Chapter 1
INTRODUCTION TO CORPORATE FINANCE
SLIDES
CHAPTER WEB SITES
Section Web Address
1.1 www.cfo.com
1.4 www.business-ethics.com
1.6 www.protiviti.com/en-US/Documents/Surveys/2014-SOX-
Compliance-Survey-Protiviti.pdf
CHAPTER ORGANIZATION
1.1 What Is Corporate Finance?
The Balance Sheet Model of the Firm
The Financial Manager
1.2 The Corporate Firm
The Sole Proprietorship
The Partnership
The Corporation
1.1 Key Concepts and Skills
1.2 Chapter Outline
1.3 What Is Corporate Finance?
1.4 Balance Sheet Model of the Firm
1.5 The Capital Budgeting Decision
1.6 The Capital Structure Decision
1.7 Short-Term Asset Management
1.8 The Financial Manager
1.9 Hypothetical Organization Chart
1.10 The Corporate Firm
1.11 Forms of Business Organization
1.12 A Comparison
1.13 The Importance of Cash Flow
1.14 The Goal of Financial Management
1.15 The Agency Problem
1.16 Managerial Goals
1.17 Managing Managers
1.18 Regulation
1.19 Quick Quiz
A Corporation by Another Name…
1.3 The Importance of Cash Flows
1.4 The Goal of Financial Management
Possible Goals
The Goal of Financial Management
A More General Goal
1.5 The Agency Problem and Control of the Corporation
Agency Relationships
Management Goals
Do Managers Act in the Stockholders’ Interests?
Stakeholders
1.6 Regulation
The Securities Act of 1933 and the Securities Exchange Act of 1934
Sarbanes-Oxley
ANNOTATED CHAPTER OUTLINE
Slide 1.0 Chapter 1 Title Slide
Slide 1.1 Key Concepts and Skills
Slide 1.2 Chapter Outline
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1.1. What is Corporate Finance?
Slide 1.3 What Is Corporate Finance?
Corporate finance addresses several important questions:
1. What long-term investments should the firm choose? (Capital budgeting)
2. Where will we get the long-term financing to pay for the investments?
(Capital structure)
3. How will we manage the daily financial activities of the firm? (Working
capital)
A. The Balance Sheet Model of the Firm
Slide 1.4 Balance Sheet Model of the Firm
The Balance Sheet presents a picture of the firm at a point in time, and it
provides a model by which to address the three basic questions that
corporate finance managers must answer.
Slide 1.5 The Capital Budgeting Decision
1. Long-term investment decisions determine the level of fixed
assets.
Slide 1.6 The Capital Structure Decision
2. Financing policy determines the liabilities and equity side of the
balance sheet.
Slide 1.7 Short-Term Asset Management
3. Short-term asset management choices (e.g., conservative versus
aggressive) affect the level of net working capital.
A. The Financial Manager
Slide 1.8 The Financial Manager
Financial Managers should make decisions that increase firm value, which
effectively involves 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 risk 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?
These broad categories, however, can be summarized with two concrete
responsibilities:
a. Selecting value creating projects
b. Making smart financing decisions
Slide 1.9 Hypothetical Organization Chart
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 (i.e., data processing).
The treasurer handles cash and credit 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.
1.2. The Corporate Firm
Slide 1.10 The Corporate Firm
Although many forms of business organizations exist, the corporate form
is the standard by which we address most large scale problems. This
approach, however, does not imply that the methods we develop are
inappropriate for other business types.
Slide 1.11 Forms of Business Organization
A. The 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. The 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. The Corporation
– A distinct legal entity composed of one or more owners
Slide 1.12 A Comparison
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. Recent tax laws reduce the level of double taxation, but it has not been eliminated.
D. A Corporation by Another Name…
Corporations exist around the world under a variety of names. Table 1.2
lists several well-known companies, along with the type of company in the original language.
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. LLC’s are a hybrid form of organization that
falls between partnerships and corporations. Investors in LLC’s have the
protection of limited liability, but they are taxed like partnerships. LLC’s
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.
1.3. The Importance of Cash Flow
Slide 1.13 The Importance of Cash Flow
To create value, the firm must generate more cash than it uses. Stated
differently, the firm must generate sufficient cash flow, after taxes, to
compensate investors for providing the firm with financing.
Additionally, the value of the cash flows generated by the firm must be
analyzed in light of both the timing of the cash flows, as well as the risk of
the cash flows.
Lecture Tip: It is an important reminder for students to reiterate that Net
Income and Cash Flow can be extremely different values for various
reasons, some of which are non-cash expenses (e.g., depreciation,
amortization), revenue recognition principles, and credit policies.
1.4. The Goal of Financial Management
Slide 1.14 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.
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 1990’s because their goal was to maximize market
share. They raised substantial amounts of capital in IPO’s 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 funds. In fact, many of these companies
have gone out of business.
B. 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 1996 annual report. 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.
A subsequent article also 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, and, 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
their holdings of the firm’s common stock). However, the prevalence of
“social responsibility” funds may make for an interesting discussion, as
would the increasing focus on behavioral finance and the impact of
investor emotions on trading behavior.
C. A More General Goal
The more general goal is to maximize the market value of owners’ equity.
Many students think 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. One particularly good opener to this topic that many students
can relate to 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?
1.5. The Agency Problem and Control of the Corporation