Corporate Finance Fundamentals

CHAPTER 1: INTRODUCTION TO CORPORATE FINANCE 1.1 CORPORATE FINANCE AND THE FINANCIAL MANAGER 1.2 FORMS OF BUSINESS ORGANIZATION 1.3 THE GOAL OF FINANCIAL MANAGEMENT 1.4 THE AGENCY PROBLEM AND CONTROL OF THE CORPORATION 1.5 FINANCIAL MARKETS AND THE C ORPORATION CHAPTER 2: FINANCIAL STATEMENTS, TAXES, AND CASH FLOW 2.1 THE BALANCE SHEET 2 2 2 4 4 5 6 6

Chapter 1: Introduction to Corporate Finance

1.1 Corporate Finance and the Financial Manager
1. What is corporate finance? Corporate finance is a study of ways to answer:  What long-term investments should you take on?  Where will you get long term financing to pay for your investment?  How will you manage your everyday financial activities such as collecting from customers and paying suppliers  Corporate finance is the study of the relationship between business decisions and the value of the stock in the business. 2. Directors are elected by the shareholders of a corporation. The corporation employs mangers to represent the owners interests and make decisions on their behalf.  VP of finance coordinates the activities of the treasurer and the controller. i. Controller handles cost and financial accounting, tax payments, and management information systems ii. Treasurer is responsible for managing firm s cash and credit, it s financial planning and capital expenditures 3. Capital budgeting: process of planning and managing a firm s long-term investments  Financial manager tries to identify investment opportunities that are worth more to the firm that they cost of acquire  Value of cash flow generated by an asset > cost of asset  Evaluating size, timing, and risk of future cash flow are important 4. Capital/Financial structure: the specific mixture of long-term debt and equity the firm uses to finance its operations.  How much to borrow? i.e. what mixture of debt and equity is the best as this will affect the risk and value of the firm i. Debts are tax deductible. Company can save a lot of cash flows. High-risk profile. High bankruptcy risk. If a company cannot meet interest rate money, can have bankruptcy risk. Faster than issuing shares. Borrowing from bank is faster. ii. Equity requires double taxation. If dividends can t be met, company will not go bankrupt. But share price might drop.  What are the least expensive sources of funds for the firm? 5. Working capital management: managing the firm s short-term assets (e.g. inventory) and it s short term liabilities (e.g. money owed to suppliers)  A day to day activity that ensures the firm has sufficient resources to continue its operations and avoid costly interruptions

1.2 Forms of Business Organization

1. Sole Proprietorship  Business owned by one person Advantages Simplest to start, least regulated

Disadvantages Owner has unlimited liability (i.e. no distinction between personal and business

Owner keeps all the profits

income -> all business income is taxed as personal income) Life of business is limited to owner s own life span Limited capital Hard ownership transfer becos this transfer requires the sale of the entire biz to a new owner.

2. Partnership  Two or more owners  General partnership: i. Partners share gains and losses ii. All have unlimited liability for all partnership debts iii. Transfer is not easy as it requires a new partnership to be formed  Limited partnership: i. One or more general partners will run the business and have unlimited liability, but there will be more limited partners who will not actively participate in running the biz ii. Limited partner s debts is limited to the amount that partner contributes to the partnership iii. E.g. real estate venture, law firm, accounting firm iv. Limited partner s interest can be sold without breaking the partnership, but might be hard to find a buyer  Central problem: the ability of growth for such businesses can be seriously limited by an inability to raise cash for investment 3. Corporation  Business owned by stockholders  It is a person separate and distinct from its owners  Stockholders elect board of directors who then elect managers i. Managers are charged with running the corporation s affairs in the stockholders interests ii. Management may not be shareholders of the company Advantages Disadvantages Easier to raise money (i.e. easy to access the external capital market) Double taxation (i.e. profits earned will first be taxed at corporate level, shareholders dividends will be taxed at personal level) Agency issues

