Part 1: Overview

Introduction to Corporate Finance

1.1 What is Corporate Finance?
 The purpose of the firm is to create value for the owner. The value is reflected in the
framework of the simple balance sheet model of the firm.
 Objective of the Corporate Firm (class definition):
1. Maximize value of the firm
2. Maximize share price
3. Maximize wealth of shareholders
The Balance Sheet Model of the Firm

 The assets of the firm are on the left side of the balance sheet. These assets can be
thought of as current and fixed.
 Fixed Assets: Those that will last a long time, like buildings. Some fixed assets are
tangible, such as machinery and equipment. Other fixed assets are intangible, including
patents and trademarks.
 Current Assets: Those that have short lives, such as inventory.
 The forms of financing are represented on the right side of the balance sheet.
 Current Liability: A short-term debt. Represents loans and other obligations that must
be repaid within one year.
 Long-Term Debt: Debt that does not have to be repaid within one year.
 Shareholders’ Equity: Represents the difference between the value of the assets and the
debt of the firm.
 Capital Budgeting: The process of making and managing expenditures on long-lived
assets.
 Capital Structure: The proportions of the firm’s financing from current and long-term
debt and equity.
  Net Working Capital: Current assets minus current liabilities.

The Financial Manager

 Treasurer: Responsible for handling cash flows, managing capital expenditure decisions,
and making financial plans.
 Controller: Handles the accounting function, which includes taxes, cost and financial
accounting, and information systems.
1.2 The Corporate Firm
 Businesses can take other forms. In this section we consider the three basic legal forms of
organizing firms, and we see how firms go about the task of raising large amounts of
money under each form.
The Sole Proprietorship
 Sole Proprietorship: A business owned by one person.
 The sole proprietorship is the cheapest business to form. No formal charter is required,
and few government regulations must be satisfied for most industries.
 A sole proprietorship pays no corporate income taxes. All profits of the business are taxed
as individual income.
 The sole proprietorship has unlimited liability for business debts and obligations. No
distinction is made between personal and business assets.
 The life of the sole proprietorship is limited by the life of the sole proprietor.
 The sole proprietor is the only owner, so the equity available to the business is limited to
her personal wealth.
The Partner
  Any two or more people can get together and form a partnership. Partnerships fall into
two categories:
1. General partnerships
2. Limited partnerships.
 General Partnerships: All partners agree to provide some fraction of the work and cash
and to share the profits and losses. Each partner is liable for all of the debts of the
partnership. A partnership agreement specifies the nature of the arrangement. The
partnership agreement may be an oral agreement or a formal document setting forth the
understanding
 Limited Partnerships: Permit the liability of some of the partners to be limited to the
amount of cash each has contributed to the partnership. Limited partnerships usually
require that (1) at least one partner be a general partner and (2) the limited partners do not
participate in managing the business. Here are some things that are important when
considering a partnership:
1. Partnerships are usually inexpensive and easy to form. Written documents are
required in complicated arrangements. Business licenses and filing fees may be
necessary.
2. General partners have unlimited liability for all debts. The liability of limited partners
is usually limited to the contribution each has made to the partnership. If one general
partner is unable to meet his or her commitment, the shortfall must be made up by the
other general partners.
3. The general partnership is terminated when a general partner dies or withdraws (but
this is not so for a limited partner). It is difficult for a partnership to transfer
ownership without dissolving. Usually all general partners must agree. However,
limited partners may sell their interest in a business.
4. It is difficult for a partnership to raise large amounts of cash. Equity contributions are
usually limited to a partner’s ability and desire to contribute to the partnership. Many
companies start life as a proprietorship or partnership, but at some point they choose
to convert to corporate form.
5. Income from a partnership is taxed as personal income to the partners.
6. Management control resides with the general partners. Usually a majority vote is
required on important matters, such as the amount of profit to be retained in the
business.
 It is difficult for large business organizations to exist as sole proprietorships or
