Ch 1.

Introduction to
Corporate Finance

1. Corporate Finance
Def: Corporate Finance (Financial Management)
is an area dealing with Capital budgeting, Capital
structure and working capital Management.
Capital budgeting is the process of planning and
managing a firms long term investments.
Capital structure is the mixture of debt and
equity maintained by a firm
Working capital management is about managing
short term assets and liabilities.

2. Forms of Business
Organization
1) sole proprietorship:
A business is owned by a single owner. Income is taxed
as personal income.
Advantage:
- easy and inexpensive to set up
- owner keeps all profits

Disadvantage:
- unlimited liability
- limited to life of owner
- limited capability of raising capitals

 2) Partnership
A business is formed by two or more individuals.
Income is taxed as personal income to partners.
Advantage:
- easy and inexpensive to set up

Disadvantage:
- unlimited liability
- limited life until the partnership is maintained
- limited in transferring ownership
- limited to raise capitals

 3) Corporation: a business created as a

distinct legal entity composed of one or
more individuals and entities. Ownership
is separated from management.

Advantage:
- easy to raise capital
- easy to transfer ownership
- limited liability
- unlimited life

 Disadvantage:
- expensive and not easy to set up
- double taxation: taxes on corporate and
shareholders
4) Limited Liability Company (LLC)
A hybrid of partnership and corporation
Taxed like partnership but rating limited liability for
owners.
5) Another name of corporation: joint stock
companies, public limited companies, limited
liability companies,

3. Goal of Financial
Management
To maximize the current value per share (stock) of the existing
stock.
In general, to maximize the market value of the existing owners
equity.
Sarbanes-Oxley in 2002
- companys annual report must have an assessment of
companys internal control structure and financial reporting. The
auditor must evaluate and attest to managements assessment to
these issues.
- increase the cost of audit to the companies. To avoid the this
cost, public firms have chosen go dark their stocks are no
longer traded in the major stock exchange markets. Or to save
the compliance costs, US firms decided to go public on the London
Stock Exchanges Alternative Investment Market

4. Agency problem and control of

corporation
1) agency relationship: a relation in which one
hires others to represent ones interest.
E.g) stock holders and managers
2) agency problem: the possibility of conflict of
interest between the stock holders and
management of the firm.
E.g) a renovation project benefiting managers
but costing stockholders.
E.g) a very risk project benefiting stockholders
but risking the position of the management.

 3) agency costs: cost of conflict on interest

between stockholders and managers.
Two types of agency costs:
(1) indirect cost: lost investment
opportunities.
(2) direct cost:
- corporate expenditure benefiting
managers but costing stockholders
- an expense in order to monitor the
managers behavior.

 4) how to align interest of management

with that of share (stock) holders?
- Compensation basing on the performance
(e,g) stock option to employee
(e.g) salaries
- Control of the firm: manager replacement
(e.g) proxy fight to step down managers
(e.g) takeover leading to replace the
existing managers with new managers.

 5) Stakeholders: someone other than

a stockholder or creditor who
potentially has a claim on the cash
flows of the firm. E.g) employees,
customers, suppliers, government.
These groups exert control over the
firm.

5. Financial markets and corporation

Financial markets in which corporations can raise
capitals by selling equities or borrowing.
Primary market: original sale of equity or debt by
corporations or government
- public offering registering with SEC
- private offering not registering with SEC
Secondary market: the market where securities
are bought and sold after the original sale. E.g)
NYSE

 Dealer versus Auction Markets

- Dealer market (over-the-counter): dealers who
own securities are connected electronically.
- Auction market: it has physical location and
match those who wish to sell with those who wish
to buy.
Trading in corporate securities: NYSE, AMEX, OTC,
NASDAQ
Listing: stocks that trade on an organized
exchange are said to be listed on that exchange.
To be listed, firms must meet certain minimum
criteria concerning, for example, asset size,
number of shareholders, etc.