FIN516 CORPORATE FINANCE

LECTURE 1

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Learning Goals
1. Define Corporate finance, the major areas of finance, and the career opportunities available in this field, and the legal forms of business organization. 2. Describe the managerial finance function and its relationship to economics and accounting. 3. Identify the primary activities of the financial manager within the firm. 4. Explain why wealth maximization, rather than profit maximization, is the firms goal and how the agency issue is related to it.
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What is Corporate Finance?

At the macro level, finance is the study of financial institutions and financial markets and how they operate within the financial system in both the U.S. and global economies. At the micro level, finance is the study of financial planning, asset management, and fund raising for businesses and financial institutions. Financial management can be described in brief using the following balance sheet.
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Macro Finance
ABC Company Balance Sheet As of December 31, 19xx
Assets: Current Assets Liabilities & Equity: Current Liabilities Accounts payable Notes Payable Total Current Liabilities Long-Term Liabilities Total Liabilities Equity: Common Stock Paid-in-capital Retained Earnings Total Equity Total Liabilities & Equity

Working Capital

Cash & M.S. Accounts receivable Inventory Total Current Assets Fixed Assets: Gross fixed assets Less: Accumulated dep. Goodw ill Other long-term assets Total Fixed Assets Total Assets

Working Capital

Investment Decisions

Financing Decisions

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What is Corporate Finance?

A well-developed financial system is a hallmark and essential
characteristic of any modern nation. Financial markets, financial intermediaries, and financial management are the important components. Financial markets and financial intermediaries facilitate the flow of funds from savers (surplus economic units) to borrowers (deficit economic units). Financial management involves the efficient use of financial resources in the production of goods.
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developed

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 Corporate finance is concerned with the duties of the financial manager in the business firm. The financial manager actively manages the financial affairs of any type of business, whether private or public, large or small, profit-seeking or not-forprofit. Increasing globalization has complicated the financial management function. Changing economic and regulatory conditions also complicate the financial management function.
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Corporate Finance

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Basic Forms of Business Organization

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Corporate Organization

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Other Limited Liability Organizations

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The Corporate Finance Function

The size and importance of the Corporate finance function depends on the size of the firm. In small companies, the finance function may be performed by the company president or accounting department. As the business expands, finance typically evolves into a separate department linked to the president.
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The Corporate Finance Function

Relationship to Economics
The field of finance is actually an outgrowth of economics. In fact, finance is sometimes referred to as financial economics. Financial managers must understand the economic framework within which they operate in order to react or anticipate to changes in conditions.
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The Corporate Finance Function

Relationship to Economics
The primary economic principal used by financial managers is marginal analysis which says that financial decisions should be implemented only when benefits exceed costs.

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The Corporate Finance Function

Relationship to Accounting
The firms finance (treasurer) and accounting (controller) functions are closely-related and overlapping. In smaller firms, the financial manager generally performs both functions.

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The Corporate Finance Function

Relationship to Accounting
One major difference in perspective and emphasis between finance and accounting is that accountants generally use the accrual method while in finance, the focus is on cash flows. The significance of this difference can be illustrated using the following simple example.
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The Corporate Finance Function

Relationship to Accounting
Finance and accounting also differ with respect to decision-making. While accounting is primarily concerned with the presentation of financial data, the financial manager is primarily concerned with analyzing and interpreting this information for decision-making purposes. The financial manager uses this data as a vital tool for making decisions about the financial aspects of the firm.
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Key Activities of the Corporate Financial Manager

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Goal of the Firm

Maximize Profit???
Which Investment is Preferred?
EPS ($) Investm ent A B $ $ Year 1 2.90 $ $ Year 2 $ $ Year 3 3.00 $ $ Total 2.90 3.00

Profit maximization fails to account for differences in the level of cash flows (as opposed to profits), the timing of these cash flows, and the risk of these cash flows.
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Goal of the Firm

Why?

Maximize Shareholder Wealth!!!

Because maximizing shareholder wealth properly considers cash flows, the timing of these cash flows, and the risk of these cash flows. This can be illustrated using the following simple valuation equation: Share Price = Future Dividends Required Return
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level & timing of cash flows risk of cash flows

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Goal of the Firm

Maximize Shareholder Wealth!!!
It can also be described using the following flow chart:

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Goal of the Firm

Economic Value Added (EVA)
conomic value added (EVA) is a popular measure used by many firms to determine whether an investment - proposed or existing - positively contributes to the owners wealth.