partnerships.
 The main advantage to a sole proprietorship or partnership is the cost of getting started.
 The disadvantages, which may become severe, are:
1. Unlimited liability
2. Limited life of the enterprise
3. Difficulty of transferring ownership.
a. These three disadvantages lead to (4) difficulty in raising cash.
The Corporation
 It is a distinct legal entity. Corporations can enter contracts and may sue and be sued.
 Starting a corporation is more complicated than starting a proprietorship or partnership.
The incorporators must prepare articles of incorporation and a set of bylaws.
 Bylaws: The rules to be used by the corporation to regulate its own existence, and they
concern its shareholders, directors, and officers. Bylaws range from the briefest possible
statement of rules for the corporation’s management to hundreds of pages of text.
 In its simplest form, the corporation comprises three sets of distinct interests:
1. The shareholders (the owners)
2. The directors
3. The corporate officers (the top management).
 Shareholders: Control the corporation’s direction, policies, and activities.
 Directors: The shareholders elect a board of directors, who in turn select top
management.
 Corporate Officers: Members of top management serve as corporate officers and
manage the operations of the corporation in the best interest of the shareholders.
 There may be a large overlap among the shareholders, the directors, and the top
management. Even in larger corporations, top management usually own shares and often
serve on the board of directors.
 While overlap between shareholders, directors, and corporate officers is common, the
potential separation of ownership from management gives the corporation several
advantages over proprietorships and partnerships:
1. Because ownership in a corporation is represented by shares of stock, ownership can
be readily transferred to new owners. Because the corporation exists independently of
those who own its shares, there is no limit to the transferability of shares as there is in
partnerships.
2. The corporation has unlimited life. Because the corporation is separate from its
owners, the death or withdrawal of an owner does not affect the corporation’s legal
existence. The corporation can continue after the original owners have withdrawn.
3. The shareholders’ liability is limited to the amount invested in the ownership shares.
If a shareholder purchased $1,000 in shares of a corporation, the potential loss would
be $1,000. In a partnership, a general partner with a $1,000 contribution could lose
$1000 plus any other indebtedness of the partnership.
 Limited liability, ease of ownership transfer, and perpetual succession are the major
advantages of the corporate form of business organization. These give the corporation an
enhanced ability to raise cash.
 A big disadvantage to incorporation. The federal government taxes corporate income
(the states do as well).
 When corporate income is paid out to investors through a dividend, shareholders have to
pay personal income tax on the dividend income. This is double taxation for shareholders
when compared to taxation on sole proprietorships and partnerships.
A Corporation by Another Name
 The corporate form of organization has many variations around the world. The exact laws
and regulations differ from country to country, of course, but the essential features of
public ownership and limited liability remain. These firms are often called joint stock
companies, public limited companies, or limited liability companies.
1.3 The Importance of Cash Flows
 The most important job of a financial manager is to create value from the firm’s capital
budgeting, financing, and net working capital activities. They do this by:
1. Try to buy assets that generate more cash than they cost.
2. Sell bonds, stocks, and other financial instruments that raise more cash than they cost
 The arrows in Figure 1.3 trace cash flow from the firm to the financial markets and back
again. Suppose we begin with the firm’s financing activities.
1. To raise money, the firm sells debt and equity shares to investors in the financial
markets. This results in cash flows from the financial markets to the firm (A).
2. This cash is invested in the investment activities (assets) of the firm (B) by the firm’s
management.
3. The cash generated by the firm (C) is paid to shareholders and bondholders (F). The
shareholders receive cash in the form of dividends; the bondholders who lent funds to
the firm receive interest and, when the initial loan is repaid, principal.
4. Not all of the firm’s cash is paid out. Some is retained (E), and some is paid to the
government as taxes (D).
 Over time, if the cash paid to shareholders and bondholders (F) is greater than the cash
raised in the financial markets (A), value will be created.

