Chapter 1 The Scope of Corporate Finance
Chapter Overview
The Opening Focus looks at an issue close to most students’ hearts – digital music. It details Ap-
ple’s successful strategy in selling songs for about a dollar each, downloaded into its iPod MP3
player. Students may not realize that Apple sells more iPods than computers. Apple has found a
Discussion Questions:
1. What do you imagine were the interactions between the finance function and operations func-
tion at Apple when the iPod was being developed? On what business criteria does Apple’s
strategy depend?
2. What can a firm do to make a low profit margin strategy more successful? What are other ex-
amples of tie-ins, like Apple’s iTunes and iPod?
This chapter looks at:
1-1. The Role of Corporate Finance in Business Today
Technology
1. Smart Concepts Video. The SmartConcepts video is an excellent introduction to a corporate
finance course. It talks about Given Industries, an Israeli company that uses high tech imaging
2. Smart Practices Video. This interviews Tom Cole, Deutsche Bank, Leveraged Finance
3. Smart Practices Video. This quotes Joshua Haines, senior credit analyst at the Private Bank,
2 Instructor’s Manual
4. Smart Practices Video. This quotes Bill Eckmann, investment banker, concerning his career
in investment banking.
5. Smart Concepts Video. This quotes David Nickel, controller for Intel Corp.’s Communica-
tions Group, about how finance can help business increase shareholder value.
6. Smart Ethics Video. Andy Bryant, executive vice president of finance and enterprise systems
7. Smart Practices Video. This quotes Vince LoForti, chief financial officer of Overland Stor-
Lecture Guide
1-1: The Role of Corporate Finance in Modern Business
1-1a: How Finance Interacts with Other Functional Business Areas
1-1b: Career Opportunities in Finance
Give students some examples of jobs they can get as finance graduates. The college career services
1-2: Corporate Finance Essentials
The instructor can use this slide to introduce the topics that will be covered throughout the semes-
1-2a: External Financing: Raising Capital, Key Facts
Explain that internal financing – the profits that a firm generates that are not paid to sharehold-
ers as dividends are the most important source of firm financing. A company seeks capital market
Student Interaction:
• Ask students how many of them give money directly to a company. Few will (unless
they own their own business.) This is a good springboard to how corporations receive
Chapter 1 The Scope of Corporate Finance 3
This section provides an opportunity to bring in current events, while explaining the external
financing choices a firm has. The Google IPO made news in the summer of 2004. It was an inno-
The Capital Budgeting Function
Capital budgeting is the function perhaps most highly associated with corporate finance –
what projects should a firm invest in? Note how the nature of investment has changed over time.
Investment used to mean building a factory and stocking it with equipment. Today’s business
The Financial Management Function
Note that this function covers the theory that financial managers put into practice in their jobs.
The Corporate Governance Function
Talk to students about the nexus of stakeholders concerned with a corporation. Corporations must
be concerned with
• Shareholders
• Debtholders/Creditors
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Risk Management Function
Note that a great deal of finance is about the risk-return relationship. An investor (or a
firm) expects to be compensated for taking on higher risk; in other words, higher risk, then higher
1-2b Debt and Equity: The Two Flavors of Capital
1-2c Financial Intermediation and Modern Finance
Figure 1.1 Growth in Global Security Issues
1-3a Business Organizational Forms in the U.S.
For sole Proprietorships, note that the principles of finance apply to all three forms of the business
organization. The main advantages to a proprietorship are its ease of formation, subject to few
regulations and no corporate income taxes, all of which are at least somewhat quantifiable. Ask
students what is another big, but non-quantifiable advantage of a proprietorship. Most students
will point to the idea of being one’s own boss as an attraction of owning your own business – but
one that is very hard to quantify.
• When talking about the advantage of no corporate income taxes, ask student how many
of them own stock, and how their income from the stock is taxed. Until a tax law
change in 2003, dividends were fully taxed at the individual’s marginal tax rate. Under
Chapter 1 The Scope of Corporate Finance 5
Corporations in the U.S. Double Taxation Problem
While double taxation is cited as disadvantage of the corporate form, note that this is not necessari-
Case 1: Business distributes all of its earnings
Proprietorship Corporation
Earnings before taxes $40,000 $40,000
Corporate taxes — 6,000
It’s better to be a proprietorship than a corporation.
Case 2: Business wants to reinvest earnings
Proprietorship Corporation
Earnings $40,000 $40,000
Salary to owner — 20,000
Taxable income 40,000 20,000
Corporate taxes — 3,000
Business Organizational Forms in the U.S. (continued)
S-Corporations and LLCs.
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1-3b Forms of Business Organization Used by Non-U.S. Companies
This section reinforces the section of the text that describes other forms of organization popular
among foreign companies. In other words, the “American way” may not work for all corporations
in all countries.
