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Theory of Corporate Finance

RWJ-Chapter 1

+What is Corporate Finance?

What long-term investments should the firm engage in? Capital Budgeting: The process of planning and managing a firm’s

long-term investments Investment opportunities: value vs. cost of these opportunities What do we need to learn?

How can the firm raise money for the required investments? Capital Structure: The mixture of debt and equity to support long-

term investments What do we know? And Why is important?

How much short-term cash flow does a company need to pay its bills? Working Capital Management: Capital required for the firm’s day to

day activities (current assets and liabilities) What do we know? And why is it important?

+What is our Strategy?

We learn: The basic tools to answer these questions

Financial Statements Cost of Equity Cost of Debt Project Evaluation Firm and Bond Valuations

To link these tools in our 3 fundamental questions

Moreover, corporate finance is a very important tool for investments? Why?

+Let’s examine these questions in a Balance-Sheet Model

The Capital Budgeting Decision

Current Assets

Fixed Assets 1. Tangible 2. Intangible

What long-term investments should the firm engage?

Current Liabilities

Long-Term Debt

Shareholders’ Equity

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The Capital Structure Decision

Current Assets

Fixed Assets 1. Tangible 2. Intangible

How can the firm raise the money for the required investments?

Current Liabilities

Long-Term Debt

Shareholders’ Equity

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The Net Working Capital Investment Decision

Current Assets

Fixed Assets 1. Tangible 2. Intangible

Current Liabilities

Long-Term Debt

Shareholders’ Equity

NetWorking Capital

How much short-term cash flow does a company need to pay its bills?

+Goals of Financial Management

Maximize the current value of the firm. How can a financial manager do it?

Identify the best investments Find the best financial arrangements (i.e., best capital

structure)

Who are the owners of the firm? Shareholders: “Residual Owners”

+Agency Problem and Agency Cost

Agency problem exists whenever the principal hires another agent to represent his/her interest

Two types of agency problems: Between shareholders and managers (equity-related

agency problems) Between shareholders and bondholders (debt-related

agency problems)

Agency costs: the costs of devising appropriate incentives for managers and then monitoring their behavior

+Agency Problem between Shareholders and Managers

Managerial goals may be different from shareholder goals Expensive perquisites Risk aversion (managers might be more risk averse) Free cash related problems (Hubris)

How can shareholders control managerial behavior? Directors (Board of Directors)

BOD can devise compensation plan to align the management incentives

BOD can also fire badly performing managers