Chapter 1

Introduction to
Corporate Finance
McGraw-Hill/Irwin
Copyright 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
Learning Objectives
What is finance?
Financial manager and financial management
Legal forms of business organization
The goal of financial management
The agency problems
Financial markets and institutions
Principles underlying the financial management
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DEFINITION OF FINANCE

Finance can be defined as the art and science of
managing money.
Finance is concerned with the process,
institutions, markets, and instruments involved in
the transfer of money among individuals,
businesses, and governments
Simply finance deals with matters related to
money and the markets

The Financial Manager
Financial managers try to answer some or all of
these questions
The top financial manager within a firm is usually
the Chief Financial Officer (CFO)
Treasurer oversees cash management, credit
management, capital expenditures, and financial
planning
Controller oversees taxes, cost accounting, financial
accounting and data processing
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Financial Management Decisions
Capital budgeting
What long-term investments or projects
should the business take on?
Capital structure
How much should the firm borrow to pay for
its assets?
What is the best mixture of debt and equity?
The least expensive sources of funds?
Working capital management
How do we manage the day-to-day finances
of the firm?
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Forms of Business Organization
Three major forms
Sole Proprietorship
Partnership
General
Limited
Corporation
Limited Liability Company
Limited Liability Partnerships
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Sole Proprietorship
Advantages
Easiest to start
Least regulated
Single owner keeps all the
profits
Taxed once as personal
income
Disadvantages
Limited to life of
owner
Equity capital
limited to owners
personal wealth
Unlimited liability
Difficult to sell
ownership interest
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Partnership
Advantages
Two or more owners
More capital available
Relatively easy to start
Income taxed once as
personal income
Disadvantages
Unlimited liability
General partnership
Limited partnership
Partnership
dissolves when one
partner dies or
wishes to sell
Difficult to transfer
ownership
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Partnership
Two or more persons come together as co-owners.

General Partnership:
All partners are fully responsible for liabilities incurred by the
partnership.
Limited Partnerships:
One or more partners can have limited liability, restricted to
the amount of capital invested in the partnership. There must
be at least one general partner with unlimited liability. Limited
partners cannot participate in the management of the
business and their names cannot appear in the name of the
firm.
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Corporation
Advantages
Limited liability
Unlimited life
Separation of ownership
and management
Transfer of ownership is
easy
Easier to raise capital
Disadvantages
Separation of
ownership and
management
May involve double
taxation in some
countries (income
taxed at the
corporate rate and
then dividends
taxed at the
personal rate)
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Summary of
3 Business Forms
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Goal of Financial Management
What should be the goal of a corporation?
Maximize profits?
Minimize costs?
Maximize market share?
Maximize the current value of the companys
stock?
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Maximizing Shareholders Wealth
Maximizing the share price is equivalent to
maximizing shareholders wealth
Why is this a valid goal?
Decisions are made in shareholders best
interest
Considers cash flows not profits
Incorporates time dimension
Does not consider profitability but also risk

The Agency Problem
Agency relationship
The relationship exists when a principal hires
an agent to represent his/her interests
Stockholders (principals) hire managers
(agents) to run the company
Agency problem
Conflict of interest between principal and
agent
Agent may not work in the best interest of the
principal
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Management Goals
Management goals may be different from
shareholder s goals
Management may be more interested in:
Consuming expensive perks
Its own survival
Its independence
Management may focus on increased
growth and size rather than increasing
shareholders wealth
Agency Costs
Costs due to the conflict of interest between
shareholders and management
Direct
Corporate expenditure that benefits management but
costs shareholders, e.g. country club membership
Costs to monitor management actions, e.g. auditor costs
Indirect
Lost opportunity due to management forgoing profitable
but risky projects for fear of losing job if project fails

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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 goal
Corporate control
The threat of a takeover may result in better management
Other stakeholders
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Financial Markets
Primary market
A market where the firm sells its securities to public for the first
time
Secondary markets
A market in which the securities issued by firms are traded.
Listed securities trade in an organized exchange, e.g. the stock
market (NYSE) or Bursa Malaysia
Over-the-counter securities are bought from or sold to a dealer
Money Market
Market for short-term debt instruments (maturity periods of one
year or less).

Capital Market
Market for long-term financial securities (maturity greater than
one year).


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ROLE OF FINANCIAL MARKET


FIRM

2.
Investment


INVESTOR

Secondary
Market

GOVERNMENT
Cash
Security
Cash flow
Tax
Reinvest
3. Dividend, etc
1. Primary Market

Five Foundational
Principles of Finance
Cash flow is what matters
Money has a time value
Risk requires a reward
Market prices are generally right
Conflicts of interest cause agency problems


End of Chapter
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