:Course Name

Principles of Finance

Chapter (1)
Introduction to Corporate
Finance

Prof. Khaled Alzubi

 After studying this chapter, you should be
able to:

LO1 :Define the basic types of financial management

decisions and the role of the financial manager.

LO2 : Explain the goal of financial management.

LO3 : Articulate the financial implications of the

different forms of business organization.

LO4 : Explain the conflicts of interest that can arise

between managers and owners
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 Chapter Outline

1.1: Corporate Finance and the Financial Manager

1.2: Forms of Business Organization

1.3: The Goal of Financial Management

1.4: The Agency Problem and Control of the

Corporation

1.5: Financial Markets and the Corporation

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 Corporate Finance and the Financial :1.1
Manager

 In this section, We start by defining corporate finance and

the financial manager’s job.

Finance is the art and science of managing wealth.

 WHAT IS CORPORATE FINANCE?

 In order to define corporate finance, we shall answer the
three following questions:
 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 ?

 In a large corporation, the financial manager would be in

charge of answering the three questions 4
 Corporate Finance and the Financial :1.1
Manager
 THE FINANCIAL MANAGER

 Managers represent the owners’ (the stockholders) interests and make

decisions on their behalf.
 The top financial manager within a firm is usually the Chief Financial
Officer (CFO).
 The (CFO) function is usually associated with a top officer of the firm
FIGURE 1.1
 The (CFO) coordinates the activities of the treasurer and the controller.

I. The controller’s office handles cost and financial accounting, tax

payments, and management information systems

II. The treasurer’s office is responsible for managing the firm’s cash
and credit, its financial planning, and its capital expenditures

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6 FIGURE 1.1
A Sample
simplified
Organizational
Chart
 Corporate Finance and the Financial :1.1
Manager
 FINANCIAL MANAGEMENT DECISIONS

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 Corporate Finance and the Financial :1.1
Manager
 FINANCIAL MANAGEMENT DECISIONS

A. Capital budgeting
 The process of planning and managing a firm’s long term
investments.
 The financial manager tries to identify investment opportunities
that are worth more to the firm than they cost to acquire.
 For example, for a large retailer such as Wal-Mart, deciding whether to
open another store would be an important capital budgeting decision.
 Financial managers must be concerned not only with how much
cash they expect to receive, but also with when they expect to
receive it and how likely they are to receive it.
 Evaluating the size, timing, and risk of future cash flows is the
essence of capital budgeting
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 Corporate Finance and the Financial :1.1
Manager
 FINANCIAL MANAGEMENT DECISIONS

B. Capital structure
 The long-term financing it needs to support its long-term
investments.
– The mixture of debt and equity maintained by a
firm.

 First, how much should the firm borrow? That is, what
mixture of debt and equity is best? The mixture chosen
will affect both the risk and the value of the firm.
 Second, what are the least expensive sources of funds for
the firm?

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 Corporate Finance and the Financial :1.1
Manager
 FINANCIAL MANAGEMENT DECISIONS

B. Capital structure
 If we picture the firm as a pie, then the
firm’s capital structure determines how
that pie is sliced

 Where
• B : is the value of the debt (Bond)
• S : is the value of the equity (stock)

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 Corporate Finance and the Financial :1.1
Manager
 FINANCIAL MANAGEMENT DECISIONS

C. Working capital management

– The term working capital refers to a firm’s short-
term assets, such as inventory, and its short-term
liabilities, such as money owed to suppliers
• Some questions about working capital that must be answered
are the following:
– (1) How much cash and inventory should we keep on hand?
– (2) Should we sell on credit? If so, what terms will we offer, and to
whom will we extend them?
– (3) How will we obtain any needed short-term financing? Will we
purchase on credit or will we borrow in the short term and pay cash
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 Corporate Finance and the Financial :1.1
Manager

maximize shareholders’
wealth

Capital Capital Working capital

budgeting structure management

 The objective of the financial manager is to maximize

shareholders’ wealth.
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 Forms of Business Organization :1.2

Three major forms :

A. Sole proprietorship.
 A business owned by a single
individual.
B. The Partnership
 A business formed by two or more
individuals or entities.
C. Corporation.
 A business created as a distinct legal
entity composed of one or more
individuals or entities.
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 Forms of Business Organization :1.2

A. Sole proprietorship

 A sole proprietorship Is a business owned by one person.

Many businesses that later become large corporations start
out as small proprietorships.
• Advantages • Disadvantages
– Easy to start and less – The owner has unlimited liability
regulated. for business debts.
– Single owner keeps all the – Limited to life of owner.
profits. – Equity capital limited to owner’s
– Taxed once as personal personal wealth.
income – Difficult to sell ownership
interest.
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 Forms of Business Organization :1.2

B. PARTNERSHIP

 A partnership is similar to a proprietorship except that there

are two or more owners
 Partnerships fall into two categories:
1) General partnerships.
 All partners share in gains or losses; all have unlimited
liability for all partnership debts.
2) limited partnerships.
 Permit the liability of some of the partners to be limited to
the amount of cash each has contributed to the partnership
and they cannot help in running the business.
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 Forms of Business Organization :1.2

C. Corporation
 A corporation is a legal “person” separate and distinct from its owners ,
and it has many of the rights, duties, and privileges of an actual person .
 Advantages  Disadvantages
 Limited liability  Not easy to start and more
 regulated
Unlimited life
 Double taxation (income
Transfer of ownership is easy
taxed at the corporate rate and
 Easier to raise capital. then dividends taxed at the
personal rate).
 Separation of ownership and Separation of ownership and
management. management.

 The advantages of the corporate form may come to

outweigh the disadvantages. 16
 Forms of Business Organization :1.2

 A CORPORATION BY ANOTHER NAME . . .

 These firms are often called joint stock

companies, public limited companies, or
limited liability companies, depending on the
specific nature of the firm and the country of
origin.

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 The Goal of Financial Management :1.3

A. POSSIBLE GOALS !!!

 we might come up with some ideas like the following:
– Avoid financial distress , bankruptcy and Survive
– Maximize sales or market share.
– Minimize costs and Maximize profits.
– Maintain steady earnings growth and Beat the competition

 The goals we’ve listed here are all different, but they tend to fall
into two classes. The first of these relates to profitability. The
second group, involving bankruptcy avoidance.
What we need, therefore, is a goal that encompasses
both factors. 18
 The Goal of Financial Management :1.3

B. THE GOAL OF FINANCIAL MANAGEMENT

 The goal of financial management is to maximize

the current value per share of the existing stock.

- The financial manager acts In the shareholders’

(stockholders’) best interests by making decisions that
increase the value of the stock. The appropriate goal
for the financial manager can thus be stated quite
easily: Maximize the market value of the existing
owners’ equity (wealth)

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 The Goal of Financial Management :1.3

C. A MORE GENERAL GOAL

 Our goal does not imply that the financial

manager should take illegal or unethical
actions in the hope of increasing the value of
the equity in the firm.

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 The Agency Problem and Control of the :1.4
Corporation

 We’ve seen that the financial manager acts

in the best interests of the stockholders by
taking actions that increase the value of the
stock.

 However, management might pursue its

own goals at the stockholders’ expense.

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 The Agency Problem and Control of the :1.4
Corporation
 AGENCY RELATIONSHIPS

 The relationship between stockholders and

management is called an agency relationship.
 Such a relationship exists whenever someone (the
principal) hires another (the agent) to represent his or
her interests.

 The possibility of conflict of interest between the

stockholders and management of a firm is called an
agency problem.

