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Chapter Outline
1.1 What is Corporate Finance?
1.2 Corporate Securities as Contingent Claims on
Total Firm Value
1.3 The Corporate Firm
1.4 Goals of the Corporate Firm
1.5 Financial Institutions, Financial Markets, and the
Corporation
1.6 Trends in Financial Markets and Management
1.7 Outline of the Text

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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 (Figure 1.1)

Total Value of Assets:
Total Firm Value to Investors:

Current
Current Assets Liabilities

Long-Term
Debt

Long-term
Assets
1 Tangible
Shareholders’
2 Intangible Equity

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The Balance-Sheet Model of the Firm (Figure 1.1)

The Capital Budgeting Decision

Current
Liabilities
Current Assets
Long-Term
Debt

Long-term What long-

Assets term
investments Shareholders’
1 Tangible should the Equity
2 Intangible firm engage
in?
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The Balance-Sheet Model of the Firm (Figure 1.1)

The Capital Structure Decision

Current
Liabilities
Current Assets
Long-Term
How can the firm Debt
raise the money
Long-term for the required
Assets investments?
1 Tangible Shareholders’
2 Intangible Equity

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The Balance-Sheet Model of the Firm (Figure 1.1)

The Net Working Capital Investment Decision

Current
Liabilities
Current Assets
Net
Working Long-Term
Capital Debt

Long-term How much short-

Assets term cash flow
1 Tangible does a company
Shareholders’
need to pay its
2 Intangible bills? Equity

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Capital Structure (Figure 1.2)

The value of the firm can be

thought of as a pie.

The goal of the manager is 70%50%30%

25%
to increase the size of the DebtDebt
Equity
pie.
75%
50%
The Capital Structure Equity
decision can be viewed as
how best to slice up the pie.

If, how you slice the pie affects the size of the
pie, then the capital structure decision matters.

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Hypothetical Organization Chart (Figure 1.3)

Board of Directors

Chairman of the Board and

Chief Executive Officer (CEO)

President and Chief

Operating Officer (COO)

Vice President Finance

Treasurer Controller

Cash Manager Credit Manager Tax Manager Cost Accounting

Capital Expenditures Financial Planning Financial Accounting Data Processing

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The Financial Manager

To create value, the financial manager

should:
1.  Try to make smart investment decisions
–  Buy assets that generate more cash than they
cost
2.  Try to make smart financing decisions
–  Sell bonds, shares and other financial
instruments that raise more cash than they cost

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The Firm and the Financial Markets (Figure 1.4)

Firm Firm issues securities (A) Financial

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

Ultimately, the firm
must be a cash
generating activity.
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Taxes (E)
The cash flows from
the firm must exceed
Government
the cash flows from
the financial markets.
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Cash Flows
•  Identification of cash flows
–  Reporting of sales versus collection of cash
–  Reporting of expenses versus payment of expenses
•  Timing of cash flows
–  A dollar received today is worth more than a dollar
received next year
•  Risk of cash flows
–  Amount and timing of future cash flows is not certain
–  Investors prefer to receive cash flows earlier than later

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Corporate Securities as Contingent Claims on
Total Firm Value
•  Debt - a promise by the borrowing firm to
repay a fixed dollar amount by a certain date.
•  The shareholder’s claim on firm value is the
residual amount that remains after the
debtholders are paid.
•  If the value of the firm is less than the
amount promised to the debtholders, the
shareholders get nothing.

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Debt and Equity as Contingent Claims (Figure 1.5)

Payoff to Payoff to
debt holders shareholders
If the value of the firm If the value of the
is more than $F, debt firm is less than $F,
holders get a shareholders get
maximum of $F. nothing.
$F

$F
Value of the firm (X)
Debt holders are promised $F.
If the value of the firm is less than $F,
they get whatever the firm is worth.
Algebraically, the bondholder’s
claim is: Min[$F,$X]
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$F
Value of the firm (X)
If the value of the firm
is more than $F, share
holders get everything
above $F.
Algebraically, the shareholder’s
claim is: Max[0,$X – $F]
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Combined Payoffs to Debt and Equity (Figure 1.5)

Combined Payoffs to debt holders If the value of the firm is less than
and shareholders $F, the shareholder’s claim is:
Max[0,$X – $F] = $0 and the debt
holder’s claim is Min[$F,$X] = $X.
The sum of these is = $X
Payoff to shareholders
$F
If the value of the firm is more than
Payoff to debt holders $F, the shareholder’s claim is:
Max[0,$X – $F] = $X – $F and the
$F debt holder’s claim is:
Value of the firm (X)
Min[$F,$X] = $F.
Debt holders are promised $F.
The sum of these is = $X

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1.3 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
•  The Income Trust
•  Advantages and Disadvantages
–  Liquidity and Marketability of Ownership
–  Control
–  Liability
–  Continuity of Existence
–  Tax Considerations
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A Comparison of Partnership and Corporations

Corporation Partnership

Liquidity and marketability Shares can easily be 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 taxation with Partnership income is taxable

dividend tax credit at partner level

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 of existence Perpetual life Limited life

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Forms of Business Organization

•  Corporate structure separates ownership from
management
–  Advantages:
•  Ease of ownership changes
•  Perpetual life and succession
•  Limited liability

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Goals of the Corporate Firm

•  What are firm decision-makers hired to do?

