Corporate Finance, 2e by Smart, Megginson, Gitman © 2007 Thomson South-Western

Chapter 1 The Scope Of Corporate Finance Professor XXXXX Course Name / Number © 2007 Thomson South-Western

What is Corporate Finance? The activities involved in managing cash flows in a business environment

The Core Principles of Finance The time value of money The opportunity to earn a return on invested funds means that a dollar today is worth more than a dollar in the future. Compensation for risk Investors expect compensation for bearing risk.

The Core Principles of Finance Don’t put your eggs in one basket Investors can achieve a more favorable trade-off between risk and return by diversifying their portfolios. Markets are smart Competition for information tends to make markets efficient. No arbitrage Arbitrage opportunities are extremely scarce.

The 5 Basic Corporate Finance Functions Financing (Capital-Raising) Capital Budgeting Financial Management Risk Management Corporate Governance

The Financing Function Businesses can raise money in 2 ways: externally from investors or creditors IPOs Primary market transactions Secondary market transactions internally by retaining operating cash flows Most common method

Raising Capital: Key Facts Most financing from internal rather than external sources Most external financing is debt Primary vs. secondary market transactions or offerings Financial intermediaries declining as a source of capital for large firms Securities markets growing in importance

The Total Value of Primary (Capital-Raising) Corporate Security Issues, 1990 –2004

Growth in Global Security Issues

The Capital Budgeting Function Capital Budgeting – selecting the best projects in which to invest the firm’s resources

The Capital Budgeting Function The capital budgeting process consists of three steps. Step 1 - identifying potential investments Step 2 - analyzing those investments to identify which will create shareholder value Step 3 - implementing and monitoring the investments selected in step 2

The Financial Management Function Managing daily cash inflows and outflows Forecasting cash balances Building a long-term financial plan Choosing the right mix of debt and equity

The Corporate Governance Function Hires and promotes qualified, honest people, and structures employees’ financial incentives to motivate them to maximize firm value In practice the incentives of stockholders, managers, and other stakeholders often conflict. Dimensions of corporate governance: Board of directors Securities and Exchange Commission Sarbanes-Oxley Act of 2002

Value of Global Mergers & Acquisitions

The Risk Management Function Identifying, measuring, and managing all types of risk exposures Some risks are insurable, and some risks can be reduced through diversification. Financial instruments like forwards, futures, options, and swaps may also be used to hedge market risks such as interest-rate, price, and currency fluctuations.

Business Organizational Forms in the United States Sole Proprietorships No Distinction Between Business & Owner Easy To Set Up, Operate; Business Earnings Taxed As Personal Income Limited Life, Limited Access to Capital, Unlimited Personal Liability Partnerships Two Or More Owners Joint and Several Liability Limited Life, Limited Access to Capital, Unlimited Personal Liability Limited Partnerships One Or More General Partners with Unlimited Personal Liability Most Partners are Totally Passive with Limited Liability - Limited Partners; Share of Profits Taxed as Partnership Income

Business Organizational Forms in the United States Separate Legal Entity With Many of the Economic Rights & Responsibilities of Individuals Unlimited Life, Limited Liability, Separable Contracting, Unlimited Access to Capital Owned by Shareholders, Who Elect the Board of Directors In the U.S., Incorporation is Executed At State Level and Governed by State Law Corporations Are there any disadvantages for corporations? YES! Double taxation

Taxation of Business Income AFTER the Jobs and Growth Tax Relief Reconciliation Act of 2003

Business Organizational Forms in the United States S Corporations Shareholders are taxed as partners while still retaining Limited Liability as Corporate Shareholders Status is Subject to Several Eligibility Requirements Limited- Liability Companies Combines the Partnership’s Pass-Through Taxation with the S Corporation’s Limited Liability

Forms of Business Organizations Used by Non-U.S. Companies Limited-Liability Companies Britain: public limited companies (PLC) Germany: Aktiengesellschaft (AG) France: Société Générale Spain, Mexico, and elsewhere in Latin America: Sociedad Anónima State-Owned Enterprises Historically, the telephone, television, utility, airline and railroad companies in many European countries Privatization programs have reduced the role of the states around the world How much has been raised through Privatization Programs?

Worldwide Privatization Revenues

What Should a Financial Manager Try to Maximize? Maximize Profit? Earnings per share are backward-looking, dependent on accounting principles, Do not fully consider cash flow timing Ignores risk Maximize Shareholder Wealth? Maximize stock price, not profits Shareholders, as residual claimants, have better incentives to maximize firm value.

World Stock Market Capitalization

Agency Costs Managers act as agents of the owners who hired them and gave them decision-making authority to manage the firm for the owners’ benefit. In practice however, self-interests may cause managers to pursue objectives other than shareholder-wealth maximization. This conflict of goals gives rise to managerial agency problems.

How Agency Costs Can Be Controlled Ways to overcome agency problems: Takeovers Monitoring and bonding Compensation contracts Executive compensation packages

Importance of Ethics Widespread publicity surrounding numerous ethical violations began with the Enron collapse in late 2001. Society in general and the financial community in particular are developing and enforcing ethical standards. Ethical behavior is necessary in order to maximize shareholder’s wealth.