10.04.23 1

AD 311 Business Finance

Fall 2009

Attila Odabaşı

Lect 1: Introduction to Corporate Finance

(ref. Ch 1)

10.04.23 2

Main Points

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 managementUnderstand the conflicts of interest that can

arise between owners and managersUnderstand the various types of financial

markets

10.04.23 3

Corporate Finance

Some important questions that are answered using financeWhat 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?

10.04.23 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

10.04.23 5

Financial Management Decisions

Capital budgetingWhat long-term investments or projects

should the business take on?

Capital structureHow should we pay for our assets?Should we use debt or equity?

Working capital managementHow do we manage the day-to-day

finances of the firm?

Forms of Business Organization

Three major forms in the United StatesSole proprietorship

PartnershipGeneral

Limited

CorporationS-Corp

Limited liability company

10.04.23 6

Sole Proprietorship

A business form for which there is one owner. This single owner has unlimited liability for all debts of the firm.

Oldest form of business organization.

Business income Business income is accounted for on your personalpersonal income tax formincome tax form.

10.04.23 7

10.04.23 8

Sole Proprietorship

AdvantagesEasiest to start

Least regulated

Single owner keeps all the profits

Taxed once as personal income

DisadvantagesLimited to life of

owner

Equity capital limited to owner’s personal wealth

Unlimited liability

Difficult to sell ownership interest

Partnerships

A business form in which two or more individuals act as owners.

Business income Business income is accounted for on each partner’s personalpersonal income tax formincome tax form.

General PartnershipGeneral Partnership -- all partners have unlimited liability and are liable for all obligations of the partnership.

Limited PartnershipLimited Partnership -- limited partners have liability limited to their capital contribution (investors only). At least one general partner is required and all general partners have unlimited liability.

10.04.23 9

10.04.23 10

Partnership

AdvantagesTwo or more

owners

More capital available

Relatively easy to start

Income taxed once as personal income

DisadvantagesUnlimited liability

General partnership

Limited partnership

Partnership dissolves when one partner dies or wishes to sell

Difficult to transfer ownership

Corporations

A business form that legally separate from its owners.

An artificial entity that can own assets and incur liabilities.

Business income Business income is accounted for on the income tax form of the corporationincome tax form of the corporation.

Separation of ownership and management

10.04.23 11

10.04.23 12

Corporation

AdvantagesLimited liability

Unlimited life

Separation of ownership and management

Transfer of ownership is easy

Easier to raise capital

DisadvantagesSeparation of

ownership and management

Double taxation (income taxed at the corporate rate and then dividends taxed at the personal rate)

10.04.23 13

Şirketlerin Sınıflandırılması

Borçlar Yasasına göre düzenlenmiş Adi şirketler

Türk Ticaret Yasasına göre düzenlenmiş Şahıs şirketleri

Kollektif şirketler

Komandit şirketler

Sermaye şirketleri Hisseli Komandit şirketler

Anonim şirketler

Limited şirketler

Kooperatif Yasasına göre düzenlenmiş Kooperatifler

10.04.23 14

Goal Of Financial Management

What should be the goal of a corporation?Maximize sales or market share?

Minimize costs?

Maximize profit?

Maintain steady growth?

Maximize the current value of the company’s stock?

10.04.23 15

Shortcomings of Alternative Perspectives

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...

Shortcomings of Alternative Perspectives

Profit maximizing: Maximizing a firm’s earnings after taxes.

Problems: Long-term or short-term? Do we mean accounting profits or some measure of

cash flow? Could increase current profits while harming firm (e.g.,

defer maintenance).

10.04.23 16

10.04.23 17

Shortcomings of Alternative Perspectives

Maximize market share – This has been a strategy of many of the dot.com companies. They issued stock and then used it primarily for advertising to increase the number of “hits” to their web sites. Many firms failed to translate those ‘hits’ to money to pay the expenses etc...

10.04.23 18

Stockholder’s view..

From a stockholder perspective, the purpose of a for-profit business should be to make money for its owners. How? Maximizing the current stock price increases the wealth of the owners of the firm.

The more general goal is: Maximize the current value of the owner’s equity. 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.

10.04.23 19

Maximization of Shareholder Wealth!

Do not forget that if stockholders win (residual owners), it must be true that everyone else is winning also.

This goal does not imply that the financial manager should take illegal or unethical actions in the hope of increasing the value of the equity.

10.04.23 20

The Agency Problem Agency relationship

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

Agency costs

Direct costs: unneeded expenses for management, monitoring costs (auditors)

Indirect costs: sub optimal decisions, lost oppotunities

Managing Managers

Managerial compensation

• 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

Incentives include, stock optionsstock options,, perquisitesperquisites,, and bonusesbonuses.

10.04.23 21

10.04.23 22

Managing Managers

Corporate controlControl of the firm rests with stockholders. They

elect the board of directors, who in turn hire and fire managers.

Ways of replacing managers:Proxy fights

Takeover

Stakeholders (customers, suppliers, government) sometmes may attempt to exercise cotrol on the firm as well.

Financial Markets

Businesses interact continually with the financial financial markets.markets.

Financial MarketsFinancial Markets are composed of all institutions and procedures for bringing buyers and sellers of financial instruments together.

The purpose of financial markets is to efficiently allocate savings to ultimate users.

10.04.23 23

10.04.23 24

Financial markets and the corporation

10.04.23 25

What are some types of Markets?

A market is a method of exchanging one asset (usually cash) for another asset.Physical assets vs. financial assets

Financial Markets:Debt and equity securities are bought and soldFinancial markets differ in detail:

Type of securities traded: debt, equity, derivatives, ...How trading is conducted? outcry auction, electronic

systemsWho the buyers and sellers are?

10.04.23 26

Primary versus Secondary Markets

Financial markets function as both primary and secondary markets.Primary market: original sales of securities by

corporations (or governments).The transaction raises money for the corporation.

Secondary markets: securities are bought and sold after the original sale.The transaction does not raise money for the

corporation.

10.04.23 27

How are secondary markets organized? By the way that orders from buyers and sellers

are matched:Auction markets,

An auction market has a physical location like Wall Street or Istanbul Stock Exchange (ISE).

Buyers and sellers are matched directly.Dealers markets.

Dealers buy and sell for themselves, at their own risk.

Like car dealers; opposite of real-estate agents. Most dealer markets are called over-the-counter

(OTC) markets.

10.04.23 28

Auction MarketsNYSE and AMEX are the two largest

auction markets for stocks.

NYSE is a modified auction, with a “specialist.”

Specialist is a market maker.

10.04.23 29

Dealer MarketsDealers buy and sell for themselves, at

their own risk. Dealers are connected electronically.

Computerized quotation system keeps track of bid and ask prices, but does not automatically match buyers and sellers.

NASDAQ: National Association of Securities Dealers Automated Quotation system.