–  Managers of the corporation are obliged to make
efforts to maximize shareholder wealth

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The Set-of-Contracts Perspective

•  The firm can be viewed as a set of contracts.
•  One of these contracts is between shareholders and
managers.
•  The managers will usually act in the shareholders’
interests.
–  The shareholders can devise contracts that align the
incentives of the managers with the goals of the
shareholders.
–  The shareholders can monitor the managers’ behaviour.
•  This contracting and monitoring is costly.
–  These costs are agency costs that arise from conflicts f
interest between managers and shareholders

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Managerial Goals

•  Managerial goals may be different from

shareholder goals
–  Expense preferences
–  Survival
–  Independence
–  Self-sufficiency
•  Increased growth and size of firm are not
necessarily the same thing as increased
shareholder wealth.

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Separation of Ownership and Control

Board of Directors

Debtholders

Shareholders
Management

Debt
Assets
Equity

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The Agency Problem O1.

•  The agency relationship

•  Will managers work in the shareholders’ best
interests?
–  Agency costs
– Direct agency costs
– Indirect agency costs
•  Control of the firm
•  How do agency costs affect firm value (and
shareholder wealth)?
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Do Shareholders Control Managerial Behaviour?

•  Shareholders vote for the board of directors,

who in turn hire the management team.
•  Contracts can be carefully constructed to be
incentive compatible.
•  There is a market for managerial talent—this
may provide market discipline to the
managers—they can be replaced.
•  If the managers fail to maximize share price,
they may be replaced in a hostile takeover.
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Stakeholders

•  In addition to shareholders and management,

employees, customers, suppliers, and the
public all have a financial interest in the firm
and its decisions.
•  Different stakeholders may have different
goals.
•  What’s ethical or socially responsible
investing?
–  Does it create value?

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Financial Institutions, Financial Markets,
and the Corporation (Figure 1.6)
•  Financial Institutions
Indirect finance
Funds Deposits Financial Loans Funds
suppliers intermediaries demanders

Direct finance

Funds Financial Funds

suppliers intermediaries demanders

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Financial Markets

Money versus Capital Markets

•  Money Markets
– For short-term debt instruments
•  Capital Markets
– For long-term debt and equity

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Financial Markets

Primary versus Secondary Markets

•  Primary Market
–  When a corporation issues securities, cash flows
from investors to the firm.
–  Usually an underwriter is involved
•  Secondary Markets
–  Involve the sale of “used” securities from one
investor to another.
–  Securities may be exchange traded or trade over-
the-counter in a dealer market.
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Financial Markets

Stocks and Investors

Bonds
Firms securities
Money Bob Sue
money

Primary Market
Secondary
Market

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Listing

•  Listing on an organized exchange

•  Enhances trading liquidity
•  cross list on domestic and foreign exchanges
•  Facilitates raising equity
•  To be listed, firms must meet certain minimum
criteria.
•  Listing on Canadian exchange – “comply or
explain” regime
•  Listing on U.S. exchange– significant disclosure
requirement (SOX) and compliance costs
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Foreign Exchange Market

•  Foreign exchange market is the world’s

largest financial market for trading currencies
•  Is an over-the-counter market.
•  Many different types of participants:
•  Importers and exporters
•  Portfolio managers
•  Foreign exchange brokers
•  Traders

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Trends in Financial Markets and
Management
•  Integration and globalization
•  Increased risk from volatility
•  Financial Engineering reduces costs related to
– Risk
– Taxes
– Financing costs
•  Improved computer technology allows
economies of scale and scope

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Trends in Financial Markets and
Management (cont.)

•  Deregulation is opening the possibility for

further changes.
•  Recent financial crisis: causes and recovery.
•  These trends have made financial management
a much more complex and technical activity.

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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 is the difference between a primary
market and a secondary market?
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Chapter Summary

Introduces:
•  Ways for financial managers to increase the
value of the firm by managing:
–  investments in assets;
–  capital structure - debt and equity; and
–  net working capital.
•  Different forms of business organization
•  Role and classification of financial markets
•  Latest trends in financial management
© 2015 McGraw–Hill Ryerson Limited