Chapter One Overview of Corporate Finance Principles of Corporate Finance Canadian Edition Lawrence J. Gitman and Sean Hennessey BZUPAGES.COM © 2005 Pearson Education Canada Inc.

Learning Goals LG1 – Define finance and describe its three major areas and career opportunities. LG2 – Review basic forms of business organization, their strengths and weaknesses. LG3 – Describe managerial finance function and differentiate from economics and accounting. BZUPAGES.COM © 2005 Pearson Education Canada Inc.

Learning Goals (continued) LG4 – Identify key activities of financial manager within the firm. LG5 – Explain why wealth maximization is firm’s goal. LG6 – Explain how EVA, stakeholder focus, and ethical behaviour relate to firm’s goal. LG7 – Discuss agency issue as it relates to owner wealth maximization. BZUPAGES.COM © 2005 Pearson Education Canada Inc.

What is 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 Canadian 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. BZUPAGES.COM © 2005 Pearson Education Canada Inc.

What is Finance? Macro Finance Working Working Capital Capital Investment Decisions Financing Decisions BZUPAGES.COM © 2005 Pearson Education Canada Inc.

What is Finance? A well-developed financial system is a hallmark and essential characteristic of any modern developed nation. Financial markets, financial intermediaries, and financial management are the important components. Financial markets and financial intermediaries facilitate the flow of funds from borrowers to savers. Financial management involves the efficient use of financial resources in the production of goods. BZUPAGES.COM © 2005 Pearson Education Canada Inc.

Areas of Specialization in Finance Financial Markets Markets of users and savers of funds. Financial Services Design and delivery of financial advice and products to individuals, businesses, government. Managerial Finance Financial management of business firms. BZUPAGES.COM © 2005 Pearson Education Canada Inc.

Areas of Employment in Finance Financial Analyst Capital budgeting analyst/manager Project finance manager Cash manager Credit analyst/manager Pension fund manager BZUPAGES.COM © 2005 Pearson Education Canada Inc.

Basic Forms of Business Organization Sole Proprietorship Owned by one person, operated for personal profit. Partnerships Owned by two or more people, operated for joint profit. Corporations “Legal entity”, owned by individuals, operated for joint profit. BZUPAGES.COM © 2005 Pearson Education Canada Inc.

Sole Proprietorship STRENGTHS: Low organizational cost Income taxed once as personal income Independence Secrecy Ease of dissolution WEAKNESSES: Unlimited liability Limited funding Proprietor must be all Difficult to develop staff career opportunities Lack of continuity on death of proprietor BZUPAGES.COM © 2005 Pearson Education Canada Inc.

Partnerships STRENGTHS: Improved funding sources Increased managerial talent Income split by partnership contract, taxed as personal income WEAKNESSES: Unlimited liability to all partners Partnership dissolved upon death of partner Difficult to liquidate or transfer ownership BZUPAGES.COM © 2005 Pearson Education Canada Inc.

Corporations STRENGTHS: Owners’ liability limited Large capitalization possible, greater funding Ownership readily transferable Indefinite life Professional management WEAKNESSES: Higher tax rates Expensive organization Greater government regulation When publicly traded, lacks secrecy BZUPAGES.COM © 2005 Pearson Education Canada Inc.

Corporate Organization Chart BZUPAGES.COM © 2005 Pearson Education Canada Inc.

Organization of Finance Functions CFO – Chief Financial Officer Treasurer responsibilities: Financial planning, fund raising, capital expenditure decisions, cash and credit management. Controller responsibilities: Corporate accounting, cost accounting, and tax management. BZUPAGES.COM © 2005 Pearson Education Canada Inc.

Relationship to Economics Fundamental Economic Principle: Marginal Analysis Financial decisions should be made and actions taken only when the added benefits exceed the added costs. BZUPAGES.COM © 2005 Pearson Education Canada Inc.

Relationship to Accounting Cash Flows Accrual Basis: recognizes sales revenue and expenses incurred to make sale at time of sale. Cash Basis: recognizes revenues and expenses as they occur. BZUPAGES.COM © 2005 Pearson Education Canada Inc.

