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Key Concepts and Skills

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0 Introduction to Corporate Finance
Chapter 1 Introduction to Corporate Finance McGraw-Hill/Irwin Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.

1 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 1-1

2 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 www: This is a good place to show the students the web site that accompanies the book, including the various features that they can access for study purposes (study guide, quizzes, web links, etc.). Click on the “web surfer” icon to go directly to the site ( 1-2

3 Corporate Finance Some important questions that are answered using finance: What long-term investments should the firm take on? Where will we get the long-term financing to pay for the investment? How will we manage the everyday financial activities of the firm? Emphasize that “business finance” is just another name for “corporate finance” mentioned under the four basic types. Students often get confused by the terminology, especially when different terms are used to refer to the same thing. 1-3

4 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, credit management, capital expenditures, and financial planning Controller – oversees taxes, cost accounting, financial accounting and data processing Video Note: This video looks at the changing role of the Chief Financial Officer (CFO). 1-4

5 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? Provide some examples of capital budgeting decisions: what product or service will the firm sell, should we replace old equipment with newer, more advanced equipment, etc. Be sure to define debt and equity. Provide some examples of working capital management: who should we sell to on credit, how much inventory should we carry, when should we pay our suppliers, etc. 1-5

6 Forms of Business Organization
Three major forms in the United States Sole Proprietorship Partnership General Limited Corporation C-Corp S-Corp Limited Liability Company www: Clicking on the “web surfer” will take you to a web site ( that will provide a discussion about which form of business may be appropriate for an entrepreneur. The following pages will provide links to specific pages on the web site that provide additional information about the legal aspects of each form of business, as well as a discussion of the advantages and disadvantages. 1-6

7 Sole Proprietorship Advantages Disadvantages Easiest to start
Least regulated Single owner keeps all the profits Taxed once as personal income Disadvantages Limited to life of owner Equity capital limited to owner’s personal wealth Unlimited liability Difficult to sell ownership interest www: Click on the “web surfer” for more information about sole proprietorships. If you click on the “--Sole Proprietorship” link, you will be taken to an index that will provide a link to information about husband and wife sole proprietorships. 1-7

8 Partnership Advantages Disadvantages 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 www: Click on the “web surfer” for more information about partnerships. If you click on the “—Partnerships” link, you will go to an index that provides links to additional information about limited partnerships, partnership agreements, and buy-sell agreements. Note that unlimited liability applies to all partners in a general partnership but only to the general partners in a limited partnership. Written agreements are essential due to the unlimited liability. Limited partners cannot be involved in the business or else they may be deemed as general partners. 1-8

9 Corporation Advantages Disadvantages 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 taxed at the corporate rate and then dividends taxed at the personal rate) www: Click on the “web surfer” to go to a page that discusses corporations. If you click on the “—Corporations” link it will take you back to an index that provides links to additional information on corporations as well as limited liability corporations. Discuss how separation of ownership and management can be both an advantage and a disadvantage: Advantages You can benefit from ownership in several different businesses (diversification) You can take advantage of the expertise of others (comparative advantage) Easier to transfer ownership Disadvantage Agency problems if management goals and owner goals are not aligned The Lecture Tip in the instructor’s manual provides additional discussion of limited liability companies and S-corporations. A pertinent discussion is the implementation of Sarbanes-Oxley and the effect it has had. Although increased information flow is good for shareholders, it has come at a cost. In fact, some firms have chosen to “go dark,” while others have avoided going public altogether. 1-9

10 Goal of Financial Management
What should be the goal of a corporation? Maximize profit? Minimize costs? 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? Try to have the students discuss each of the goals above and the inherent problems of the first three goals: Maximize profit – Are we talking about long-run or short-run profits? Do we mean accounting profits or some measure of cash flow? Minimize costs – We can minimize costs today by not purchasing new equipment or delaying maintenance, but this may not be in the best interest of the firm or its owners. Maximize market share – This has been a strategy of many of the “” companies. They issued stock and then used it primarily for advertising to increase the number of “hits” to their web sites. Even though many of the companies have a huge market share, they still do not have positive earnings and their owners are not happy. Maximize the current value of the company’s stock There is no short run vs. long run here. The stock price should incorporate expectations about the future of the company and consider the trade-off between short-run profits and long-run profits. The purpose of a for-profit business should be to make money for its owners. Maximizing the current stock price increases the wealth of the owners of the firm. This is analogous to maximizing owners’ equity for firms that do not have publicly traded stock. Non-profits can also follow the same principle, but their “owners” are the constituencies that they were created to help. The instructors manual (IM) provides a letter to stockholders that was written by former Coca-Cola CEO Roberto Goizueta. A Lecture Tip also provides a brief discussion of an article that appeared in Fortune magazine that discusses Coke vs. Pepsi and their different philosophies on business in the early 1990’s. Another Lecture Tip addresses the implicit assumption in this goal, i.e., that investors are rational. Also be sure to note that this goal is not specific to corporations, but is generally applied to any form of business, including not-for-profits. 1-10

