the long-term financing to pay for the
investment? (Capital structure)
3. How will we manage the everyday financial activities of the firm?
(Working capital)
B. The Financial Manager
The Chief Financial Officer (CFO) or Vice-President of Finance
coordinates the activities of the treasurer and the controller.
The controller handles cost and financial accounting, taxes, and
information systems.
The treasurer handles cash management, financial planning, and capital
expenditures.
Video Note: The Role of the Chief Financial Officer – This video looks at the changing role of the
CFO.
C. Financial Management Decisions
The financial manager is concerned with three primary categories of
financial decisions.
1. Capital budgeting – process of planning and managing a firm’s
investments in fixed assets. The key concerns are the size, timing
and riskiness of future cash flows.
2. Capital structure – mix of debt (borrowing) and equity (ownership
interest) used by a firm. What are the least expensive sources of
funds? Is there an optimal mix of debt and equity? When and
where should the firm raise funds?
3. Working capital management – managing short-term assets and
liabilities. How much inventory should the firm carry? What credit
policy is best? Where will we get our short-term loans?
1.2. Forms of Business Organization
A. Sole Proprietorship – A business owned by one person.
Advantages include ease of start-up, lower regulation, single owner keeps
all the profits, and taxed once as personal income.
Disadvantages include limited life, limited equity capital, unlimited
liability and low liquidity.
B. Partnership – A business with multiple owners, but not incorporated.
General partnership – all partners share in gains or losses; all have
unlimited liability for all partnership debts.
Limited partnership – one or more general partners run the business and
have unlimited liability. A limited partner’s liability is limited to his or her
contribution to the partnership and they cannot help in running the
business.
Advantages include more equity capital than is available to a sole
proprietorship, relatively easy to start (although written agreements are
essential), and income taxed once at personal tax rate.
Disadvantages include unlimited liability for general partners, dissolution
of partnership when one partner dies or wishes to sell, low liquidity.
C. Corporation – A distinct legal entity composed of one or more owners.
Corporations account for the largest volume of business (in dollar terms)
in the U.S. Advantages include limited liability, unlimited life, separation of ownership and
management (ability to own shares in several companies without having to work for all of them),
liquidity, and ease of raising capital.
Disadvantages include separation of ownership and management (agency costs) and double
taxation. The new tax laws reduce the level of double taxation, but it has not been eliminated.
Lecture Tip: Although the corporate form of organization has the
advantage of limited liability, it has the disadvantage of double taxation. A small business of 75
or fewer stockholders is allowed by the IRS to form an S-Corporation. The S-Corp.
organizational form provides limited liability but allows pretax corporate profits to be
distributed on a pro rata basis to individual shareholders, who are only obligated to pay
personal income taxes on the income. A similar form of organization is the limited liability
corporation, or LLC. LLCs are a hybrid form of organization that falls between partnerships
and corporations. Investors in LLCs have the protection of limited liability, but they are taxed
like partnerships. LLCs first appeared in Wyoming in 1977 and have skyrocketed since. They are
especially beneficial for small and medium sized businesses such as law firms or medical
practices.
D. A Corporation by Another Name…
Corporations exist around the world under a variety of names. Table 1.1
lists several well-known companies, along with the type of company in the
original language.
1.3. The Goal of Financial Management
A. Possible Goals
Profit Maximization – this is an imprecise goal. Do we want to maximize
long-run or short-run profits? Do we want to maximize accounting profits
or some measure of cash flow? Because of the different possible
interpretations, this should not be the main goal of the firm.
B. Other possible goals that students might suggest include minimizing costs
or maximizing market share. Both have potential problems. We can
minimize costs by not purchasing new equipment today, but that may
damage the long-run viability of the firm. Many “dot .com” companies
got into trouble in the late ‘90s because their goal was to maximize market
share. They raised substantial amounts of capital in IPOs and then used
the money on advertising to increase the number of “hits” on their site.
However, many firms failed to translate those “hits” into enough revenue
to meet expenses and they quickly ran out of capital. The stockholders of
these firms were not happy; stock prices fell dramatically and it became
difficult for these firms to raise additional funds. Many of these companies
have gone out of business.
C. The Goal of Financial Management
From a stockholder (owner) perspective, the goal of buying the stock is to
gain financially. Thus, the goal of financial management in a corporation
is to maximize the current value per share of the existing stock.
Lecture Tip: The late Roberto Goizueta, former chairman and CEO of
the Coca-Cola Company, wrote an essay entitled “Why Share-Owner
Value?” that appeared in the firm’s 1997 annual report. That essay is
reprinted in full at the end of this material. It is an excellent introduction
to the goal of financial management at any level. It may also be useful to
discuss how Mr. Goizueta’s vision transferred to the stock market’s
valuation of the company. The following article illustrates the difference
in strategy between Coca-Cola and Pepsi-Co during Mr. Goizueta’s
tenure.
“How Coke is Kicking Pepsi’s Can,” Fortune, October 28, 1996.
Coke focused on soft drinks while Pepsi-Co diversified into other areas.
Pepsi-Co’s goal was to double revenues every 5 years, while Mr. Goizueta
focused on return on investment and stock price. The article states that
Goizueta “has created more wealth for stockholders than any other CEO
in history.” In mid-1996, Pepsi-Co sold at 23 times earnings with return
on equity of about 23% and Coke sold at 36 times earnings with a return
on equity of around 55%. The article goes on to discuss the differing
strategies in more detail. It provides a nice validation of Mr. Goizueta’s
remarks in his letter to the shareholders.
Lecture Tip: The validity of this goal assumes “investor rationality.” In
other words, investors in the aggregate prefer more dollars to fewer and
less risk to more. Rational investors will act as risk-averse, return-seekers
in making their purchase and sale decisions. Given different levels of risk
aversion and wealth preferences, the only single goal suitable for all
shareholders is the maximization of their wealth (which is represented by
the value of their holdings of the firm’s common stock).
D. A More General Goal – To maximize the market value of owners’ equity.
Many students think that this means that firms should do “anything” to
maximize stockholder wealth. It is important to point out that unethical
behavior does not ultimately benefit owners.
Ethics Note: Any number of ethical issues can be introduced for
discussion – several of which are discussed in more detail in later
sections. One particularly good opener to this topic is the issue of the
responsibility of the managers and stockholders of tobacco firms. Is it
ethical to sell a product that is known to be addictive and dangerous to the
health of the user even when used as intended? Is the fact that the product
is legal relevant? Do recent court decisions against the companies
matter? What about the way companies choose to market their product?
Are these issues relevant to financial managers?
E. Sarbanes-Oxley
“Sarbox” or “SOX,” as it is commonly referred to, was designed to reduce
the likelihood of corporate scandals by increasing investor protection by
limiting certain actions by executives and increasing overall reporting
requirements. The latter in particular has increased the cost of
incorporation and has led some firms to avoid going public or even to “go
dark.”