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Corporate Finance:
Introduction & Basic Terminology

January 12, 2016

Based on Berk et al, Ch. 1.

Course Resources
Textbook: Corporate Finance, Berk, DeMarzo,
Stangeland; 3d Canadian Edition
The same textbook as was used in
ECO358H1F this year.

Slides: to be posted on portal.utoronto.ca

Office Hours & TA support:
TAs: Shiny Zhang, Tomy Lee, David Cimon
OH: TBA. In the meantime, please e-mail
katya.malinova@utoronto.ca

Basic Organization
We have:
2-hour a week lectures, typically 3-5 and
5-7pm, with few exceptions (e.g., today and
Jan 19).
occasional 1-hour tutorials

Next week (January 19) the lectures are

2-4pm and 6-8pm. No tutorials.

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What is Corporate Finance?

Corporate Finance addresses the following four
questions:
1. What long-term investments should the firm
engage in?
2. How can the firm raise the money for the
required capital expenditure (& how to
distribute cash back to stakeholders)?
3. How should short-term operating cash flow be
managed?
4. How (if at all) does the form of financing affect
investment and vice versa? [Will return to this
question in a couple of weeks.]
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Balance-Sheet Model of the Firm

Total Value of Assets:

Total Firm Value to Investors:

Current
Liabilities

Current Assets

Long-Term
Debt

Fixed Assets
1 Tangible
2 Intangible

Shareholder
s Equity
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Balance-Sheet Model of the Firm

1. The Capital Budgeting Decision
Current
Liabilities

Current Assets

Long-Term
Debt
Fixed Assets
1 Tangible
2 Intangible

What long-term
investments
should the firm
engage in?

Shareholders
Equity
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The Balance-Sheet Model of the Firm

2. The Capital Structure Decision
Current Liabilities
Current Assets
Long-Term Debt
How can the firm
raise the money for
the required
investments?

Fixed Assets
1 Tangible
2 Intangible

Shareholders
Equity

Balance-Sheet Model of the Firm

3. The Net Working Capital Investment Decision
Current
Liabilities

Current Assets
Net
Working
Capital

Fixed Assets
1 Tangible
2 Intangible

How much shortterm cash flow

does a company
need to pay its
bills?

Long-Term
Debt

Shareholders
Equity
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The Firm and the Financial Markets

Firm
Invests
in assets
(B)

Ultimately, the firm

must be a cash
generating activity

Financial
markets

Retained
cash flows (D)
Short-term debt
Cash flow
from firm (C)

Dividends and
debt payments (F)
Taxes (E)

Current assets
Fixed assets

Firm issues securities (A)

Long-term debt
Equity shares

Government
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Debt and Equity are Contingent

Claims on Total Firm Value

The basic feature of a debt is that it is a

promise by the borrowing firm to repay a fixed
dollar amount by a certain date.
The shareholders claim on firm value is the
residual amount that remains after the
debtholders are paid.
If the value of the firm is less than the amount
promised to the debtholders, the shareholders
get nothing.
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Debt and Equity as Contingent Claims

Payoff to
debt holders

Payoff to
shareholders

If the value of the firm

is more than $F,
debtholders get $F.

If the value of the

firm is less than $F,
shareholders get
nothing.

$F

$F

$F

Value of the firm (X)

Value of the firm (X)

Debtholders are promised $F.

If the value of the firm is less than $F, they
get whatever the firm is worth.
The bondholders claim is: Min[$F,$X]

If the value of the firm is more

than $F, shareholders get
everything above $F.

The shareholders claim is: Max[0,$X $F]

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Combined Payoffs to Debt and Equity

Combined Payoffs to debtholders
and shareholders

If the firm value $X is less than $F, the

shareholders claim (equity value) is $0,
the debtholders claim (debt value) is $X.
The sum of these is = $X = firm value

Debtholders get F;
shareholders get X-F.

$F

Debtholders get X;
shareholders get 0.

$F

Value of the firm (X)

Debtholders are promised $F.

Shareholders are the residual
claimants (i.e., get the remainder).

If the firm value $X is more than $F, the

shareholders claim is $X $F, the
debtholders claim is $F.
The sum of these is = $X = firm value

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Forms of Business Organization

The corporate form of business is the standard method
for solving the problems encountered in raising large
amounts of cash.
However, businesses can take other forms.
Most common forms of organization:
The Sole Proprietorship
The Partnership
General Partnership
Limited Partnership

Limited Liability Companies & The

Corporation

Each form has advantages/disadvantages.

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Sole Proprietorships
Business is owned and run by one person
Typically has few, if any, employees
Advantages
Easy to create

Disadvantages
Unlimited personal liability
Limited life

Partnerships: similar to a sole proprietorship

but with more than one owner.
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Partnership vs Corporations
Corporation

Partnership

Liquidity and marketability

Shares can easily be

exchanged

Subject to substantial
restrictions.