Accounting vs. Financial Views Accounting View (Accrual Basis) Income Statement Peakes Quay, Inc. For year ended 12/31 Financial View (Cash Basis) Cash Flow Statement Peakes Quay, Inc. For year ended 12/31 Sales revenue $100,000 Less: Costs 80,000 Net Profit $ 20,000 Cash inflow $ 0 Less: Cash outflow 80,000 Net cash flow ($80,000) BZUPAGES.COM © 2005 Pearson Education Canada Inc.

Financial Manager–Key Activities Financial Analysis & Planning Balance Sheet Current Assets _______________ Fixed Current Liabilities _______________ Long-Term Funds (Debt & Equity) Making Investment Decisions Making Financing Decisions BZUPAGES.COM © 2005 Pearson Education Canada Inc.

Should Firms Maximize Profit? Corporations commonly define profit as “Earnings per Share” (EPS). A measure of total earnings divided by total number of ownership shares. EPS ignores critical factors of the timing of the returns. cash flows available to common shareholders. risk factors facing the firm. BZUPAGES.COM © 2005 Pearson Education Canada Inc.

Or Should Firms Maximize Shareholder Wealth? Evaluating Shareholder Wealth addresses factors of timing, cash flows and risk ignored by the EPS. Therefore, Maximizing Shareholder Wealth is a more comprehensive goal for the firm, its managers and employees. This can be explored through “economic valued added” and a focus on stakeholders. BZUPAGES.COM © 2005 Pearson Education Canada Inc.

Economic Value Added – EVA® EVA measures whether an investment contributes to shareholder wealth. EVA is calculated by subtracting cost of funds used from after-tax operating profits. While popular, EVA is essentially derived from the concept of “net present value.” BZUPAGES.COM © 2005 Pearson Education Canada Inc.

What about Stakeholders? Stakeholders include groups that have direct economic links to the firm. Stakeholders include not only owners, but also employees, customers, suppliers, and creditors. Maintaining positive stakeholder relationships helps maximize long-term benefits to shareholders. BZUPAGES.COM © 2005 Pearson Education Canada Inc.

Importance of Ethics The standards of conduct or moral judgment: Honesty, trustworthiness, fair dealing are foundations of sustainable business relations: With customers, With suppliers, With creditors, With employees, With owners. Ethical behaviour is necessary to achieve the goal of maximizing shareholder wealth. BZUPAGES.COM © 2005 Pearson Education Canada Inc.

Internal Ethical Review Are rights of stakeholders being violated? Does firm have extra duties to stakeholders? Will a decision unfairly discriminate benefits among stakeholders? If stakeholders are harmed, should this be remedied? How? What is the relationship between shareholders and stakeholders? BZUPAGES.COM © 2005 Pearson Education Canada Inc.

Financial Goals of a Company Maximize sales. Maximize cash flow. Maximize market share. Maximize profit. Minimize costs. Maximize return on sales, investment, equity. Ensure earnings stability. Achieve target goals for sales, profits, market share or return. BZUPAGES.COM © 2005 Pearson Education Canada Inc.

Agency Issues: The Principal-Agent Problem Whenever ownership is independent of management there exists potential problem of conflicts. The owner’s goals for the firm are best described as maximizing shareholder wealth. Managers are also concerned with personal wealth, job security, lifestyle, and benefits. These concerns may conflict with shareholder interests. BZUPAGES.COM © 2005 Pearson Education Canada Inc.

Resolving the Agency Problem Good corporate governance by the Board of Directors is the heart of any resolution. Agency Costs – the costs of this governance: Monitoring costs, Bonding costs, Structuring compensation costs. Market forces, such as the potential for hostile takeover provide some deterrence. Legal forces, fraud, and fiduciary misconduct laws aim to act as deterrents as well. BZUPAGES.COM © 2005 Pearson Education Canada Inc.

Current View on Incentive Plans Executive compensation packages generally include incentive plans that grant stock options, performance-based shares, or cash bonuses upon meeting or exceeding corporate goals. Such packages may also include long-term benefits that can protect the manager against poor corporate performance. BZUPAGES.COM © 2005 Pearson Education Canada Inc.

Overview of Text Part 1: Introduction to Corporate Finance Part 2: Financial Analysis and Planning Part 3: Important Financial Concepts Part 4: Long-Term Financial Decisions Part 5: Long-Term Investment Decisions Part 6: Working Capital Management Part 7: Special Topics in Corporate Finance BZUPAGES.COM © 2005 Pearson Education Canada Inc.