Chapter 1

Introduction to Corporate Finance

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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 the financial manager
 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. In what long-lived assets should the firm invest?
2. How can the firm raise cash for required capital
expenditures?
3. How should short-term operating cash flows be
managed?

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The Balance Sheet Model of the Firm
Total Value of Assets: Total Value of the Firm to Investors:
Current
Liabilities
Current Assets
Long-Term
Debt

Fixed Assets
1. Tangible
Shareholders’
2. Intangible Equity

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The Capital Budgeting Decision
Current
Liabilities
Current Assets
Long-Term
Debt

Fixed Assets
In what long-
1. Tangible term assets Shareholders’
2. Intangible should the firm Equity
invest?

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The Capital Structure Decision
Current
Liabilities
Current Assets
Long-Term
How should the Debt
firm raise funds
for the selected
Fixed Assets
investments?
1 Tangible Shareholders’
2 Intangible Equity

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Short-Term Asset Management

Current
Liabilities
Current Assets
Net
Working Long-Term
Capital Debt

How should
Fixed Assets
short-term
1 Tangible operating cash
Shareholders’
flows be
2 Intangible managed? Equity

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The Financial Manager

The financial manager’s primary goal is to increase the

value of the firm by:
1. Selecting value-creating projects
2. Making smart financing decisions

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Hypothetical Organization Chart
Board of Directors

Chairman of the Board and

Chief Executive Officer (CEO)

Vice President and

Chief Financial Officer (CFO)

Treasurer Controller

Cash Manager Credit Manager Tax Manager Cost Accounting

Manager

Financial Accounting Information Systems

Capital Expenditures Financial Planning Manager Manager

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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

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A Comparison of Corporations and
Partnerships
  Corporation Partnership

Liquidity Shares can be easily Subject to substantial

exchanged restrictions

Voting rights Usually each share gets one General partner is in charge;
vote limited partners may have
some voting rights

Taxation Double Partners pay personal taxes

on partnership profits
Reinvestment and dividend Broad latitude All net cash flow is
payout 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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1.3 The Importance of Cash Flows

Cash for securities issued by the firm (A) Financial

markets
Firm
Invests
invests in Retained
in assets cash flows (E)
assets
(B) (B)
Short-term debt
Current assets Cash flow Dividends and Long-term debt
Fixed assets from firm (C) debt payments (F)
Equity shares

Taxes
Ultimately, the firm The cash flows from
must be a cash- the firm should exceed
Government (D)
generating activity. 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 costs?
◦ Maximize market share?
◦ Maximize shareholder wealth?

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1.5 The Agency Problem and Control
of the Corporation
 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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Management Goals
 Management 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
 The Securities Act of 1933 and the Securities
Exchange Act of 1934
◦ Issuance of Securities (1933)
◦ Creation of SEC and reporting requirements (1934)
 Sarbanes-Oxley (“Sarbox”)
◦ Increased reporting requirements and responsibility of
corporate directors

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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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