Identification of Cash Flows

 Much of the information about cash flows we obtain is in the form of accounting
statements, and much of the work of financial analysis is to extract cash flow information
from these statements. The following example illustrates how this is done:
Timing of Cash Flows
 The value of an investment made by a firm depends on the timing of cash flows.
 One of the most important principles of finance is that individuals prefer to receive cash
flows earlier rather than later. One dollar received today is worth more than one dollar
received next year.

 At first, it appears that Product A would be best. However, the cash flows from Product B
come earlier than those of A. Without more information, we cannot decide which set of
cash flows would create the most value for the bondholders and shareholders. It depends
on whether the value of getting cash from B up front outweighs the extra total cash from
A.
Risk of Cash Flows
 The firm must consider risk. The amount and timing of cash flows are not usually known
with certainty. Most investors have an aversion to risk.
The Goal of Financial Management
 Say we restrict our discussion to for-profit businesses; the goal of financial management
is to make money or add value for the owners.
Possible Goals
 Survive
 Avoid financial distress and bankruptcy
 Beat the competition
 Maximize sales or market share
 Each of these possibilities presents problems as a goal for the financial manager
 The goals we’ve listed here are all different, but they tend to fall into two classes. The
first of these relates to profitability.
o The goals involving sales, market share, and cost control all relate, at least
potentially, to different ways of earning or increasing profits.
o The goals in the second group, involving bankruptcy avoidance, stability, and
safety, relate in some way to controlling risk.
  Unfortunately, these two types of goals are somewhat contradictory
The Goal of the Financial Manager
 The financial manager in a corporation makes decisions for the stockholders of the firm.
 The goal of financial management is to maximize the current value of the existing
stock.
 The current stock value reflects the total value of owning a piece of the firm.
 Stockholder are entitled to both the current and future cash flows of the firm. They also
bear the costs of any risks associated with those cash flows.
 Therefore, the current stock value reflects how shareholders weigh the sometimes
conflicting goals of getting cash flows sooner versus later, or increasing profits versus
reducing risk.
 By maximizing stock value, managers can also make the firm’s other investors and
stakeholders better off. This occurs because the stockholders in a firm are residual
owners. By this we mean that they are entitled only to what is left after employees,
suppliers, and creditors (and everyone else with legitimate claims) are paid what they are
due.
 If any of these groups go unpaid, the stockholders get nothing. So if the stockholders are
winning in the sense that the leftover, residual portion is growing, it is usually true that
everyone else also is winning.
 In those situations, creditors may prefer a safer strategy to guarantee that they will be
paid, while stockholders may prefer a riskier strategy with upside potential.
A More General Goal
 If our goal is as stated in the preceding section (to maximize the value of the stock), an
obvious question comes up: What is the appropriate goal when the firm has no traded
stock?
 Maximize the value of the existing owners’ equity.
 With this in mind, we don’t care whether the business is a sole proprietorship,
partnership, or corporation. For each of these structures, good financial decisions increase
the value of the owners’ equity, and poor financial decisions decrease it.
The Agency Problem and Control of the Corporation
