1. © 2005 McGraw-Hill Ryerson Limited © 2003 The McGraw-Hill Companies, Inc. All rights reserved.

2. Introduction To Corporate Finance Chapter One

3. © 2005 McGraw-Hill Ryerson Limited Key Concepts and Skills Know the basic types of financial management decisions and the role of the financial manager Know the financial implications of the different forms of business organization Know the goal of financial management Understand the conflicts of interest that can arise between owners and managers Understand the various types of financial markets and financial institutions Understand current trends in Canadian financial markets 1.1

4. © 2005 McGraw-Hill Ryerson Limited Chapter Outline Corporate Finance and the Financial Manager Forms of Business Organization The Goal of Financial Management The Agency Problem and Control of the Corporation Financial Markets and the Corporation Financial Institutions Trends in Financial Markets and Financial Management 1.2

5. © 2005 McGraw-Hill Ryerson Limited Corporate Finance Some important questions that are answered using finance –What long-term investments should the firm take on (capital budgeting)? Open a new store, acquire new equipment, etc. –Where will we get the long-term financing to pay for the investment (capital structure – debt vs. equity)? –How will we manage the everyday financial activities of the firm (working capital management – inventory, money owed to suppliers, accounts receivable)? 1.3

6. © 2005 McGraw-Hill Ryerson Limited 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) –Treasurer – oversees cash management, capital expenditures and financial planning –Controller – oversees taxes, cost accounting, financial accounting and data processing (MIS) –Show Fig. 1.1 @ page 4! 1.4

7. © 2005 McGraw-Hill Ryerson Limited Financial Management Decisions Capital budgeting –What long-term investments or projects should the business take on? Capital structure –How should we pay for our assets? –Should we use debt or equity? Working capital management –How do we manage the day-to-day finances of the firm? 1.5

8. © 2005 McGraw-Hill Ryerson Limited Forms of Business Organization Three major forms in Canada –Sole proprietorship – owned by one person –Partnership – owned by many partners General – all partners unlimited liability Limited – some partners do not actively participate and have limited liability –Corporation – legal entity separate from its owners In other countries, corporations are also called joint stock companies, public limited companies and limited liability companies 1.6

9. © 2005 McGraw-Hill Ryerson Limited Sole Proprietorship Advantages –Easiest to start –Least regulated –Single owner keeps all the profits –Taxed once as personal income Disadvantages –Unlimited liability –Limited to life of owner –Equity capital limited to owner’s personal wealth –Difficult to sell (transfer) ownership interest 1.7

10. © 2005 McGraw-Hill Ryerson Limited Partnership Advantages –Two or more owners –More capital available –Relatively easy to start –Income taxed once as personal income Disadvantages –Unlimited liability General partnership Limited partnership –Partnership dissolves when one partner dies or wishes to sell –Difficult to transfer ownership 1.8

11. © 2005 McGraw-Hill Ryerson Limited Corporation Advantages –Limited liability –Unlimited life –Separation of ownership and management –Transfer of ownership is easy –Easier to raise capital Disadvantages –Separation of ownership and management –Double taxation (income – corporate profits - is taxed at the corporate rate and then dividends are taxed at the personal rate) 1.9

12. © 2005 McGraw-Hill Ryerson Limited An International Perspective 1.10

13. © 2005 McGraw-Hill Ryerson Limited Goal Of Financial Management What should be the goal of a corporation? –Maximize profit? Avoid bankruptcy? –Minimize costs? Survive in business? –Maximize market share? –Maximize the current value of the company’s stock? Does this mean we should do anything and everything to maximize owner wealth? 1.11

14. © 2005 McGraw-Hill Ryerson Limited Primary Goal of Financial Management Three equivalent goals of financial management: –Maximize shareholder wealth –Maximize share price –Maximize firm value –OR: to maximize the current value per share of existing stock (note: For the stock price to be an accurate measure of the financial manager’s performance, we need capital markets to do their pricing job correctly - we need capital markets to be efficient. In an efficient capital market, all available information is incorporated into stock prices, and thus what the financial manager knows, the shareholders know it, too). 1.12

15. © 2005 McGraw-Hill Ryerson Limited The Agency Problem Agency relationship –Principal hires an agent to represent their interests –Stockholders (principals) hire managers (agents) to run the company Agency problem –Conflicts of interest can exist between the principal and the agent Agency costs –Direct agency costs (luxurious jet, auditors) –Indirect agency costs (lost opportunity) 1.13

16. © 2005 McGraw-Hill Ryerson Limited Managing Managers Managerial compensation –Incentives can be used to align management and stockholder interests (tie perform. to share value, labour market) –The incentives need to be structured carefully to make sure that they achieve their goal Corporate control –The threat of a takeover may result in better management Conflicts with other stakeholders –The incentives need to be structured carefully to make sure that they achieve their goal (a stakeholder is anybody with a claim on the cash flows of the firm, such as creditors, employees, and shareholders, of course. Somehow stakeholders may push for higher costs to the firms, such as employee benefits, social and environmental considerations. Firms nevertheless need to take account of these considerations). 1.14

17. © 2005 McGraw-Hill Ryerson Limited Work the Web Example The Internet provides a wealth of information about individual companies One excellent site is finance.yahoo.com Click on the web surfer to go to the site, choose a company and see what information you can find! 1.15

18. © 2005 McGraw-Hill Ryerson Limited What is the role of financial markets in corporate finance? Cash flows to and from the firm (show Fig. 1.3, page 15) Money (short-term debt) vs. capital markets (long-term debt and shares: TSX) Primary (public offerings->underwritten by an investment dealer) vs. secondary markets (transferring ownership: auction markets and dealer markets) How do financial markets benefit society? (transfer, raise?) 1.16

19. © 2005 McGraw-Hill Ryerson Limited Cash Flows to and from the Firm 1.17

20. © 2005 McGraw-Hill Ryerson Limited Financial Institutions Financial institutions act as intermediaries between suppliers and users of funds Institutions earn income on services provided: –Indirect finance – Earn interest on the spread between loans and deposits –Direct finance – Service fees (i.e. bankers acceptance and stamping fees) 1.18

21. © 2005 McGraw-Hill Ryerson Limited Trends in Financial Markets and Management Financial Engineering Derivative Securities Advances in Technology – i.e. E-business Deregulation (large institutions) Corporate Governance Reform (stronger, independent BoD) 1.19

22. © 2005 McGraw-Hill Ryerson Limited Quick Quiz What are the three types of financial management decisions and what questions are they designed to answer? What are the three major forms of business organization? 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? 1.20

23. © 2005 McGraw-Hill Ryerson Limited Summary 1.9 You should know: –The advantages and disadvantages between a sole proprietorship, partnership and corporation –The primary goal of the firm –What an agency relationship and cost are –The role of financial markets 1.21