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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
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