11 The Agency Problem Agency relationship Agency problem
Principal hires an agent to represent his/her interests Stockholders (principals) hire managers (agents) to run the company Agency problem Conflict of interest between principal and agent Management goals and agency costs A common example of an agency relationship is a real estate broker – in particular if you break it down between a buyer’s agent and a seller’s agent. A classic conflict of interest is when the agent is paid on commission, so they may be less willing to let the buyer know that a lower price might be accepted or they may elect to only show the buyer homes that are listed at the high end of the buyer’s price range. Direct agency costs – the purchase of something for management that can’t be justified from a risk-return standpoint, and monitoring costs. Indirect agency costs – management’s tendency to forgo risky or expensive projects that could be justified from a risk-return standpoint. A Lecture Tip provides an example that illustrates conflicts may also arise between bondholders and stockholders. 1-11

12 Managing Managers Managerial compensation Corporate control
Incentives can be used to align management and stockholder interests 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 Other stakeholders Incentives – discuss how incentives must be carefully structured. For example, tying bonuses to profits might encourage management to pursue short-run profits and forego projects that require a large initial outlay. Stock options may work, but there may be an optimal level of insider ownership. Beyond that level, management may be in too much control and may not act in the best interest of all stockholders. The type of stock can also affect the effectiveness of the incentive. A recent issue with option’s backdating also seems to run counter to the purpose of aligning incentives. Corporate control – ask the students why the threat of a takeover might make managers work toward the goals of stockholders. Other groups also have a financial stake in the firm. They can provide a valuable monitoring tool, but they can also try to force the firm to do things that are not in the owners’ best interests. 1-12

13 Work the Web Example The Internet provides a wealth of information about individual companies One excellent site is Click on the web surfer to go to the site, choose a company and see what information you can find! 1-13

14 Financial Markets Cash flows to the firm Primary vs. secondary markets
Dealer vs. auction markets Listed vs. over-the-counter securities NYSE NASDAQ Video Note: This video discusses how capital is raised in financial markets and shows an open-outcry market at the Chicago Board of Trade. Discuss the cash flows to the firm. You might have students turn to Figure 1.2 in their book to see an illustration of the cash flows. The main point is that cash comes into the firm from the sale of debt and equity. The money is used to purchase assets. Those assets generate cash that is used to pay stakeholders, reinvest in additional assets, repay debtholders, and pay dividends to stockholders. The Lecture Tip in the IM provides an interesting example of full disclosure in a firm’s IPO prospectus. Students are often confused by the fact that the NASDAQ is an OTC market. Explain that the NASDAQ market site is just a convenient place for reporters to show how stocks are moving, but that trading does not actually take place there. You may wish to note the evolution of these particular markets, e.g., moving to publicly traded firms, emergence of electronic trading, and increased industry consolidation. www: Click on the NYSE and NASDAQ hyperlinks to go to their respective web sites 1-14

15 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? 1-15

16 Ethics Issues Is it ethical for tobacco companies to sell a product that is known to be addictive and a danger to the health of the user? Is it relevant that the product is legal? Should boards of directors consider only price when faced with a buyout offer? Is it ethical to concentrate only on shareholder wealth, or should stakeholders as a whole be considered? Should firms be penalized for attempting to improve returns by stifling competition (e.g., Microsoft)? These Ethics Issues can be addressed throughout the chapter or as a dedicated discussion as given here. The second issue relates to the buyout offer for Gillette that was rejected due to information regarding the launch of the highly successful “Sensor” razor. 1-16

17 End of Chapter 1-17

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