 We’ve seen that the financial manager acts in the best interests of the stockholders by
taking actions that increase the value of the stock. However, in large corporations,
ownership can be spread over a huge number of stockholders.
 This dispersion of ownership arguably means that management effectively controls the
firm. In this case, will management necessarily act in the best interests of the
stockholders? Put another way, might not management pursue its own goals at the
stockholders’ expense?
 Corporate governance represents rules and practices that ensure that management acts in
the interests of stockholders and other groups with a claim to the firm’s cash flows. It
varies quite a bit around the world.
Agency Relationships
 Agency Relationship: The relationship between stockholders and management. Such a
relationship exists whenever someone (the principal) hires another (the agent) to
represent his or her interests.
Management Goals
 The new investment is expected to favorably impact the share value, but it is also a
relatively risky venture. The owners of the firm will wish to take the investment (because
the stock value will rise), but management may not because there is the possibility that
things will turn out badly and management jobs will be lost. If management does not
take the investment, then the stockholders may lose a valuable opportunity. This is one
example of an agency cost.
 Agency Costs: The costs of the conflict of interest between stockholders and
management. These costs can be indirect or direct.
o Indirect Agency Cost: A lost opportunity, such as the one we have just described.
o Direct Agency Costs: Come in two forms.
1. The first type is a corporate expenditure that benefits management but costs
the stockholders. Perhaps the purchase of a luxurious and unneeded corporate
jet would fall under this heading
2. The second type of direct agency cost is an expense that arises from the need
to monitor management actions. Paying outside auditors to assess the
accuracy of financial statement information is one example.
Do Manager Act in the Stockholders’ Interests?
 Whether managers will, in fact, act in the best interests of stockholders depends on two
factors. First, how closely are management goals aligned with stockholder goals? This
question relates, at least in part, to the way managers are compensated.
 Second, can managers be replaced if they do not pursue stockholder goals? This issue
relates to control of the firm.
Managerial Compensation
 Management will frequently have a significant economic incentive to increase share
value for two reasons.
 First, managerial compensation, particularly at the top, is usually tied to financial
performance in general and often to share value in particular.
 The second incentive managers have relates to job prospects. Better performers within
the firm will tend to get promoted. More generally, managers who are successful in
pursuing stockholder goals will be in greater demand in the labor market and command
higher salaries.
 Deferred Compensation: Money paid to an executive several years after it is earned.
Control of the Firm
  Control of the firm ultimately rests with stockholders. They elect the board of directors,
who, in turn, hire and fire management.
 Proxy: The authority to vote someone else’s stock.
 Proxy Fight: Develops when a group solicits proxies in order to replace the existing
board and thereby replace existing management.
 Another way that management can be replaced is by takeover. Firms that are poorly
managed are more attractive as acquisitions than well-managed firms because a greater
profit potential exists from a change in management.
Stakeholders
 Stakeholders: Employees, customers, suppliers, and even the government all have a
financial interest in the firm. In general, a stakeholder is someone who potentially has a
claim on the cash flows of the firm.

