Big Picture of Finance

 What is finance? The Science of Managing Money.

 1. Who manages money? Individuals and

corporation.
 Is there any reason to distinguish individuals from
corporation?
 Yes, corporations have more complicated financial
issues than individuals. (capital raising, agency
problem…)

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Big Picture of Finance
 2. Topics covered by Finance:

 Individual
 Earn money  spend for necessities  save or
invest the remaining
 Personal finance investment

 Corporation
 Find a project  Find a funding resources for
the project.
  Perform the project.  Evaluate the
performance of the project.
 Corporate finance
 We will focus on investments and corporate finance.
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Big Picture of Finance

 3. How to manage money: By doing

valuation
 Finance theories are mostly about valuation
(determining the value of bond, stock, project,
company…). Please refer to our syllabus or
chapters in textbooks.
 Discounted cash flow valuation!

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Course outline

Topic Chapters
Introduction and Overview of Corporate Finance 1
Financial Statements and Cash Flow 2
Working with financial statements 3
Introduction to Time Value of Money 5
Discounted Cash Flow Valuation 6

Bond Valuation 7
Stock Valuation 8
History of Capital Markets 12
Risk, Return, and Security Market Line 13
Cost of Capital 15

Net Present Value and Other Investment Criteria 9

Capital Investment Decisions 10
Project Analysis 11

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Chapter1: Introduction To Corporate
Finance

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Chapter 1 Outline

 Overview of Financial Management

 The Goal of Financial Management

 The Agency Problem and Control of the

Corporation

 Financial Markets and the Corporation

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Corporate Finance

 Some important questions that are answered

using finance
 What long-term investments should the firm
take on? (Capital Budgeting)
 Where will we get the long-term financing to
pay for the investment? (Raising Capital)
 How will we manage the everyday financial
activities of the firm? (Cash Management)

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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)
 Video : This video looks at the changing role
of the Chief Financial Officer (CFO) at the
Fortune 500 company, Abbot Laboratories.

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Forms of Business Organization

 Three major forms in the United States

 Sole proprietorship
 Partnership
 General
 Limited
 Corporation
 Limited liability company

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Sole Proprietorship
 Advantages  Disadvantages
 Easiest to start  Limited to life of owner
 Least regulated  Equity capital limited to
 Single owner keeps all owner’s personal wealth
the profits  Unlimited liability
 Taxed once as personal  Difficult to sell
income ownership interest

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Partnership
 Advantages  Disadvantages
 Two or more owners  Unlimited liability
 More capital available  General partnership

 Relatively easy to start  Limited partnership

 Income taxed once as  Partnership dissolves

personal income when one partner dies
or wishes to sell
 Difficult to transfer
ownership

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Corporation
 Advantages  Disadvantages
 Limited liability
 Unlimited life
 Separation of ownership
and management
 Transfer of ownership is
easy
 Easier to raise capital
 Separation of ownership
and management
 Double taxation (income
taxed at the corporate
rate and then dividends
taxed at the personal
rate)
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Goal Of Financial Management

 What should be the goal of a corporation?

(hint: who are owners of the firm?)
 Maximize profit?
 Minimize costs?
 Maximize market share?
 Maximize the current value of the company’s
stock?

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Goal Of Financial Management

 A letter to stockholders written by former Coca-

Cola CEO Roberto Goizueta

At The Coca-Cola Company, our publicly stated

mission is to create value over time for the
owners of our business. In fact, in our society,
that is the mission of any business: to create
value for its owners.

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”How Coke is Kicking Pepsi’s Can,”
Fortune, October 28, 1996.
 Coke focused on soft drinks while Pepsi-Co diversified
into other areas. Pepsi-Co’s goal was to double revenues
every 5 years, while Mr. Goizueta focused on return on
investment and stock price.

 Goizueta "has created more wealth for stockholders than

any other CEO in history.

In mid-1996, Pepsi-Co sold at 23 times earnings with

return on equity of about 23% and Coke sold at 36 times
earnings with a return on equity of around 55%.

.
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The Agency Problem
 Agency relationship
 Principal hires an agent to represent his/her interest
 Stockholders (principals) hire managers (agents) to
run the company
 Agency problem
 Conflict of interest between principal and agent
 Agency costs
Direct agency costs – the purchase of something for
management that can’t be justified
Indirect agency costs – management’s tendency to
make value reducing investment decisions (e.g., M&A)

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Mechanisms To Reduce Agency
Problem
 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
 A 1993 study performed at the Harvard Business
School indicates that the total return to shareholders
is closely related to the nature of CEO
compensation; specifically, higher returns were
achieved by CEOs whose pay package included
more option and stock components. (See The Wall
Street Journal, November 12, 1993, p. B1).

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Mechanisms To Reduce Agency
Problem
 Threat of hostile takeover
 The threat of a takeover may result in better
management
 Movie, Pretty Woman
 Why does the threat of a takeover might make
managers work towards the goals of
stockholders?
 High stock price discourages takeovers.
 Shareholder intervention
 Threat of firing
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Financial Markets
 Video : This video discusses how capital is raised in financial
markets and shows an open-outcry market at the Chicago Board
of Trade.

 Primary vs. secondary markets

 Primary market – the market in which securities are sold by
the company. Public and private placements of securities,
SEC registration and underwriters are all part of the primary
market.
Secondary market – the market where securities that have
already been issued are traded between investors. The stock
exchanges, such as the New York Stock Exchange, and the
over-the-counter market, such as the Nasdaq, are part of the
secondary market.

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Work the Web Example
 The Internet provides a wealth of information
about individual companies
 One excellent site is finance.yahoo.com

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Quick Quiz

 What are the three types of financial

management decisions and what questions
are they designed to answer?
 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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End of Chapter

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