EVA is calculated by subtracting the cost of funds used to finance an investment from its after-tax operating profits. Investments with positive EVAs increase shareholder wealth and those with negative EVAs reduce shareholder value.
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Goal of the Firm

What About Other Stakeholders?
Stakeholders include all groups of individuals who have
direct economic link to the firm including: Employees Government Customers Suppliers Creditors Owners The "Stakeholder View" prescribes that the firm make a conscious effort to avoid actions that could be detrimental to the wealth position of its stakeholders. Such a view is considered to be "socially responsible."
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The Role of Ethics

Ethics Defined
Ethics is the standards of conduct or moral judgment have become an overriding issue in both our society and the financial community Ethical violations attract widespread publicity Negative publicity often leads to negative impacts on a firm
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The Role of Ethics

Considering Ethics
To assess the ethical viability of a proposed action, ask: Does the action unfairly single out an individual or group? Does the action affect the morals, or legal rights of any individual or group? Does the action conform to accepted moral standards? Are there alternative courses of action that are less likely to cause actual or potential harm?
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The Role of Ethics

Ethics & Share Price
Ethics programs seek to: reduce litigation and judgment costs maintain a positive corporate image build shareholder confidence gain the loyalty and respect of all stakeholders The expected result of such programs is to positively affect the firm's share price.
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The Agency Issue

The Agency Problem
Whenever a manager owns less than 100% of the
firms equity, a potential agency problem exists. In theory, managers would agree with shareholder wealth maximization. However, managers are also concerned with their personal wealth, job security, fringe benefits, and lifestyle. This would cause managers to act in ways that do not always benefit the firm shareholders.
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The Agency Issue

Resolving the Problem
Market Forces such as major shareholders and the threat of a hostile takeover act to keep managers in check. Agency Costs may be incurred to ensure management acts in shareholders interests. (incentive)

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Financial Institutions & Markets

Firms that require funds from external sources can obtain them in three ways: through a bank or other financial institution through financial markets through private placements

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The Relationship between Financial Institutions and Financial Markets

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Business Taxes
Both individuals and businesses must pay taxes on income. The income of sole proprietorships and partnerships is taxed as the income of the individual owners, whereas corporate income is subject to corporate taxes. Both individuals and businesses can earn two types of income -- ordinary and capital gains. Under current law, tax treatment of ordinary income and capital gains change frequently due frequently changing tax laws.
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Business Taxes
Ordinary Income
Ordinary income is earned through the sale of a firms goods or services and is taxed at the rates depicted in Table 1.4 on the following slide.

Example
Calculate federal income taxes due if taxable income is $80,000. Tax = .15 ($50,000) + .25 ($25,000) + .34 ($80,000 - $75,000) Tax = $15,450
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Business Taxation
Ordinary Income

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Business Taxation
Average & Marginal Tax Rates A firms marginal tax rate represents the rate at which additional income is taxed. The average tax rate is the firms taxes divided by taxable income.
Example
What is the marginal and average tax rate for the previous example? Marginal Tax Rate = 34% Average Tax Rate = $15,450/$80,000 = 19.31%
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Business Taxation
Debt versus Equity Financing In calculating taxes, corporations may deduct operating expenses and interest expense but not dividends paid. This creates a built-in tax advantage for using debt financing as the following example will demonstrate.
Example Two companies, Debt Co. and No Debt Co., both expect in the coming year to have EBIT of $200,000. During the year, Debt Co. will have to pay $30,000 in interest expenses. No Debt Co. has no debt and will pay not interest expenses.
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Business Taxation
Debt versus Equity Financing

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Business Taxation
Debt versus Equity Financing As the example shows, the use of debt financing can increase cash flow and EPS, and decrease taxes paid. The tax deductibility of interest and other certain expenses reduces their actual (after-tax) cost to the profitable firm. It is the non-deductibility of dividends paid that results in double taxation under the corporate form of organization.
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Business Taxation
Capital Gains A capital gain results when a firm sells an asset such as a stock held as an investment for more than its initial purchase price. The difference between the sales price and the purchase price is called a capital gain. For corporations, capital gains are added to ordinary income and taxed like ordinary income at the firms marginal tax rate.
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