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Corporate Finance, 7/e

2005 The McGraw-Hill Companies, Inc. All Rights Reserved.
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CHAPTER
1
Introduction to
Corporate Finance
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Corporate Finance, 7/e
2005 The McGraw-Hill Companies, Inc. All Rights Reserved.
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Chapter Outline
1.1 What is Corporate Finance?
1.2 Corporate Securities as Contingent Claims on
Total Firm Value
1.3 The Corporate Firm
1.4 Goals of the Corporate Firm
1.5 Financial Markets
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Corporate Finance, 7/e
2005 The McGraw-Hill Companies, Inc. All Rights Reserved.
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Four Basic Areas of Finance
Corporate Finance: Procurement and utilization of money or fund
for a trading concern.
Investment: Determinants of stock prices, risk involved in stock,
selection and management of the portfolio.
Financial Market and Institutions: Bridging the gap between net
borrowers and savers
International Finance: Extension of the above disciplines to
different economies of different currencies, different legal and
socio-cultural aspects under different risk return situations.

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2005 The McGraw-Hill Companies, Inc. All Rights Reserved.
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1.1 What is Corporate Finance?
Corporate Finance addresses the following three questions:
1. What long-term investments should the firm engage in?
Capital budgeting decision
2. How can the firm raise the money for the required
investments?
Capital structure decision
3. How much short-term cash flow does a company need to pay
its bills?
Cash and Working capital management
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2005 The McGraw-Hill Companies, Inc. All Rights Reserved.
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The Balance-Sheet Model
of the Firm

Current Assets

Fixed Assets
1 Tangible
2 Intangible

Total Value of Assets:

Shareholders
Equity

Current
Liabilities

Long-Term
Debt

Total Firm Value to Investors:
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Corporate Finance, 7/e
2005 The McGraw-Hill Companies, Inc. All Rights Reserved.
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The Balance-Sheet Model
of the Firm

Current Assets

Fixed Assets
1 Tangible
2 Intangible


Shareholders
Equity

Current
Liabilities

Long-Term
Debt

What long-
term
investments
should the
firm engage
in?
The Capital Budgeting Decision
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Corporate Finance, 7/e
2005 The McGraw-Hill Companies, Inc. All Rights Reserved.
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The Balance-Sheet Model
of the Firm
How can the firm
raise the money
for the required
investments?
The Capital Structure Decision

Current Assets

Fixed Assets
1 Tangible
2 Intangible


Shareholders
Equity

Current
Liabilities

Long-Term
Debt

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Corporate Finance, 7/e
2005 The McGraw-Hill Companies, Inc. All Rights Reserved.
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The Balance-Sheet Model
of the Firm
How much short-
term cash flow
does a company
need to pay its
bills?

The Net Working Capital Investment Decision
Net
Working
Capital

Shareholders
Equity

Current
Liabilities
Current Assets

Fixed Assets
1 Tangible
2 Intangible


Long-Term
Debt

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2005 The McGraw-Hill Companies, Inc. All Rights Reserved.
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1.3 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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2005 The McGraw-Hill Companies, Inc. All Rights Reserved.
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1.4 The Goal of Financial Management
What is the correct goal?
Maximize sales?
Maximize profit?
Minimize costs?
Minimize Risk?
Avoid Bankruptcy?
Maximize shareholder wealth?
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2005 The McGraw-Hill Companies, Inc. All Rights Reserved.
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1.4 Goals of the Corporate Firm
Board of director and managers of the corporation are
obliged to make efforts to maximize shareholder wealth.
In an ideal situation the goal of profit maximization and
of wealth maximization are not conflicting to each other.
In reality there is considerable conflict. The separation
of ownership and control is a property of company.
(Why?) However, quite often this is a source of agency
cost.
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2005 The McGraw-Hill Companies, Inc. All Rights Reserved.
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Agency Cost
Managers are naturally inclined to act in their own best interests.
Expensive perquisites like high salaries and allowances of the
agency (rationalized on motivational point) increases cost.
High short term profit adds to the credentials of board of
directors. High scale investment makes the firm dependent on the
present agency.
Risky investment. If successful, credit goes to the agency, if
failure loss goes to the shareholders.
High investment: This makes the firm dependent on the present
board.
High retention of earnings: Capital gain tax is less than dividend
tax. Such an argument allows the management to distribute less
dividend and retain more earnings and thereby, to finance big and
risky investment.
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Solution to agency problem

Managerial Compensation
Hostile takeover
Formal contract
Market effects
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1.6 Financial Markets and Corporation
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-the-counter in
a dealer market.
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Financial Markets

Firms


Investors
Secondary
Market
money
securities
Sue Bob
Stocks and
Bonds
Money
Primary Market
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Secondary market:
Auction vs. OTC markets
Auction market has a single physical location where trading is done
through bidding. Both DSE and CSE are auction markets. Shares
in USA are traded mostly (around 85%) in auction market. NYSE
is an auction market. The other form of secondary market is over-
the-counter (OTC) or dealers market where communication
between buyers and sellers with dealers are done through
electronic media. Mostly bonds and some shares are traded in OTC
markets. NASDAQ (National Association of Securities Dealers
Automated Quotation) is an OTC market. Auction markets are
different from dealer markets in two ways:
Trading in a given auction exchange takes place at a single site on the floor
of the exchange whereas dealers market is spread out.
Transaction prices of shares in auction markets are communicated almost
immediately to the public.