Chapter 1

Introduction to Corporate Finance

Copyright © 2012 by McGraw-Hill Education. All rights reserved.

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 business environment in the

Middle East• Understand the conflicts of interest that can

arise between owners and managers• Understand the various types of financial

markets

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Chapter Outline

• Corporate Finance and the Financial Manager

• Forms of Business Organization• The Goal of Financial Management• The Business Environment in the

Middle East – An Additional Aspect• The Agency Problem and Control of

the Corporation• Financial Markets and the

Corporation 1-3

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?

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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) who coordinates the activities of:– Treasurer – oversees cash management, credit

management, capital expenditures, and financial planning

– Controller – oversees taxes, cost accounting, financial accounting and data processing

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Financial Management Decisions

(1) 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.

– Evaluating the size, timing and risk of future cash flows is the essence of capital budgeting.

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Financial Management Decisions

(2) Capital structure– “The mixture of debt and equity

maintained by a firm.”– The mixture chosen will affect both the

risk and the value of the company.– What are the least expensive sources of

funds for the firm?

Financial Management Decisions

(3) Working capital management– “A firm’s short-term assets and

liabilities.”– Managing the firm’s working capital is a

day-to-day activity that ensures that the firm has sufficient resources to continue its operations and avoid costly interruptions.

Forms of Business Organization

• Three major forms in the United States– Sole Proprietorship (owned by one person)– Partnership (owned by 2 or more)

• General• Limited

– Corporation• Joint stock company• Public limited company• Limited Liability Company

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Sole Proprietorship

• Advantages– 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

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Partnership• All partners share in gains or losses as

described in the “partnership agreement” which can be informal oral agreement or lengthy, formal written agreement

• In a limited partnership, 1 or more general partners will run the business and have unlimited, but there will 1 or more limited partners who will not actively participate in the business.

Partnership

• In a general partnership, general partners have unlimited liability for partnership debts and the partnership terminates when a general partner wishes to sell out or dies.

Partnership

• Advantages– 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

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Corporation

• “A business created as a distinct legal entity composed of one or more individuals or entities.”

• Forming a corporation involves preparing articles of incorporation (or a charter) and a set of bylaws. They should include the corporation’s name, its intended life, its business purpose and the number of shares that can be issued.

Corporation

• The bylaws are rules describing how the corporation regulates its existence. They can be amended or extended from time to time by the stockholders.

Corporation

• Advantages– 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)

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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?

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Goal of Financial Management

• The goal of financial management is to maximize the current value per share of the existing stock.

• Corporate finance could be defined as the study of the relationship between business decisions (identify investments and financing arrangements) and the value of the stock in the business.