Limited liability (i.e. max amount they lose is the amount invested in the company; private assets will not be lost) Easy ownership transfer (i.e. stocks can be sold easily)

Complex regulations (i.e. tedious to setup as need to follow a lot of legal regulations; many public corporations became private corporations later on)

 Limited Liability Corporation (LLC) i. Hybrid of partnership and corporation

ii. Goal of this entity is to operate and be taxed like a partnership but retain limited liability for owners iii. E.g. Goldman Sachs, one of Wall Street s last remaining partnerships, decided to convert to from a private partnership to an LLC. Later it went public to become a publicly held corporation.  Firms are often called joint stock companies, public limited companies, or limited liability companies

1.3 The Goal of Financial Management

1. The goal of financial management is to maximize the current value per share of the existing stock.  i.e. maximize stock value 2. Total value of stock = total value of shareholder s equity 3. The goal of financial management can also be stated as to maximize the market value of the existing owners equity.

1.4 The Agency Problem and Control of the Corporation

1. Agency relationship: relationship between stockholders and management  Exists whenever someone (the principal) hires another (the agent) to represent his or her interests 2. Agent problem: conflict of interest between principal and agent  E.g. when u hire an agent to sell a car at a flat fee. The agent s incentive is to make the sale, not necessarily get you the best price. However if based on commission based, this might not be a problem. 3. Agency cost: costs of the conflict of interest between stockholders and the management. Can be direct and indirect. Indirect cost can be the lost of opportunity. 4. Direct agency cost comes in two forms.  Corporate expenditure that benefits management but costs the stockholders. E.g. purchase of luxurious jet.  Arises from the need to monitor management actions. E.g. paying outside auditors to assess the accuracy of financial statement info. 5. Some managers tend to maximize the amount of resources over which they have control, or more generally, corporate power or wealth. This could lead to overemphasis on corporate size or growth. Some management is accused of overpaying to buy up another company just to increase the size of the business. If overpayment occurs, the purchase does not benefit the stockholders of the purchasing company. 6. Whether managers will act in stockholders interests depends on two factors:  How closely the management goals are aligned with the stockholder goals  Can managers be replaced if they do not pursue stockholder goals

7. Solutions to agency problems:  Managerial compensation: Management will frequently have a significant economic incentive to increase share value for 2 reasons i. Managerial compensation is usually tied to financial performance. E.g. managers are frequently given the option to buy stock at bargain price. The more the stock is worth, the more value is this option. ii. Relates to job prospects. Better performers will tend to get promoted.  Control of firm ultimately rests with stockholders who elect board of directors and who in turn hire and fire managers.  Proxy fight: an impt mechanism by which unhappy stockholders can act to replace existing management  Takeover: managers can be replaced by takeovers. Avoiding takeover by another firm gives management another incentive to act in the stockholders interests.

1.5 Financial Markets and the Corporation

1. Primary market refers to the original sale of securities by governments and corporations.  Corporation is the seller and the transaction raises money for the corporation  Corporation engages two types of primary market transactions i. Public offering involves selling securities to the general public ii. Private placing is a negotiated sale involving a specific buyer 2. Secondary markets are those in which these securities are bought and sold after the original sale.  Transaction involves on owner or creditor selling to another  Provide the means for transferring ownership of corporate securities  Secondary markets are still critical to large corporations because investors are more willing to purchase securities in a primary market transaction when they know that those securities can later be resold if desired  Two types of secondary markets: i. Auction markets: has a physical location and primary purpose is to match those who wish to sell with those who wish to buy ii. Dealer markets (over the counter markets e.g. NASDAQ): dealers buy and sell for themselves at their own risks 3. Stocks that trade on an organized exchange are said to be listed on that exchange. To be listed, certain criteria must be met, e.g. asset size and number of shareholders.

Chapter 2: Financial Statements, Taxes, and Cash Flow

2.1 The Balance Sheet
1. What is corporate finance? Corporate finance is a study of ways to answer: