Chapter 1 Fm1n2

CHAPTER 1
The Scope of Corporate

Finance
What is Finance?
Concerned with maintenance and creation of
economic value or wealth.
Focuses on decision making with an eye toward
creating wealth.
The activities involved in managing cash flows in a
business environment.
Companies must make best use of capital, while
balancing needs of corporate shareholders,
managers, and other stakeholders.

2
SITI AISHAH BINTI KASSIM (FM1
& FM2)
The Financial Manager
Would be in charge of answering the three
questions:
What long-term investments should you take
on?
Where will you get the long term financing to
pay for your investment?
How will you manage your everyday financial
activities such as collecting from customers
and paying suppliers?
3
& FM2)
The Financial
Management Function
Financing
(Capital-Raising)
Capital Budgeting
Financial Management
Corporate Governance
Risk Management
4
& FM2)
The Legal Forms of Business
Organization
1. Sole Proprietorship: a business owned by a single
individual and has a minimum amount of legal structure.
Advantages:
a. Easily established with few complications
b. Minimal organizational costs
c. Does not have to share profits or control with others.
Disadvantages:
a. Unlimited liability for the owner
b. the amount of equity is limited to the amount of the
owners personal wealth
c. Business terminates immediately upon death of owner
5
& FM2)
Organization
2. Partnership: a business formed by two or more
individuals or entities.
Two types of partnership:
General Partnership: all the partners share in
gains or losses (agreements) and all have
unlimited liability for all partnership debts.
Limited Partnership: one or more general
partners will run the business and have
unlimited liability, but there will be one or more
limited partners who will not actively participate
in the business.

6
& FM2)
Organization
1. Corporation: a business created as a distinct legal entity
composed of one or more individuals or entities.
Advantages:
a. Ownership (represented by shares of stock) can be readily
transferred
b. The life of corporation is not limited
c. Limited liability of owners
d. Ability to raise large amounts of capital is increased
Disadvantages:
a. Due to corporation is a legal person, it must pay taxes
b. Most difficult and expensive form of business to establish

7
& FM2)
The Goal of Financial
Management
The goal of financial management
to maximize the current value per share of existing
stock
Maximize Profit?
Earnings per share are backward-looking, dependant on
accounting principles
Do not fully consider cash flow timing
Ignores risk
Maximize Shareholder Wealth?
Maximize stock price, not profits
Shareholders as residual claimants, have better
incentives to maximize firm value.

8
& FM2)
The Agency Problems
The possibility of conflict of interest between the
stockholders and management of a firm.
Managers act as agents of the owners who hired them
and gave them decision-making authority to manage
the firm for the owners benefit.
In practice however, self-interests may cause
managers to pursue objectives other than shareholder-
wealth maximization.
This conflict of goals gives rise to managerial agency
problems.

9
& FM2)
How Agency Costs Can Be
Controlled
Ways to overcome agency problems:
Takeovers
Monitoring and bonding
Compensation contracts
Executive compensation packages
10
& FM2)
C. Cash flow from
firms assets
F. Dividends and
debt payments
Financial Markets and The
Corporation
Financial
Markets

Short-term debt
Long-term debt
Equity shares
A. Firm issues securities
B. Firm invests
in assets

Current Assets
Fixed Assets
D. Government
Other stakeholders
E. Reinvested cash flows

11
& FM2)
Corporation
A. Firm issues securities
to raise cash
B. Firm invests in assets
C. Firms operations
generate cash flow
D. Cash is paid to
government as taxes.
Other stakeholders
may receive cash.

E. Reinvested cash flows
are plowed back into
firm.
F. Cash is paid out to
investors in the form of
interest and dividends.
* Refer previous page
12
& FM2)
Corporation
Primary versus Secondary Markets
Primary Market: the original sale of securities by
governments and corporations.
Two types:
a. Initial Public Offering (IPO) the first time
issued in market to the public
b. Private Placements a negotiated sale involving
a specific buyer
Secondary Markets: these securities are bought
and sold after the original sale.
13
& FM2)
The 5 Core Principles of Finance
1. The Time Value of Money
The opportunity to earn a return on invested
funds means that a dollar today is worth
more than a dollar in the future.
Business decisions involved a trade-off
between spending money today and
receiving money in the future.

14
& FM2)
2. Compensation of Risk
Investors expect compensation for bearing
risk.

3. Dont Put Your Eggs in One Basket
Investors can achieve a more favorable
trade-off between risk and return by
diversifying their portfolios (Harry
Markowitz, 1990).
15
& FM2)
4. Markets are Smart
Competition for information tends to make
markets efficient.
Prices of financial assets quickly, and
accurately, reflect all information that
investors have access to.
Investors should just simply buy and hold a
diversified portfolio than try to pick winners
and losers in the stock market.
16
& FM2)
5. No Arbitrage
Arbitrage refers to a trading strategy in
which an investor simultaneously buys
and sells the same asset in different
markets at different prices to earn an
instant, risk-free profit.
17
& FM2)
THE END

Chapter 1 Fm1n2

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CHAPTER 1

The Scope of Corporate

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