• Non-U.S. systems show many common patterns. In almost all capitalist economies,
1-4 The Corporate Financial Manager’s Goals
Point out the differences between profit and share price maximization. As the Enron and World-
com cases (and subsequent criminal prosecutions) showed, it is possible to manipulate accounting
1-4b Agency Costs in Corporate Finance
Agency costs include:
• Bonding management to the firm
• Monitoring the firm
• Residual loss
Student Interaction:
• Give students examples (or ask them for examples) of how to mitigate these costs. For
example, stock options and stock grants were initially designed to bond managers to
the firm by giving them a large enough ownership stake so that they would want to in-
crease share price. Boards of directors are charged with monitoring firms. Institution-
al investors are becoming more active in corporate governance, forcing the firing of
mean?
Point out that when chief financial officers were surveyed, only 38% unequivocally said that
Chapter 1 The Scope of Corporate Finance 7
agers left the firm and formed their own advertising agency. The original firm changed its name to
Cordiant and was very damaged by the executives’ departure. In hindsight, the advertising firm
1-4c Why are Ethics Important in Corporate Finance?
Corporate scandals and bankruptcy have focused attention on the question of ethics, or standards of
Financial Management Role
This slide emphasizes the main point of this chapter – that managers’ key role is to maximize
shareholders’ wealth by accepting projects whose marginal benefits exceed marginal costs.
Chapter 1 Resource Articles
Welch, Ivo, “The Top Achievements, Challenges, and Failures of Finance,” Yale ICF Working Pa-
per No. 00-67, available at http://papers.ssrn.com/abstract=291987. This paper lists Welch’s as-
sessment of the top ten achievements of finance and the most important challenges for Finance to
work on, as well as its failures to date.
Jensen, Michael C., “Value Maximization, Stakeholder Theory, and the Corporate Objective Func-
Grinyer, John R., C. Donald Sinclair and Daing Nasir Ibrahim, “Management Objectives in Capital
Budgeting,” Financial Practice and Education, Fall/Winter 1999. This paper outlines some con-
flicting perceptions about the objectives of financial management. It considers capital project in-
8 Instructor’s Manual
Enrichment Exercises
1. Tell the story of corporate finance by making up stories involving students. For example, on
the first day I pick a student at random. (I teach very large, introductory finance courses and I
have 200+ unknown students from whom to pick.) I say, “John has just invented a cure for
Book Value Balance Sheet
__________________________________________________________________
Assets Liabilities
Fixed Assets $2,000 Common Stock $2,000
Next, I pick another student and identify him/her as a pre-med student taking finance so he
knows how to invest all the money he’ll make as a world-class surgeon. He overhears John
Market Value Balance Sheet
__________________________________________________________________
Assets Liabilities
Fixed Assets $ 2,000 Common Stock $20,000
Intangible Assets 18,000
I ask the class how the market will know that John’s company is worth $20,000. Usually
someone will say that John must distribute information about his company – balance sheets,
Chapter 1 The Scope of Corporate Finance 9
dents will believe it is very risky because it is medical in nature and untested. I ask why form-
Assets Liabilities
I point out that later in the course, we’ll be looking at how debt adds value and we’ll learn
how to quantify that value added.
2. Break students into small groups. Tell them that in a survey of Fortune 500 companies, execu-
tives said the following goals were most important to their firms:
i. Maximization of the percent return on total asset investment
Questions for groups:
After the discussion, point out to students that while all the goals are good goals for the
most part, they can conflict with shareholder wealth. For example, all use net income, an ac-
Answers to Concept Review Questions
1. Many companies have connections between other functional areas and finance. For example,
any company with international dealings must look at the impact of foreign exchange on its
business. Does the firm generate revenues overseas? Does it have foreign suppliers? What
impact do currency changes have on operations? If the dollar weakens, then imports become
10 Instructor’s Manual
more expensive for U.S. citizens and domestic production companies may benefit. On the oth-
2. The five most important career paths for finance professionals are in corporate finance, com-
mercial banking, investment banking, money management and consulting. Corporate finance is
concerned with the duties of the financial manager in a business firm, while commercial bank-
ing involves providing loans and other financial services to a bank’s customers. Investment
banking involves three main types of activities: (1) helping corporate customers obtain funding
3. The five basic corporate functions are financing (or capital raising), capital budgeting, finan-
cial management, corporate governance, and risk management. These functions are all related,
for example, a company needs financing to fund its capital budgeting choices. The financial
management decision concerns management of its internal cash flows and its mix of external
4. Issues in corporate finance and risk management have become more prominent in recent years.
For example, executive stock options have been touted as a way to align the interests of man-
5. A financial intermediary is an institution that raises capital by issuing liabilities against itself,
and then uses the funds so raised to make loans to corporations and individuals. Borrowers, in
Chapter 1 The Scope of Corporate Finance 11
6.
Advantages of Proprietorships and Partnerships
Disadvantages
1. Easy to form
1. Limited life
2. Few regulations
2. Unlimited liability
3. No corporate income taxes
3. Hard to raise capital
4. Being one’s own boss
Advantages of Corporations
Disadvantages
1. Unlimited life
1. Double taxation
2. Easy to transfer ownership
2. Costly set up
3. Limited liability
3. Costly period reports required
4. Easier to raise capital
Hybrid forms are successful because they can combine the advantages of several forms or or-
ganization. For example, the limited liability partnership has the advantages of a partnership,
without the disadvantage of unlimited liability.
7. The idea that all successful private companies organized as proprietorships or partnerships
must become corporations is largely opinion. There are many proprietorships and partnerships
8. An agency cost occurs when a conflict arises between parties within a firm. The primary agen-
cy conflicts arise between managers and shareholders and shareholders and bondholders, but
there can also be conflicts between top management and operating management, managers and
employees, and stockholders and customers, suppliers, the government and the community.
9. Advantages of sophisticated compensation packages
• Allow better alignment among shareholder and management interests
• When a large part of a manager’s wealth is invested in company stock, he/she will work
10. Unethical behavior can have severe financial consequences for a company. For example, Ar-
thur Anderson went bankrupt because of the fallout from its involvement in Enron’s collapse.
12 Instructor’s Manual
11. The U.S Congress passed the Sarbanes-Oxley Act of 2002 in response to the accounting scan-
dals surrounding Enron, WorldCom and other companies that went bankrupt in 2001, and due
to concerns about auditors’ conflicts of interest. The law was passed in an effort to improve
corporate governance practices in U.S. public companies. The act established a new Public
Answers to End-of-Chapter Questions
Q1–1. Why must a financial manager have an integrated understanding of the five basic finance
functions? Why has the risk-management function become more important in recent years?
Why is the corporate governance function considered a finance function?
A1-1. A financial manager needs to know all five basic finance areas because they all impact his
or her job. While the manager’s primary responsibilities may be in raising money or choos-
Q1–2. Enter the home page of the Careers in Business Web site (http://www.careers-in–
business.com), and page through the finance positions listed and their corresponding sala-
ries. What skill sets or job characteristics lead to the variation in salaries? Which of these
positions generally require prior work experience?
Q1–3. What are the advantages and disadvantages of the different legal forms of business organi-
zation? Could the limited liability advantage of a corporation also lead to an agency prob-
lem? Why? What legal form would an upstart entrepreneur likely prefer?
Chapter 1 The Scope of Corporate Finance 13
A1-3. Advantages of Proprietorships and Partnerships
Advantages of Corporations
Disadvantages
Q1-4. Can there be a difference between maximizing profit and maximizing shareholder wealth? If
so, what could cause this difference? Which of the two should be the goal of the firm and its
management?
A1-4. Profit maximization and maximizing shareholder wealth could conflict. For example, a
company could accept very high return (and also very high risk projects) that do not return
Q1-5. Define a corporate stakeholder. Which groups are considered stakeholders? Would share-
A1-5. Stakeholders include anyone with an interest in the company, including stockholders.
Stakeholders are also management, employees, the government, the community, suppliers,
Q1-6. What is meant by an “agency cost” or “agency problem”? Do these interfere with maximiz-
ing shareholder wealth? Why or why not? What mechanisms minimize these
costs/problems? Are executive compensation contracts effective in mitigating them?
A1-6. Agency cost or agency conflict refers to any time a decision is made that does not maximize
14 Instructor’s Manual
Q1-7. Are ethics critical to the financial manager’s goal of maximizing shareholder wealth? How
are the two related? Is establishing corporate ethics policies and requiring employee compli-
ance enough to ensure ethical behavior by employees?
A1-7. Ethics are critical to stockholder wealth maximization. Unethical behavior can have severe
financial consequences to a company. For example, Arthur Anderson was unable to contin-
Q1-8. What are the key provisions of the Sarbanes-Oxley Act of 2002? How has this act changed
the way corporate America conducts business?
A1-8. The U.S Congress passed the Sarbanes-Oxley Act of 2002 in response to the accounting
scandals surrounding Enron, WorldCom and other companies that went bankrupt in 2001,
and due to concerns about auditors’ conflicts of interest. The law was passed in an effort to
improve corporate governance practices in U.S. public companies. The act established a
new Public Company Accounting Oversight Board, with the power to license auditing firms
Act requires that each member of the audit committee must also be a member of the board
of directors – but otherwise be independent (not an officer or employee) – and mandates
that at least one of the committee members must be a “financial expert.”
The Key Provisions of SOX are: (And this list is not exhaustive)
• Sections 401, 404 and 408: Full Disclosure – was an attempt to improve corporate
disclosure and prevent fraudulent use of off balance sheet items. Also required cor-
porate managers to sign-off on the disclosure as accurate and truthful.