Corporate Finance Ross Westerfield Jaffe
Sixth Edition
1
Chapter One
Introduction to Corporate Finance
Prepared by
Gady Jacoby
University of Manitoba
and
Sebouh Aintablian
American University of Beirut
Chapter Outline
What is Corporate Finance?
Corporate Securities as Contingent Claims on Total Firm Value
The Corporate Firm
Goals of the Corporate Firm
Financial Institutions, Financial Markets, And The Corporation
Trends in Financial Markets and Management
Outline of the Text
What is Corporate Finance?
Corporate Finance addresses the following three questions:
What long-term investments should the firm engage in?
How can the firm raise the money for the required investments?
How much short-term cash flow does a company need to pay its bills?
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:
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
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
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
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 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
Hypothetical Organization Chart
Chairman of the Board and Chief Executive Officer (CEO)
Board of Directors
President and Chief Operating Officer (COO)
Treasurer
Controller
Cash Manager
Capital Expenditures
Credit Manager
Financial Planning
Tax Manager
Financial Accounting
Cost Accounting
Data Processing
Vice President Finance
The Financial Manager
To create value, the financial manager should:
Try to make smart investment decisions.
Try to make smart financing decisions.
The Firm and the Financial Markets
Cash flow from firm (C)
Taxes (E)
Firm
Government
Firm issues securities (A)
Retained cash flows (D)
Invests in assets (B)
Dividends and debt payments (F)
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.
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 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.
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 whatever the firm is 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]
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
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.
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
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 with dividend tax credit
Partnership income is taxable.
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
Goals of the Corporate Firm
What are firm decision-makers hired to do?
The traditional answer is that the managers of the corporation are obliged to make efforts to maximize shareholder wealth.
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’ behaviour.
This contracting and monitoring is costly.
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.
Separation of Ownership and Control
Board of Directors
Management
Assets
Debt
Equity
Shareholders
Debtholders
The Agency Problem
The agency relationship
Will managers work in the shareholders’ best interests?
Agency costs
Direct agency costs
Indirect agency costs
Control of the firm
How do agency costs affect firm value (and shareholder wealth)?
Do Shareholders Control Managerial Behaviour?
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.
Financial Institutions, Financial Markets, and the Corporation
Financial Institutions
Indirect finance
Direct finance
Loans
Financial intermediaries
Deposits
Funds suppliers
Funds demanders
Financial intermediaries
Funds suppliers
Funds demanders
Financial Markets
Money versus Capital Markets
Money Markets
For short-term debt instruments
Capital Markets
For long-term debt and equity
Financial Markets
Primary versus Secondary 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.
Financial Markets
Firms
Investors
Secondary Market
money
securities
Sue
Bob
Stocks and Bonds
Money
Primary Market
Trends in Financial Markets and Management
Integration and globalization
Increased volatility
Financial Engineering reduces costs related to
Risk
Taxes
Fnancing costs
Improved computer technology allows Economies of scale and scope
Regulatory dialectic
Outline of the Text
Overview
Value and Capital Budgeting
Risk
Capital Structure and Dividend Policy
Long-Term Financing
Options, Futures, and Corporate Finance
Financial Planning and Short-Term Finance
Special Topics
