8/12/2019 Corporate Fin

1/25

Chapter 1

2009 Cengage Learning/South-Western

The Scope of Corporate

Finance

8/12/2019 Corporate Fin

2/25

2

Corporate Finance in Modern Business

By taking actions that generate benefits inexcess of costs, firms generate wealth for theirinvestors.

When contemplating all business decisions,managers should ask:

Does this action create value for thefirms shareholders?

8/12/2019 Corporate Fin

3/25

3

Career Opportunities in Finance

CorporateFinance

Budgeting, financial forecasting, cashmanagement, credit administration,investment analysis, fund procurement

Commercial

Banking

Consumer banking

Corporate banking

InvestmentBanking

High income potential

Very competitive industry

MoneyManagement

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

8/12/2019 Corporate Fin

4/25

4

Financial Management

External Financing

Capital Budgeting

Corporate Governance

Risk Management

CorporateFinance

Functions

Corporate Finance Functions

8/12/2019 Corporate Fin

5/25

5

The External Financing Function

Raising capital to support companies operationsand 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.

8/12/2019 Corporate Fin

6/25

6

Capital Budgetingselecting thebest projects in which to investthe resources of the firm, basedon each projects perceived risk

and expected return.

Select investments for which the marginal benefits exceedthe marginal costs.

The Capital Budgeting Function

8/12/2019 Corporate Fin

7/25

7

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 equityclaims on firms, and

to ensure that companies can pay off theirobligations when they come due.

Involves obtaining seasonal financing, managinginventories, paying suppliers, collecting from customers,and investing surplus cash

8/12/2019 Corporate Fin

8/25

8

The Corporate Governance Function

Developing ownership and corporate governancestructures for companies that ensure that managers

behave ethically and make decisions that benefitshareholders.

Dimensions ofcorporate

governance

Boards of directors

Compensation packages

Auditors

Countrys legal environment - inU.S., Sarbanes-Oxley Act of 2002

The takeover market disciplines firms that do not

govern themselves.

8/12/2019 Corporate Fin

9/25

9

The Risk Management Function

Managing firms exposures to all types of risk,

both insurable (such as loss caused by fire orflood) and uninsurable,

in order to maintain optimum risk-return trade-offs and thereby maximize shareholder value.

Modern risk management focuses on adverse

interest rate movements, commodity pricechanges, and currency value fluctuations.

8/12/2019 Corporate Fin

10/25

10

Debt & Equity: Two Flavors of Capital

DebtCapital

Borrowed money. The borrower is obliged to pay interest,

at a specified annual rate, on the fullamount borrowed, as well as to repay

the principal amount at the debtsmaturity.

EquityCapital

An ownership interest usually in the

form of common or preferred stock. Common stockholders receive returns

on their investments only aftercreditors and preferred stockholdersare paid in full.

8/12/2019 Corporate Fin

11/25

11

Financial Intermediation

FinancialIntermediary

An institution that raises capital byissuing liabilities against itself, andthen lends that capital to corporateand individual borrowers.

Examples: insurance companies,savings and loan institutions, creditunions, commercial banks, pensionfunds, mutual funds.

Pension funds and mutual funds, have surged toprominence as corporate finance shifts towardsgreater reliance on market-based externalfunding.

8/12/2019 Corporate Fin

12/25

12

Total Value of Primary Corporate Security Issues,1990 - 2006

8/12/2019 Corporate Fin

13/25

13

SoleProprietorships

No distinction between business andperson

Easy to set up, operate; taxed aspersonal income

Personal liability, limited life, difficult to

transfer

Partnerships Two or more business owners

Partners - liable for every partnersactions

Limited

Partnerships

One or more general partners & manylimited partners

Limited liability of corporation, taxbenefits of partnership

Business Organizational Forms in the U.S.

8/12/2019 Corporate Fin

14/25

8/12/2019 Corporate Fin

15/25

The FinanceFunction inthe

Organizational Structureof A TypicalLarge

Corporation

15

8/12/2019 Corporate Fin

16/25

16

Corporations in the U.S.

The Jobs and Growth Tax Relief ReconciliationAct of 2003 (Tax Relief Act of 2003) dramaticallyreduced the double taxation problem.

Double TaxationProblem

Taxation of corporate income at boththe company and the personal levels.

This is the single greatest disadvantageof the corporate form.

8/12/2019 Corporate Fin

17/25

17

Taxation of Business Income for Corporations andPartnerships

Before the Tax Relief Act of 2003

After the Tax Relief Act of 2003

8/12/2019 Corporate Fin

18/25

18

S Corporations

Allow shareholders to be taxed aspartners yet retain their limited liabilitystatus.

Must meet certain criteria like having75 or fewer shareholders.

Can become regular corporations later.

Limited

LiabilityCompanies

Combine partnerships pass-throughtaxation with S corporations limited

liability. Popular with professional service firms.

Business Organizational Forms in the U.S.

8/12/2019 Corporate Fin

19/25

19

The Growth of Stock Market Capitalization

8/12/2019 Corporate Fin

20/25

20

The Corporate Financial Managers Goals

Maximize profit? Earnings reflect past performance, rather than current

or future performance.

Ignores the timing of the profits.

Ignores cash flows.

Ignores risk.

What should a financial manager tryto maximize?

8/12/2019 Corporate Fin

21/25

21

The Corporate Financial Managers Goals

Maximize shareholder wealth? As measured by the market price of the firms stock.

A firms 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.

What should a financial manager tryto maximize?

8/12/2019 Corporate Fin

22/25

22

The Corporate Financial Managers Goals

Focus on stakeholders? Many firms seek to preserve the interests of other

stakeholders, such as employees, customers, taxauthorities, and the communities where the firmsoperate.

Doing so provides long-term benefits to shareholdersand is in line with the primary goal of maximizingshareholder wealth.

What should a financial manager tryto maximize?

8/12/2019 Corporate Fin

23/25

23

Agency Costs in Corporate Finance

To overcome agency problems:

Rely on market forces to exert managerial discipline;

Incur monitoring and bonding costs to supervisemanagers; and

Structure executive compensation packages to alignmanagers interests with stockholders interests.

Agency Problems The conflict between the goals of afirms owners and its managers.

The actual workings of many compensation plans havebeen harshly criticized in recent years.

8/12/2019 Corporate Fin

24/25

24

Ethics in Corporate Finance

Today, society in general and the financialcommunity in particular are developing andenforcing higher ethical standards.

The U.S. Congress passed the Sarbanes-OxleyAct in 2002 to enforce higher ethical standardsand increase penalties for violators.

8/12/2019 Corporate Fin

25/25

25

The Scope of Corporate Finance

Financial managers should seek to maximizeshareholders wealth.

How?

By performing the five basic duties of corporate finance:External financing, capital budgeting, financialmanagement, risk management, corporate governance.

Select investments for which the marginalbenefits exceed the marginal costs.