Chapter 1

Introduction to Corporate Finance

Copyright 2015 by the McGraw-Hill Education (Asia). All rights reserved.

Key Concepts and Skills

Know

the basic types of financial management

decisions and the role of the Financial Manager
Know the financial implications of the various
forms of business organization
Know the goal of financial management
Understand the conflicts of interest that can arise
between owners and managers
Understand the various regulations that firms
face
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Chapter Outline
1.1 What is Corporate Finance?
1.2 The Corporate Firm
1.3 The Importance of Cash Flows
1.4 The Goal of Financial Management
1.5 The Agency Problem and Control of the
Corporation
1.6 Regulation
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1.1 What Is Corporate Finance?

Corporate Finance addresses the following
three questions:
1.
2.
3.

What long-term investments should the firm

choose?
How should the firm raise funds for the selected
investments?
How should short-term assets be managed and
financed?
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Balance Sheet Model of the Firm

Total Value of Assets:

Current Assets

Total Firm Value to Investors:

Current
Liabilities
Long-Term
Debt

Fixed Assets
1 Tangible
2 Intangible

Shareholders
Equity
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The Capital Budgeting Decision

Current
Liabilities

Current Assets

Long-Term
Debt
Fixed Assets
1 Tangible
2 Intangible

What long-term
investments
should the firm
choose?

Shareholders
Equity

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The Capital Structure Decision

Current Assets

How should the

firm raise funds
for the selected
Fixed Assets
investments?
1 Tangible
2 Intangible

Current
Liabilities
Long-Term
Debt

Shareholders
Equity

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Short-Term Asset Management

Current Assets

Fixed Assets
1 Tangible
2 Intangible

Current
Liabilities
Net
Working
Capital

How should
short-term assets
be managed and
financed?

Long-Term
Debt

Shareholders
Equity

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The Financial Manager

The Financial Managers primary goal is to
increase the value of the firm by:
1. Selecting value creating projects
2. Making smart financing decisions

1-9

Hypothetical Organization Chart

Board of Directors
Chairman of the Board and
Chief Executive Officer (CEO)
President and Chief
Operating Officer (COO)
Vice President and
Chief Financial Officer (CFO)

Treasurer

Controller

Cash Manager

Credit Manager

Tax Manager

Cost Accounting

Capital Expenditures

Financial Planning

Financial Accounting

Data Processing
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1.2 The Corporate Firm

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.

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Forms of Business Organization

The Sole Proprietorship

The Partnership

General Partnership
Limited Partnership

The Corporation

1-12

A Comparison
Corporation

Partnership

Liquidity

Shares can be easily

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

Double

Partners pay taxes on

distributions

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

Continuity

Perpetual life

Limited life
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International Corporations

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1.3 The Importance of Cash Flow

Firm

Firm issues securities (A)

Invests
in assets
(B)

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

Dividends and
debt payments (E)
Taxes (D)

Current assets
Fixed assets

Financial
markets

Ultimately, the firm

must be a cash
generating activity.

Government

Long-term debt
Equity shares

The cash flows from

the firm must exceed
the cash flows from
the financial markets.

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1.4 The Goal of Financial Management

What is the correct goal?

Maximize profit?
Minimize cost?
Maximize market share?
Maximize shareholder wealth?

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1.4 Goal of Finance

Maximizing profit?

Maximizing profit is not a suitable goal

because:

Profits can be increased by reducing cost.

This is discussed in the next slide.

Profits are not cash flows

Risk is not taken into account

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1.4 Goal of Finance

- Minimizing cost?

Minimizing cost is not a suitable goal because:

Minimizing costs may increase current profits but

the future well-being of the company may be
affected, for example,

Reducing maintenance costs may result in machines

breaking down earlier in the future
Reducing R&D expenditures may cause the products to
be less competitive
Reducing headcount may reduce the quality of service

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1.4 Goal of Finance

- Maximizing market share?

Maximizing market share is not a suitable

goal because:

In order to increase market the firm may large

amounts in advertising and promotion
Having a large market share may not translate
into higher profits if the firm cannot increase
revenue much more by increasing prices

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1.4 Goal of Finance

- Maximizing shareholder wealth?

This is the right goal of finance because:

It avoids the problems of the other goals by taking risk

into consideration, as well as the impact on future cash
flows of the firms actions

An investment may promise high returns, but if the risks

involved are too high, then the investment may not be
viable.
As the share price depends not only on current cash flows
but future cash flows as well, any action taken by the firm
would consider not just the short term effects but the long
term effects to the firm
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1.5 The Agency Problem

Agency

relationship

Principal

hires an agent to represent his/her interest

Stockholders (principals) hire managers (agents) to
run the company
Agency

problem

Conflict

of interest between principal and agent

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Managerial Goals

Managerial goals may be different from

shareholder goals

Expensive perquisites
Survival
Independence

Increased growth and size are not necessarily

equivalent to increased shareholder wealth

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Managing Managers
Managerial

compensation

Incentives

can be used to align management and

stockholder interests
The incentives need to be structured carefully to
make sure that they achieve their intended goal
Corporate

control

The

threat of a takeover may result in better

management

Other

stakeholders
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1.6 Regulation

Securities Acts

Each country has its own securities acts to govern

the operations of the securities markets in relation to

Trading of securities
Issue of new securities
Corporate disclosure and insider trading

Sarbanes-Oxley (Sarbox)

Increased reporting requirements and responsibility

of corporate directors
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Corporate Governance

Corporate governance relates to the rights and

responsibilities of various stakeholders in the
firm
A firm with good corporate governance would

Respect the rights of the shareholders and other

stakeholders
Ensure that the board of directors represent the best
interests of shareholders
Operate in a transparent manner
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Quick Quiz
What

are the three basic questions Financial

Managers must answer?
What are the three major forms of business
organization?
What is the goal of financial management?
What are agency problems, and why do they
exist within a corporation?
What major regulations impact public firms?
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