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 The Agency Problem and Control of the 1.4
Corporation
 MANAGEMENT GOALS
• Agency costs refers to the costs of the conflict of
interest between stockholders and management.
 These costs can be direct or indirect .
A. Direct costs come in two forms.
 The first type is a corporate expenditure
(compensation) that benefits management but costs
the stockholders
 The second type of direct agency cost is an expense
that arises from the need to monitor management
actions. Paying outside auditors to assess the
accuracy of financial statement information could
be one example.
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 The Agency Problem and Control of the 1.4
Corporation
 MANAGEMENT GOALS

B. An indirect agency cost is a lost opportunity

 The new investment is expected to
favorably impact the share value, but it is
also a relatively risky the management do
not take it.

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  Managerial Compensation

 Managerial compensation: can be used to encourage

managers to act in the best interest of stockholders

– 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
– One commonly cited tool is stock options so they
will be more likely to try to maximize owner
wealth.

 The second incentive managers have relates to job

prospects. Better performers within the firm will tend
to get promoted.
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  Control of the Firm
 An important mechanism by which unhappy
stockholders can act to replace existing
management is called a proxy fight. A proxy fight
develops when a group solicits proxies in order to
replace the existing board and thereby replace
existing managers.

 Another way that managers can be replaced is by

takeover. Firms that are poorly managed are more
attractive as acquisitions because a greater profit
potential exists

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 The Agency Problem and Control of the 1.4
Corporation

 Stakeholders

 Are other groups, besides stockholders, that have

a vested interest in the firm and potentially have
claims on the firm’s cash flows. Stakeholders can
include creditors, employees and customers.

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 Financial Markets and the Corporation : 1.5

FIGURE 1.2 Cash Flows between the Firm and

the Financial Markets

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 Financial Markets and the Corporation : 1.5

 CASH FLOWS TO AND FROM THE FIRM

 A financial market, like any market, is just a way of bringing

buyers and sellers together. In financial markets, it is debt and
equity securities that are bought and sold.

 he financial markets is illustrated in (Figure 1.2)

 (A) firm selling shares of stock and borrowing money to raise cash.
Cash flows to the firm from the financial markets.
 (B) The firm invests the cash in current and fixed assets.
 (C) These assets generate cash,
 (D) some of which goes to pay corporate taxes . After taxes are paid,
 (E) some of this cash flow is reinvested in the firm.
 (F) The rest goes back to the financial markets as cash paid to
creditors and shareholders.
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 Financial Markets and the Corporation : 1.5

 PRIMARY VERSUS SECONDARY MARKETS

Stocks and
Investors
Bonds
Firms securities
Money Bob Sue
money

Primary Market
Secondary Market

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 Financial Markets and the Corporation : 1.5

 PRIMARY VERSUS SECONDARY MARKETS

 Financial markets function as both primary and

secondary markets for debt and equity securities.
A. The term primary market
 The corporation is the seller, and the transaction raises
money for the corporation. Corporations engage in two types
of primary market transactions: public offerings and private
placements.
 a corporation is directly involved only in a primary market
transaction (when it sells securities to raise cash)
B. The secondary markets
 A secondary market transaction involves one owner or
creditor selling to another. Therefore, the secondary markets
provide the means for transferring ownership of corporate
securities.
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 Financial Markets and the Corporation : 1.5

 DEALER VERSUS AUCTION MARKETS

 There are two kinds of secondary markets:

1. Auction markets
 First, an auction market or exchange has a physical location (like
Wall Street).
 Brokers match buyers and sellers, they do not actually own the
stocks and long-term debt (Bond),with little dealer activity.

2. Dealer markets. Generally speaking, dealers buy and

sell for themselves, at their own risk.
 Dealer markets in stocks and long-term debt are called over-the-
counter (OTC) markets. Most trading in debt securities takes place
over the counter.
 Most of the buying and selling is done by the dealer.

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 Financial Markets and the Corporation : 1.5

 TRADING IN CORPORATE SECURITIES

 The equity shares of most of the large firms in the

United States trade in organized auction markets.
The largest such market is the New York Stock
Exchange (NYSE).
 LISTING

 Stocks that trade on an organized exchange are

said to be listed on that exchange. To be listed,
firms must meet certain minimum criteria
concerning, for example, asset size and number of
shareholders. These criteria differ from one
exchange to another.
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