Introduction To Corporate Finance

Chapter One
Introduction to Corporate
Finance
1-1
What is Corporate Finance?
• Corporate finance attempts to find the answers to the following

questions:
• What investments should the business take on?
THE INVESTMENT DECISION
• How can finance be obtained to pay for the required investments?
THE FINANCE DECISION
• Should dividends be paid? If so, how much?
THE DIVIDEND DECISION
1-2
The Financial Manager
• Financial managers try to answer some or all of these questions.

• The top financial manager within a firm is usually the General
Manager–Finance.
• Corporate Treasurer or Financial Manageroversees cash management,
credit management, capital expenditures and financial planning.
• Accountantoversees taxes, cost accounting, financial accounting and data
processing.
1-3
The Investment Decision
• Capital budgeting is the planning and control of cash outflows in the

expectation of deriving future cash inflows from investments in non-
current assets.
• Involves evaluating the:

• size of future cash flows
• timing of future cash flows
• risk of future cash flows.
1-4
Cash Flow Size
• Accounting income does not mean cash flow.
• For example, a sale is recorded at the time of sale and a cost is

recorded when it is incurred, not when the cash is exchanged.
1-5
Cash Flow Timing
• A dollar today is worth more than a dollar at some future date.
• There is a trade-off between the size of an investment’s cash flow

and when the cash flow is received.
1-6
Cash Flow Timing
Which is the better project?
Future Cash Flows
Year Project A Project B
1 $0 $20 000
2 $10 000 $10 000
3 $20 000 $0
Total $30 000 $30 000
1-7
Cash Flow Risk
• The role of the financial manager is to deal with the uncertainty

associated with investment decisions.
• Assessing the risk associated with the size and timing of expected
future cash flows is critical to investment decisions.
1-8
Cash Flow Risk
Which is the better project?
Future Cash Flows
Pessimistic Expected Optimistic
Project 1 $100 000 $300 000 $500 000
Project 2 $200 000 $400 000 $600 000
1-9
Capital Structure
• A firm’s capital structure is the specific mix of debt and equity used to
finance the firm’s operations.
• Decisions need to be made on both the financing mix and how and
where to raise the money.
1-10
Working Capital Management
• How much cash and inventory should be kept on hand?
• Should credit terms be extended? If so, what are the conditions?
• How is short-term financing acquired?
1-11
Dividend Decision
• Involves the decision of whether to pay a dividend to shareholders or

maintain the funds within the firm for internal growth.
• Factors important to this decision include growth opportunities,

taxation and shareholders’ preferences.
1-12
Corporate Forms of Business Organisation
The three different legal forms of business

organisation are:
• sole proprietorship
• partnership
• company.
1-13
Sole Proprietorship
• The business is owned by one person.

• The least regulated form of organisation.
• Owner keeps all the profits but assumes unlimited liability for the
business’s debts.
• Life of the business is limited to the owner’s life span.
• Amount of equity raised is limited to owner’s personal wealth.
1-14
Partnership
• The business is formed by two or more owners.

• All partners share in profits and losses of the business and have
unlimited liability for debts.
• Easy and inexpensive form of organisation.
• Partnership dissolves if one partner sells out or dies.
• Amount of equity raised is limited to the combined personal wealth
of the partners.
• Income is taxed as personal income to partners.
1-15
Company
• A business created as a distinct legal entity composed of one of more

individuals or entities.
• Most complex and expensive form of organisation.
• Shareholders and management are usually separated.
• Ownership can be readily transferred.
• Both equity and debt finance are easier to raise.
• Life of a company is not limited.
• Owners (shareholders) have limited liability.
1-16
Possible Goals of Financial Management
• Survival
• Avoid financial distress and bankruptcy
• Beat the competition
• Maximise sales or market share
• Minimise costs
• Maximise profits
• Maintain steady earnings growth
1-17
Problems with these Goals
• Each of these goals presents problems.

• These goals are either associated with increasing profitability or
reducing risk.
• They are not consistent with the long-term interests of shareholders.
• It is necessary to find a goal that can encompass both profitability
and risk.
1-18
The Firm’s Objective
• The goal of financial management is to maximise shareholders’

wealth.
• Shareholders’ wealth can be measured as the current value per share

of existing shares.
• This goal overcomes the problems encountered with the goals

outlined above.
1-19
Agency Relationships
• The agency relationship is the relationship between the shareholders

(owners) and the management of a firm.
• The agency problem is the possibility of conflict of interests between

these two parties.
• Agency costs refer to the direct and indirect costs arising from this
conflict of interest.
1-20
Do Managers Act in Shareholders’ Interests?
The answer to this will depend on two factors:
• how closely management goals are aligned with shareholder goals
• the ease with which management can be replaced if it does not act in
shareholders’ best interests.
1-21
Alignment of Goals
The conflict of interests is limited due to:
• management compensation schemes
• monitoring of management
• the threat of takeover
• other stakeholders.
1-22
Cash Flows between the Firm and the Financial
Markets
Total Value of the Firm
Total Value of to Investors in
Firm’s Assets the Financial Markets
A. Firm issues securities

B. Firm Financial
invests in Markets
assets
E. Retained cash flows F. Dividends and Short-term debt
Current debt payments Long-term debt
Assets Equity shares
Fixed C. Cash flow from
Assets firm’s assets
D. Government
1-23

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Chapter One

• Corporate finance attempts to find the answers to the following

• Financial managers try to answer some or all of these questions.

• Capital budgeting is the planning and control of cash outflows in the

• Involves evaluating the:

• Accounting income does not mean cash flow.

• For example, a sale is recorded at the time of sale and a cost is

• A dollar today is worth more than a dollar at some future date.

• There is a trade-off between the size of an investment’s cash flow

Which is the better project?

Future Cash Flows

Year Project A Project B

2 $10 000 $10 000

Total $30 000 $30 000

• The role of the financial manager is to deal with the uncertainty

Which is the better project?

Future Cash Flows

Pessimistic Expected Optimistic

Project 1 $100 000 $300 000 $500 000

Project 2 $200 000 $400 000 $600 000

• How much cash and inventory should be kept on hand?

• Should credit terms be extended? If so, what are the conditions?

• How is short-term financing acquired?

• Involves the decision of whether to pay a dividend to shareholders or

• Factors important to this decision include growth opportunities,

The three different legal forms of business

• The business is owned by one person.

• The business is formed by two or more owners.

• A business created as a distinct legal entity composed of one of more

• Each of these goals presents problems.

• The goal of financial management is to maximise shareholders’

• Shareholders’ wealth can be measured as the current value per share

• This goal overcomes the problems encountered with the goals

• The agency relationship is the relationship between the shareholders

• The agency problem is the possibility of conflict of interests between

The answer to this will depend on two factors:

• how closely management goals are aligned with shareholder goals

The conflict of interests is limited due to:

• management compensation schemes

• the threat of takeover

A. Firm issues securities

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