Voting Rights

Usually each share gets

one vote

General Partner is in
charge; limited partners
may have some voting
rights.

Taxation

Typically double with dividend

tax credit

Partnership income is
taxable.

Reinvestment and
dividend payout

Broad latitude

All net cash flow is

distributed to partners.

Liability

Limited liability

General partners may have

unlimited liability. Limited
partners enjoy limited
liability. Also: LLP in Canada.

Continuity of existence

Perpetual life

Limited life

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Types of U.S. Firms

Source: www.bizstats.com
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Figure 1.1

Copyright 2015 Pearson Canada Inc.

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Ownership vs Control of Corporations

The Corporate Management Team

In a corporation, ownership and direct control
are typically separate.
Board of Directors
Elected by shareholders
Have ultimate decision-making authority
Chief Executive Officer (CEO)
Board typically delegates day-to-day decision
making to CEO.

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Organizational Chart of a
Typical Corporation

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Goals of the Corporate Firm

What are firm decision-makers hired to do?
The traditional answer is that the managers of the
corporation are obliged to make efforts to maximize
shareholder wealth.
In the absence of financial distress, maximizing
shareholder value = maximizing the firm value.

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Goals of the Corporate Firm:

Questions and Issues
Are the shareholder goals always aligned? (Thankfully, yes,
for the important financial decisions.)
Are managerial goals the same as the shareholder goals?
(Examples?)
In addition to shareholders and management, employees,
customer, suppliers, and the public all have a financial
interest in the firm and its decisions.
Bottom line: shareholder interests may differ from those of
other stakeholders.
We will discuss/touch upon:
conflicts of interest between shareholders & managers;
shareholders & debtholders.
corporate governance/executive compensation
Other issues to consider: the firm and society & socially
responsible investing.
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The Agency Problem

The agency relationship
Manager = an agent of shareholders

Managers may act in their own interest rather than in the

best interest of the shareholders.
One potential solution is to tie management s compensation
to firm performance.
Potential problem: how should performance be
measured? (What is the problem?)

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Do Shareholders Control
Managerial Behavior?
Shareholders vote for the board of directors, who in turn
hire the management team.
Contracts can be carefully constructed to be incentive
compatible.
There is a market for managerial talentthis may provide
market discipline to the managersthey can be replaced.
If the managers fail to maximize share price, they may be
replaced in a hostile takeover.
If a CEO is performing poorly, shareholders can express their
dissatisfaction by selling their shares. The selling pressure
may drive the share price down.
Low share prices may entice a Corporate Raider to buy
enough shares so they have enough control to replace current
management. The share price will rise after the new
management team fixes the company.

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Financial Markets
Primary versus Secondary Markets:
Primary Market
When a corporation issues securities, cash flows from investors to
the firm.
Usually an underwriter is involved.
Any costs that are associated with issuance are paid by the
firm => need to understand the mechanisms & costs for
security issuance (will touch upon when discussing IPOs).

Secondary Markets
After the initial transaction in the primary market, the shares
continue to trade in a secondary market between investors.
E.g., transactions between investors on a stock exchange.
Trading costs are borne by investors/shareholders => not
directly paid by the firm.
Yet, it is still important to understand these. Why?
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Trading Costs and Corporate

Finance
The stock market provides liquidity to
shareholders.
Liquidity (extremely loosely):
The ability to easily sell (and buy) an asset.
low transaction costs
easy to find somebody to trade with

Liquidity is valuable: provides flexibility to investors

regarding the timing and the duration of their
investments in a firm.
If it is difficult for shareholders to (re-)sell their
shares, they will require to be compensated & demand
higher returns on their investment.
=> Higher costs of equity capital for companies when
raising capital!
We briefly discussed the organization of the market in
ECO358; further discussion is beyond the scope of the
ECO358/ECO359 sequence.

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Rough Outline of the Course

Financial Statements: Basics Definitions.
Did most of this in ECO358H1F in the fall of 2015; review Ch. 2 if
you took a different ECO358.

Basics of Capital Budgeting & Project Valuation.

Financial Decision Making, Competitive Markets, NPV & Alternative
Investment Rules.
We did most of this in ECO358, review Ch. 3 if you missed it.
We will zoom into Alternative Investment Decision Rules a bit more.

Capital Structure Decisions.

Capital Structure in a Perfect Market.

Debt and Taxes.
Payout Policy: dividends vs. repurchases vs. retaining cash.
Financial Distress Costs & Managerial Incentives.

Advanced Valuation:
Capital Budgeting and Valuation with Leverage.
Valuing Investments using Real Options.

Long-Term Financing
Raising Equity Capital, IPOs.

Intro to Mergers and Acquisitions.

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