Corporate Finance 1-0© Professor Ho-Mou Wu
Introduction to 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 money for the
required investments?
3. How much short-term cash flow does a
company need to pay its bills?
4. (RWJ )
1-1Corporate Finance© Professor Ho-Mou Wu
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:
1-2Corporate Finance© Professor Ho-Mou Wu
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
(Investment Decision)
1-3Corporate Finance© Professor Ho-Mou Wu
The Balance-Sheet Model of the Firm
How can the firm
raise the money
for the required
investments?
The Capital Structure Decision
(Financing Decision)
Current
Assets
Fixed Assets
1 Tangible
2 Intangible
Shareholders’
Equity
Current
Liabilities
Long-Term
Debt
1-4Corporate Finance© Professor Ho-Mou Wu
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
(Financial Decision)
Net
Working
Capital
Shareholders’
Equity
Current
Liabilities
Long-Term
Debt
Current
Assets
Fixed Assets
1 Tangible
2 Intangible
1-5Corporate Finance© Professor Ho-Mou Wu
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
1-6Corporate Finance© Professor Ho-Mou Wu
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.
1-7Corporate Finance© Professor Ho-Mou Wu
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.
1-8Corporate Finance© Professor Ho-Mou Wu
Financial Markets
Firms
Investors
Secondary
Market
money
securities
SueBob
Stocks and
Bonds
Money
Primary Market
1-9Corporate Finance© Professor Ho-Mou Wu
Investment Environment
1-10Corporate Finance© Professor Ho-Mou Wu
Two Elements of Investment: Time and Risk
1-11Corporate Finance© Professor Ho-Mou Wu
Risky Investment and Capital Budgeting
1-12Corporate Finance© Professor Ho-Mou Wu
• 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.
Capital Structure :Debt and Equity
1-13Corporate Finance© Professor Ho-Mou Wu
Debt and Equity as Options
$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]
1-14Corporate Finance© Professor Ho-Mou Wu
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
1-15Corporate Finance© Professor Ho-Mou Wu
Corporate Governance
Separation of Ownership and Control
Board of Directors
Management
Assets
Debt
Equity
S
hareholders
D
ebtholders
1-16Corporate Finance© Professor Ho-Mou Wu
Asymmetric Information and Agency Costs
• There is asymmetric information between shareholders
and managers.
• How to induce managers to 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.
• (Agency Cost) This contracting and monitoring is costly.