Regulation
 Until recently, the main thrust of federal regulation has been to require that companies
disclose all relevant information to investors and potential investors. Disclosure of
relevant information by corporations is intended to put all investors on a level
information playing field and reduce conflicts of interest.
End of Chapter Questions
1. Agency Problems. Who owns a corporation? Describe the process whereby the owners
control the firm’s management. What is the main reason that an agency relationship exists
in the corporate form of organization? In this context, what kinds of problems can arise?
My Answer: Shareholders own the corporation and then they elect a board of directors to manage
the corporation. Agency problems arise when the goals of shareholders and management differ.
For example, shareholders may want to take up a risky business venture in order to maximize the
share value. However, management may not want to do that in fear of job loss or decrease in job
security.
Textbook Answer: In the corporate form of ownership, the shareholders are the owners of the
firm. The shareholders elect the directors of the corporation, who in turn appoint the firm’s
management. This separation of ownership from control in the corporate form of organization is
what causes agency problems to exist. Management may act in its own or someone else’s best
interests, rather than those of the shareholders. If such events occur, they may contradict the goal
of maximizing shareholders’ wealth.
2. Not-for-Profit Firm Goals. Suppose you were the financial manager of a not-for-profit
business (a not-for-profit hospital, perhaps). What kinds of goals do you think would be
appropriate?
My Answer: Maximize the existing owners’ equity.
Textbook Answer: Such organizations frequently pursue social or political missions, so many
different goals are conceivable. One goal that is often cited is revenue minimization; that is,
provide whatever goods and services are offered at the lowest possible cost to society. A better
approach might be to observe that even a not-for-profit business has equity. Thus, one answer is
that the appropriate goal is to maximize the value of the equity.
3. Goal of the Firm. Evaluate the following statement: Managers should not focus on the
current stock value because doing so will lead to an overemphasis on short-term profits at
the expense of long-term profits.
My Answer: Partly false, the current stock value is the total value of owning a portion of the firm.
If the firm is doing well, this usually means that the manager is getting compensated well too.
Textbook Answer: Presumably, the current stock value reflects the risk, timing, and magnitude of
all future cash flows, both short-term and long-term. If this is correct, then the statement is false.
4. Ethics and Firm Goals. Can the goal of maximizing the value of the stock conflict with
other goals, such as avoiding unethical or illegal behavior? In particular, do you think
subjects like customer and employee safety, the environment, and the general good of
society fit into this framework, or are they essentially ignored? Think of some specific
scenarios to illustrate your answer
My Answer: Maximizing the value of the stock most can conflict with other goals. It has not been
uncommon for firms to partake in unethical activities to gain a higher profit. For example, the
fast-fashion company, Shein, has been accused of child labour and inhumane working conditions
in order to afford pricing their products so cheaply.
Textbook Answer: An argument can be made either way. At the one extreme, we could argue that
in a market economy, all of these things are priced. There is thus an optimal level of, for
example, ethical and/or illegal behavior, and the framework of stock valuation explicitly includes
these. At the other extreme, we could argue that these are noneconomic phenomena and are best
handled through the political process. A classic (and highly relevant) thought question that
illustrates this debate goes something like this: “A firm has estimated that the cost of improving
the safety of one of its products is $30 million. However, the firm believes that improving the
safety of the product will only save $20 million in product liability claims. What should the firm
do?”
5. International Firm Goal. Would the goal of maximizing the value of the stock differ for
financial management in a foreign country? Why or why not?
Textbook Answer: The goal will be the same, but the best course of action toward that goal may
be different because of differing social, political, and economic institutions
6. Agency Problems and Corporate Ownership. Corporate ownership varies around the
world. Historically, individuals have owned the majority of shares in public corporations
in the United States. In Germany and Japan, however, banks, other large financial
institutions, and other companies own most of the stock in public corporations. Do you
 think agency problems are likely to be more or less severe in Germany and Japan than in
the United States?
Textbook Answer: We would expect agency problems to be less severe in countries with a
small percentage of individual ownership. Fewer individual owners should reduce the
number of diverse opinions concerning corporate goals. The high percentage of institutional
ownership might lead to a higher degree of agreement between owners and managers on
decisions concerning risky projects. In addition, institutions may be better able to implement
effective monitoring mechanisms on managers than can individual owners, based on the
institutions’ deeper resources and experiences with their own management. The increase in
institutional ownership of stock in the United States and the growing activism of these large
shareholder groups may lead to a reduction in agency problems for U.S. corporations and a
more efficient market for corporate control.
7. Agency Problems and Corporate Ownership. In recent years, large financial
institutions such as mutual funds and pension funds have become the dominant owners of
stock in the United States, and these institutions are becoming more active in corporate
affairs. What are the implications of this trend for agency problems and corporate
control?
Same answer as question 6
8. Executive Compensation. Critics have charged that compensation to top managers in the
United States is too high and should be cut back. For example, focusing on large
corporations, Larry Culp of General Electric was one of the best-compensated CEOs in
the United States during 2020, earning about $73 million. Are such amounts excessive?
In answering, it might be helpful to recognize that superstar athletes such as Cristiano
Ronaldo, top earners in the entertainment field such as Kanye West and Oprah Winfrey,
and many others at the top of their respective fields earn at least as much, if not a great
deal more.
Textbook Answer: How much is too much? Who is worth more, Mark Parker or LeBron James?
The simplest answer is that there is a market for executives just as there is for all types of labor.
Executive compensation is the price that clears the market. The same is true for athletes and
performers. Having said that, one aspect of executive compensation deserves comment. A
primary reason executive compensation has grown so dramatically is that companies have
increasingly moved to stock-based compensation. Such movement is obviously consistent with
the attempt to better align stockholder and management interests. In recent years, stock prices
have soared, so management has cleaned up. It is sometimes argued that much of this reward is
due to rising stock prices in general, not managerial performance. Perhaps in the future,
executive compensation will be designed to reward only differential performance, that is, stock
price increases in excess of general market increases.