McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
1-0
Chapter Outline
What is Corporate Finance?
Corporate Securities as Contingent Claims
on Total Firm Value
The Corporate Firm
Goals of the Corporate Firm
Financial Markets
Outline of the Text
McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
1-1
What is Corporate Finance?
Corporate Finance addresses the following
three questions:
1. What long-term investments should the firm
engage in?
2. How can the firm raise the money for the
required investments?
3. How much short-term cash flow does a
company need to pay its bills?
McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
1-2
The Balance-Sheet Model of the Firm
Current
Assets
Fixed Assets
1 Tangible
2 Intangible
Total Value of Assets:
Shareholders’
Equity
Current
Liabilities
Long-Term
Debt
Total Firm Value to Investors:
McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
1-3
The Balance-Sheet Model of the Firm
Current
Assets
Fixed Assets
1 Tangible
2 Intangible
Shareholders’
Equity
Current
Liabilities
Long-Term
Debt
What long-
term
investments
should the
firm engage
in?
The Capital Budgeting Decision
McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
1-4
The Balance-Sheet Model of the Firm
How can the firm
raise the money
for the required
investments?
The Capital Structure Decision
Current
Assets
Fixed Assets
1 Tangible
2 Intangible
Shareholders’
Equity
Current
Liabilities
Long-Term
Debt
McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
1-5
The Balance-Sheet Model of the Firm
How much short-
term cash flow
does a company
need to pay its
bills?
The Net Working Capital Investment Decision
Net
Working
Capital
Shareholders’
Equity
Current
Liabilities
Long-Term
Debt
Current
Assets
Fixed Assets
1 Tangible
2 Intangible
McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
1-6
Capital Structure
The value of the firm can be
thought of as a pie.
The goal of the manager is
to increase the size of the
pie.
The Capital Structure
decision can be viewed as
how best to slice up a the
pie.
If how you slice the pie affects the size of the pie,
then the capital structure decision matters.
50%
Debt
50%
Equity
25%
Debt
75%
Equity
70%
Debt
30%
Equity
McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
1-7
Hypothetical Organization Chart
Chairman of the Board and
Chief Executive Officer (CEO)
Board of Directors
President and Chief
Operating Officer (COO)
Vice President and
Chief Financial Officer (CFO)
Treasurer Controller
Cash Manager
Capital Expenditures
Credit Manager
Financial Planning
Tax Manager
Financial Accounting
Cost Accounting
Data Processing
McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
1-8
The Financial Manager
To create value, the financial manager
should:
1. Try to make smart investment decisions.
2. Try to make smart financing decisions.
McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
1-9
Cash flow
from firm (C)
The Firm and the Financial Markets
T
ax
es
(
D
)
Firm
Government
Firm issues securities (A)
Retained
cash flows (F)
Invests
in assets
(B)
Dividends and
debt payments (E)
Current assets
Fixed assets
Financial
markets
Short-term debt
Long-term debt
Equity shares
Ultimately, the firm
must be a cash
generating activity.
The cash flows from
the firm must exceed
the cash flows from
the financial markets.
McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
1-10 Corporate Securities as Contingent Claims on
Total Firm Value
• The basic feature of a debt is that it is a
promise by the borrowing firm to repay a
fixed dollar amount of by a certain date.
• The shareholder’s claim on firm value is the
residual amount that remains after the
debtholders are paid.
• If the value of the firm is less than the
amount promised to the debtholders, the
shareholders get nothing.
McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
1-11
Debt and Equity as Contingent Claims
$F
$F
Payoff to
debt holders
Value of the firm (X)
Debt holders are promised $F.
If the value of the firm is less than $F, they
get the whatever the firm if worth.
If the value of the firm
is more than $F, debt
holders get a
maximum of $F.
$F
Payoff to
shareholders
Value of the firm (X)
If the value of the
firm is less than $F,
share holders get
nothing.
If the value of the firm
is more than $F, share
holders get everything
above $F.
Algebraically, the bondholder’s
claim is: Min[$F,$X]
Algebraically, the shareholder’s
claim is: Max[0,$X – $F]
McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
1-12
Combined Payoffs to Debt and Equity
$F
$F
Combined Payoffs to debt holders
and shareholders
Value of the firm (X)
Debt holders are promised $F.
Payoff to debt holders
Payoff to shareholders
If the value of the firm is less than
$F, the shareholder’s claim is:
Max[0,$X – $F] = $0 and the debt
holder’s claim is Min[$F,$X] = $X.
The sum of these is = $X
If the value of the firm is more than
$F, the shareholder’s claim is:
Max[0,$X – $F] = $X – $F and the
debt holder’s claim is:
Min[$F,$X] = $F.
The sum of these is = $X
McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
1-13
The Corporate Firm
• The corporate form of business is the
standard method for solving the problems
encountered in raising large amounts of cash.
• However, businesses can take other forms.
McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
1-14
Forms of Business Organization
• The Sole Proprietorship
• The Partnership
– General Partnership
– Limited Partnership
• The Corporation
• Advantages and Disadvantages
– Liquidity and Marketability of Ownership
– Control
– Liability
– Continuity of Existence
– Tax Considerations
McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
1-15
A Comparison of Partnership and Corporations
Corporation Partnership
Liquidity Shares can easily be
exchanged.
Subject to substantial
restrictions.
Voting Rights Usually each share gets one
vote
General Partner is in charge;
limited partners may have
some voting rights.
Taxation Double Partners pay taxes on
distributions.
Reinvestment Broad latitude All net cash flow is
distributed to partners.
Liability Limited liability General partners may have
unlimited liability. Limited
partners enjoy limited
liability.
Continuity Perpetual life Limited life
McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
1-16
Goals of the Corporate Firm
• The traditional answer is that the managers of
the corporation are obliged to make efforts to
maximize shareholder wealth.
McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
1-17
The Set-of-Contracts Perspective
• The firm can be viewed as a set of contracts.
• One of these contracts is between shareholders and
managers.
• The managers will usually act in the shareholders’
interests.
– The shareholders can devise contracts that align the
incentives of the managers with the goals of the
shareholders.
– The shareholders can monitor the managers behavior.
• This contracting and monitoring is costly.
McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
1-18
Managerial Goals
• Managerial goals may be different from
shareholder goals
– Expensive perquisites
– Survival
– Independence
• Increased growth and size are not necessarily
the same thing as increased shareholder
wealth.
McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
1-19
Separation of Ownership and Control
Board of Directors
Management
Assets
Debt
Equity
S
hareholders
D
ebtholders
McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
1-20
Do Shareholders Control Managerial Behavior?
• Shareholders vote for the board of directors,
who in turn hire the management team.
• Contracts can be carefully constructed to be
incentive compatible.
• There is a market for managerial talent—this
may provide market discipline to the
managers—they can be replaced.
• If the managers fail to maximize share price,
they may be replaced in a hostile takeover.
McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
1-21
Financial Markets
• Primary Market
– When a corporation issues securities, cash flows
from investors to the firm.
– Usually an underwriter is involved
• Secondary Markets
– Involve the sale of “used” securities from one
investor to another.
– Securities may be exchange traded or trade over-
the-counter in a dealer market.
McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
1-22
Financial Markets
Firms
Investors
Secondary
Market
money
securities
SueBob
Stocks and
Bonds
Money
Primary Market
McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
1-23
Outline of the Text
I. Overview
II. Value and Capital Budgeting
III. Risk
IV. Capital Structure and Dividend Policy
V. Long-Term Financing
VI. Options, Futures and Corporate Finance
VII. Financial Planning and Short-Term Finance
VIII. Special Topics
