1. Chapter Outline1.1 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
1.6 Outline of the Text
2. What is Corporate Finance? Corporate Finance addresses the following three questions:
What long-term investments should the firm engage in?
How can the firm raise the money for the required investments?
How much short-term cash flow does a company need to pay its bills?
3. The Balance-Sheet Model of the Firm
Current Assets
Fixed Assets
1 Tangible
2 Intangible
Total Value of Assets:
Shareholders’ Equity
Current LiabilitiesLong-Term Debt
Total Firm Value to Investors:
4. The Balance-Sheet Model of the Firm
Current Assets
Fixed Assets
1 Tangible
2 Intangible
Shareholders’ Equity
Current LiabilitiesLong-Term Debt
What long-term investments should the firm engage in?The Capital Budgeting Decision
5. The Balance-Sheet Model of the FirmHow 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 LiabilitiesLong-Term Debt
6. The Balance-Sheet Model of the FirmHow much short-term cash flow does a company need to pay its bills?
The Net Working Capital Investment DecisionNet Working Capital
Shareholders’ Equity
Current LiabilitiesLong-Term Debt
Current Assets
Fixed Assets
1 Tangible
2 Intangible
7. Capital StructureThe value of the firm can be thought of as a pie.The goal of the manager is to increase the size of the pie.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.50% Debt50% Equity25% Debt75% Equity70% Debt30% Equity
8. Hypothetical Organization ChartChairman of the Board and Chief Executive Officer (CEO)Board of DirectorsPresident and Chief Operating Officer (COO)Vice President and Chief Financial Officer (CFO)TreasurerControllerCash ManagerCapital ExpendituresCredit ManagerFinancial PlanningTax ManagerFinancial AccountingCost Accounting Data Processing
9. The Financial ManagerTo create value, the financial manager should:
Try to make smart investment decisions.
Try to make smart financing decisions.
10. Cash flowfrom firm (C)The Firm and the Financial MarketsTaxes (D)FirmGovernmentFirm issues securities (A)Retained cash flows (F)Investsin assets(B)Dividends anddebt payments (E)Current assetsFixed assetsFinancialmarketsShort-term debt
Long-term debt
Equity sharesUltimately, the firm must be a cash generating activity.The cash flows from the firm must exceed the cash flows from the financial markets.
11. 1.2 Corporate Securities as Contingent Claims on Total Firm ValueThe basic feature of a debt is that it is a promise by the borrowing firm to repay a fixed dollar amount of by a certain date.
The shareholder’s claim on firm value is the residual amount that remains after the debtholders are paid.
If the value of the firm is less than the amount promised to the debtholders, the shareholders get nothing.
12. Debt and Equity as Contingent Claims$F$FPayoff to debt holdersValue of the firm (X)Debt holders are promised $F. If the value of the firm is less than $F, they get the whatever the firm if worth. If the value of the firm is more than $F, debt holders get a maximum of $F. $FPayoff to shareholdersValue of the firm (X)If the value of the firm is less than $F, share holders get nothing. If the value of the firm is more than $F, share holders get everything above $F. Algebraically, the bondholder’s claim is: Min[$F,$X]Algebraically, the shareholder’s claim is: Max[0,$X – $F]
13. Combined Payoffs to Debt and Equity$F$FCombined Payoffs to debt holders and shareholdersValue of the firm (X)Debt holders are promised $F. Payoff to debt holdersPayoff to shareholdersIf the value of the firm is less than $F, the shareholder’s claim is: Max[0,$X – $F] = $0 and the debt holder’s claim is Min[$F,$X] = $X.
The sum of these is = $XIf the value of the firm is more than $F, the shareholder’s claim is: Max[0,$X – $F] = $X – $F and the debt holder’s claim is:
Min[$F,$X] = $F.
The sum of these is = $X
14. 1.3 The Corporate FirmThe 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.
15. Forms of Business OrganizationThe 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
16. 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
General Partner is in charge; limited partners may have some voting rights.
Taxation
Double
Partners pay taxes on distributions.
Reinvestment
Broad latitude
All net cash flow is distributed to partners.
Liability
Limited liability
General partners may have unlimited liability. Limited partners enjoy limited liability.
Continuity
Perpetual life
Limited life
17. 1.4 Goals of the Corporate FirmThe traditional answer is that the managers of the corporation are obliged to make efforts to maximize shareholder wealth.
18. The Set-of-Contracts PerspectiveThe 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.
19. Managerial GoalsManagerial goals may be different from shareholder goals
Expensive perquisites
Survival
Independence
Increased growth and size are not necessarily the same thing as increased shareholder wealth.
20. Separation of Ownership and ControlBoard of DirectorsManagementAssetsDebtEquityShareholdersDebtholders
21. Do Shareholders Control Managerial Behavior?Shareholders vote for the board of directors, who in turn hire the management team.
Contracts can be carefully constructed to be incentive compatible.
There is a market for managerial talent—this may provide market discipline to the managers—they can be replaced.
If the managers fail to maximize share price, they may be replaced in a hostile takeover.
22. 1.5 Financial MarketsPrimary 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.
23. Financial Markets
Firms
InvestorsSecondary MarketmoneysecuritiesSueBobStocks and BondsMoneyPrimary Market
24. 1.6 Outline of the TextOverview
Value and Capital Budgeting
Risk
Capital Structure and Dividend Policy
Long-Term Financing
Options, Futures and Corporate Finance
Financial Planning and Short-Term Finance
Special Topics