Econ 371

Business Finance 1

Pirapa Tharmalingam
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 Course Format
Lectures
Case examples
Assignments
Exams

Textbook :
Brealy, Myers, Marcus, Maynes, Mitra
Fundamentals of Corporate Finance
5th ed (or 3rd or 4th ed)
Supplementary material
Provided if need be (current news paper articles etc.)
 Grading
Assignments - 30%
Individual - 10%
Group - 20%

Midterm Exam - 30%

Final Exam - 40%

 Chapter 1

Organizing a Business:
- Sole Proprietorship
- Partnership
- Corporations
- Hybrid forms

Investment & Financing Decisions

The Job of the Financial Manager

Objectives of the Corporation

 Organizing a Business
Three main forms of business:
Sole Proprietorship
Partnership (General and Limited)
Corporations

Hybrid forms (LLP, LLC, PC, etc.)

Sole proprietorship is the primary form of business that is

easy to form and dissolve.

Partnerships are dominant forms for specialized business

like medical clinics and law firms.
Properties of Different Forms of Business

Sole
Attributes Partnership Corporation
Proprietorship
Who owns
The manager Partners Shareholders
the business
Are Managers &
No No Usually, yes
owners separate?
What is the General - unlimited
Unlimited Limited
owners' liability Limited - limited

Owners and business

No No Yes
taxed separately?
 Properties of a Corporation

A legal entity that allows the owners to be free of

liabilities.

Shareholders are owners, but the corporations are run

by employees led by the CEO.

Although the separation of ownership and control adds

flexibility to the operation, it also creates the agency
problems.

Corporations are the dominant form of business in the

modern day. More than 88% of business transactions in
Canada are done by corporations.
Corporate Organization
 Investment & Financing Decisions

The financial manager has to determine:

- What capital investment projects to invest in

(This is called the capital budgeting decision)

- How to pay for those assets

(This is called the financing decision)
 The Investment Decision

The financial manager needs to place a value on

the future benefits from the investment projects.
In order to achieve this, he/she needs to account
for the

- amounts of benefits

- timing of the benefits, and

- the risks associated with the future benefits

produced by the asset.
 The Financing Decision

In order to raise money for the investments and

operations of the firm, the financial manager can resort
to
- internally generated funds
or
- external financing sources.
Two broad categories of external financing
- Debt financing
- Equity financing
The choice between these two external sources is the
subject matter of Capital Structure Decision.
 Who is the Financing Manager?

Anyone responsible for a significant corporate

investment or financing decision.

- Under the Chief Financial Officer, there are usually two

broad categories of job descriptions:

- The Treasurer looks after the cash, raising new

capital and maintaining relationship with stakeholders.

- The Controller prepares financial statements,

manage internal accounting and looks after tax affairs.
 Goals of the Corporation

Shareholders want managers to maximize market value

of the corporation.

Increasing market value increases shareholder wealth.

maximizing profit does not necessarily increase overall

market value.

the objective should be to maximize the current share

price.

Using unethical means to increase share price will only

lead to failure.
 The Agency Problem

- The behaviour of the managers may not always be

conducive to the health of the corporation.
- Managers are hired as the agents of the owners.
- When the personal goals of these agents create conflict
in their roles in the corporation, they create Agency
Problems.

- Managers may overindulge in unnecessary expenses.

- They may shy away from attractive projects.
- They may engage in empire building.
 The Agency Problem

Agency problems can be reduced in several ways:

Compensation plans
Employee stock options

Board of Directors

Threat of takeovers

Specialist monitoring
 Chapter 2
Flow of Savings to Corporations
The financial market:
Primary market
Secondary market
Other financial markets
Financial intermediaries:
Mutual funds
Pension funds
Financial institutions:
Banks
Insurance companies
Functions of financial markets and intermediaries
Value Maximization and the cost of capital
 Flow of Savings to Corporations

(2) (1)
Firm's
Financial
operations (4a) Investors
Manager

Real assets (3) (4b)

(1) Cash raised from investors
(2) Cash invested in firm
(3) Cash generated by operations
(4a) Cash reinvested
(4b) Cash returned to investors
 The Financial Market
Definitions
A physical or network oriented market where financial securities are
issued and traded.

Primary Market: A new issue of stocks or bonds is known as a

primary issue. The market where these are traded is the primary
market.

Secondary Market: The sales and purchase of securities of existing

issues among market participants is called the secondary
transaction. The markets where this happens are called the
secondary market.
 The Financial Market
Capital Market: A market where long term debt and equity
securities are traded among investors.

Fixed Income Market: A market where securities promising

fixed amount of income, such as bonds, are traded among
investors.

Money Market: A market where short term securities are

traded among investors.

Derivative Market: A market where derivative securities, such

as futures and options, are traded among investors.
 Functions of Financial Intermediaries
Financial intermediary: The organizations that raise money
from investors and provide financing for corporations and other
businesses.
Mutual Funds: These are financial intermediaries that sell units
to investors and purchase securities with the funds.

$ $

Corporation Intermediary Investors

Investors
Security Security
Financial Intermediation in Canada
Holdings of Canadian Corporate Bonds.
2007, Q3. Total $760bn.
Adapted from CANSIM database http://cansim2.statcan.ca

Other financial
institutions
16% Non-residents
29%
Banks
12%

Mutual Funds Governments

9% 5%

Pension plans Persons and non-

12% financial business
6%
Insurance companies
11%
Financial Intermediation in Canada
Holdings of Canadian Corporate Stocks.
2007 Q3. Total $1.65 trln.
Adapted from CANSIM database http://cansim2.statcan.ca

Other financial
institutions
1%
Banks
7% Non-residents
Governments
7%
Mutual funds 5%
17%

Pension plans
13% Persons and non-
Insurance companies financial business
1% 49%
 Financial Institutions
A financial institution does more than just pool and invest
savings. It raises financing by accepting deposits or
selling policies.

71 banks in Canada manage about $2.5 trillion of assets

Trust companies, credit unions and caisses populaires

accept deposits and make loans.

Insurance companies include health, life, property and

casualty insurance companies. They make massive
investments in corporate stocks and bonds.
 Functions of Financial Markets and
Intermediaries

Transporting cash across time

Risk transfer and diversification

Offering liquidity

Creating a payment mechanism

Providing information on commodity prices, interest rates

and company stock values.
 Value maximization & cost of capital

Well functioning financial markets allow individuals and

corporations to share risks and transport savings across
time.

The cost of capital is the minimum acceptable rate of

return for capital investments.

Capital investments by the firm should offer rates of

return at least as high as those available in financial
markets at the same level of risk.