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CHAPTER

Introduction to
Corporate Finance

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What is Corporate Finance?

Corporate Finance is an area of finance dealing
with the financial decisions corporations make
and the tools and analysis used to make those
decisions.

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The Balance-Sheet Model

of the Firm
Total Value of Assets:
Current Assets

Total Firm Value to Investors:

Current
Liabilities
Long-Term
Debt

Fixed Assets
1 Tangible
2 Intangible

Shareholders
Equity

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The Balance-Sheet Model

of the Firm
The Capital Budgeting Decision

Current
Liabilities

Current Assets

Long-Term
Debt
Fixed Assets
1 Tangible
2 Intangible

What longterm
investments
should the
firm engage
in?

Shareholders
Equity

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The Balance-Sheet Model

of the Firm
The Capital Structure Decision

Current Assets

How can the firm

raise the money
for the required
Fixed Assets
investments?
1 Tangible
2 Intangible

Current
Liabilities
Long-Term
Debt

Shareholders
Equity

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The Balance-Sheet Model

of the Firm

The Net Working Capital Investment Decision

Current Assets

Fixed Assets
1 Tangible
2 Intangible

Current
Liabilities
Net
Working
Capital

How much shortterm cash flow

does a company
need to pay its
bills?

Long-Term
Debt

Shareholders
Equity

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Capital Structure
The value of the firm can be
thought of as a pie.
The goal of the manager is
to increase the size of the
pie.

70%50%30%
25%
DebtDebt
Equity
75%
50%
Equity

The Capital Structure

decision can be viewed as
how best to slice up a 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

Board of Directors
Chairman of the Board and
Chief Executive Officer (CEO)
President and Chief
Operating Officer (COO)
Vice President and
Chief Financial Officer (CFO)

Treasurer

Controller

Cash Manager

Credit Manager

Tax Manager

Cost Accounting

Capital Expenditures

Financial Planning

Financial Accounting

Data Processing

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The Firm and the Financial Markets

Firm

Firm issues securities (A)

Invests
in assets
(B)

Retained
cash flows (F)
Short-term debt
Cash flow
from firm (C)

Ultimately, the firm

must be a cash
generating activity.

Dividends and
debt payments (E)
Taxes (D)

Current assets
Fixed assets

Financial
markets

Government

Long-term debt
Equity shares

The cash flows from the

firm must exceed the
cash flows from the
financial markets.

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The Corporate Form

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
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

Shares can easily be

exchanged.

Subject to substantial
restrictions.

Voting Rights

Usually each share gets

one vote

Taxation

Double

General Partner is in
charge; limited partners
may have some voting
rights.
Partners pay taxes on
distributions.

Reinvestment and
dividend payout

Broad latitude

All net cash flow is

distributed to partners.

Liability

Limited liability

Continuity

Perpetual life

General partners may

have unlimited liability.
Limited partners enjoy
limited liability.
Limited life

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Goals of the Corporate Firm

The traditional answer is that the managers of the
corporation are obliged to make efforts to maximize
shareholder wealth.
Other possible goals of management are as follows
Survival of the firm
Avoid financial distress and bankruptcy
Maximize sales or market share
Minimize costs
Maximize Profits
Maintain steady growth of earnings
Maintain steady growth or expansion of the firm

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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 behavior.

This contracting and monitoring is costly.

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The Agency Problem

The agency relationship

In an agency relationship the members of the
management team are the agents.
The equity investors (shareholders) are the
principals.
Will managers work in the shareholders best
interests?
Agency costs
The monitoring costs of the shareholders
The costs of implementing control devices.

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Managerial Goals
Managerial goals may be different from shareholder
goals
Survival: organizational survival means management will
always try to command sufficient resources to avoid the firms
going out of business.
Independence and self-sufficiency: This the freedom to take
decisions without encountering external parties or depending
on outside financial markets.

These two basic financial objectives of managers will

lead to the maximization of corporate wealth. Increased
in corporate growth and size are not necessarily the
same thing as increased shareholder wealth.

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Separation of Ownership and Control

Board of Directors

Assets
Equity

Shareholders

Debt

Debtholders

Management

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Do Shareholders Control
Managerial Behavior?
Shareholders vote for the board of directors,
who in turn hire the management team.
Contracts can be carefully constructed better
compensation based on performance.
There is a market for managerial talentthis
may provide market discipline to the
managersthey can be replaced.
If the managers fail to maximize share price,
they may be replaced in a hostile takeover.

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Financial 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-thecounter in a dealer market.

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Financial Markets

Firms

Stocks and
Bonds
Money

Investors
John

securities

Tom

money
Primary Market
Secondary
Market

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Money Market vs. Capital Market

Money Market: The financial markets in which
funds are borrowed or loaned for short periods
(generally one year or less).
Capital Market: The financial markets for stocks
and long-term debt (generally longer than one
year).

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Auction Market vs. Dealer Market

The equity securities of most large corporations
are traded in organized auction markets.
Example: New York Stock Exchange (NYSE),
Dhaka Stock Exchange (DSE), Chittagong Stock
Exchange (CSE), Bombay Stock Exchange
(BSE) etc.
Most debt securities are traded on dealer
markets. Some stocks are also traded in dealer
markets.

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Over The Counter (OTC) Market

In OTC market trading of stocks, bonds, commodities
etc. are conducted directly between two parties.
In February 1971, the National Association of Securities
Dealers made available to dealers and brokers in the
OTC market an automated quotation system called the
National Association of Securities Dealers Automated
Quotation (NASDAQ) system. NASDAQ is an example
of OTC market.

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Listings
Firms that want their equity shares to be traded
on the national stock exchange must apply for
listings. To be listed in the national stock
exchanges a company is expected to satisfy
minimum requirements.

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End of the Chapter