Ch. 1: Introduction to Corporate Finance

Corporate Finance (Financial Management) is the study of:

• Capital Budgeting
• What long-term projects should you invest in?
• What lines of business will you be in and what sorts of buildings, machinery, and equipment will you need?
• Capital Structure
• Where will you get the long-term financing to pay for you investment?
• How do you choose between debt and equity financing?
• Working Capital Management
• How will you manage everyday financial activities?
• How do we choose between keeping cash/inventory on hand and short-term borrowing?

Who answers these questions? The Chief Financial Officer (CFO) manages:

• Controller
• cost and financial accounting
• tax payments
• management information systems
• Treasurer
• cash and credit Management
• financial planning
• capital expenditures - plants, property, and equipment (PPE)

Forms of Business Organization

• Sole Proprietorship
• Advantages
  • Easy to start
  • Little regulation
  • Owner keeps the profits (income pass-through)
  • Taxed once as personal income
• Disadvantages
  • Limited to life of owner
  • Equity capital is limited to personal wealth
    • What about debt financing?
    • Isn’t this too tied to the wealth of the owner
  • Unlimited liability
  • Difficult to sell ownership interest (succession planning)
    • Hard to value: separation of assets (ownership) and management
    • New owner needs to have capital or debt capacity
• Partnership
• Advantages
  • Easy to start
  • More access to capital (2+ owners)
  • Taxed once as personal income
• Disadvantages
  • Unlimited liability (for general partners)
  • Partnership dissolves when one partner dies or wishes to sell
  • Difficult to transfer ownership
• Corporations
• Special types of corporations
  • Limited Liability Corporations (LLC)
  • S Corporations
  • C Corporations
  • 501(c)(3) Corporations
• Formation of a corporation
  • Articles of incorporation (charter)
    • name
    • intended life
    • business purpose
    • number of shares
  • Bylaws
    • rules to regulate corporations existence
    • description of how directors are elected
• Advantages
  • Limited liability
  • Unlimited life
  • Easy to transfer ownership
  • Easier to raise capital
• Disadvantages
  • Separation of ownership and management
  • Double taxation

Goals of financial Management

• What is the criterion for management decisions?
  • Survival
  • Avoid financial distress and bankruptcy
  • Beat the competition (What does this mean?)
  • Maximize sales or market shares
  • Minimize costs
  • Maximize profits
  • Maintain steady earnings growth
• Maximize the current market value per share of the existing stock (owner’s equity)
  • Why are debtholders typically okay with this criterion?
  • How does this account for short vs. long-term profits?
• Ethical Considerations
  • Is it ethical for companies to pollute the environment in the course of manufacturing their product?
  • Is it ethical for tobacco companies to sell a product that is known to be addictive and dangerous to consumers?
  • Should the board consider only price when faced with a buyout offer?
  • Should other stakeholders besides simply shareholders be considered in making financial decisions?
  • Should firms be penalized for improving profits through anticompetitive actions?

The Principal/Agent Relationship

• Conflicts of interest (agency costs)
  • Monitoring costs
  • Bonding costs
  • Residual costs
• Keeping management in check
  • Managerial compensation
  • Corporate control
    • proxy fights
    • takeover
  • Sarbanes-Oxley Act of 2002
    • Bonding costs - prohibits personal loans from a company to its officers
    • Monitoring costs - greater disclosure requirements
    • Some companies went private rather than incur these costs
• Other principal/agent relationships in the firm

Financial Markets

• Cash flows to and from the firm
  1. Firm issues securities
  2. Firm invests in assets
  3. Firm’s assets generate cash flows
  4. Firm pays taxes and salaries
  5. Firm reinvests
  6. Firm pays dividends and services debt
• Primary (Public or private placement) vs. secondary markets
• Dealer markets (OTC securities) vs. Auction markets (Listed securities)